UK Interest Rates During the Financial

Crash
2027 words (8 pages) Essay in Banking

07/05/18

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Central banks always have responsibility to keep a stable economy which includes stable
prices, low inflation rate and confidence in the local economy. The main tool used by
central banks for these propose is monetary policy which will influence the interest rate,
and the way of conduct it varies from country to country. This essay will look into the Bank
of England and explain the transmission of monetary policy and how the policy affected by
the credit crunch.

The Bank of England gained its independent right to set up interest rate according to the
target inflation rate since May 1997. The preferred target inflation rate in the United
Kingdom is 2% and the Bank of England sets appropriate interest rate to ensure the real
inflation rate is moving towards the target inflation rate in an acceptable time period.
However, the fixed target inflation rate does not necessary mean a constant interest rate. An
Overview of the change of interest rate in UK banks from 1973 to 2009, from which a
fluctuate trend could be observed among the whole period and there was a sharply decrease
from nearly 15% to 5% during 1989 to 1993 when the United Kingdom was experiencing
an economy recession. After 1993, the interest rate was relatively stable until 2008.
However, between 2008 and 2009 the interest rate deeply drops from 5.25% to 0.5% for the
recent credit crunch. From the data from the Bank of England’s report, the interest rate
decreased at a rate of 1% per month constantly from October 2008 to January 2009 after the
Lehman Brother’s bankrupt.

It is well known that a low interest rate represents a loose monetary policy which is aim to
increase the inflation rate and the economy. It may illustrate how the interest rate set by the
Bank of England conduct the monetary policy. The official rate set by the Bank of England
direct influence the market rates includes the repo rate, bond rate, inner bank borrowing
rate and so on. Then the market rate sets the asset prices in the financial market which will
in turn affects people’s expectations of the economy. Also, the official rates would give
people the signal about how will the market moves. For instance, a decrease in official rate
will shows a loose monetary policy to the public and people would expect a rise in the price
level and then may increase their domestic consuming demand. In addition, the official rate
change will affect the exchange rate directly for it alters the domestic investment
rate.(Mishkin, 2006).

At the second stage, the official rate indirectly affects the domestic demand and net external
demand, which forms the total demand, via the market rates, asset prices, expectations and
exchange rate. Then the total demand influences the domestic inflation rate. Finally, the
domestic inflation and import prices decide the inflation. For example, as mentioned above,
a decrease interest rate will increase the public’s domestic demand and also would decrease
the exchange rate against foreign currencies which may consequently increase the export
demand for the goods will be cheaper for foreign consumers. As a result, the total demand
will increase and may eventually raise the price level and lead to an increase in inflation
rate.

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Timing effect is another factor that the Bank of England concerns for the monetary policy.
That is to say, the effects of changing interest rate are not instantly but take time to fully
function. Some channels may be more sensitive to the change while others may not. The
Bank of England estimates that a monetary policy may takes up to 2 years to be fully
influence the inflation rate. The past statistic data supports this view that the inflation rate
was nearly 2.3% in 2007 and increased to 2.9% in March 2009 during which period a sharp
decrease in interest rate could be observed.

The reason for this sharp decline of interest rate from 2008 to 2009 is mainly accounts for
the credit crunch recently. The credit crunch shows a strong shortage in capital supply and
declining quality of borrowers’ financial health (Mizen, 2008). Also, the credit crunch
gives very bad expectation to the public about the economy and the price of real estate was
declining relatively. Consequently, investors are lack of motivation to invest for the low
earnings due to the declining prices and a high risk for the credit crunch. On the other hand,
for the householders may feel less wealth for the decreasing prices and lack of sense of the
financial safety, they may reduce the consuming and prefer to deposit in the bank. Both
phenomena are not preferable for a growing economy in that the Bank of England cut the
rate sharply to increase the supply of capital and wish to encourage the amount of invest
and consume to cease the recession. In fact, the GDP growth rate from 2008 to 2009 was
only 0.7% and the growth rate from 2007 to 2008 was 3% (Fedec, 2009). The growth in the
first quarter in 2009 was even worse, which was 4.1%, that may be the reason for the Bank
of England cuts the rate to 0.5%, which was only one tenth compared to the same time last
year. As the data shows the inflation rate rose in response to the loose monetary police, the
GDP growth rate may not be very optimistic for the pessimistic among the public.

References:
Bank of England, 2008 “How Monetary Policy Works”, Bank of England,
http://www.bankofengland.co.uk/monetarypolicy/how.htm

Bank of England, 2009 “Base Rate”, Bank of England,

http://www.bankofengland.co.uk/statistics/rates/baserate.pdf

Bank of England, 2008 “Monetary Policy Framework”, Bank of England,

http://www.bankofengland.co.uk/monetarypolicy/framework.htm

Fedec A,2009, “No End Yet to British Resession”, TradingEconomics,

http://www.tradingeconomics.com/Economics/GDP Growth.aspx?Symbol=GBP

Mizen P, 2008, “The Credit Crunch of 2007 2008: A Discussion of the Back ground,
Market Reactions, and Policy Responses”, Federal Reserve Bank of St. Louis Review,
90(5). pp.531 67
Mishkin, F.S., Eakins, S.G. 2006, Financial Markets and Institutions, Fifth Edition, Pearson
International Edition, pp. 219 244.
RateInflation, “UK Historic Inflation Rate”, RateInflation
http://www.rateinflation.com/inflation rate/uk historical inflation rate.php?form=ukir

Part B

Securitization started from 1970s firstly in the US market and then also trivial in the Europe
after the new rules was adopted. It is welcomed by most banks because it brings additional
way for banks making profits and it is an off balance sheet activity. However, due to variety
risks associated with securitization and the endless re securitization, it may lead to sever
financial crises. In fact, this would be the main reason for the Northern Crisis and the recent
credit crunch (Mizen, 2008). This essay will first introduce the process of securitization
then explain the risks in the process with a special focus on mortgage backed securitization
and discuss its effects in the credit crunch.

The definition of securitization is quite straightforward: it is “the process of pooling and

repackaging loans into securities that are then sold to investors” (Ergungor, 2003). There
are many assets would be securitized such as: mortgages, home equity loans, manufactured
housing loans, credit card receivables and so on. By securitization, banks are able to sell
those illiquidity assets to different investors. Besides, banks would create derivates by
pooling assets together. There are variety types of securitization depending on the backed
asset or payment method. For instance, the most popular type of securitization is Mortgage
Backed Securitization (MBS), and there are Asset Backed Securitization (ABS), and
Collateralized Debt Obligation (CDO).

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Basically, the progress of mortgage backed securitization creates a mortgage pool and the
agency sells shares of the pool to different investors according to their preferences. Then
the cash flows from the mortgage passed along to investors (Van, 1998). Agencies usually
pooled together mortgage and divide those payments into several parts and develop
different cash flows to create different type of securities which may have different maturity
or yields, and sell them to investors with different risk attitude. The total sum of cash parts
will be equal to the whole.

The progress of securitization brings considerable benefits to banks. First of all, as banks
are regulated to meet the minimal capital requirement which may reduce profits banks
would earn. As a result banks may prefer to engage in securitization which is off balance
sheet so that do not require banks to meet the capital requirement and gives a more
attractive opportunity for banks earning. On the other side, investors prefer less risky and
higher return which could be fulfilled by buying the debts through securitization. It is less
risky for it is backed by mortgage and has a higher rate than deposit. Besides, as the Great
Depression and bank fails not very long before, investors no longer consider deposit in the
bank as a safe heaven (Ergungor, 2003).

In this procedure, agencies do not really have cost except transaction costs which will be
induced from investors. In addition, if another investor buys a share, he may also securitize
it and sell it to others. In that way, one mortgage would be re securitized many times.
Consequently, if one mortgage fails to repay, many securities may face the risk of default
which to some extend enlarge the risk to the whole financial system. In contrast to default
risk, agencies also face repayment risk in the process. To be more specific, for example, if
the borrower expects the interest rate would fall then he may repay the debt early to
refinance in a lower cost, meanwhile, agency are suppose to produce constant repayment
periodically to investors who buy the MBS. As a result, the agency have to reinvest the
amount of money repaid early by borrowers and which forces them engage in a
reinvestment risk in case the interest rate may fall.

Mizen(2008) points out that the credit crunch started from 2007 is very complicated for
now there are many financial innovations giving ways to packaging and reselling assets.
Then he argues that the main reason for these financial crises is mispricing risk of the
products which are mortgage backed securities. Historical events show that the beginning
of this credit crunch was a serial of mortgage defaults. Then these defaults bring
downgraded subprime related mortgage products which then lead to countrywide mortgage
bank losses in the U.S. However, this trend did not stop; it soon spread to European banks
which have tight relationship to the U.S. financial markets. It is acknowledged that the
Credit crunch of 2007 2008 develops after this the full scale (Mizen, 2008).

The amount in billions of dollars of household credit market debt outstanding from 1950 to
2009. It could be seen that the trend of growing was much shaper after 2000 and peaked in
2009 when the approximately $11 trillion is mortgage debt (Bubbles, 2008). It is not hard
to imagine that 1% of the total amount of mortgage debt was securitized and only 1% of the
securitized debt was re securitized when some of them default, how great the amount of
dollars would be involved in. That was what happened in the Credit Crunch, for a trivial
subprime mortgage market, financial institutions are tied in a line and the re securitization
strength this tie and increase the risk and the price of default. Once one default, the whole
will suffer, the globalization also enlarges the scale that will suffer.

References:

Bubble H,2008, “A Decade of Slow Growth: Why the United States will Face a Decade of
Economic Stagnation and Face a L Shaped Recession. 10 Charts and Pictures as to Why
This will Occur.”, http://www.doctorhousingbubble.com/a decade of slow growth why the
united states will face a decade of economic stagnation and face a l shaped recession 10
charts and pictures as to why this will occur/

Ergungor E,2003, “Securitization”, Federal Reserve Bank of Cleveland, August 15, 2008

Mizen P, 2008, “The Credit Crunch of 2007 2008: A Discussion of the Back ground,
Market Reactions, and Policy Responses”, Federal Reserve Bank of St. Louis Review,
90(5). pp.531 67

Van H, James C (1998), Financial Market Rates and Flows, Chapter 13, PP 119. Prentice
Hall