The causes of the 2007-2008 financial crisis incorporating the perspective of

industry professionals from the UK financial services sector

Summary

The interest and focus on the credit crisis and resulting financial crash continues to be of

value for academics, governments and research bodies. Its impact, beginning in 2007, is

part of the collective memory. The study aims to examine the crisis via a unique approach,

examining it from the academic literature and secondary source perspective and from the

individual perspective. This two issue perspective approach is rarely seen in the literature,

which tends to focus on the macro impact while ignoring the personal impact on those

involved. The principal aim was to identify the causes of the credit crisis from these two

perspectives. The objectives were to identify the root causes of the credit crisis, the

opinions of individuals in the Financial Services industry and to ascertain to what extent a

correlation exists between the findings of the literature review and primary research. The

methods used were to conduct a literature review incorporating secondary sources and to

obtain primary data, via a qualitative structured interview with a range of Financial Service

Industry professionals. The main conclusions were that the principal causes of the crisis

were the USA sub prime mortgage crisis, over expansion of credit and lending by banks,

the practices of the credit ratings agencies and the risky investment practices of the banks,

the catalyst for this being the rise in US interest rates and this together with the banks use

of risky financial instruments caused the resulting contagion. Most of the interviewees

were affected by the crisis, some being affected negatively. There was a significant degree

of correlation between the findings of the literature review and the primary research. Both

highlighted the same or overlapping causes, both agreeing on the significance of the rise

in US interest rates. There was no one overall cause to the crisis, but a number of

connected causes. What was clear was the importance of the transmission mechanisms.

Introduction

In 2007 and 2008 a major catastrophe impacted on the global financial markets. The

consequences of this were severe. The most significant was a serious financial crisis and

the plunging into recession of those countries affected. The crisis developed into the

largest financial shock since the Great Depression (Tong and Wei, 2008) and it was the

most severe recession since World War II (Watcher, 2010). The UK was affected in a

number of deleterious ways. There was a collapse of the housing market (Park, 2008), a

major recession (Sapienza and Zingales, 2009) and the collapse of major financial

institutions (Goldestein, 2010).

The focus of this paper is on the prime origins and causes of this credit crunch, defined as

a sharp decline in the supply of credit (Bernanke and Lown, 1991) preceded by the ability

or willingness of banks to lend at a particular rate (Hubbard, 2008). The unique nature of

this crisis incorporated a number of additional factors i.e. the users of the credit not being

able to meet their commitments to repay and the preceding shock that set the train of

events in motion, this being the sub prime crisis in the USA, itself sparked by the rise in

USA interest rates.

The prime causes of the credit crunch are considered to originate in the USA i.e. the sub

prime mortgage crisis, the over expansion of credit and lending by banks, the practices of

the credit ratings agencies and the risky investment practices of the banks. These

practices were crucial, due to their investments and dealings in financial instruments such

as, Collateralized Debt Obligations (CDO’S), Derivatives and Credit Default Swaps

(CDS's)

Sub prime mortgages were a financial innovation designed to provide home ownership to

riskier borrowers (Arestis and Karakitos, 2009). These mortgages were being lent to

borrowers who, if interest rates subsequently rose, might be unable to repay them. Another

factor was the way such mortgages were sold and repackaged by the banks, which led to

the credit contagion spreading on a global scale. Sub prime mortgages were bundled into

CDO’s or portfolios (Salter, 2010) given good ratings (triple or double A) by the ratings

agencies, and sold to investor’s world wide (UCC, 2007). The over expansion of credit was

made worse by the rating agencies. They were supposed to grade securities based on

their risk but were handing out AAA scores on securities that were very risky (Samuelson,

2009). The government were also involved via a lack of effective regulation. Lax regulation

may have been the lever that pushed the world into the financial crisis (Bardhan, 2009).

The consequences for the UK were severe e.g. the contraction suffered by the economy

was 6.2% (Gilmore and King, 2010). This necessitated swift and extreme action by the UK

monetary authorities e.g. the nationalisation of Northern Rock (Hawes, 2010) and the rapid

inflow of government financial support to RBS and Lloyds TSB (Guynn, 2010).

The paper will evaluate the above suggested causes and determine whether there were

other contributory causes. This will be founded on a literature review and the use of

secondary supporting material. Qualitative primary research will be undertaken, to identify

the opinions of professionals within the Financial Services Industry as to the causes, via

structured interviews. This will elicit a valuable alternative perspective, enabling any

correlation between the literature review to be ascertained.

As a consequence of the above, the aims and objectives of this study can be stated.

The principal aim is to identify the causes of the credit crisis from two perspectives,

namely the academic and the personal. A supplementary aim is to come to a

conclusion as to what caused the crisis.

There are three specific but interrelated objectives to this study:

To identify and determine the root causes of the credit crisis

To identify the opinions of individuals in the Financial Services industry

To ascertain to what extent there is a correlation, if any, between the literature

review and primary research

Literature Review

The possible causes of the crisis will now be examined and consideration as to other

contributory causes.

Background of the crisis

Arguably, it was the USA sub prime crisis that was the catalyst. Sub prime mortgages were

property loans to borrowers on relatively low incomes with inadequate security. Roche

(1998 cited Calomiris and Charles 1999, p.16) states they were loans to borrowers who

had past credit problems or to people with unconventional borrowing needs. A problem

could emerge if such borrowers experienced future repayment difficulties. Schwarzman

(2008) stated that the “The idea of lending money to, basically, poor people, is how the

story started”. However, it could be argued that these mortgages were a dormant catalyst

and “for the story to start” (i.e. the crisis) it was necessary for there to be a catalyst that

provided the spark.

The effect of the rise in interest rates

The rise began in 2007, as homeowners faced interest rate resets which increased

mortgage payments by as much as 30 percent (Fuchita et al, 2009). The consequence of

this was examined by Gwinner and Sanders (2008). They found that as interest rates had

risen, subprime defaults and foreclosures increased. The consequences of this are

focussed on by Berger and Bouwman (2009). The sub-prime lending crisis has been

characterized by turmoil in financial markets as banks have experienced difficulty in selling

loans in the syndicated loan market and in securitizing loans (Berger and Bouwman,

2009).This was a key condition for market contagion i.e. the growth of such financial

instruments when accompanied by the investment practices of the banks.

The severity of the financial crisis

The financial market turmoil in 2007 and 2008 led to the most severe financial crisis since

the Great Depression (Brunnermeier, 2009). This emphasises the significance of the crisis

that followed. In the USA 2.97 million jobs were lost during 2008 (UCA, 2008) and USA

real GDP was falling at an annual rate of 6% (Blinder and Zandi, 2010). In the UK, GDP

fell over 6% (Gregg and Wadsworth, 2010) and unemployment rose to 8% in 2010 (Elsby

and Smith, 2010). All these sources support the negative consequences of the crisis. They

also indicate how the contagion quickly spread, for economies closely integrated via their

respective financial systems. This is reinforced by Siebert (2001, p. 316) who states that

international financial systems are prone to contagion beyond the domestic experience.

There were also serious problems for UK banks. Credit problems resulted in the

nationalizing of Northern Rock (Croughy et al, 2008). UK Bank share prices fall sharply

(BBC, 2008). The crisis resulted in severe bank losses and write downs. Announced global

losses related to the credit crisis soared to a total of $510 billion by the end of August 2008

(Fender and Gyntelberg, 2008). This clearly shows the scale of the crisis and these were

only the announced losses.

Were all banks affected equally by the crisis?

Not all banks were similarly affected, as HSBC weathered the crisis substantially better

than most (Acharya and Richardson, 2009, p.93). Why and how did HSBC manage this?

The answer relates partly to their diversification strategy i.e. in the Middle East and North

Africa (Turk-Ariss, 2009). There is a key difference in the investment practices followed in

Islamic countries to that of Western Banking. The Qu'ran explicitly outlines that gambling is

prohibited (Hassan and Lewis, 2007, p. 39). Any transactions undertaken for speculative

purposes are not allowed (Ben Arab and Elmelki, 2008). HSBC, in the Middle East would

not have relied on trading in financial instruments such as CDOs, which could represent a

form of gambling. The similarity to gambling is no less when thinking about CDOs or

CDS's, where the counter parties have no direct exposure to the underlying risks (Hazen,

2009).This would have lowered their exposure to such high risk investments. Western

banks would not be inhibited in following such potentially dangerous practices as there

were no such prohibitions applying to them.

The above suggests that perhaps another key cause of the crisis were the investment

practices of the banks, in the USA and UK. There are a number of possible reasons for

this. The crisis was preceded by rapid credit growth, a classic danger sign at the level of

individual banks and the system as a whole (Honohan, 2008). There was also a large

increase in UK available mortgage credit (Watson, 2008) and a rise in USA household debt

as a percentage of GDP from 65% in 1995 to 98% in 2005 (Cynamon and Fazzari 2008,

pg. 20). The above illustrate the growth in bank credit leading up to the crisis. However,

this does not provide the reasons for the cause. What is more important are the practices

of the banks, which led to the over expansion and the associated culture that was linked to

this.

Risky Financial Instruments

The key criticism of the banks in the USA and UK are their dealings in risky financial

instruments, such as CDO’s, Derivatives and CDS’s. A CDO is the securitization of a pool

of debt obligations into tranches of securities with various levels of exposure to the

underlying credit risk (Avesani et al, 2006). Derivatives are financial contracts, whose

value is “derived” from the future price of an underlying asset (Jacque, 2010, p.2). A bank

after buying a corporate bond can insure itself by buying a CDS, by paying a fixed

insurance fee to a protection seller in exchange for a payment by the seller contingent

upon a credit event or default (Brunnermeier, 2008). The extent of the growth in such

instruments is highlighted by Wainwright (2009) and Ertürk and Özgür (2009). In the last

two or three years there has been a huge increase in CDOs (Wainwright, 2009) and an

explosive increase in CDS's and derivatives (Ertürk and Özgür, 2009). The key problem

however is the degree of risk involved in dealing in them. Dealing in financial instruments

such as CDO's, derivatives (Crotty et al, 2010) and CDS's (Foster et al, 2010) are high

risk. The outcome of such practices is described by Brunnermeier (2009) i.e. the rise in

popularity of securitized products led to a flood of cheap credit, and lending standards fell.

The domino effect

Once the catalyst occurred (i.e. the rise in USA interest rates) and the sub prime borrowers

began to default the values of these instruments quickly fell. This outcome is highlighted

by White (2008) who states that the actual and anticipated losses from these mortgage

loans caused dramatic declines in the value of mortgage backed securities. Steinbucks et

al (2008) describe the consequences in that lenders were unable to sell sub prime

products in secondary markets as potential buyers saw their potential future value

deteriorating. This inability to sell would lead to liquidity problems. When significant doubts

arose in the summer of 2007 about the performance of these securities, market liquidity

dried up (Eichengreen, 2008). This is describing the consequence of the inability to sell the

instruments as banks became reluctant to lend to each other or provide credit. Banks were

holding assets with little or no value or that were impossible to value due to their

complexity. As the value of Mortgage backed securities fell (Crotty and Epstein, 2009) it

became increasingly difficult to value them (Davies, 2009).

The outcome was that The Bank of England provided emergency liquidity assistance to

the Royal Bank of Scotland and HBOS (Britain, 2010). As market liquidity dried up the

central bank intervened to support the system. There was a sharp slowdown in the growth

of bank lending to firms and households and in the growth of money holdings of the non-

financial sector (Dale, 2009), falls in UK house prices started in late 2007 (Astley et al,

2009) and the Government partly nationalised Bradford & Bingley in September 2008 and

HBOS, Lloyd’s and RBS in October 2008 (Pritchard, 2009). There was also a significant

amount of Quantitative Easing by the Bank of England i.e. the Bank purchased £200 billion

of assets financed by the issuance of central bank reserves (Dale, 2010). Without this

assistance the crisis might have been even more severe.

The role of credit ratings agencies

Another possible initiator of the crisis was the role of the Ratings Agencies. Their role was

to provide an estimate of the value for the securitised bonds created by the banks, by

giving them a rating e.g. ratings with the letter “A” carry minimal to low credit risk, whereas

“C” denote bonds in poor standing or actual default (Lowenstein, 2008). Coval et al (2008),

highlights the significance of these ratings in terms of the volume created. A defining

feature of structured finance activities has been the large quantities of triple-A rated

securities manufactured (Coval et al, 2008). There was widespread use of such ratings by

the investors and banks that purchased and dealt in the bonds. Investors relied on the

ratings issued by the credit rating agencies, which played a crucial verification and

certification function (Arewa, 2010). This highlights the role of the agencies in being the

arbiters of which bonds should be purchased by investors i.e. the higher the rating the

safer the bond. This is not a cause for concern provided the ratings have been carried out

effectively and the ratings given reflect the underlying value of the bonds. Arewa (2010)

focuses on the mismatch between the degree of risk involved and the rating that had been

given. Many structured finance instruments were actually far riskier than their ratings might

have suggested (Arewa, 2010). This was due to the bonds being composed of high risk

low value real assets i.e. sub prime mortgages extended to borrowers with tarnished credit

histories (Sender, 2010). The consequence is that banks and other investors were

purchasing and dealing in such bonds with little idea of their value. This view is reinforced

by Epstein (2009) i.e. CDOs were so complex and opaque that few bankers, customers or

regulators really understood how they would work in normal times, much less in a crisis

(Epstein, 2009). The complexity of these investments is confirmed by Das (2006, p.283)

who states that Mortgage Backed Securities structures reached levels of complexity only

second to derivatives. If investments were triple A rated by a firm like Moody's, the problem

was an investor felt reassured and didn't worry about the complexities of investing in

mortgage based portfolios (Lowenstein, 2008). All of the above support the complexity and

valuation problem with such instruments.

After the outbreak of the subprime crisis, it became evident that credit rating agencies had

actively contributed to the real estate bubble by over-rating senior tranches in special

purpose vehicles (Lannoo, 2008). Not only were they complicit in providing inadequate and

unjustified ratings, they were a real cause of the crisis. However, it may be that the

investment practices of the banks were more significant. A significance of how serious the

crisis ultimately became is that since 2007 even highly-rated debt products have

performed poorly e.g. the value of AAA-rated mortgage-backed securities fell 70% from

January 2007 to December 2008 (Pagano and Volpin, 2009). This problem can be

attributed to a conflict of interest for CRAs as they were paid by issuers, thus their interests

were more aligned to that of the securities issuers than the investors (Pagano and Volpin,

2009).

Ancillary causes of the crisis

There are a number of possible ancillary causes, particularly the lack of banking regulation

in the USA. Many believe the USA deregulatory Financial Services Modernization Act

(FSMA) set the stage for the financial meltdown (Catanach, 2009). Such deregulation

made it possible for the key causes of the crisis to proceed unhindered. The FSMA

provided the opportunity to combine commercial banking with investment banking within

one organization (Tang, 2007). The motives of this were related to reducing unit costs,

such as through economies of scale. However, focussing on reducing costs may have

been to the detriment of the increased risks that might be posed by deregulation. Allowing

banks to combine commercial and investment operations, although theoretically implying

greater risk sharing, may have resulted in more than proportional risks being taken by one

operation (investment) which were insufficiently balanced by the risks in the other

(commercial). In addition, by deregulating there was an absence of sufficient scrutiny of

such practices. This is highlighted by Catanach (2009) i.e. it allowed companies to expand

into other lines of business, but failed to create a sufficient guardian to oversee systemic

risk to the economy. It was lax financial sector regulation that contributed to the full global

nature of the crisis right from its inception (Acharya and Schnabl, 2010). Thus the lack of

effective regulation may have been a significant cause and may have created a climate

where banks were able to take increasing risks with depositors’ money.

The impact of the Basel Accord

A related issue is the impact of Basel 2. This aimed to make the requirements which apply

to banks more risk sensitive and representative of modern risk management practices and

provide incentives to improve their practices (FSA, 2005). Such measures might have

helped to prevent the crisis developing i.e. in inhibiting the risky banking practices prior to

2008. However, the following source implicitly reveals a weakness in the timing of the

introduction of Basel 2. The capital requirements directive came into effect on 1st January

2007, provisions being made to allow some banks to operate under Basel I capital

requirements until 1st January 2008 (Benford and Nier, 2007). Although Basel 2 had good

intentions, its inception may have been too late. The new rules were not fully operational

throughout 2007 and were unable to inhibit banking practices. The lack of regulation is

highlighted in a report criticising The International Monetary Fund (IMF) by its Independent

Evaluation Office (2011) i.e. risks were downplayed, there was light touch regulation and

over endorsement of the financial practices in the main financial centres (IEO, 2011).

Banking culture and bonuses

An additional ancillary cause may have been the operational culture of the banks. Priewe

(2010) argues that there can be no question that short-term incentives for bankers

contributed to risk taking and speculative behaviour. This is reinforced by Matthews and

Matthews (2010) i.e. by ignoring the risks, bankers have at the very least, contributed to

the making of the recession, if not actually causing it. In contrast, Friedman and Kraus

(2010) oppose this, stating that bankers’ bonuses do not appear to have been responsible

for the crisis. Nevertheless, an open minded perspective could take the view that the

availability of large bonuses combined with the needs of the banks to provide good

shareholder returns, must have encouraged a culture of risk taking and over optimism in

the profits from trading in such risky financial instruments.

Research Design

The research philosophy of this paper is epistemological, which is concerned with the

nature of knowing and construction of knowledge (Williams, 1998), as opposed to others

such as ontology, which is concerned with the study of what exists, and how things that

exist are understood and categorized (O'Leary, 2007) and axiology, an approach which

studies judgements about value (Saunders et al, 2007, pg. 592). The specific orientation is

interpretivist, which aims to develop a deep understanding of the phenomenon under

investigation (Shanks et al, 1993 cited Truong and Corbitt, 2002, pg. 6) in contrast to a

positivist orientation. Positivism indicates a philosophy of absolute empiricism where direct

experience is the only legitimate claim to knowledge (Chávez and Lincoln, 2010). The

positivist approach has a number of benefits e.g. hypotheses testing (DeLuca and

Gallivan, 2008). However, it does have drawbacks e.g. the positivist approach favours

quantitative methods which are able to “prove” results (Knowles and Michielsens, 20011).

This would be inappropriate in this study as quantitative methods would not be able

“prove” the causes of the credit crisis, which was linked to individual and organisational

behaviour. In contrast the interpretivist has some major advantages e.g. the strength and

power of the approach lies in its ability to address the complexity and meaning of

situations. (Black, 2006)

The interpretivist approach does not attempt to identify hard and fast “laws” but attempts to

interpret opinions, attitudes and beliefs. In addition, it is difficult when conducting a survey

via a “rich” interview (as in this study) to be “value free” i.e. research that is objective,

scientific and without the opinions of the researcher himself (Abercrombie et al, 2000, p.

372). It is unlikely that the interviewer will ask every question or interpret every response in

the same way. Nevertheless, this approach is a better way of gathering meaning and

understanding when dealing with the highly complex world of finance and economics. Here

there are no “laws”. There are no rules, laws or dogmata in economics (Becker, 2007).The

research approach to be adopted will be inductive, which aims at building theory from

observation and findings (Bryman and Bell, 2007) as opposed to deductive, which aims at

testing a hypothesis based on a theory through empirical data collection and scrutiny with

this aim in mind (Bogojevski, 2010). The benefit of induction is that it moves from the

specific to the general, so that particular instances are observed and then combined into a

larger whole or general statement (Elos and Kynga, 2008). In the credit crisis individual

events can be built up into a holistic picture of causation. Also, an inductive approach

provides a convenient and efficient way of analysing qualitative data (Thomas 2006).

The next consideration is the research strategy. This is a systematic plan of finding the

information you need quickly and efficiently (Ouachita University, 2011).The strategy is to

obtain qualitative data via the use of an in depth structured interview. Qualitative data are

gathered primarily in the form of spoken or written language rather than in the form of

numbers (Polkinghorne, 2005). Structured interviews are interviews where interviewers

physically meet respondents and ask the questions face to face (Saunders et al, 2007, pg.

357). The use of such methods does involve possible weaknesses e.g. using a structured

interview can be contaminated by consultation or distorted by the interviewer (Saunders et

al, 2007, pg. 358).

However, a qualitative approach gives data that provide a deeper and more multifaceted

insight (Foss and Ellefsen, 2002) and can produce vast amounts of data e.g. verbatim

notes (Pope et al, 2000). A structured interview can use open and closed questions and

more complicated questions and assures that the respondents are whom one wants,

which improves reliability, (Saunders et al, 2007, pg. 357-359). The principal benefit will

be to provide “rich “data i.e. data referred to as rich, since it captures the richness of detail

and nuance of the phenomena being studied (Collis and Hussey, 2003, pg.57). This is

because the number of people to be interviewed will be relatively small, the aim being no

more than 7 people. This is the intended research sample. This does pose some possible

weaknesses e.g. the sample may be small and unrepresentative of the wider population

(Gratton and Jones, 2009, pg. 157). Nevertheless, there are a number of distinct benefits

of using a small number e.g. the purpose of qualitative research is to generate, “rich” data

from a small sample group, with many published studies interviewing fewer than 6

participants (Gratton and Jones, 2009, pg. 168). The data obtained will be highly detailed,

comprehensive and focused on the research issue. Despite its time consuming nature and

limited number of respondents, it will provide valuable information about the causes of the

crisis that are specific to them and relate to their own experience and involvement in it. In

summary, the method chosen will be a mono method i.e. adopting a single approach to

research (Leeds University, 2011).

Any research that is undertaken must be credible. As social researchers we have to

demonstrate that our interpretations and understandings are credible (Matthews and Ross,

2010, pg. 53). If the research is not credible then any findings analysis will have little value

quality. All research must be reliable and valid. Reliability has to do with how well you have

carried out your research project and validity with whether your methods, approaches and

techniques relate to or measure the issues you have been exploring (Blaxter et al 2006,

pg. 221). The interview ensures reliability and validity in that the questions focus on the

crisis, its causes and how the respondents were involved in or connected to it. They are all

working within the Financial Services industry and were directly involved or connected to

the crisis. The key point with validity is whether the interview is actually measuring what is

intended i.e. the causes of the crisis. The interview questions are geared to answer this

and the literature review has been used to inform the content of the questions. Thus

“adequate coverage” of the issues to be measured should be assured. This method is

referred to as content validity i.e. the extent to which the measurement device provides

coverage of the investigative questions (Blumberg et al, 2005). The focus for the literature

review has also been the crisis and its causes, whether direct of indirect.

An additional concern is the ethical considerations. Ethical issues are fundamental to

critical research and include a concern with research practices and critical awareness of

whose interest the research serves (Cassell and Symon, 2003, pg. 182). The research

sample should not experience any disadvantage or be embarrassed in any way. The

collection of the primary research will be based on a full range of ethical concerns that will

be rigorously applied. This will include issues such as: participation will be voluntary,

consent will be sought prior to the research commencing, the privacy of the participants

and confidentiality of the collected data will be a priority, the interviewer will behave

appropriately and be objective and participants will be informed of the research purpose

and its intended outcome.

For the primary research to be carried out a sample was needed, a sample is a subset of

the population that is selected for the study (SAS Institute, 1999). A sampling frame has

then to be constructed i.e. the specific data from which the sample is drawn, such as a

telephone book (CSULB, 2011). For this study the sampling frame would consist of all

those who work in the financial services industry. The number chosen to question is no

more than 7. However, they will be representative of those working in the industry and thus

will reflect the required range of opinions. Another consideration is the time required to

conduct the interview and this is an additional reason for a limited sample number. The

technique chosen was purposive i.e. individuals chosen by pre-determined criteria relevant

to the research question (Daymon and Holloway, 2001, pg. 273). The purposive strategy

will be homogeneous, the sampling focusing on one particular sub group in which all the

sample members are similar (Saunders et al, 2007, pg. 232). The benefits of a

homogeneous sample are fewer variables that may be predictive of the outcome under

study or confounding variables that might impact the results (Holzemer, 2010, pg. 88). The

individuals chosen were selected by contacts resulting from personal connection.

Research findings, Analysis and Interpretation

This chapter presents the results of the primary research together with analysis and

interpretation of those findings, in conjunction with the research conducted for the literature

review. The questionnaires for the primary research are in Appendix xxx.

The primary research consisted of 7 interviews with professionals from Financial Services

Industry. Their opinions were sought as to the principal causes of the crisis. A number of

common themes were given i.e. the increase in US household debt, the collapse of the

housing market, banks running low on capital, lack of regulation (particularly of derivatives)

and banking practices.

The justification for their views focused on the banks taking too many risks in dealing in

derivatives as they were complex and difficult to value, over lending to consumers

(particularly for house purchase), their pursuit of profits, the consequential impact of rising

interest rates on the housing market and the banks and the impact of this on the financial

markets i.e. unavailability of credit and liquidity drying up. These opinions are reinforced by

the literature review, in that the above resulted in the collapse of the housing market (Park,

2008), market liquidity drying up (Eichengreen, 2008), the consequence being the collapse

of major financial institutions (Goldestein, 2010).

The connection between the US sub prime crash and the UK banking collapse was to be

increasing interest rates. The importance of interest rates was noted by Gwinner and

Sanders (2008) i.e. as interest rates had risen, subprime defaults and foreclosures

increased.

The US ratings agencies were not considered to be responsible for the crisis but were

viewed as an important element and its transfer to the global scene. Reasons given

included the agencies not fully understanding the complexity of the products they were

valuing, giving too high a rating, the markets receiving a false view of this, investors putting

too much faith in them the agencies being too close to the buyers and sellers of the

products being rated. The view that they were an important element in the crisis is

supported by Samuelson (2009). In relation to investors putting too much faith in the

agencies, this was shown by Arewa (2010). The risks involved were also highlighted by

Arewa (2010). The complexity issue was discussed by Epstein (2009) in relation to CDO’s.

This was also confirmed by Das (2006, p.283). The important point raised concerning the

close relationship between the agencies and the market was highlighted by Pagano and

Volpin (2009) as a conflict of interest.

There was a consensual that banks in the US and UK were not effectively regulated. The

reasons given were the regulators having little knowledge of what the banks were doing

because of the complexity of the instruments, consequently allowing the banks to take too

many risks, the banks keeping one step ahead of the regulators (particularly the

investment parts of the banks). It was also felt that tighter regulation should have come in

earlier e.g. BASEL 2. This view of lax regulation is supported by Bardhan (2009) and by

Acharya and Schnabl (2010). The respondents believed that lax regulation was evident in

both the US and UK. In terms of the US this is endorsed by Catanach (2009) in discussing

the FSMA.

All agreed that BASEL 2 was an improvement on BASEL 1, in that it improves risk

management and capital requirements, although it took too long to negotiate and came in

too late. One respondent believed there was a need to separate investment banking from

commercial banking, which BASEL 2 does not do. The issue of BASEL 2 coming in too

late was evidenced by Benford and Nier, (2007). The view expressed of separating

investment and commercial banking is appropriate in light of the report by The

Independent Evaluation Office (2011).

All agreed as well that CDO’s and derivatives were connected to the credit crisis, in that

they were not properly regulated, too complex and difficult to value, banks became over

exposed to them, resulting in the contagion quickly spreading when the toxicity of the debt

became apparent. The growth of CDO’s was highlighted by Wainwright (2009) and Ertürk

and Özgür (2009) and dealing in such instruments as high risk by Crotty et al (2010) and

Foster et al (2010). Contagion was noted by Siebert (2001, p. 316) and Berger and

Bouwman (2009).

All considered the banking practices of the banks were too risky (e.g. higher loan to value

ratios, self certificated mortgages), lent too much (particularly to house buyers), were in

pursuit of profit and did not understand what they were buying (CDO’s). This attitude to risk

was reflected by Schwarzman (2008) when referring to sub prime mortgages. The

outcome of such practices was described by Brunnermeier (2009).

The respondents felt the banks adopted those practices in pursuit of profit and market

share and to provide shareholder returns. The reference to lending too much was noted by

Honohan (2008). In relation to house buyers, Watson (2008) indicated the large increase

in UK mortgage credit. Respondents also mentioned that because regulation was weak,

the bonus culture, freely available liquidity, low interest rates and ignoring affordability

occurred. In terms of the bonus culture, Priewe (2010) argued that short-term incentives

for bankers contributed to risk taking and speculative behaviour.

All said there attitude to risk had not changed since working in the sector and that they

were more aware or more knowledgeable of risk than before. Most said they were carried

along by the period leading up to the crisis in some way. Some suggested that it was due

to cheap credit and profit opportunities. Most respondents were affected by the crisis

although not directly involved in it. Some had seen work load increasing as their bank

adapted to the regulatory requirements, one had more business as an adviser as clients

wanted help to deal with the crisis. Three were negatively affected in losing money, had

difficulty obtaining credit or lost their job. These individual effects resulted from the

contraction suffered by the economy during the recession, as noted by Gilmore and King

(2010), (Gregg and Wadsworth, 2010) and (Elsby and Smith, 2010).

The response by the government was regarded by the respondents as fast, effective and

appropriate, providing credit to the system, taking over banks where necessary, setting up

the Compensation Scheme and stabilizing the system. As mentioned by Hawes (2010)

there was swift and extreme action by the UK monetary authorities. Guynn (2010) referred

to the rapid flow of government financial support. Some criticized the government for

allowing too lax a regulation and being more interested in bank profits generating tax

inflows.

All felt the Bank of England had responded well to the crisis, doing a good job via

Quantitative Easing (QE), keeping the credit markets liquid and helping to prevent a

serious recession. Even though they felt the Bank prevented a serious recession, it was

the most severe recession since World War II (Watcher, 2010). However, the significance

of QE was highlighted by Dale (2010).

On the basis of the preceding discussion it will now be possible to make the required

conclusions to the study, which follows in the next chapter.

Conclusion

This chapter brings together the results, discussion and analysis and makes summative

conclusive points, which attempt to answer the set objectives and study aim. It will also

critically evaluate the quality of the research findings and research process and suggest

opportunities for further research.

Study Aim and Objectives

The principal aim of this paper was to identify the causes of the credit crisis from two

perspectives. A supplementary aim was to come to a conclusion as to what caused the

crisis.

There were three specific but interrelated objectives to this study:

1. To identify and determine the root causes of the credit crisis.

2. To identify the views and opinions of individuals working in the Financial Services

industry.

3. To ascertain to what extent there is a correlation, if any, between the evaluated

findings of the literature review and primary research.

In the introduction the prime or root causes of the crisis were considered to be the USA

sub prime mortgage crisis, over expansion of credit and lending by banks, the practices of

the credit ratings agencies and the banks risky investment practices.

The literature review focussed on these possible causes, in addition to examining the

possibility of any ancillary causes. It was clear from the review that these were the prime

causes. It became evident in the review that the catalyst which initiated the crisis was the

rise in US interest rates. This in turn impacted on the sub prime borrowers, the financial

system and its liquidity, the banks and ultimately the economy, necessitating government

action. Throughout this process was the significance of the banks having dealt heavily in

risky financial instruments. The fall in their value resulted in major liquidity problems and

led to the contagion throughout the financial system. The literature review also revealed a

number of ancillary causes i.e. the lack of effective bank regulation, the timing of the

introduction of BASEL 2 and the operational culture of the banks.

The principal themes of the primary research were the increase in US household debt, the

collapse of the housing market, banks running low on capital, lack of regulation and

banking practices. The key transmission mechanism for the crisis was the rise in US

interest rates. The use of CDO’s was also considered to be very important. Supplementary

factors were believed the banks pursuit of profits and bonus culture, the US ratings

agencies (in contrast to the literature review) and the late introduction of BASEL 2. In

terms of the personal impact, some were affected personally by the crisis, some

negatively.

As a result of the above it is evident that there is a significant degree of correlation

between the findings of the literature review and primary research. Both highlighted the

same or overlapping causes. However, the literature review suggested the laxity of bank

regulation was an ancillary cause whereas in the primary research it was considered to be

a prime cause. In addition, the US ratings agencies was a prime cause in the literature

review but a less important factor in the primary research. Both agreed on the key

transmission mechanism i.e. the rise in US interest rates.

There was no one cause to the crisis, but a number of connected causes. What is clear is

the importance of the transmission mechanisms i.e. the rise in US interest rates and the

contagion caused by the banks dealing in risky financial instruments.

Quality of Research Findings and Research Process

The choice of research topic and evolution of the study focus was based on the fact that

there is little evidence, if any, of using the personal views of industrial professionals and

combining it with a traditional literature review. This unique two perspective approach

justifies the choice of the research topic. However, the crisis per se is a major area of

academic literature. This impacted on the time available to conduct the review. The aims

and objectives evolved as a consequence of conducting the research proposal and

beginning the research process for the study.

The literature review was extensive and ensured the information collected was reliable,

valid and objective and sufficient to provide support for the concluding points. The use of a

narrow primary research sample has implications for generalisability, although the aim was

to obtain, focussed, relevant and appropriate “rich” qualitative data. The data obtained was

sufficient to contrast and compare with the literature review and to reveal evidence of

correlation perspectives. Time would have been a limiting factor if a larger sample had

been chosen.

Overall, the quality of the research findings can be considered sound, reliable, valid and

objective. The issue of generalisability is influenced by the relatively small primary

research sample. Despite this, the significance of the wide literature review did underpin

the findings of the primary research, although there were some conflicts between the two.

Suggestions for further research would include wider studies, incorporating a larger

research sample, focused on the personal impacts of the crisis. In addition, studying why

the crisis did not impact on other countries or regions e.g. The Middle East and the related

significance of their use of the Islamic banking model.

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