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The financial crisis - 10 years on What happened, and what has been done since?

Setting the scene

In the years leading up to the financial crisis, the British bank Northern Rock had expanded aggressively, turning to international money markets to fund its rapid growth. However, when problems in the US sub-prime mortgage market started to spread to Europe in the summer of 2007, this source of financing dried up. Northern Rock was left facing a severe liquidity crisis.

On 14 September, Northern Rock’s perilous position was made public. Despite liquidity support from the Bank of England, a run on Northern Rock was triggered - the first UK bank run for over 140 years. In response, the Chancellor, Alistair Darling, announced that the Government would guarantee all existing deposits on 17 September.

At the time of Northern Rock’s failure the legal framework for dealing with failing banks was deficient in two important ways. Any deposits over £2,000 would not be fully reimbursed, and if Northern Rock were to be declared insolvent and put into administration, deposits would have been frozen, with a long wait before even partial reimbursement.

Since the crisis...

Deposits are now fully guaranteed up to a limit of £85,000 through the Financial Services Compensation Scheme (FSCS).

The UK now also has a comprehensive resolution framework that allows banks to fail in an orderly manner. This regime gives the authorities a variety of options for dealing with a failing or failed bank quickly and fairly, without using taxpayers’ money for a bailout.

Fannie and Freddie

In the US, two huge mortgage finance agencies, Fannie Mae (Federal National Mortgage Association) and Freddie Mac (Federal Home Loan Mortgage Corporation), were taken over by the US Government. The $187.5 billion bailout was one of the largest in US history.

Fannie Mae and Freddie Mac’s main business was packaging up home loans into products called mortgage-backed securities that were then sold on to investors. As the US housing market steadily weakened and then collapsed, so did Fannie and Freddie.

The scale of the bailout immediately heightened concerns about the stability of the entire financial system, and institutions already known to be vulnerable came under increased scrutiny. One of these was the leading US investment bank Lehman Brothers.

Since the crisis...

The financial crisis revealed how a seemingly isolated issue in one country could have far-reaching consequences. The interconnectedness of global finance meant that the UK financial system had become dangerously exposed to the fall-out from the US sub-prime mortgage market.

Before the crisis, oversight of the UK financial system was shared between the Bank of England, the FSA and the Treasury. This left no authority with clear responsibility for monitoring how risks were building up across the financial system. In response, the Bank of England’s Financial Policy Committee was established in 2013. The FPC is charged with spotting risks as they emerge and making sure the financial system is resilient enough to support the economy if the risks crystallise.

Lehman Brothers on the brink

Lehman Brothers had been heavily involved in selling collateralised debt obligations (CDOs) – complex financial products based on mortgage-backed securities. This left the bank dangerously exposed to the US sub-prime mortgage crisis, and on 10 September Lehman Brothers announced Q3 net losses of $3.9 billion, on top of a Q2 loss of $2.8 billion.

On 13 September, the president of the Federal Reserve Bank of New York, Timothy Geithner, convened a meeting of senior bankers to discuss Lehman’s future. The British bank Barclays emerged as a possible buyer, but concerns over the deal caused Barclays to walk away.

While one of Lehman Brothers' rivals, fellow investment bank Bear Stearns, had been bailed out earlier in the year (14 March 2008), it became increasingly clear that Lehman Brothers would be allowed to fail.

Since the crisis...

Lehman Brothers was part of the ‘shadow banking’ or ‘market-based finance system’, defined by the Financial Stability Board as ‘entities and activities structured outside the regular banking system that perform bank-like activities'. The shadow banking system grew rapidly in the years leading up to the crisis, and was not subject to the same level of oversight as the regular banking system.

Shadow banking plays an important role in the financial system by offering alternative sources of credit. But it also allowed banks to move certain risky activities off their balance sheets, including sub-prime mortgage-backed securities and collateralised debt obligations.

The crisis showed that shadow banking risks can easily spill over into the regular banking system. Consequently, shadow banking has been a major focus of reform: led by the FSB, regulators are establishing system-wide oversight to assess financial stability risks from shadow banking. Risky off-balance sheet activities are now regulated far more strictly, having shrunk by 40% since 2007.

Lehman Brothers fails

A day of chaos on Wall Street quickly spread round the world. After attempted rescue deals fell through, Lehman Brothers filed for bankruptcy in the early hours of the morning.

Like Lehman Brothers, the US investment bank Merrill Lynch had been heavily involved in selling complex financial products like CDOs. By mid-September it too was close to collapse, having lost $19.2 billion between July 2007 and July 2008. Bank of America stepped in and agreed to buy Merrill Lynch for $50 billion, saving it from bankruptcy.

On the same day, credit rating agencies downgraded insurance giant American International Group (AIG), sparking a liquidity crisis. AIG had been insuring banks against losses on their CDOs by using a kind of credit protection known as credit default swaps, and they ran into acute financial difficulty as these losses began to mount rapidly.

Since the crisis...

The crisis highlighted numerous weaknesses in the international regulatory framework. Since 2008, new rules have been implemented that aim to correct these deficiencies.

Banks have to hold more and better quality capital to provide a more effective buffer against losses. Capital requirements for large banks are ten times higher than before the crisis.

Excess leverage has also been curbed: banks must abide by a leverage ratio which stipulates how much high-quality capital a bank must hold against its assets. The new rules also include much tougher liquidity requirements.

AIG rescued

AIG’s liquidity crisis intensified, and at 9pm EDT the Federal Reserve Board announced that the US Government had stepped in to bail out the insurance company. The immediate support was an $85 billion credit facility. By March 2009 the US Treasury and Federal Reserve had committed $182.3 billion to the rescue.

The authorities had decided that AIG was too big and too interconnected to fail. As of 30 June 2008 the company’s consolidated total assets totalled more than $1 trillion and it was the largest provider of conventional insurance in the world.

AIG also sat at the centre of a dense web of financial contracts: had it been allowed to go bankrupt, AIG could have taken down many of the banks it had sold credit protection to.

Since the crisis...

Since the crisis the Financial Stability Board (FSB) has created a framework for identifying Systemically Important Financial Institutions (SIFIs). These are banks and insurance companies whose size, complexity and interconnectedness would cause severe problems for the global economy if they failed.

SIFIs are now subject to more stringent supervision and extra requirements: the bigger the bank and the riskier its business, the more capital it must hold against possible losses. Recognising that SIFIs operate across multiple countries, the FSB has focused on improving cross-border cooperation when designing and implementing resolution plans for failing banks.

The FSB has also led improvements to the use of credit default swaps. These contracts must be more transparent, and many are now traded through central counterparties. This has reduced the complexity of the interconnected network through which contagion spread in 2008.

Liquidity squeeze intensifies

As liquidity became an ever-increasing concern in the wake of Lehman Brothers’ bankruptcy, we extended our Special Liquidity Scheme.

The SLS allowed banks to swap high-quality but illiquid assets for UK Treasury bills. Because Treasury bills are a liquid asset, banks were able to use them as collateral to borrow cash.

Since the crisis...

Lack of liquidity and a reliance on short-term funding contributed to the severity of the crisis. Post-crisis reforms have focused on improving the stability of banks’ funding and increasing their ability to cope with periods of stress.

In order to enhance short-term resilience, banks must now hold enough highly liquid assets to be able to withstand a 30-day liquidity stress. As a result, UK banks’ buffers of liquid assets have increased by over 40% since 2010, now standing at over £700bn.

The new rules also require banks to balance short-term and long-term funding. Short-term funding often dries up suddenly in times of uncertainty. By making banks less dependent on it, they are in a better position to withstand unexpected shocks.

Lloyds TSB announces HBOS merger

A day after its share price fluctuated wildly, it was announced that HBOS, Britain’s sixth-biggest bank and largest mortgage provider, would merge with Lloyds TSB, itself the fifth-biggest bank in Britain.

The fallout from Lehman Brothers meant that already vulnerable banks like HBOS became even weaker as the crisis continued to intensify.

Since the crisis...

The collapse of HBOS revealed problems with the way banks were supervised in the UK. Prior to the crisis, both prudential and conduct regulation were the responsibility of the Financial Services Authority (FSA). This left the FSA with too many objectives to juggle, and in 2013 it was abolished and its responsibilities split between the newly created Prudential Regulation Authority of the Bank of England (PRA) and the Financial Conduct Authority (FCA).

The FSA failed to ensure that adequate resources were devoted to the supervision of large systemically important firms like HBOS. Now, the PRA has a judgement-based supervisory approach, where the amount of resource dedicated to a firm is proportionate to the risk it poses to the financial system.

Another contributing factor to HBOS’s demise was that its board and senior management failed to set an appropriate strategy for the bank or challenge its flawed business model. In the aftermath of the crisis it proved difficult to hold the executives of failed banks to account. To prevent this from happening again, we launched the Senior Managers and Certification Regime in 2016. The SM&CR requires firms to allocate clear roles and responsibilities to senior individuals like the CEO and Chair, making it easier to establish accountability if things go wrong.

Rescue plans

In the UK, the Yorkshire bank Bradford & Bingley was nationalised. The Government took control of the bank’s mortgage and loan books, while its branches and deposits were sold to the Spanish banking group Santander.

Bradford & Bingley had been struggling to convince the market of its viability in the months leading up to Lehman Brothers’ collapse. Its rapid expansion into buy-to-let mortgages left Bradford & Bingley vulnerable to a downturn in the housing market. And as short-term funding dried up after Lehman Brothers went bankrupt, Bradford & Bingley’s ability to support itself also evaporated.

Meanwhile in the US, the government’s plan to stabilise the financial system by purchasing $700 billion of ‘troubled assets’ was rejected by Congress. The Dow Jones stock market index suffered its largest single-day point drop following the unsuccessful vote. The Troubled Asset Relief Program was eventually voted though on 3rd October.

Since the crisis...

Faced with Bradford & Bingley’s collapse, the UK authorities now had the option of nationalising the bank in an orderly fashion. Following the chaotic run on Northern Rock twelve months before, Parliament had passed the Banking (Special Provisions) Act 2008 in February 2008, which allowed the UK Government to nationalise UK banks under emergency circumstances.

The Act has now been replaced by a comprehensive resolution regime, which gives the regulator several options when faced with a failing or failed bank. These include ‘bail-in’, a tool that enables losses to be imposed on the failed bank’s shareholders and other creditors. Bail-in ensures that investors bear losses rather than the taxpayer.

HBOS and RBS rescued

The British banks HBOS and RBS were in dire financial straits, and we stepped in to provide emergency liquidity. This peaked at £25.4 billion for HBOS and £36.6 billion for RBS.

To maintain financial stability, this assistance was not made public until November 2009, when the then Governor of the Bank of England, Mervyn King, disclosed details of the operation to the Treasury Committee.

Since the crisis...

Our arrangements for providing liquidity in times of stress are now more formally organised. We have worked with banks to ensure they have appropriate collateral ready should they need to borrow from us – allowing them to access up to £320 billion in additional liquidity. We consider it important to retain the ability to delay disclosure of certain forms of liquidity assistance. This is because prematurely revealing that a bank needs liquidity assistance can increase financial instability rather than avoid it, for example by causing a bank run.

When RBS failed, the authorities had no way of protecting the bank’s retail depositors and ensuring that critical services like payments continued smoothly without rescuing the whole bank. To make sure that banks can fail without disrupting banking services to individuals and small businesses, from 2019 large UK banks must separate core retail banking services from their riskier investment and international banking activities. This is known as ring-fencing.

Remuneration rules have also been progressively strengthened to better align pay with performance and to discourage excessive risk-taking and misconduct.

System-wide support

It was becoming apparent that the chaos unleashed by Lehman Brothers’ demise could not be calmed by isolated interventions. Instead, a coordinated, system-wide response was needed.

Accordingly, the UK authorities announced a comprehensive financial support package aimed at recapitalising the banks and providing sufficient liquidity to the financial system. In the case of the most vulnerable banks, this meant part-nationalisation. As part of this, eight major UK banks committed to increasing their capital, allowing them to absorb losses more effectively in the future.

On the same day, the Icelandic bank Landsbanki collapsed, putting the deposits of its many UK customers in danger. Despite operating in the UK, Landsbanki was regulated by the Icelandic authorities. When the Icelandic government refused to guarantee UK deposits, the Chancellor, Alistair Darling, moved quickly to freeze Landsbanki’s assets in the UK to protect British deposit-holders.

Since the crisis...

Since 2014 we have carried out stress tests on the UK’s banks. These involve looking at a range of “what if” scenarios, such as a sudden downturn in economic conditions. Stress tests allow us to assess banks’ resilience and make sure they have enough capital to withstand shocks, and to support the economy if a stress does materialise.

The drastic action taken by the UK government to protect UK deposits in Icelandic banks showed a clear need for a more cooperative approach to supervising international banks. The PRA now requires a clear split of supervisory responsibilities for branches of non-EU banks to be agreed with the home state supervisor. Only subsidiaries of non-EU banks are allowed to hold significant amounts of retail deposits. And if an international bank fails, its resolution plan must minimise risks to the UK’s financial stability.

International coordination

By October it was clear that what had started as a seemingly self-contained problem in the US sub-prime mortgage market had developed into a global crisis that required a global response.

After a meeting of Finance Ministers and Central Bank Governors in Washington DC on 10 October, the G7 agreed to a five-point Plan of Action to stabilise financial markets and restore the flow of credit to support economic growth.

Since the crisis...

Since the crisis, international cooperation has increased dramatically. Founded in 2009, the Financial Stability Board is charged with promoting and monitoring global financial stability. The FSB has spearheaded international reforms and tracks implementation of new international standards.

The FSB comprises senior policy makers from finance ministries, central banks, and supervisory and regulatory authorities, drawn from the G20 countries, other significant financial centres and international bodies. The FSB’s policies and recommendations are not legally binding. Instead the FSB acts as a coordinating body, with its members committing to implement its standards at national level.

Looking forward

Ten years on from Lehman Brothers’ collapse, the global financial system is safer and more resilient. And work is ongoing to implement the last of the post-crisis reforms at both international and domestic levels. But one thing is certain: the next crisis will not look like the last one. New risks to financial stability have appeared in the last ten years, and will continue to emerge.

The Bank of England is already carrying out work on green finance and how climate change could affect the firms we supervise, and financial stability more broadly.

Technology will continue to have a transformative impact on financial services, and we actively monitor the impact of cryptoassets and Fintech. While Fintech can pose a number of challenges for banks, there are clear prospects for new financial technologies to make the financial system more efficient, effective and resilient.

Cyber risk is a growing concern, so going forward we will conduct cyber stress tests to check that banks’ systems are operationally resilient and can recover quickly after an attack.

We aim to ensure that the UK financial system is resilient to, and prepared for, the wide range of risks it could face. That way, the system can serve UK households and businesses in bad times as well as good.

Credits:

Created with images by: João Barbosa - "The need to keep growing" - IMF Photographic archives via Wikimedia Commons

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