Chapter 2: Literature Review
The increasing rate of globalisation has seen organisations growing larger and larger at a very rapid rate with increased competition in almost all industries which forces organisations to implement contemporary management and marketing techniques in their business models. The past decade has seen companies in almost all industries and sectors of the economy grow at a extraordinary rate especially the financial sector which in turn provided liquidity and capital to other sectors which eventually grew as well. The travel and tourism industry of the United Kingdom was no exception and it displayed signs of stable growth throughout the years with several industry giants like British Airways leading the way where organisations were not only making hefty profits but were maximising shareholder wealth as well. British Airways along with other organisations in the travel and tourism industry have also grown substantially, while airlines and travel and tour operations in other parts of the world also witnessed stable growth. The literature review chapter highlights the factors of financial crisis while focussing on the financial crisis which started in 2008 from the financial sector of the United States of America and quickly spread to other parts of the world like a financial tsunami. The chapter focuses on several conditions of financial crisis and the context of financial crisis in light of various theories presented by practitioners. The factors leading to the financial crisis and its implications are also discussed in this chapter along with a review of the subprime mortgage crisis which developed due to decline in the housing market and poor credit management by banks and financial institutions. The literature review chapter will also present an overview of British Airways. The literature reviewed in this chapter is collected from various books, periodical articles, journal articles, websites and reports.
Financial crisis is a scenario where companies, sectors of economy and economical conditions of countries as a whole are hit by a financial meltdown or calamity. A financial crisis significantly impacts organisations directly or indirectly doing business in a market or organisations which are linked to the affected organisations along with all individuals who are related to these organisations in one way or the other and individuals who are dependent on the affected individuals. This implies that in a financial crisis when larger organisations are heavily affected it has a trickle down affect on smaller organisations and the people associated with these organisations. The financial and banking sector is the foundation of an economy and if there is a crisis in this sector it deeply affects all other sectors in the economy and it has usually been seen that if a crisis starts from the financial or banking sector in an economy it affects all other sectors of the economy whereas if there is a crisis in any other sector it is not necessary that the crisis will spread out to other sectors of the economy. A financial crisis rises to a disturbing level when major leading organisations in industries start to go bankrupt and in some circumstances whole sectors of the economy are completely wiped out. This implies that the failure of banks and financial institutions is the most significant factor and cause of financial crisis. The financial crisis explained here was that of a global nature whereas there are other forms of financial crisis which include sovereign defaults and stock exchange crashes. In a sovereign default entire countries go bankrupt and during a stock market crash almost all shares being traded in the market decline to very low levels. Several individuals have presented theories on financial crisis, the factors leading to financial crisis and how financial crisis start and develop in economies and the steps which can be taken to reduce the effects of financial crisis and steer organisations and countries out of these financial crises. The theories related to financial crisis are explained in the following sections.
Causes of Financial Crisis
Jean Charles Leonard de Sismondi (1773-1842) evaluated and discussed several significant depressions in the history of the world and analysed various factors and reasons of depressions and financial crisis in different parts of the world. The theory presented by this practitioner was designed on an evaluation of equilibrium within an economy between demand and supply. Several researchers and scholars have analysed the factors and causes of financial crisis and depressions throughout history in several parts of the world and these researchers identified that the oil crisis of 1973 was mainly responsible for the financial crisis and depression in the 1970's and 1980's.
Minsky's Theory regarding Financial Crisis
The post -Keynesian ideological theory was analysed and explained quite effectively by Hyman Minsky in order to find the causes and factors of economic crisis and Minsky was of the view that the post-Keynesian theory was applicable in almost all closed economies. Minsky presented a theory regarding the susceptibility and sensitivity of an economy during a financial crisis and his theory was knitted around the characteristics of a capitalistic economy. The theory established that there is a higher risk of financial risk when the vulnerability of the market is higher and financial crisis becomes evident in fragile conditions. That is the main reason why Minsky recommended that individuals, companies and economies implement specific risk minimisation strategies to deal with financial crisis especially in fragile and susceptible conditions or behaviour of markets. Minsky recommended specific strategies to minimise risks in various circumstances which are described below.
Hedging: This is the first risk minimisation strategy which is implemented to diversify risks through investing wisely in derivatives such as futures and options trading or some other similar strategies where risk is diversified. Under this strategy it is expected that both short term and long term liabilities related to interest and principal payments of loans will be covered by actual cash and income flows in the current scenario.
Speculation: The phenomenon of revolving and rolling credit and investment in order to minimise risk is referred to as speculation. In this strategy the interest payments of loans are covered by the cash and income flows while principal payment of loans is financed through other sources.
The vulnerability of markets and the sensitivity of business cycles are interrelated which implies that in times of a recession or financial crisis both companies and individuals find it very difficult to acquire financing and loans from banks and financial institutions and select alternative methods such as hedging and speculation to minimise and diversify risk which act as safe strategies in times of financial crisis where finances are hard to come by.
Individuals, companies and economies around the world move towards a speculative mode of investment and financing in the context of changing scenarios and economical conditions around the world. This implies that all liabilities and obligations of companies and individuals would not be in fact covered which would ultimately create a chain reaction as it was seen in the recent financial crisis which started in 2008. The phenomenon of obtaining loans and financing with an intention of reinvestment has become a norm today which is widely used by organisations and economies of developing countries because it leads to direct growth within an organisation and economy. Banks, credit houses and financial institutions have always been under a misconception that the conditions and environment of an economy and the financial conditions as a whole will remain stable and positive in the near future and no extraordinary financial calamities will take place and that is why these loans are easily approved and thought to be safe.
Recent Financial Crisis
Philipp (2008) presented an overview of the events leading to the financial crisis which started in 2008 and analysed the domino effect of the sub prime crisis which started in the United States and hit the entire global economy quite rapidly. His study found that financial crisis and disaster were results extraordinary leverage, ambiguous regulatory framework of the banking system and poor credit management. The study not only found the causes of the recent financial crisis which is still not over but it also presented several recommendations for avoiding financial crisis through active policy making, providing an efficient regulatory framework and devising policies for effective credit management and governance of banks and financial institutions.
Söhnke et al (2007) highlighted an intriguing cross case empirical study of 334 banks which made up 80 percent of the entire banking equity of the world. Their research primarily aimed at analysing and evaluating the effects of various financial crises on the regulatory frameworks of banks which were mainly situated in 28 developing and developed countries of the world. Their research not only analysed these banks and the effects of financial crises on these banks but also found that the reaction of banks with respect to financial crisis were mixed and this reaction was quite slow with respect to a global financial crisis.
Viral (2009) analysed and studied the shifting of financial risk among financial institutions which eventually led to the financial crisis and turmoil facing the world today. This specific study found that banks have a limited liability and the presence of interdependent relationships among banks leads to an overall aggregate industry risk where all banks are subject to phenomenal risk due to industry risk. This research presented several recommendations for banks and financial institutions especially prudential banking regulations and general banking and financial regulations.
Factors of the Current Financial Crisis
The financial crisis which started in 2008 from the banking sector of the United States of America and took the whole world like a financial tsunami is still pretty much present and is stirring entire economies of countries. This crisis did not magically appear from nothingness but the pressure was building since late last century. There are many factors and reasons for the current financial crisis but the most significant factor is the rapid decline in real estate prices in the United States in 2007 which eventually led to bankruptcy of many large banking and financial institutions as these organisations had heavy investments in mortgages and real estate securities. It was a norm among the financial institutions and banks in the United States & United kingdom provided loans on sub prime real estate or in other words real estate which did not have significant resale value. There was no proper verification and regulatory framework for approval of loans and financial agreements of such nature. Many banks were refinancing these loans and providing refinancing services for mortgages on this form of real estate. These financial institutions and organisations were also heavily involved in inter-bank and inter-organisation agreements based on these subprime mortgages. Banks and financial institutions had also invested quite heavily in mortgage backed securities which proved later on to have a very high risk and very low profitability potential. When companies and financial institutions started filing bankruptcies, the companies which had either invested in these companies or were dependent on these companies for generation of business started to tumble as well and started facing significant amount of losses. The effects of the financial crisis were so extraordinary in the USA & UK that some the largest banks of the countries either had to be rescued by the government by providing liquidity to these banks or had to file for bankruptcy. This had various negative implications for international organisations, banks and financial institutions as well which were directly or indirectly linked to these organisations. The main problem was that the banks and financial institutions were focussed on short term benefits rather than long term stability and profitability and as the long term consequences had not been analysed by the banks regarding actions related to sub-prime mortgages the bubble finally burst and the result was a major financial crisis affecting the entire global economy in one way or the other. The effects of this financial crisis could not only be seen in the United Kingdom & United States of America but also in other developed countries of the world such as Germany, France and many other countries of the world. The main factors and causes of the financial crisis are the decline in real estate prices, poor credit management and greediness and these three major causes of financial crisis.
Recession in the Airline Industry
The recession in economy affected several sectors and one of the hardest hit sectors was the airline industry. The number of visitors to the United Kingdom declined consequently in the wake of the financial crisis. This is not the first time that airlines are witnessing bad financial conditions as the September 11 terrorist attacks in the United States of America had impacted the global airline industry quite significantly and record breaking high oil prices also caused major problems for many airlines across the globe but this time around many airlines are worrying that the current conditions may have long term implications and many airlines may fid it difficult to survive on the longer run. The increase in discount fare airlines and decrease in number of passengers has added to the problems of many large airlines which are already in significant amount of trouble due to a downturn in economy. Another major problem is the big gap between demand and supply where the demand of passengers has fallen considerably while supply in the form of airlines has increased and there is not enough demand to meet the high level of supply (Carey 2009).
The International Air Transport Association also revised its future outlook in light of the current recession after the global airlines industry booked a loss of more than $4.7 billion in 2009 which is considerably higher than the association's forecast of $2.5 billion for 2009. The association expects that the revenues of the industry will decrease by a significant margin of 12 percent while the decline in industry revenue after the September 11 terrorist attacks were 7 percent which clearly implies the magnitude of the financial crisis in the airline industry. IATA also implies that the demand has not kept up pace with the increase in supply of airlines and carriers and this gap in supply and demand is also a major factor contributing to the recession in airline industry. The agency suggested that the airlines of Europe including the United Kingdom were expected to book losses of $1 billion in 2009 with a 2.9 percent decline in GDP will also result in a 6.5 percent decrease in demand of passengers. The International Air Transport Association suggests that the recovery in the airline industry is dependent on the overall recovery of the economy. As the future of overall economy is quite uncertain the future of airline industry especially in the United Kingdom is also uncertain (IATA 2009).
Airlines were one of the hardest hit sectors of the tourism industry in the United Kingdom and airlines in the country reported major losses after the financial crisis took toll and affected various countries of the world including the United Kingdom. Two very good examples are Ryan Air and British Airways who are facing major problems due to the financial crisis. Ryan Air was one of the most booming airlines before the financial crisis started showing its effects and the management of the company has implied that they had to cut down their fares in order to sell more tickets and increase the number of passengers even in seasons which were considered busy and overbooked in previous years. According to recent figures the passengers of Ryan Air refused to pay on average more than €30 per air ticket and refused to pay hefty amounts on baggage handling and refused any increase in in-flight expenses. Ryan Air reported a loss of 9.6 million pounds in the last quarter of 2009 albeit the last quarter of the year is considered the busiest and most profitable quarter in the airline industry (Lea 2010).
Impact of recession on British Airways
The recession affected almost all airlines in the international airlines industry as well as in the United Kingdom and British Airways was no exception and was also quite adversely affected by the recession. The airlines was so much affected by the financial crisis that in July 2009 the management of the company was desperately looking to raise 600 million pounds just to stay afloat. The company management devised a solution of selling convertible bonds of 350 million pounds to existing shareholders and acquiring loans against the guarantee of pension fund managers of the company. British Airways was looking at a second quarter loss of nearly 100 million pounds despite being the third biggest airline in Europe. The company which was once one of the most profitable airlines in the industry while reporting a profit of 712 million pounds was facing a considerable loss of 375 million pounds (Manage Investing 2009).
The chief executive Willie Wash also implied that the airline may have to be closed down due to financial problems in the future due to severe losses in wake of recession and financial crisis of 2008. One of the main problems the airline was facing was the significant decline in number of passengers. The company witnessed a decline not only in economical class passengers but in business class passengers as many companies discontinued providing business class facilities to their executives as a part of cuts in transport expenditures. The decline in business class passengers was so severe that the company was also considering the removal of larger business class seats from airplanes and replacing them with normal seats to increase the overall capacity of airplanes and increase revenues through this increased capacity (Robertson 2010).
Financial crisis and its relationship with recession in the entire economy
The financial crisis which started in the United States banking sector quite rapidly spread to other sectors and also spread to other parts of the world. The worst hit regions of the financial crisis were the United States of America and many countries of Europe including the United Kingdom. Financial crisis are of various types and major financial crisis usually affect entire economies and the worst financial crisis result in entire economies going into recession. The financial crisis which started in 2008 was one of the most severe financial crises the world has ever seen as the largest banks and financial institutions such as Lehman Brothers had to file bankruptcy. The financial crisis has a very strong relationship with the recession of an economy as major financial crisis may lead to recession in an economy. The financial crisis has several short term and long term implications on a country's economy. The recent financial crisis not only caused many companies to shut down and economies to go into recession but it has also brought several other problems for the public and private sectors where companies had to implement salary cuts, cost and expense cutting measures, fire employees, face decreased revenues and reduced levels of cash flows. The financial and banking sector of the economy was worst his sector of the economy but this does not imply that other sectors were safe. The financial crisis impacted almost all sectors of the economy including the manufacturing sectors, automobile industry, service industry, airlines and many other sectors of the economy (Gokhale 2008).
This chapter provided an overview of the literature studied and analysed in the current research with respect to financial crisis and its impact on the Untied Kingdom airline industry specifically on British Airways in the United Kingdom. The literature reviewed in this chapter was collected from various sources including books, journal articles, periodicals and websites. The chapter presented the causes and effects of financial crisis in light of various theories and concepts. The concept of financial crisis was discussed comprehensively along with the causes of financial crises. The chapter also discussed the events during the recent financial crisis and the factors leading to the recent financial crisis. The chapter also explained the recession in the airlines industry and describing the impact of the financial crisis on British Airways. The last section of the chapter discussed financial crisis and its implications along with its relationship to recession and economic downturn. The next chapter of the dissertation will present various methods of research available at the disposal of a researcher and the research strategy implemented for collecting, interpreting and analysing data in the current research.