Law and Finance after the Financial Crisis

The Untold Stories of the UK Financial Market

Abdul Karim Aldohni

• Publisher: Routledge
• Year: 2016
• ISBN:
  9781317385578
• Edition: 1
• Topic: Business
• Subtopic: Finance
• Index: Business

The 2008 financial crisis has become one of the defining features of the twenty first century's first decade. The series of events which unfolded in the aftermath of the crisis has exposed major structural flaws in many of the financial systems around the globe, triggering a global call for legal and regulatory reforms to address the problems that have been uncovered.

This book deals with a neglected angle of the 2008 financial crisis looking in-depth at the implicit effects of the 2008 crisis on the UK financial market. The book considers new trends in finance which have emerged since the crisis as well as the challenges faced by some older practices in the UK financial markets. After providing a reflective account of the history of law and creditors in the UK the book investigates the proliferation of certain forms of financing that have recently become very visible parts of the UK financial market's structure, such as high cost short term lending and peer to peer lending. It provides legal and economic accounts of these forms of alternative lending, charting their developments, current status and critically assesses their impact on the UK financial market. Also examined are the ongoing funding difficulties faced by Small and Medium Enterprises (SMEs) and the suitability of the UK current legal framework to support these institutions. The book goes on to look at the viability and safety of some other post crisis trends such as banks use of Contingent Convertible Bonds (CoCos) to improve their resilience.

1
Introduction

Providing a different narrative: the 2008 financial crisis and the UK financial market

Abdul Karim Aldohni

How the 2008 financial crisis changed the UK financial market

The 2008 financial crisis is one of the most defining features of the twenty-first-century’s first decade. The series of events that was unfolded in the aftermath exposed major structural flaws in many of the financial governance systems around the globe. This triggered global calls for legal and regulatory changes in order to address the problems that were uncovered by the crisis. Therefore, the financial era that followed the 2008 financial crash has had a dominant theme – that is, regulatory reforms. In this regard, some major collective actions were taken at the international level to deal with the uncovered regulatory defaults. The Basel Committee on banking supervision introduced Basel III, which is ‘a comprehensive set of reform measures’ that aims to improve banks’ management, governance and ability to absorb shocks; and to strengthen banks’ transparency and disclosure’.¹ Further, at the domestic level, countries such as the UK, which host major international financial markets, were very swift to take on the regulatory challenge and reassure investors not only of their ability to stabilise their financial markets but also their commitment to improve their resilience.

In the UK, the Banking (Special Provisions) Act 2008 was introduced to deal with the failing banks, providing short-term emergency measures for up to 12 months. The 2008 Act enabled UK-incorporated banks and building societies to be taken into public ownership, provided a framework to compensate shareholders and included some further provisions to empower the Treasury.² Following the expiry of this emergency legislation, the Banking Act 2009 came into force. The 2009 Act established a Special Resolution Regime – a permanent framework that provides UK financial authorities with tools to deal with failing UK banks and building societies.³

Despite the radical regulatory changes that were introduced by the Banking Acts 2008 and 2009, it can be suggested that the beginning of a new regulatory era for the banking and financial sector in the UK was effectively marked by the breaking-up of the Financial Services Authority (FSA), which came into force on 1 April 2013. Under the new regime the FSA has been replaced by two regulatory bodies, the Prudential Regulatory Authority (PRA) and Financial Conduct Authority (FCA). This signifies the return of prudential regulatory responsibilities⁴ to the Bank of England (‘the Bank’) since the PRA is established as a subsidiary of the Bank.⁵ Despite its significance, the restructure of the regulatory authorities was not the only vital part of the UK national reform agenda. Further important changes to the legal and regulatory framework of the financial sector were introduced. They aimed at supporting the newly established authorities and promoting stability in the UK banking and financial market. For example, the Financial Services Act 2012 (FSA 2012) amended the Financial Services Market Act 2000 in order to accommodate the newly allocated powers of the FCA and the PRA. The FSA 2012 also established an independent Financial Policy Committee (FPC) at the Bank. The FPC is tasked with a primary objective to reduce systemic risk and protect the financial system resilience. Therefore its mandate includes ‘identifying, monitoring and taking action to remove or reduce systemic risks with a view to protecting and enhancing the resilience of the UK financial system’.⁶ The FPC also has a secondary objective to provide the required support of the government’s economic policy.⁷

Additionally, the government established the Independent Commission on Banking (ICB) in 2010 to review and make recommendations in order to promote the UK banking system. The ICB final report in 2011 recommended certain reforms to ensure a more stable and competitive banking sector in the UK. Many of the final report’s recommendations and other provisions, including those on ring fencing, were implemented by the Financial Services (Banking Reform) Act 2013. The notion of ring fencing stemmed from the regulator’s determination to protect depositors (individuals and small businesses) and, consequently, tax-payers from banks’ exposure to the securities markets. Deposit takers, primarily retail banks, are prohibited from dealing in investment as principal.⁸ This means that they are not allowed to buy, sell, subscribe for or underwrite designated investments (for example shares, debentures, alternative debentures, life policies, options) as principal.⁹ By setting a ring fence around these deposits, a clear line is being drawn between ‘the high street and the trading floor’.¹⁰

At first glance, these regulatory changes might seem as the only recognisable major effects that the 2008 financial crisis has had on the UK financial market. This view is understandable and expected given the clear and direct links that these regulatory changes have with the events unfolded by the 2008 financial crisis. For instance, the failure of the FSA to foresee the problems with the soundness and safety of the banking system before they were exposed by the 2008 financial crisis has led to the creation of a separate regulator, the PRA, to perform effective prudential supervision; while supervising the business conduct is now conducted by another regulator, the FCA. Another example, the loss of depositors’ money which was invested in highly speculative and complicated securities, has led to the enforcement of ring fencing in order to protect retail banks deposits.

However, a careful look into the UK financial market post 2008 reveals more implicit effects that the crisis had on the market and which exceed the obvious regulatory ones. These implicit or indirect effects probably have subtle links with the 2008 crisis but they are by no means less important than the regulatory ones. For a start, the landscape of the UK financial market itself has changed over the last few years with the disappearance of some of the market’s main regional players (such as Northern Rock in the north east of England, which was fully nationalised and then sold to Virgin Money),¹¹ and the break-up of some of its large banking institutions (Lloyds TSB).

More importantly, the financial shock that the UK market experienced in 2008 has primarily impacted on credit flow as banks became either scared or were financially incapable of lending. Therefore, the market suffered from a sharply bipolar division of easy/reckless lending pre 2008 and hardly any lending post 2008. This shift from one extreme to another created a credit gap in the market, which many viewed as a serious problem while others saw an opportunity. New trends, such as peer-to-peer lending and crowdfunding, which emerged not long before 2008, started to gain significance in the UK market after 2008. They provide a service that the shrinking banking sector has become less able to offer and they benefit from new platforms that the new digital technology made available for their business. To a certain extent the same can be said about high cost short term credit providers, whose proliferation, although long established in the UK market, post 2008 can be attributed to the same factors that peer-to-peer lenders benefited from (i.e. the shortage in the credit supply and the use of online platforms to reach wider groups of customers).

These alternative forms of lending, which have become very visible parts of the UK financial market’s structure, are not the only new emerging trends post 2008. In the last few years a relatively new type of hybrid bonds, known as contingent convertible capital instruments (Cocos), have been widely considered as an essential instrument to improve banks’ resilience. Banks have been increasingly using Cocos to promote the resilience of their capital structure as these instruments convert into a capital cushion at time of sever financial stress. Cocos are a new financial innovation that is designed to avoid the shortcomings of pre 2008 crisis hybrid bonds.

Moreover, the UK financial market’s landscape was not only shaped by the emergence of new trends post 2008 but also by the failure of some of the old practices in this market. The ethical finance sector, for instance, has been an integrated part of the UK market for hundreds of years yet the inability of some its institutions to withstand the ethical challenges of the 2008 events has undermined its credibility. Finally, the strain that the 2008 crisis put on credit supply has had a reverberating impact across the business sector. Small and medium enterprises (SMEs) are specifically affected by the reduction of funding available in the UK financial market. These institutions are particularly vulnerable at a time of economic crisis yet they play a central role in social renewal and economic recovery and growth.

It can be suggested that the above identified issues share a number of common features: first, they stem from new conditions imposed – one way or another – by the financial meltdown of 2008; second, they deepen our understanding of the financial crisis; and finally, they influence our perception of the post-2008 UK financial market. For these reasons they are no less important than the legal and regulatory changes, which are the obvious manifestation of how the crisis of 2008 changed the UK financial market.

About this book

This collection of essays is neither designed nor aims to provide any analysis or assessment for the legal and regulatory changes that took place in the UK financial market in the wake of the 2008 crisis. This subject has been widely addressed by an extensive volume of the published literature since 2008.

Instead, this book deals with a neglected angle in the narrative of the 2008 financial crisis, which is no less important than the legal and regulatory reforms that followed the 2008 crisis. This collection of essays, therefore, provides an in-depth insight into, what can be arguably described as, the implicit effects of the 2008 crash on the UK financial market.

It is important to note from the outset that this book does not claim to deal with all the implicit effects that the 2008 financial crisis has had on the UK financial market. Rather, it identifies a selection of the 2008 crisis by-products and provides an extensive analysis of their nature and legal context.

To achieve its objective the book clearly identifies two threads that run through its chapters and map on to its central objective. The first thread focuses on the rising new trends in the UK financial market post 2008. The second thread, which complements the first, reflects on the strain the crisis put on some of the older practices in the UK financial market and examines the market’s relationship with some aspects of the business sector post 2008.

Book structure

Given that the main objective of this edited collection is to examine the implicit manifestations of the 2008 financial crisis in the UK financial market, it is important to provide a reflective account of the 2008 financial crisis in the UK context. Chapter 2 examines the 2008 financial crisis from a unique perspective. Instead of focusing on the questionable financial practices in the run-up to the crisis, which have been widely addressed by an extensive body of the published literature since 2008, the chapter traces its origins to the shift in the nature of debt. Through the use of the history lens the chapter documents the nature of this shift and the enduring role it has played in making debt a destabilising influence on the economy. The chapter highlights the replacement of the relational understanding of debt by a more commodified understanding. It argues that the key lesson that the history of the construction of debt offers is that regulatory systems that fail to remember the fictional character of the commodified understanding of debt are inevitably unlikely to promote stability.

After providing a reflective account of the 2008 financial crisis in the UK context from a historic perspective, the book investigates some of the new trends that have emerged or proliferated as implicit effects of the crisis. Chapter 3 examines one of these new financial trends in the UK market, namely peer-to-peer lending platforms. By using loan-level data and empirical research (interviews), the chapter provides an insight into the evolution of this business and its turning point which was marked by the crisis. The chapter explains why borrowers and lenders participate in the peer-to-peer market highlighting some of the innovative features that this new form of finance is providing. It also speculates about the impact that peer-to-peer lenders may have on the conventional banking sector in the near future.

Chapter 4 deals with another rising financial trend at the retail financial level, that is high cost short term credit providers. The chapter charts the evolution of the consumer credit market in the UK in order to contextualise the proliferation of the high cost short term credit sector post 2008. It illustrates how the rapid expansion of the consumer credit market resulted in continuing record levels of consumer debt and increasing evidence of irresponsible lending practices with particular reference to the high cost short term credit sector post 2008. The chapter analyses the UK legal and regulatory approach in dealing with this phenomenon. It provides a damning critique of the regulation and the ineffective legislative framework that offered little or no protection to consumers. It also charts the legal and regulatory developments that have taken place since 2008 in this respect.

Chapter 5 is also an integral part of the first thread – emerging new trends – of this edited collection as it analyses another implicit effect of the 2008 crisis on the UK financial market. The chapter focuses on a new instrument, namely convertible contingent capital instruments (Cocos), which, post 2008, have become widely used by banks to improve their resilience. The chapter provides a detailed account of the context in which these instruments are being used through addressing the nature and function of regulatory bank capital. It also examines the nature of Cocos as ideal complements for equity by considering the arguments in favour and against their adoption as part of the framework for regulatory capital requirements. The chapter touches upon some of the regulatory aspects of these instruments within the UK financial market.

As highlighted earlier, the second thread in this book’s argument concerns the challenge that was brought about by the crisis to the credibility of some of the older practices in the UK financial market and also entails the strain that the crisis put on this market’s relationship with some aspects of the business sector post 2008. In this regard Chapter 6 brings particular focus to the topic of ethical finance given its historic roots in the UK financial market. In the wake of the 2008 crisis many argued that the financial business culture needs to be changed and that ethical finance could have an important role to play. On the other hand, one of the main ethical banks in the UK market, Co-operative Bank, has failed to withstand the test of the 2008 financial cri...

Table of contents

• Cover
• Title
• Copyright
• Contents
• Notes on contributors
• 1. Introduction: providing a different narrative: the 2008 financial crisis and the UK financial market
• 2. Law, creditors and crises: the untold story of debt
• 3. Peer-to-peer lending and financial innovation in the UK
• 4. High cost short term credit in the new UK marketplace
• 5. Contingent convertible capital: a perfect tool for more resilient banks
• 6. Exploring the myth of ethical finance in the UK financial market post the 2008 financial crisis: the prospects and challenges
• 7. SMEs and access to finance: a vulnerability perspective
• 8. Conclusion: the lessons to be learned from the now told stories of the 2008 financial crisis
• Index