Literature Review - Royal Bank of Scotland

Introduction

It is a known fact that the world is going through one of the most toughest times ever faced in the form of economic downturn. While the debate on the real cause of this phenomenon continues, it is by far proved that de-regulation of economic policies which were supposed to keep a watch on the economic progress and avaoid another era of "Great Depression", was the real cause of the entire saga. Though the saga still continues and nobody ever knows when the eceonomy can actually get back on track, this dissertation majorly focuses on the role of de-regulation in the financial crisis, what the authorities can do in this situation to initiate the recovery, and a comprehensive explanation of the banking credit crunch on the basis of theories of risk and uncertainity by taking the case study of Royal Bank of Scotland

Literature Review

Royal Bank of Scotland - History

The birth of royal bank of scotland dates back to 1707 when Equivalent society was formed by a group of employees of the failed Company of Scotland to protect the compensation they received out of the company , as part of arrangements of the 1707 Acts of Union (Wikipedia, 2008). In 1728, the Royal Bank of Scotland became the first bank in the world to offer an overdraft facility to its customers (Wikipedia, 2008). The Royal Bank of Scotland began its spate of acquisitions immediately after the world war and continued till 2007 when it ended with the infamous acquisition of ABN Amro Bank which pushed the bank to incur losses worth 24.1 billion pounds (FT, 2008).

Deregulation of economic policies and their impact on Royal Bank of Scotland

The era of deregulation actually dates back to the time when Margaret Tatcher was the PM of UK and the country's economy was almost sinking. Tatcher, it is said toed the path of her US counterpart, Reagen and his advisors who strongly advocated for privatisation, state budget cuts,moves against labor and deregulation of financial markets. The central idea was to curb the inflation levels and they strongly felt that the state beaurocracy was a major hurdle to it. The deregulation of banking industry in the UK resulted in banks and other financial institutions competing with each other over a range of financial services.many building societies like Halifax and Abbey International converted to banks with shareholders. This inturn resulted in a number of mergers and acquisitions and enabled the long established banks to take over building societies and benefit from the customer base of the latter.

For more than three decades, many of the economic faculties around the world believed that the Margarite way of handling the economy was absolute and unquestionable, but after the economic downturn, there are people who believe that it is this deregulation spree taken by the predecessors of Thatcher that has led to the present situation. There are people who point out that countries like the USA, UK, Ireland, Canada, Australia, Ireland who were the first to adopt the neo-liberal policies are the epicenters of the current catastrophe. It is also a known fact that UK suffered the most of all the European economies.

Though it wouldn't be totally appropriate to attribute the downturn to Thatcher's policies of deregulation, it could be said that the continual of them inspite of the changing economic conditions by her predecessors lead to the current situation.

RBS and Deregulation

Royal Bank of Scotland's fall into losses can most probably be attributed to its reckless lending to foreign borrowers. The acquisition spree of RBS majorly started off in the year 2000 when the bank acquired Natwest. The battle between RBS and Bank of Scotland for Natwest was considered a significant moment in the scottish corporate history.The American interests of RBS alone made them one of the top ten banks in the US. The bank went on to get a major stake in Bank of China.It looked like there was no stopping them until they came upon the ABN AMRO deal. They initially wanted to deal with American Operations but since it had already been awarded to bank of America, they had to settle for the rest. In the process they formed a consortium with Fortis and Santandar, two other Dutch banks who were interested in ABN's operation. The cost of the entire operation was slated to be 49 billion pounds. They had successfully acquired ABN in the year 2007 but soon enough realized that coughing up money in those circumstances was beyond the scope of the organization.The year 2008 was profitable for RBS in terms of its core businesses of High Street and commercial lending activities in the UK. However, they were drastically outweighed by its international banking and financial trading arm. Apart from the above mentioned factor, its aggressive international takeover spree also lead to its downfall. The most famous among them is its takeover of ABN AMRO.

On 19th January, 2009, the company laid out its huge list of bad and to be cleared debts before the public. That was just a day after the Brown administration promised a bail out package for the affected firms. In the statement make on 19th jan , 2009, the copany said that it suffered losses upto 7-8 billion pounds over day to day lending and trading activities. In addition, it said that it was writing off the amount of 15- 17 billion pounds from the value of ABN AMRO it took over in the year 2007. To top it all, the bank also mentioned that it had paid 15- 20 billion pounds for other businesses and that would also have to be written off. The Chief Executive of the bank, Stephen Hester, had admitted then that the bank which transformed into the one of the world's biggest banks had committed some major blunders. It looked like the last and major takeover of RBS had indeed brought the consortium to its knees and signalled the complete downfall.The UK Government had to pump in close to 20 billion pounds to acquire 60% of the stake in the organization. The government was also criticized on this move as it would cost a good deal to the tax payer. However, the point to emphasize is that it is the lack of proper measures by the regulatory bodies on the banks especially over mergers and acquisitions that brought about the crisis for the bank. Another noticeable point here is that the regulatory measures weren't thought of even after banks in US and UK were hit by the sub- prime crisis which was looming large over the financial institutions across the world.

Overview of Porter's diamond theory of national influences:

The diamond theory of porter for the competitive advantage of nations offers a mechanism that can help understand the position of the nation/geographical area in a global competition. Traditionally, the economy of the nation was adjudged by the following factors :

  1. Land resources
  2. Location
  3. Natural Resources
  4. People
  5. Labor

Porter stressed that since the above four factors can hardly be influenced, they cannot be made use of to get a complete view of the nation's economy. Porter mentions that actual industrial growth never relied on the above mentioned factors. He formulated a set of factors which are group of interconnected firms, suppliers, and institutions which coordinate with each other to produce the desired impact to the competitive and stablized environment.

The factors considered for Competitive advantage for countries in Porter's Diamond Framework are as follows:

  1. Firm Strategy, Structure and Rivalry - Porter stresses the fact that the worl is a dynamic place to be in and it is direct competition that brings out the best in an organization and increases productivity and innovation.
  2. Demand Conditions - The more demanding the customers in an economy, the greater the pressure faced by the organizations and thus more stress on factors like quality, innovation etc.
  3. Supporting industries - It could also depend on the proximity of the concerned organizations with the supporting industries. This can help in the exchange on information and can promote continous exchange of ideas and innovations.
  4. Specialized Factor Conditions - Porter emphasizes that it is the specialized factors of production like skilled labor,capital and infrastructure. He mentions that non key factors like unskilled labor and raw materials do not contribute to sustained competitive advantage. Specialized factors definitely involve heavy investment. This factor can indirectly be related to the above factors like demand conditions, rivalry etc.

The role of Government in Porter's model should be to act as a catalyst which should help in improve in raising their aspirations and move to the higher levels of competitive advantage.

Porter's diamond and the UK Banking Sector

One of the major problems with the Porter model for this kind of study is the role it allocates to government. Porter's model does not ignore the government but states that it has a considerable amount of influence on each of the four above mentioned factors, rather than a determinant in its own right. However, Government policies have always had influence on banks, mainly because governments have always felt it a need to interfere in this sector. We're majorly concerned with the banking sector here as banks have an impact on all other sectors through their lending policies and through their deposit taking function.

Porter's model does not refer any of the regulatory mechanisms that should be in place to monitor the sector's growth and aspirations. The major causes which led to the current situation could be as follows

  1. Deregulation repealing the Glass Steagall Act of 1933
  2. This led to majority of the banks diversifying tinto securitised assets due to low interest rates and high expected returns.

  3. The sub prime crisis in the Uk could be majorly attributed to the offering of mortgages to low income earners due to pressure from the Clinton Administration. This implied that the credit was artificially inflating the housing market.
  4. The regulatory bodies were inefficient in visualizing the impact of the subprome crisis.
  5. Risk assessment wasn't done appropriately. The risk assessment teams of the indivual institutions failed in this case.

Following are the remedies which the government can use:

  1. Banking bailouts
  2. Special Liquidity Scheme - This scheme has already been introduced by the Government of UK to temporarily swap their mortage backend for Treasury bills.With the market in a static state, the banks weren't able to sell or pledge the backend mortgages. Infact banks were even reluctant to offer loand to other banks due to this. The gain or loss due to the transactions, however, was laid with the bank itself. With this scheme, the government seeked to improve the liquidity position in the market.

  3. Bank Debt Guarantee- The above process can only be initiated if the government can provide a bank debt guarantee wherein the treasury has to set aside a certain amount of money to imrpove the liquidity situation. This would just be a step to increase the confidence levels in the financial institutions and wouldn't cost the taxpayer much if the financial system reacts as expected.
  4. Asset protection scheme - This is a sort of insurance scheme which covers the losses incurred by the banks to some extent. By this, the governments can actually encourage the liquidity situation. The RBS placed assets upto 325 billion pounds under this scheme.
  5. Some of the other remedies which can be followed are as follows

  6. Monetary Policies
  7. a) Reducing base rate.

  8. Fiscal stimulus policies.
  9. Improved international regulatory bodies.

The Credit Crisis

The credit crisis began in the August 2007 when interbank lending markets in the leading economies around the world began to seize up. The loans on inter bank lending markets, from overnight to several months, were not just important in keeping the flow of credit circulating amongst banks, and hence they were made without collateral being necessary, and were increasingly important to the banking model developing across market economies. That model relied to an increasing extent on wholesale markets for supplies of capital, rather than on the deposits of individuals or companies. At the same time the degree of leveraging on capital was also increasing. So with larger supplies of credit and greater leveraging higher profits were possible. As were higher risks, as banks sought out increasing rates of return to satisfy their shareholders and those of their employees whose wages and bonuses were linked to levels of business or profits. But the increasing levels of risk seemed manageable by the device of securitisation, which appeared to allow the securitising bank to simultaneously sell on the risk and replenish its capital. When a rapidly deflating housing market bubble in the USA exposed weaknesses in this banking model, and similar bubbles in Ireland, the UK, Australia and Spain also began deflating, doubts about the location and value of securitised assets led eventually to an evaporation of trust between first banks, and then other financial and non-financial companies.

By mid-2008, the trust levels in the financial sector grew to such an extent that the entire credit flows were seized up and a correlated and coordinated action by the central banks and regulatory bodies around the world was needed to control it. As was discussed above, this involved going a step further and giving the assurance to depositors, liquidating the gummed up financial markets and a guarantee to short term bonds. As with any government's reaction, all the responses have public finance consequences, the risks due to which are growing to a very large extent. The fact that it is the taxpayer who has to bear the brunt of the entire set of promises/guarantees given by the treasury itself indicates the amount of risk that is involved in the entire process.

Fiscal Risks in the crisis

Fiscal risks generally depend on the increase in expenditures incurred that the responses will have. By the end of August 2008, the USA had committed a total of $ 1.5 trillion to its banking sctor to improve the liquiduidity situation in the econmy. It had guaranteed another $ 3.6 trillion deposits. In Europe, the total money committed for the purpose was $ 2.5 trillion. In addition to that there were promises on bank deposits individually throughout most of the European countries.

The credit crisis comes in as part of the 20 year old experiment which aimed at complete deregulation of the banking sector with maximum freedom to the provate sector to persue profit, unhindered. This ideology is associated with Alan Greenspan, who's desire to ecourage deregulation led to toxic mortgage derivatives that led to desruction of $ 3 trillion capital around the world. It is certainly clear now that in majority of the advanced financial systems around the world, the regulatory system needs a major revamp. It is to be considered that tigheting of the regulation process may override the necessary correction needed to come out of the mess we're in but at the same time completely tightening the system can lead to less lending and would hinder financial innovation. Hence, a proper balance has to be made in this regard to avoid any kind of extremities.

Conclusion

The world has undergone many changes after the sub-prime crisis and recession.The situation today can be attributed mainly to the deregulation of policies and to the inability of the regulatory bodies to appropriately assess the situation and act accordingly. The fact that Royal Bank of Scotland went ahead and acuired ABN AMRO inspite of consumer apprehensions clearly speask volumes about the role played by the regulatory bodies in dealing with the crisis. Apart from the above two factors which were discussed in depth, the dissertation also focussed on credit crunch and the failure of risk management agencies in detecting the impact mortgages would make in the long run.

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