1. Credit Crunch : Causes, Consequences & Solutions By Dr. Peter WHEALE

2. Major UK banks assets(a) Sources: BankScope published by Bureau van Dijk Electronic Publishing, published accounts and Bank calculations. (a) Excludes Nationwide due to lack of interim data. (b) IFRS break. (c) 2008 H1. WHAT IS THE PROBLEM? A shortage of money market liquidity Confidence in the global financial system is lower than at any time since the World War II Lack of credit availability to business and households is presaging a world-wide recession

3. Long-run capital levels for US commercial banks 1840–1993 Source: Berger, A, Herring, R and Szegö, G (1995), The role of capital in financial institutions, Journal of Banking and Finance, pages 393–430. (a) Equity as a percentage of assets (ratio of aggregate dollar value of bank book equity to aggregate dollar value of bank book assets). (b) National Banking Act 1863. (c) Creation of Federal Reserve 1914. (d) Creation of Federal Deposit Insurance Corporation 1933. (e) Implementation of Basel risk-based capital requirements 1990.

4. Sterling liquid assets relative to total asset holdings of UK banking sector(a) Source: Bank calculations. (a) 2008 data are as of end-August 2008. (b) Cash + Bank of England balances + money at call + eligible bills + UK gilts. (c) Proxied by: Bank of England balances + money at call + eligible bills. (d) Cash + Bank of England balances + eligible bills.

5. WHAT CAUSED THIS CRISIS? Asymmetry of currency exchange systems and balance of payments disequilibria The growth of the emerging economies, particularly the export-driven economy of China and the oil and gas-exporting countries, has resulted in their amassing huge current account surpluses and foreign currency reserves Whilst Western countries, particularly the USA and the EU, has burgeoning current account deficits and paucity of foreign reserves. A global credit boom, originating in the US, fed by cheap money, abundant credit and, in the West at least, cheap imports and low inflation, encouraged unsustainable leveraging of banks assets – including collateralised asset backed securities (CDOs) As a high proportion of foreign currency reserves are denominated in dollars the US dollar has been supported by being effectively the global reserve currency and enabled the US government to sustain external deficits and lax fiscal policies.

6. Major UK banks leverage ratio(a)(b) Sources: Published accounts and Bank calculations. (a)Leverage ratio defined as total assets divided by total equity excluding minority interest. (b)Excludes Nationwide due to lack of interim data.

7. Major UK banks customer funding gap,(a) household saving ratio and foreign interbank deposits(b) Sources: Bank of England, Dealogic, ONS, published accounts and Bank calculations. (a) Customer funding gap is customer lending less customer funding, where customer refers to all non-bank borrowers and depositors. (b) Data exclude Nationwide. (c) UK household savings as a percentage of post-tax income.

8. Martin Wolf (Wolf, 2008) sums up the global crisis simply as: The high income countries with elastic credit systems and households willing to take on rising debt levels offset the massive surplus savings in the rest of the world. The lax monetary policies facilitated this excess spending, while the housing bubble was the vehicle through which it worked.

9. Mark-to-market losses on selected financial assets(a)(b) OutstandingLosses: Apr.Losses: Oct. amounts2008 Report2008 Report United Kingdom (£ billions) Prime residential mortgage-backed securities1938.217.4 Non-conforming residential mortgage-backed securities392.27.7 Commercial mortgage-backed securities333.14.4 Investment-grade corporate bonds45046.286.5 High-yield corporate bonds153.06.6 Total62.7122.6 United States (US$ billions) Home equity loan asset-backed securities (ABS)(c)757255.0309.9 Home equity loan ABS collateralised debt obligations (CDOs)(c)(d)421236.0277.0 Commercial mortgage-backed securities70079.897.2 Collateralised loan obligations34012.246.2 Investment-grade corporate bonds3,30879.7600.1 High-yield corporate bonds69276.0246.8 Total738.81,577.3 Euro area ( billions) Residential mortgage-backed securities(e)38721.538.9 Commercial mortgage-backed securities(e)342.84.1 Collateralised loan obligations1036.822.8 Investment-grade corporate bonds5,324283.8642.9 High-yield corporate bonds17529.175.9 Total344.1784.6 Source: Bank calculations. (a) Estimated loss of market value since January 2007, except for US collateralised loan obligations which are losses since May 2007. (b) Data to close of business on 20 October 2008. (c) 2005 H1 to 2007 H2 vintages. The home equity loan asset class is comprised mainly of US sub-prime mortgages, but it also includes, for example, other mortgages with high loan to value ratios. Home equity loans are of lower credit quality than US Alt-A and prime residential mortgages. (d) High-grade and mezzanine ABS CDOs, excluding CDO-squareds. (e) Germany, Ireland, Italy, Netherlands, Portugal and Spain.

10. Major UK banks equity price dispersion and implied volatility(a)(b) Sources: Bloomberg and Bank calculations. (a) Data to close of business on 20 October 2008. (b) Data exclude Bradford & Bingley and Northern Rock.

11. Major UK banks and LCFIs credit default swap premia(a)(b) Sources: Markit Group Limited, Thomson Datastream, published accounts and Bank calculations. (a) Data to close of business on 20 October 2008. (b) Asset-weighted average five-year premia. (c) April 2008 Report.

12. Equity prices of distressed institutions(a ) Sources: Bloomberg and Bank calculations. (a) Data to close of business on 20 October 2008. (b) Fannie Mae and Freddie Mac taken into conservatorship. (c) Lehman Brothers Holdings files for Chapter 11 bankruptcy protection. (d) Benelux, Icelandic and UK governments nationalise or take stakes in banks. (e) UK authorities announce comprehensive package of measures.

13. Three-month interbank rates relative to expected policy rates(a)(b) Sources: Bloomberg and Bank calculations. (a) Spread of three-month Libor to three-month overnight indexed swap rates. (b) Data to close of business on 20 October 2008. (c) April 2008 Report. (d) Fannie Mae and Freddie Mac taken into conservatorship. (e) Lehman Brothers Holdings files for Chapter 11 bankruptcy protection.

14. Major UK banks equity prices, mortgage lending and wholesale funding dependency(a)(b) Sources: Bloomberg, published accounts and Bank calculations. (a) Data to close of business 20 October 2008. (b) The size of the circles is proportional to the extent of equity price falls since 2 July 2007. (c) Wholesale funding reliance equals debt securities in issue and interbank deposits as a proportion of debt securities in issue, interbank deposits, customer deposits and Tier 1 capital. (d) Wholesale funding dependence was calculated at end-June 2008

15. The UK mortgage market: key facts The British economy is known with strong cycles with direct effect on the housing market. In average the real house price rose by almost 2.5 per cent per year. From 1997 to 2007 house price increased by 156% while average income only rose by 35%. The ratio of household debt to income rose from 100% in 2001 to 160% in 2008. There is higher house price volatility in the UK than any other major EU economies, such as France and Germany. The UK has a high level of mortgage debt, 60% of GDP. The UK mortgage market is highly competitive and household spending is positively correlated to the level of interest rate. The rate of house ownership is high in the UK when compared to some of the EU major economies.

16. Credit crunch and the UK Mortgage Market Based on a study by the Royal Institute of Chartered Surveyors the UK housing market declined to the lowest level since 1992. IMF estimates that the average house price will fall by 20 to 25 percent by 2011. The number of mortgage products has declined steadily over 2008. Many mortgage holders with high loan to value or income ratio are facing financial difficulties due to the downturn in market conditions (i.e. inflation and unemployment). Default rate among mortgage holders is accelerating and may exceed government expectations due to global market turmoil. The market price of mortgage-backed securities has deteriorated and delinquencies in the housing market has mushroomed (IMF, 2008). The issuance of mortgage-backed securities fell substantially starting from 2007. The interbank spread is till high due to fear by banks over their exposure towards distressed mortgage-backed securities (IMF, 2008). Banks introduced tighter lending criteria and also increased their mortgage lending rates.

17. Average house price and percentage change across the UK, Quarter 3, 2008 Scotland Standard Price: £134,380 Quarterly Change: -2.1% Annual Change: -6.0% The North Standard Price: £138,063 Quarterly Change: -0.3% Annual Change: -9.3% Yorkshire and the Humber Standard Price: £128,591 Quarterly Change: -5.7% Annual Change: -14.2% The East Midlands Standard Price: £147,559 Quarterly Change: -4.5% Annual Change: -13.1% East Anglia Standard Price: £169,788 Quarterly Change: -8.3% Annual Change: -13.3% Greater London Standard Price: £269,723 Quarterly Change: -7.0% Annual Change: -16.5% The South East Standard Price: £233,086 Quarterly Change: --3.4% Annual Change: -12.2% The South West Standard Price: £185,691 Quarterly Change: --5.6% Annual Change: -12.9% Wales Standard Price: £139,267 Quarterly Change: --12.5% Annual Change: -16.6% The West Midlands Standard Price: £162,861 Quarterly Change: --5.7% Annual Change: -9.5% The North West Standard Price: £137,487 Quarterly Change: --7.1% Annual Change: -10.5% Northern Ireland Standard Price: £172,762 Quarterly Change: --4.2% Annual Change: -22.6% Source: Halifax, quarter 3, 2008

18. Average house price across the UK Jan 2008 to Aug 2008 NorthYorks &EastEasternGreaterSouth WestNorthN. EastHumberMid LondonEastWestMidWestEnglandWalesScotlandIrelandUK 2008Jan150,353167,039175,791238,333350,169277,972228,644179,199164,168228,804170,151162,801225,978221,130 Feb148,105163,555172,753237,245336,928273,453224,360179,648161,454224,464165,542162,013222,955217,089 Mar149,888161,270172,619237,097340,167274,493225,513177,011160,255224,668166,484163,687217,413217,344 Apr150,174164,643170,335237,197342,301275,835225,476175,493161,646225,419164,041166,511225,657218,264 May147,314162,370168,909235,792345,936270,314222,001174,158161,393223,818163,280165,641216,341216,625 Jun147,195164,552169,019232,126336,545270,262220,113174,002159,449221,763162,168167,577220,199215,029 Jul147,965161,798169,809235,616343,182271,677222,467177,474162,664224,207163,202167,220221,447217,171 Aug144,913160,991165,089228,498326,908265,761220,303174,342158,734218,281159,734164,307205,149211,410 Source: SML, 2008

19. Inflation in the UK Source: National Statistics, Sep 2008

20. UK Unemployment Source: National Statistics, http://www.statistics.gov.uk/cci/nugget.asp?id=12

21. Mortgages and Remortgages: Fixed Rate Lending Fixed NumberFixed % of loansFixed interest rate average 2007Jan 115,300705.27 Feb 111,700745.34 Mar 142,000765.43 Apr 123,700755.50 May 141,500765.55 Jun 149,400775.62 Jul 149,200775.71 Aug 148,200765.85 Sep 124,300725.99 Oct 125,700686.09 Nov 104,800656.11 Dec 78,500646.10 2008Jan 76,900566.01 Feb 66,700525.94 Mar 64,500545.86 Apr 80,600595.80 May 85,000665.82 Jun 83,500695.86 Jul 84,800645.96 Aug 67,200586.12 Source: SML, 2008

22. Mortgages and Remortgages: Discount Rate Lending Discounted NumberDiscounted % of loansDiscounted interest rate average 2007Jan 16,600105.53 Feb 11,80085.66 Mar 12,10065.66 Apr 9,90065.67 May 10,20055.77 Jun 9,90055.86 Jul 9,50055.98 Aug 10,80066.01 Sep 11,50075.98 Oct 14,60085.95 Nov 12,00076.03 Dec 9,10075.92 2008Jan 11,90095.85 Feb 14,300115.74 Mar 12,700115.70 Apr 12,90095.65 May 8,40075.66 Jun 5,60055.81 Jul 6,50055.96 Aug 8,60076.01 Source: SML, 2008

23. Mortgages and Remortgages: Tracker Rate Lending Trucker Number Tracker % of loans Tracker interest rate average 2007Jan 26,200165.51 Feb 21,500145.60 Mar 24,900135.61 Apr 22,800145.59 May 26,000145.75 Jun 26,800145.80 Jul 26,800145.99 Aug 28,500156.05 Sep 29,000176.06 Oct 35,100196.01 Nov 35,100226.02 Dec 29,900245.91 2008Jan 41,500305.85 Feb 42,100335.77 Mar 37,300315.79 Apr 37,700275.70 May 28,200225.67 Jun 25,600215.75 Jul 37,200285.87 Aug 36,500315.95 Source: SML, 2008

24. Mortgages and Remortgages: Capped Rate Lending Capped NumberCapped % of loansCapped interest rate average 2007Jan 1,10015.32 Feb 1,00015.56 Mar 80005.57 Apr 1,20015.66 May 1,50015.76 Jun 70005.83 Jul 1,20016.03 Aug 1,10016.12 Sep 70006.11 Oct 1,30016.11 Nov 1,10016.12 Dec 60005.98 2008Jan 1,30015.95 Feb 1,50015.81 Mar 70015.72 Apr 1,00015.79 May 1,10015.67 Jun 70015.78 Jul 40005.82 Aug 30005.85 Source: SML, 2008

25. Mortgages and Remortgages: Standard Variable Rate Lending SVRs numberSVRs % of loansSVRs interest rate average 2007Jan 5,20036.10 Feb 5,00036.13 Mar 6,20036.15 Apr 7,00046.09 May 7,50046.09 Jun 6,30036.28 Jul 6,50036.36 Aug 6,30036.50 Sep 5,80036.57 Oct 7,30046.45 Nov 7,40056.49 Dec 4,20036.76 2008Jan 4,50036.48 Feb 4,40036.43 Mar 3,60036.50 Apr 4,60036.31 May 6,00056.31 Jun 6,20056.45 Jul 4,00036.39 Aug 3,40036.38 Source: SML, 2008

26. Average Monthly Base Rate Versus Mortgages and Remortgages Monthly Average Interest Rate Mortgages and Remortgages Monthly Average Interest Rate Average Monthly Base Rate Source: Bank of England and CML

27. Number of Mortgages and Remortgages, Jan 2007 to Aug 2008 Source: CML, 2008

28. Mortgage market prospects weakening consumer demand and ongoing funding constraints will dampen monthly lending figures for the rest of this year and into the first quarter of 2009 (Michael Coogan, CML, 2008). Loans for house purchases remain subdued with first-time buyers under particular pressure," (Bob Pannell, CML, 2008)

29. WHAT IS TO BE DONE? Restoring confidence in the global financial system is the most important task. A co-ordinated effort by central banks and their respective governing bodies is required to stabilise the financial system by providing adequate liquidity for international trade and economic growth. The British government has guaranteed £250 billion of debt issues from banks, extended £104 billion to banks through long-term repo agreements (bank loans covered by collateral such as bonds) and provided over £200 billion through a three-year special liquidity scheme - already more than twice the market value of all the FTSE 350 banks put together ( Davies et al., 2008). World-wide, central and national banks provision of public money to underwrite and support the global financial system amount to more than £5,000 billion, about 15% of global GDP. The Federal Reserve Bank has become the de facto worlds central banks banker and in October extended its international currency swap lines to provide liquidity in amounts up to $30 billion each to Brazil, Mexico, Korea, and Singapore.

30. WHAT IS TO BE DONE? The EU has announced that it will participate in a joint financial rescue package with the IMF and the World Bank that will provide loan facilities totalling £25 billion to Hungary. In the coming months, almost certainly, yet more public funds will be needed before the crisis in the banking and financial services industry is resolved and the IMF has expressed its willingness to extend conditional credit to emerging market countries. Once this is achieved a global financial system of regulation and control needs to be put in place which precludes the systemic asymmetries and disequilibrium in world markets we have recently witnessed. Capital levels (which have been too low) need to rise; and capital needs to be of sufficient – banks need to reduce their leverage by at least one-sixth. Liquidity standards have been inadequate and should be strengthened to ensure that firms are sufficiently resilient to a range of shocks. The current UK legal framework for depositor protection and dealing with institutions in difficulties needs to be strengthened. International arrangements for managing crises at cross-border financial institutions should be developed further. Transparency should be improved through more informative disclosure, including the provision of more information on potential future balance sheet volatility, to strengthen market discipline. The scope for and potential benefits of developing centralised infrastructures for a broad array of over-the-counter instruments should be assessed.

31. Announced capital raising commitments from UK financial institutions(a) Current Institutions capital raising commitmentsNew Tier 1 Tier 1(£ billions):capital capital:(b)ratio following capital ratiocommonpreferenceotherdividendTotalraising (per cent)effect(per cent) Barclays9.13.63.01.52.010.1>11.0 HBOS8.68.53.00.00.011.5 12.0 HSBC8.80.75(f)0.00.00.00.75 8.8 Lloyds TSB8.64.51.00.00.05.512.1 Combined Lloyds TSB and HBOS13.04.00.00.017.0 Nationwide9.7 0.5 0.510.3 RBS(d)9.115.05.00.02.022.012.1– 13.1(i) Abbey/Circa 81.00.00.00.01.0Raised by Alliance & Leicester1.25 Total51.4 Sources: Press releases, published accounts and Bank calculations. (a) Table updated to 24 October 2008. (b) As at 2008 interim results. (c) Data on a pro forma basis. (d) No dividends to be paid on ordinary shares until preference shares have been repaid. (e) HSBC group Tier 1 ratio. (f) Injection from HSBC Holdings plc to UK subsidiary, HSBC Bank plc. (g) Calculated using 2008 interim results plus capital raising commitments. (h) Combined group would pay no dividends on ordinary shares until preference shares have been repaid. The combined group will have a core Tier 1 ratio in excess of 8.5% after the capital raising. (i) As at full year 2007 results. (j) Intention is for additional capital to be raised through normal market channels between 13 October 2008 and Nationwides financial year end. (k) Calculated using full year 2007 results plus capital raising commitments. (l) Three to four percentage points improvement. (m) Equity injection by Banco Santander. (n) Percentage points.

32. Illustrative adjustment path for customer lending to reduce customer funding gap to 2003 levels(a)(b) Sources: Dealogic, published accounts and Bank calculations. (a) Data excludes Nationwide and uses Abbey data rather than Banco Santander. (b) Assumes major UK banks customer deposit growth is equal to the average annual rate since 2005. (c) Assumes 20% of the required adjustment in customer lending growth occurs in the first year, 30% in the second year, and 50% in the third year.

33. Key actions to improve resilience Macroprudential tools are needed to guard against systemic risk and to ensure banks are in a stronger position ahead of the next downturn. Capital levels have been too low and need to rise; and capital needs to be of sufficient quality to deliver higher levels of resilience. Liquidity standards have been inadequate and should be strengthened to ensure that firms are sufficiently resilient to a range of shocks. The current UK legal framework for depositor protection and dealing with institutions in difficulties needs to be strengthened. International arrangements for managing crises at cross-border financial institutions should be developed further. Transparency should be improved through more informative disclosure, including the provision of more information on potential future balance sheet volatility, to strengthen market discipline. The scope for and potential benefits of developing centralised infrastructures for a broad array of over-the-counter instruments should be assessed.