{"id":45676,"date":"2020-11-10T13:43:53","date_gmt":"2020-11-10T13:43:53","guid":{"rendered":"https:\/\/essays.homeworkacetutors.com\/2020\/11\/mergers-and-acquisitions-in-the-context-of-global-credit-crisis\/"},"modified":"2020-11-10T13:43:53","modified_gmt":"2020-11-10T13:43:53","slug":"mergers-and-acquisitions-in-the-context-of-global-credit-crisis","status":"publish","type":"post","link":"https:\/\/www.colapapers.com\/us\/mergers-and-acquisitions-in-the-context-of-global-credit-crisis\/","title":{"rendered":"Mergers and Acquisitions in the Context of Global Credit Crisis"},"content":{"rendered":"
\n

Introduction <\/h2>\n

Financial crisis is a bubble created by excessive investor inclination
\ntowards a particular market. It shadows the valuations and when the bubble
\nbursts, the investors want to exit and therefore rapidly start selling their
\nstake.<\/p>\n

Too much of capital led to lower interest rates and this in return
\nforced the investors to look for creative investment platforms where the yield
\nwas high. This requirement led to an unprecedented growth in the securitization
\nmarket as the inclination towards such derivative instruments was high.
\nInvestors were willing to take higher risks as compared to the returns they
\nwould receive for their investments. Greed for higher returns, excessive
\nleverage and low volatility led to the financial crisis of 2008. This low
\nvolatility which was a result of shadowed valuations led the borrowers to
\nborrow over and above what their asset base allowed notwithstanding the
\ncriteria of credibility.<\/p>\n

However, prior to the crisis there was a strong merger wave that took over the world financial markets<\/a>. In the wake of the strong and sustained economic growth, high corporate profits and competition; the M&A activity thrived. But soon this wave came to an end due to the skepticism of the corporate managers about the instruments of structured finance. This wave was classified by a cash sub set and excessive cash reserves of the bidder destroyed the value for the target. During this period the valuation diversity between the target and the bidder was less. In the backdrop of relaxed regulatory regime the decisions that were taken were more rational.[1]<\/a> <\/p>\n

The desire to seek higher returns while diversifying risks had led to
\nthe crisis which further led to consolidation in the banking sector as a means
\nto combat the effects of negative synergies that the crisis had entailed. Merger
\nseemed a viable option[2]<\/a> as
\nthe government players and the robust banks with better credit and equity
\npositions directed their efforts towards smaller deals with acquisitive
\nadvantages. This included targets with weak credit and equity standing. Though
\neffect of the crisis that originated in the US housing market did not reach the
\nbanking sector till 2009.<\/p>\n

Despite high leverage in the market, there was fear looming over the
\nEurope which held back the buyout activity. There was freezing of credit and
\nbanking panic that slammed leverage loans. The wall of refinancing was knocked
\ndown as there was a dearth of new buyers for these collateralized loans. [3]<\/a><\/p>\n

There is a vicious cycle that engulfs the global financial markets. It
\nconstitutes deleveraging of the assets, price decline and investor redemption
\nthat makes the financial markets uncertain and volatile. Crisis of 2008 saw a
\ndecline in the commodity, oil and equity price. Simultaneously, a collapse of
\nthe housing mortgage market made things worse. The residential mortgages were
\nbundled and sold off as securities in the form of bonds and collateralized debt
\nobligations. A lot of foreign banks bought these securities. <\/p>\n

So when the payers in the US housing mortgage<\/a> market defaulted, these buyers were affected in their respective home markets. US banks lost money and this gave rise to a liquidity crunch; the receivables from the mortgage loans were stopped as a result of which the return on securities and CDOs were affected. [4]<\/a><\/p>\n

In response to the prevailing conditions there were regulatory reforms
\nthat the financial markets were resorting to. US introduced Dodd-Frank Wall
\nStreet Act and Consumer Protection Act. A G20 summit called for Basel III
\nreforms which were however, introduced in 2010 but member states were given
\ntime to incorporate these in their domestic system. In UK about 80 new
\nlegislations were made in order to incorporate preventive measures into the
\nexisting regulatory framework as well as to remove the inadequacies of the
\nsame. [5]<\/a><\/p>\n

In this essay, we shall be evaluating the regulatory reforms that were
\nintroduced post crisis and its contribution towards the recovery of the financial
\nmarkets. We shall also analyze the following thesis question: \u201cAre the risks
\ninherent in the financial markets or is it possible to regulate these risks and
\nprovide for safer financial markets?\u201d. The first section of this essay shall
\nenumerate the reasons behind the financial crisis and its impact on the global
\nfinancial markets. In the second section we shall study EU\u2019s regulatory and
\nsupervisory response to the crisis and its internationally cooperative
\ncontribution in the G20 meetings. Also in this section we shall focus on the
\nbanking & financial sector in UK. We shall highlight similar changes that
\nwere made to the US regulatory framework. However, section 3 of this essay
\nshall talk about consolidation of the banking sector as a measure to reduce the
\neffect of crisis and the role of the government in this post crisis merger wave.
\nSection 4 shall be attributed to the findings and analysis. <\/p>\n

Reasons behind the Financial Crisis of 2008 <\/h2>\n

1. Low Volatility and High Leverage:<\/h3>\n

Low volatility means that the risk is low as the value of the security
\ndoes not fluctuate dramatically but, changes at a steady pace. And thereby
\nthere is more capital available at a lower asset base. This leverage fueled the
\nrising housing market in the US. A lot of savings turned into investments as
\nlower risks were reflected at the existing volatility rates. \u00a0Thus, the lower interest rates remained low
\nfor a considerably longer duration due to the inability of the Federal reserve
\nto raise the interest rate amidst such financial conditions. [6]<\/a><\/p>\n

Tracing the beginning of the problem, let us study the role of Fannie
\nMae and Freddie Mac in the US Housing sector. <\/p>\n

\u201cFannie
\nMae\u2019s and Freddie Mac\u2019s public purpose is to facilitate the steady flow of
\nlow-cost mortgage funds[7]<\/a>.
\nTheir primary focus is on residential mortgage market and they won\u2019t abandon it
\nor change lines. Their charter states that the mortgages that they purchase and guarantee
\nmust be below an amount specified by the\u00a0Office of Federal Housing
\nEnterprise Oversight\u00a0(OFHEO). Also, they are barred from entering the business of
\nother housing finance companies e.g. mortgage origination. They must meet
\nannual goals established by the Department of Housing and Urban Development
\n(HUD). These goals center around low and moderate income housing and housing
\nfor minorities. They are subject to risk-based and minimum capital requirements
\nand annual examinations by OFHEO. Fannie Mae and Freddie Mac
\nare driven by profits, as their shareholders demand. While fulfilling their
\npublic mission, they make their profit in two primary ways:\u00a0guarantee
\nfee\u00a0income and retained portfolios.\u201d[8]<\/a><\/p>\n

\u201cFannie
\nMae and Freddie Mac are regulated by the OFHEO (Office of Federal Housing
\nEnterprise Oversight) and the HUD (Department of Housing and Urban Development (HUD). OFHEO regulates the financial safety and soundness of Fannie Mae and
\nFreddie Mac, including implementing, enforcing and monitoring their capital
\nstandards and limiting the size of their retained portfolios. OFHEO also sets
\nthe annual\u00a0confirming loan\u00a0limits. HUD has responsibility for the
\nhousing mission of Fannie Mae and Freddie Mac.\u201d[9]<\/a><\/p>\n

\u201cThere is no doubt that Fannie Mae and
\nFreddie Mac played a critical role in US housing finance system. However, there
\nwas a danger in having so much risk concentrated in only two companies. They
\nmanaged an immense amount of\u00a0credit\u00a0and\u00a0interest rate risk. Many
\ncritics feel that, due to their size and the complexity of managing mortgage
\nrisk, they posed too large of a\u00a0systematic risk\u00a0to the US economy.
\nPut simply, there was a danger that the two companies have been allowed to take
\non too much risk at the potential expense of the American tax payer. To put
\nthings in perspective, according to Treasury Secretary Steel, at the end of
\n2006, Fannie Mae and Freddie Mac had about $4.3 trillion of mortgage credit
\nexposure, which was about 40% of total outstanding mortgage debt in the U.S. In the summer of 2007, the
\nmarket for all mortgages except those guaranteed by Fannie Mae and Freddie Mac
\ncame to a complete standstill, emphasizing the importance of the roles played
\nby the two companies. In the fall of 2007, Freddie Mac shocked the market by
\nannouncing large credit-related loses, fueling the fire for the argument that
\nthe two companies pose a tremendous risk to the entire financial system the
\nimpact of which could be seen worldwide.\u201d[10]<\/a><\/p>\n

2. Financial innovation
\nduring the period in question: <\/h3>\n

This housing bubble of the mortgage market became
\na part of a more attractive system of securitization.[11]<\/a>
\nThe mortgages tendered to the consumers purchasing houses were pooled together
\nand sold off as tradeable assets. Due to low volatility the underlying risk was
\nignored. After reaching the peak, the market saw a decline and this affected
\nthe securities backed by these mortgages. Due to consumer default and excessive
\nmortgage, the mortgage market faced a slump and house prices fell. This raised
\ninvestor panic. <\/p>\n

Although, the conditions preceding the crisis
\nwhich are characterized by high risk appetite, high leverage and low volatility
\nsignificantly contributed towards the development of structured finance[12]<\/a>
\nwithin the capital markets, it was also one of the main reasons behind the
\ncrisis. The global interconnectedness and the wrongful risk assessment of these
\ninnovative financial structures led to the disruption in the financial markets.\n<\/p>\n

\u201cThe assignment of receivables has
\ntraditionally represented a means for trading companies and finance houses to
\nraise funds readily and to predict the cash-flow with some degree of certainty
\nand independently from debtors\u2019 defaults.[13]<\/a>
\nThis was conventionally achieved through factoring agreements whereby a factor
\nwould purchase receivables for a discounted sum or for a periodic commission,
\nproviding thereby necessary funds for the assignor to continue trading without
\nhaving to rely on receivables to be serviced.[14]<\/a>
\nIn its essence securitization developed as a more sophisticated form of
\nfactoring, one of the main developments being that assets are sold to a special
\npurpose vehicle (SPV) that funds the operation by issuing bonds on the capital
\nmarket, secured on the receivables.\u201d This fairly linear process started to be
\nmore extensively employed in the US housing market in the 1970s, when two
\ngovernment-sponsored agencies\u2014\u201dFannie Mae\u201d and \u201cFreddie
\nMac\u201d began acquiring home mortgages from lending institutions and issuing
\nsecurities backed by pools of those mortgages. Subsequently investment banks as
\nwell embraced this financing model, and set up trading departments to
\nspecifically handle these securities. When banks then entered the securitization
\nmarket for their home loans new frontiers opened up, with wider classes of
\nassets being involved in the transaction and a broader category of originators
\nparticipating in the market.[15]<\/a>
\nAlthough the vehicle is sponsored by the originating company, it qualifies for
\nthe purpose of the transaction as an independent company and not as
\noriginator\u2019s subsidiary.[16]<\/a>
\nThe SPV is anyway likely to be an almost non-substantive shell entity, whose
\nonly function is to raise money through the bond issue; complementary
\nfunctions, in particular the servicing one, are mostly still carried out by the
\noriginator that will maintain existing relationships with borrowers.[17]<\/a>
\nThis risk mainly affects US courts, where assets and liabilities of an entity
\naffiliated to the insolvent one can be merged to create a single common estate
\nfor the benefit of creditors.[18]<\/a> \u201cIf
\nthe sale was to be legally characterized as a security the assets would remain
\non the originator\u2019s balance sheet, as well as their underlying liabilities,
\nhampering therefore the function of the transaction. [19]<\/a>
\nSecurities issued by the SPV are then rated by credit rating agencies, and at
\nthis stage of the transaction bonds receive a higher rating than would
\notherwise be obtained by the originator directly through a bond issue, chiefly
\nbecause of the insulation of the former from the originator\u2019s assets and
\nbusiness.\u201d[20]<\/a><\/p>\n

Over the last two decades securitization has
\nblossomed, both among financial institutions that could obviate the maturity
\nmismatch intrinsic to the lending business (especially in the context of
\nmortgages) and also bypass capital adequacy requirements, and among
\ncorporations and government agencies wanting to get most of the profits of a
\ncertain cash-flow up front. To fully appreciate the advantages of securitization,
\nhowever, an initial examination needs to look at the regulatory incentives
\nprovided by the first enactment of the Basel Accord of 1988.[21]<\/a>
\nThe Accord and the ensuing harmonized capital regulation provided the major
\nincentive for the development of the \u201coriginate-and-distribute\u201d model.[22]<\/a><\/p>\n

The way in which loans and other assets
\nweighted on balance sheets became critical in the way banks started to manage
\nrisk accumulation by separating this process from that of credit origination,
\nand by intensifying balance sheet management. This new model allowed banks to
\nlend to a wider pool of borrowers without necessarily having to hold those
\nloans to term on their balance sheets. Loans became the subject of negotiations
\namong banks and other financial institutions, such as investment funds, which
\nwere all keen to get involved in the debt finance market where they could
\noriginate loans, sell the relating risks to a wide range of investors and thus
\nremain insulated from potential defaults. The legal mechanisms through which
\nthis twofold purpose could be achieved\u2014namely the compliance with capital
\nrequirements and the risk-shifting off-balance sheet\u2014can be identified with securitization
\ntechnique.[23]<\/a>
\nWhile improving its financial ratio, originators can also improve the return on
\ncapital because they have removed assets and liabilities from their balance
\nsheet while still retaining relating profits.[24]<\/a>
\nFrom a strategic perspective, securitization provides originators with a
\ncorporate finance tool that liberates them from the tight terms of general loan
\nagreements employed by most banks. This is for the simple reason that the
\nbargaining power of investors purchasing bonds is much less constraining than that
\nof a dominant bank that is in a position to negotiate and enforce restrictive
\ncovenants. [25]<\/a><\/p>\n

The off-balance sheet structure can
\npotentially lead to the more problematic issue of the originator\u2019s disincentive
\nto monitor the quality of the receivables it originates, since they become the
\nproperty\u2014as well as the burden\u2014of some other entity further down the
\ntransaction chain. It is worth observing that during the years prior to the
\ncrisis this became particularly evident as demand for securitized products increased
\ndramatically, leading originators and CRAs to conduct little due diligence on
\nunderlying assets, and overall the exuberance that permeated the economic
\nenvironment led to a decline in the level of transparency of transactions, as
\nwell as in their supervision.[26]<\/a><\/p>\n

\u201cMoving to collateralized securities, such
\nas, for instance, residential mortgage-backed securities, which are subject of
\na securitization, so representing in essence a securitization of securitization.
\nCDSs can be more closely associated with derivatives and can be defined as a
\ntype of protection against default, whereby the seller of a CDS agrees to pay
\nthe buyer if a credit event occurs, and the buyer agrees to pay a stream of
\npayments equivalent to the payments that would be made by the borrower. Since
\nthe seller of the CDS receives payments that resemble a loan, the CDS can be
\nregarded as a form of synthetic loan, and a mechanism to acquire credit risk of
\nan unrelated party. Arguably, the over-exposure to these products in the broad
\ncontext of the global crisis is what triggered the downfall of the insurance
\ngiant AIG.\u201d [27]<\/a><\/p>\n

3. Role of Credit Rating
\nAgencies (CRAs): <\/h3>\n

Credit rating agencies rate not only
\ninstitutions but also credit instruments and securities. It is mainly about the
\nconcept of investment grade[28]<\/a> \u2013
\na rating given by these agencies keeping in mind a certain threshold. The CRAs
\nhold the view that these ratings are not for the purpose of triggering the
\ndecision whether or not to invest in a security but they give relative
\ninformation about the credit worthiness of an institution. CRAs are exempt from
\ncivil liability for their core activity and their financial duty of care as
\nsuch does not exist. [29]<\/a><\/p>\n

In US there was a system of nationally
\nrecognized CRAs called NRSRO[30]<\/a> i.e.
\nNationally Recognized Statistical Rating Organizations. This status gave CRAs
\nan unparalleled reputation and investor confidence. There was a privileged
\nmarket position for CRAs with this status. Apart from rating institutions and
\nsecurities CRAs were also caught in a web of ancillary services[31]<\/a> where
\nthe anticipatory expectations of the enterprises affected the quality of
\ninformation that reached these CRAs which inhibited the ratings. Official
\nrecognition has more cons than pros. For instance, the status of NRSRO given to
\nCRAs in US led to over \u2013 reliance on their assessments as they were implicitly
\ntaken to be backed by government that would indemnify any losses generated from
\nwrong credit ratings. It also inhibits new entries in the field and thereby
\nhampers innovation of assessment methodologies and new technology from coming
\nin .[32]<\/a><\/p>\n

CRAs were insufficiently equipped in both
\nqualitative and quantitative terms. They had no rules of procedure to follow
\nfor assessment of RMBS and CDOs.[33]<\/a>
\nThe activities of the CRAs were non- transparent and their credit ratings were
\nheavily relied upon by the investors specially with regards to investments in
\nsecuritized instruments and collateral debt obligations. Also, CRAs did not do
\nsignificant research about the underlying assets in RMBS and CDOs. For
\ninstance, certain loans underlying RMBS had no documentation. [34]<\/a><\/p>\n

Considering the Enron scandal that raised
\nconcerns, let us understand what exactly happened. Enron was a company in the
\nenergy sector that generally received good ratings from CRAs. However,
\neventually it ended up filing for insolvency. Prior to this step the company
\nwas in talks with Dynegy Inc. regarding a merger. Enron wrote down assets worth
\nUS $ 2.2 billion and though there was a further write down of USD 500 million,
\nthe CRAs ignored this at the behest of Enron that talks of merger are in
\nprocess and improvement in the financial condition of Enron was assured. As
\nthings unfolded it became clear that Enron could not survive without a merger
\nand a balanced merger agreement seemed a far-fetched idea as Dynegy had backed
\noff. Seeing this the CRAs were adamant at reducing the ratings of Enron from
\ninvestment grade to a notch above junk. Post filing of insolvency by Enron
\nthese ratings went into negative. [35]<\/a>This
\nshows that credit rating agencies were lax in dealing with the information
\navailable to them. They had detailed information about the financial position
\nof the companies but they just restricted its use. Like in the case of Enron
\noff balance sheet inquiries were ignored and only cash flow was assessed.[36]<\/a><\/p>\n

Regulatory Reforms Post Crisis <\/h2>\n

In EU the crisis was able to takeover mainly
\ndue to the inherent regulatory and supervisory flaws in its system. However, the
\ncrisis that originated in US had spread its terror in EU as well. The
\ninterconnection of global financial markets had played its role. It was evident
\nfrom the need for nationalization of Northern bank. <\/p>\n

Northern bank had to be nationalized to stop the upsurge on
\nthe road. In the wee hours of the morning people lined up at various branches
\nof the bank. The investors and depositors wanted to withdraw their money from
\nthe bank. The bank was based on the warehousing model and was heavily relying
\non securitization as a means of generating liquidity for its loan generation.
\nIt was under a compulsion to issue bonds every three months and in September
\n2007 when the crisis began to show its colors, an installment of bonds had to
\nbe issued by Northern bank. This was because most of its lending was financed
\nby mortgages that it bundled into such securities. So, once the US housing
\nmortgage market failed, the international buyers of these bonds grew skeptical
\nand ran to withdraw support. They were not ready to finance the model on which
\nNorthern bank was generating capital for its loans. Northern bank had no
\nalternate source of funding. Hence, government was left with no other option
\nthan plumbing liquid into the financial markets and guaranteeing the deposits
\nof Northern bank. This provided short term relief but could not stop the
\ncollapse of the banking sector in UK.[37]<\/a> The
\nbanks failed to assess the underlying risks associated with the
\ninter-relationship of the markets and did not imagine the derivative
\ninstruments suffering at the hands of the skeptical investors. <\/p>\n

Need was felt for a coordinated action to the crisis and
\nthus, certain short term and long term measures were taken by EU. One such
\nmeasure was introduction of European Economic Recovery Plan (EERP). The
\nobjective of EERP is to limit the negative consequences of the crisis by
\ninjecting capital to stimulate demand and purchasing power in the short term
\nwhile increasing the competitiveness in the long run. [38]<\/a>
\nThis fiscal stimulus accounts for 5% of the EU GDP.[39]<\/a>
\nLong term measure included the establishment of European System of Financial
\nSupervision (ESFS). This was mainly established in 2010 to bridge the gap in
\ninstitutional framework. It comprises of European Systemic Risk Board (ESRB)
\nand European Supervisory Authority ( ESA).[40]<\/a>
\nThe former would focus on macro prudential supervision while the latter on the
\nmicro prudential supervision. The primary role of ESA is to codify the EU rule
\nbook and draft technical standards that can be adopted as EU law.[41]<\/a>
\nThe decision of the ESA would be legally binding on the national supervisory
\nauthorities and firms.[42]<\/a><\/p>\n

Another important step that was taken was revision of the
\nCapital requirement directive (CRD) to incorporate Basel II in EU law.[43]<\/a>
\nBasel II increased the capital adequacy requirements. Basel accords are a
\nseries of recommendations on banking laws and regulations issued by Basel
\nCommittee on Banking Supervision.[44]<\/a>
\nHowever, the financial crisis intervened and Basel III was adopted. \u201cThe G20
\nLeaders at the Seoul Summit endorsed the Basel III framework and the Financial
\nStability Board\u2019s (FSB) policy framework for reducing the moral hazard of
\nsystemically important financial institutions (SIFIs), including the work
\nprocesses and timelines set out in the report submitted to the Summit.\u201d[45]<\/a> \u201cThe
\nframework includes an internationally harmonized leverage ratio to serve as a
\nbackstop to the risk-based capital measures. The new framework will be translated
\ninto the EU national laws and regulations, and will be implemented starting on
\nJanuary 1, 2013 and fully phased in by January 1, 2019.\u201d \u201cIn response to
\nthis call, in 2012 the Committee initiated what has become known as the Regulatory
\nConsistency Assessment Programme (RCAP). The RCAP process will be fundamental
\nto ensuring confidence in regulatory ratios and promoting a level playing field
\nfor internationally-operating banks.\u201d[46]<\/a> Basel
\nIII requires a 4.5% common equity ratio to risk weighted assets. It has
\nstrengthened capital requirements for complex securitization transactions and
\nrequires banks to conduct rigorous credit analysis. Under Basel III the minimum
\ncapital adequacy ratio is 8%. [47]<\/a><\/p>\n

Also EU targeted other important flaws in the system with
\nrespect to Alternative Investment Funds (AIFs), in particular hedge funds[48]<\/a>.
\nA directive on AIF was made which regulated funds instead of managers. AIF
\nmanagers who have European passport can only provide services[49]<\/a> <\/p>\n

CRAs were also heavily regulated. Third country ratings were
\nacceptable if governing regulation were similar. The idea of European Credit
\nrating agency took birth.[50]<\/a> \u201c
\nIn the European Union, apart from the annual monitoring by the Committee of
\nEuropean Securities Regulators (CESR) of compliance with the Code of Conduct
\nFundamentals for CRAs of the International Organization of Securities
\nCommissions (IOSCO), there is no supervision yet on the ins and outs of CRAs.\u201d[51]<\/a>
\n\u201cCRAs are out of reach of Directive 2003\/125 as regards the fair presentation
\nof investment recommendations. However, the European Commission is of the view
\nthat CRAs are obliged to disclose conflicts of interest as a result of art.1(8)
\nin conjunction with point 10 of Directive 2003\/125.\u201d[52]<\/a> \u201cThere is a CRA regulation of 2009 in place in the European
\nunion to deal with the supervising of CRAs. It establishes a centre point for
\nregistration of CRAs which makes their administration and governance by the EU
\nnorms easy. This way it becomes easier for the supervisors at national level to
\ndeal with CRAs efficiently. This happens by way of single registering body that
\nhas information about all the CRAs in the zone. National supervisors operate on
\nsite and job of supervisors is not related to scrutinization of method by which
\nratings are assessed by the CRAs.\u201d[53]<\/a> It
\nis further stated that no one CRA shall be associated with a client for more
\nthan four years. Also, CRAs shall not indulge in any other function than credit
\nrating. \u201cThe idea of the Commission is to achieve increased transparency and
\nintegrity by, respectively: (1) keeping data and making them public; and (2)
\nadopting procedures to prevent abuse of relevant non-public information,
\nunpermitted conflicts of interest, forms of abuse of market position, and
\npractices deviating from established methodologies within the CRA.\u201d[54]<\/a> \u201cThe
\nCommission also proposes that the body or part of the board of a CRA that
\nsupervises the board must at least have three independent non-executive
\ndirectors, in accordance with item 13 s.3 of Recommendation 2005\/162.\u201d[55]<\/a><\/p>\n

Post crisis banking sector in UK also saw some worthy reforms
\nin its regulatory regime. A lot of changes were introduced in the banking
\nsector. In Dec,2011 tougher restrictions were imposed on payment of bonuses.
\nAbout 20-30% banks were advised to defer the payment of such bonuses for the next
\nthree to five years. Also, the banks were encouraged to claw back the
\ncompensation in case employee proves to be a non-satisfactory contributor.
\nFurther, banks were levied with a temporary annual tax on their balance sheets
\nat the rate of 0.04% in January 2011 which was made permanent in 2012 at the
\nrate of 0.088%. [56]<\/a>
\nThe Financial Services Act replaced the Tripartite structure. [57]<\/a>The Bank of England is responsible for looking after the money markets
\nwhile FSA administers bank and consumer interest. The treasury provides funds
\nfor this. The financial policy committee ( FCP ) watches the Prudential
\nRegulation Authority (PRA) and the Financial Conduct Authority ( FCA). The
\nformer\u00a0 ensures sound financial health of
\nthe firms, whereas the latter ensures compliance with rules and consumer
\nprotection.[58]<\/a>\u00a0 Ring fencing is another thing; where the
\nInvestment banking arm is separated from the other functions that a bank has to
\nperform. The banks in UK can write down the interest of certain loss facing
\ncredits and convert it into capital. Bonuses are paid partially in shares and
\nnot entirely in cash. The Senior Manager and Certification Regime clarifies the
\nresponsibility of the top management of banks and allows the regulator to hold
\nsenior personnel liable. Banks have to now disclose the material risks they
\ntake. Also under these guidelines new criminal sanction to punish failure of
\nbanks are established.[59]<\/a> \u201cUnder
\nthe Financial Services Compensation Scheme up to \u00a385,000 of each customer\u2019s
\ndeposits are now 100% protected \u2013 up from \u00a32,000 in 2007. This scheme, which is
\nfunded by the banks, covers 98% of customers.\u201d[60]<\/a><\/p>\n

Internationally, EU has been very cooperative
\nin G20 meetings and negotiations. It agreed with regards to principles of
\naccountability, transparency, stringent regulatory framework, integrity of
\nfinancial markets. EU states also agreed to act for economic growth post
\ncrisis. [61]<\/a><\/p>\n

Consolidation in the Banking Sector <\/h2>\n

Mergers come in waves. The sound base for a
\nwave is a more over-valued firm acquiring a less over-valued firm. [62]<\/a> There
\nare reasons for M&A activity to take place. The force behind it ranges from
\nfinancial performance to technological innovation to market trends. Improvement
\nin the financial performance is expected by lowering the costs within the same
\nrevenue stream. These costs are reduced by economies of scale, financial and
\noperational synergies and better management. The ultimate goal is of course
\nprofit maximization. Then, there are tax benefits and expansion of market
\nshare. Further, risk diversification, flourishing regulatory shifts etc. also
\ncontribute to the rise in M&A activity.[63]<\/a><\/p>\n

Effects of M&A could be both positive or
\nnegative. There could be value creation or value destruction. There could be
\nabnormal returns in the long run and the short run with of course varying
\naffects. It could be that the initial over-valuation of the acquirer leads to
\nthe future underperformance of the target. However, success of a merger depends
\nupon how well are the organizations integrated.[64]<\/a> \u00a0<\/p>\n

The financial crisis that began in the US and
\ntrickled down to the global banking sector brought the inherent weakness of the
\nEU\u2019s banking regulations out. Fortis and Dexia became first EU banks to be
\nrescued.[65]<\/a>
\nThe impact of the crisis was seen more in developed markets than in emerging
\nmarkets. That is concentration was taking place more in developed countries than
\nin emerging markets. Consolidation in the banking sector was highest in US and
\nUK. This affected the competition in long run as due to high market share banks
\nwould charge arbitrary interest and fees or increase these charges. On the
\ncontrary there could be lack of competition due to monopolization.[66]<\/a>
\n\u201cIn the long run, evidence from extant literature suggests that the
\nconsolidation process and increase in bank concentration driven by a financial
\ncrisis will reduce after some time. Indeed, concentrated banking systems may
\nreduce fragility by boosting bank profits, which might strengthen the banking
\nsystem and create incentives for new banks to enter the market. Thus, we
\nanticipate that bank concentration in markets that experienced crisis-driven
\nconsolidation will eventually decrease.\u201d[67]<\/a><\/p>\n

During the period of crisis community banks
\nwere the main targets. Cross border consolidation not only increase the asset
\nbase of the distressed banks but also diversified its risks. [68]<\/a><\/p>\n

The mergers during this period can be termed
\nas \u201cShotgun M&A\u201d. [69]<\/a> The
\nbanks with the weaker position could merge with the ones that were in a better
\nfinancial position. The resources from these banks could help the banks in
\ntrouble to bail out from it. These deals need not necessarily be large deals. <\/p>\n

As the crisis of 2008 caused the Bear and
\nStearns and Lehman Brothers to surrender, the US government encouraged mergers
\namongst the investment and commercial banks. They set aside anti-trust
\nregulations in practice. The government supported these \u201cshotgun\u201d mergers by
\neither funding them or guaranteeing them.[70]<\/a>
\nThis was done by bringing the FDIC[71]<\/a> (
\nFederal Deposit Insurance Corporation) and TARP ( Troubled asset relief
\nprogramme) guarantee. <\/p>\n

This stabilized the condition in the short
\nrun but posed problems in the long run. Three main US banks[72]<\/a>
\nheld about 45% of the assets of all US banks. [73]<\/a>
\nThese kinds of consolidation tend to pose regulatory problems as the regulators
\ntend to be co-opted by the industries they are regulating.[74]<\/a>
\nThese consolidated giant entities would want big investments and clients. They
\nmay force smaller borrowers to use non-bank funding which is restrictive in the
\nterms of banking functions that they have to offer. They charge higher interest
\nand pose a risk of lopsided market conditions flaring up. If there has to be
\nconsolidation in the banking sector, we cannot neglect the need for regulation
\non transparency. The tax payers are entitled to know how the government is
\nusing their money in the time of crisis to bail out distressed entities. This
\nhelps eliminate systemic risks and also render confidence to the investor which
\nare essentials if a merger has to be successful. Deregulation contributed to
\nthe crisis by opening the gates of global financial markets. [75]<\/a>
\nBasel II, Pillar 3 deals with the matters of transparency. In US the
\nSarbane-Oxley Act in section 401 deals with the standards required for
\nreporting of off balance sheet assets. [76]<\/a><\/p>\n

Then the question arises how do we fund these
\ntransactions amidst the crisis. We can use bank lines of credit. It is a short
\nterm solution where unsecured credit is given for a specific period at a rate
\nabove LIBOR or standard market rate. This also helps generate commercial papers
\nfrom credit worthy companies without any collaterals. [77]<\/a><\/p>\n

There are certain problems with the \u201cshotgun\u201d
\nmergers. Century old anti-trust regulations were set aside so that mergers
\ncould take place that would prevent the collapse of the financial markets. As a
\nresult, large banks got excessive powers to the extent that it became difficult
\nfor them to be regulated. Bank transparency shoud be the norm. Banks do not
\ngenerate enough capital from basic lending activities and therefore the complex
\nstructures call for adequate pricing.\u201d[78]<\/a> \u201cAlthough
\nthe pricing discussion should focus on the cost of and returns from lines of credit,
\nbanks have traditionally underpriced specific products to meet competitive
\npressures. This is a highly debatable process in the context of the prospect of
\nbank failure and the requirements of Basel 2. Taxpayers should not be
\nsubsidizing underpriced lending facilities to large corporations, when similar
\nrelief is not available to medium sized and small business or to individuals.\u201d[79]<\/a> The
\nstruggle to earn cost of capital led the bank to adopt risky strategies like
\nemployment of CDOs, sub-prime lending and faulty risk assessment. Cost of
\nraising capital and means of credit lines shall be understood with regard to
\nboth the cases where the lines are secured as well as unsecured. The banks
\nshould strive to generate enough capital to meet the adequacy requirements, and
\nhence, avoiding the possibility of any shotgun merger. \u201d[80]<\/a> \u00a0Banks were accepting high
\nrisk for mediocre returns. There was a a lot of over-valuation and underpricing
\nin the market due to the role CRAs had to play in credit rating. CRAs deal with
\nsimilar kind of information that is required for M&A transactions. The
\nright way to go about it is to know in detail about each bank\u2019s organization.
\nIt also helps to direct the efforts in meaningful market and to have asset data
\nrelated to different product lines in a particular market. [81]<\/a><\/p>\n

Strategic buyers appear to be more bullish on
\nthe outlook for the mergers and acquisitions market than their private equity
\ncounterparts. \u201dThe three-month long survey, conducted in the fourth quarter of
\n2007 and the first quarter of 2008, examined merger and acquisition activity
\nduring the ongoing credit crunch. Strategic buyers are more optimistic than
\nprivate equity buyers: 51 percent of strategic respondents said worsening
\nmarket conditions will serve as a catalyst for an increase in M&A deals. Mid-market
\ndeals less than $500 million are expected to dominate M&A activity in the
\nnext year, with technology and financial services likely to be the most active
\nsectors for deal making, according to the survey. Reflecting the apparent
\npullback by private equity, 78 percent of executives predicted the number of
\nstrategic deals will surpass private equity deals as a result of the tightening
\ncredit markets. More than three quarters of executives also expected private
\nequity bid premiums to fall between 10to 25 percent, while half expected the
\npremiums on bids by strategic buyers to fall by that amount. Falling equity bid
\npremiums open the door for strategic buyers to win bids, Green said.\u201d[82]<\/a> \u201cThe
\nsurvey clearly indicates a more challenging and uncertain M&A environment,
\nwith deal sizes expected to drop and disagreement over whether more attractive
\nvaluations can offset the effect of tighter credit in terms of deal
\nvolume,\u201d the credit crunch appears to have shifted the playing field, at
\nleast temporarily, toward strategic buyers are expecting smaller and perhaps
\nfewer deals and seeking more assurances.\u201d[83]<\/a><\/p>\n

Another thing is regarding the good bank and
\nbad bank model. Bad banks are a useful and important strategy for dealing with the
\nproblems of failing banks. A bad bank is an entity created to hold the
\ndefaulting assets of the good bank and thereby helping the good bank get rid of
\nits financial difficulties.[84]<\/a> \u201c
\nThe key concept is that the difference between the market value and the current
\nvalue of the bad assets is the loss that the shareholders bear. The government
\nindemnifies these distressed shareholders by purchasing an equity stake in
\nthese bad banks. The concept is viable independent of whether a government
\ndecides to have one centralized \u201cbad bank\u201d or to establish a separate \u201cbad
\nbank\u201d for each systemically relevant banking institute.\u201d[85]<\/a><\/p>\n

Bad banks are a third entity created to keep
\nthe non-performing assets from the balance sheet of good banks. It is like
\nthird party creation in a triangular merger but very different in its basis.
\nThis bad bank could be a corporation or a bank. Thus, non-performing assets are
\nmanaged by bad banks and the other entity retains and manages the performing
\nassets. The bad banks are given the tedious task of turning these bad debts
\ninto receivable and generate value. Once the banks are freed from troubled
\nassets and the need to constantly write down asset values, the negative effects
\nassociated with the threat of bankruptcy, a reduction in lending due to a lack
\nof capital, and the readiness to take risks at the expense of creditors and the
\ngeneral public, can be minimized or eliminated.\u201d[86]<\/a><\/p>\n

In this kind of a structure the assets are
\ndealt separately and hence, it gives good banks a comparative advantage because
\nit keeps their cost of generating capital and cost of lending low because they
\nare not burdened by the need to turn the bad debts into good. However, one
\nmajor drawback with the system of bad banks is that, in the end they might need
\ngovernment bail-out \u201d[87]<\/a><\/p>\n

\u201cThe purpose of bad bank approach is not to
\ndiminish the existence of these firms but their resurrection. It is a
\nrestructuring mechanism where life is brought back to the bad banks in a 3-5
\nyears span. The bad assets are dealt with in a way that it generates returns
\nbut for this no new investment is made. But the old investment is recreated and
\ndealt in such a way so as to minimize the loss to the shareholders. The
\ncreation of the \u201cbad bank\u201d should also entail a special legal and taxation
\nframework which will stimulate the participation of banks and other investors.\u201d[88]<\/a><\/p>\n

\u201cThe European commission has come up with
\nasset sale or asset insurance schemes and tried to regulate its framework
\nprocedurally as well as substantially. It explains the budgetary implications
\nof such programmes and the basis on which state aid shall be given for the
\nsame. The guidance for the application of the state aid rules is based on a
\nnumber of principles like there shall be proper disclosure of the impairment
\nbefore the government intervenes. It is expected that there should be a
\ncoordinated action to assess the asset categories that need bail out and their
\nvaluation. This should be done by independent entities and persons. There shall
\nbe a uniform assessment criteria on the basis of which the EU commission shall
\ngrant acceptance to the valuation of bad assets. The burden shared by the
\ngovernment has to be adequate with relation to the shareholders and the
\ncreditors. Also, state shall be given adequate remuneration for the help that
\nit provides.\u201c [89]<\/a><\/p>\n

Conclusion and Analysis<\/h2>\n

The crisis generated in US and tricked down
\nto other industrial economies. This became possible due to the
\ninterconnectedness of these markets with US securitization market. However, the
\ngravity of impact depended on the extent of the relationship. In UK there was
\nnot much growth of securitization and its models until after the crisis.
\nNorthern bank failed because of the inherent model of its operation and loop
\nholes in the regulatory framework. In Europe the advent of the financial crisis
\nwas largely motivated by domestic issues of weak supervisory and regulatory
\nframeworks.[90]<\/a><\/p>\n

The regulatory reform that can be seen taking
\nplace after the crisis is more complex and more difficult in its enforcement.
\nIt can be seen as a measure that would have reverse impact. It shall reduce the
\navailability of credit and affect the economic growth. However, the structured
\nfinance market declined in value but not in structure. There are certain
\nproblematic features of the market that need to be catered and those require
\nmore structural reforms and less of regulatory reforms. [91]<\/a><\/p>\n

\u201cTo begin with Basel reforms have ensured
\nthat their new versions are ever more complicated than the previous ones. The
\nBasel accord aims to make the banking system safe by ensuring levelled playing
\nfield for the banks and being responsible for risk management at individual
\nbank level. In its attempt to level the playing field, it has ended up
\nincreasing covariance of bank exposure and there is nothing in the accord to
\ncombat this. In the situation where there is inconsistency with respect to
\ninstitutional environment of different countries and the endogeneity of risks,
\nthere are certain changes that Basel accord needs to incorporate. May be
\nremoving the focus from risk weighted capital adequacy to formulating better
\nnorms for use of leverage or unweighted capital come of some use.\u00a0 While some variation in risk weightings
\nshould be expected with internal model-based approaches, the considerable
\nvariation observed warrants further attention.\u201d[92]<\/a> \u201cThe
\nbanking firms became so large and interdependent that any systemic failure
\nwould lead to collapse of the entire system. It was mainly due to the cross
\ntrading of risks. The overall objective is the application of merger control in
\na manner that takes into account the requirements of financial stability for
\nthe banking system whilst preventing the creation of anticompetitive market
\nstructures.\u201d[93]<\/a><\/p>\n

\u201cBy trying to put all banks in the same line
\nby trying to deal with the risk in a similar way is absurd. By encouraging
\nbanks to increase the number of low risk assets in their portfolio serves no
\npurpose as soon the supply of capital for these assets increases and the
\nexcessive liquidity directed towards these assets makes them risky. Basel\u2019s
\napproach to risk weighting, along with the US approach to sanctioning certain
\nratings agencies and the passive acceptance of these ratings by regulators
\ngenerally, led to an explosion in the revenues of these firms and a fundamental
\nchange in their internal incentive systems.\u201d[94]<\/a><\/p>\n

Regulations encouraging or requiring other
\nfinancial intermediaries (insurance companies, pension funds, etc.) to hold
\nhighly rated instruments also contributed to the increase in demand for these
\nassets and the rewards for those who could create what appeared to be safer
\nassets. Ignoring the endogeneity of risk is innocuous in normal times but
\ndeadly in a crisis, because it encourages a simultaneous run for the exit, that
\nis a simultaneous dumping of assets and drying up of markets for these assets
\nas only sellers are to be found.[95]<\/a><\/p>\n

A lot of time of the regulators went in
\ninterpreting the complex regulatory norms rather than exercise the powers that
\nthey had. Like the FSA did not supervise Northern Rock properly. \u201cIt did not
\nallocate sufficient resources of time to monitoring a bank whose business model
\nwas so clearly an outlier; its procedures were inadequate to supervise a bank
\nwhose business grew so rapidly. The failure of Northern Rock, while a failure
\nof its own Board, was also a failure of its regulator. the FSA appears to have
\nsystematically failed in its duty as a regulator to ensure Northern Rock would
\nnot pose such a systemic risk, and this failure contributed significantly to
\nthe difficulties, and risks to the public purse, that have followed.\u201d[96]<\/a><\/p>\n

As mergers take off a lot of banks tend to
\nfocus on their individual growth and also their executives tend to be biased
\ntoward personal gains. (Not to ignore the role of market for corporate control
\nand agency costs) So, basing the executive remuneration on the rate of return
\ncan lead to enlarged risks. Mergers also converted the investments banks into
\ncommercial bank holding companies because initially these banks worked on a
\npartnership model but after financial globalization they tend to be more
\nfocused on the shareholder benefit, thereby stripping the need to work for the
\ngain of the firm.[97]<\/a><\/p>\n

\u201cCross-border banking integration is not a
\nuniform development within the euro area. A division exists between the larger
\ncountries\u2019 banking sectors and the smaller ones. Larger banking sectors\u2019
\ntransactions are more domestically focused and the majority of acquisitions are
\nby domestic banks. For the smaller banking sectors, the nature of transactions was
\npredominantly international, including the euro area. But, with the exception
\nof Spain, there do not seem to be diverging trends between the \u2018pre\u2013crisis\u2019 and
\n\u2018post-crisis\u2019 period in terms of geographic integration patterns, other than
\nthe clear fall in the number of M&A deals. Secondly, data on the most
\nactive acquirers and sellers tentatively confirm that distressed banks have
\nused both divestments and capital injections to strengthen their balance
\nsheets, whereas stronger banks seem to have used the capital they raised during
\nthe crisis to expand. Often these large banks have divested more on their
\ndomestic markets and expanded throughout the rest of the euro area. Therefore,
\ngiven their size, these banks are a crucial element in cross-border banking. The
\nimpact on the various different banking activities, such as retail and
\nwholesale activities, is not yet visible. Furthermore, the effect on other indicators
\nof banking integration such as\u00a0 mortgage
\nand deposit rates across countries is yet to be ascertained. Further
\ninvestigation will have to reveal the impact of the financial crisis on these specific
\naspects. Although a more cautious pace of expansion may have been expected in
\nthe light of the crisis, some banks have clearly seized the opportunity offered
\nby the crisis in terms of cross-border expansion. Yet, most institutes have
\nslowed their venturing into further cross-border integration for the moment. If
\nthis trend were continued it could herald an important change in the landscape
\nof the euro-area\u2019s banking sector.\u201d[98]<\/a><\/p>\n

Also we shall note here that generally the
\ninformation on which CRAs rely are the same that the MnA investors look at. So,
\nindirectly the CRA ratings help the bidders accurately price targets and hence
\ndecide upon the premium to be paid to the target. CRAs are often in the
\npossession of information that is non-public and confidential. This reduces
\ninformation asymmetry. Thus, credit rating fluctuations affect diversification.
\n[99]<\/a>
\nIt is generally seen that bidders with higher cash ratio have better rankings.[100]<\/a>
\nThe firms with credit ratings generally have been seen to have had less price
\nrevisions during the book building process, in comparision to those that do not
\nhave a rating. This reduces uncertainity about the value of the firm.[101]<\/a>
\n\u201cThe CRAs can downgrade the credit ratings of the bidder if he misuses his
\ninvestment policy and raise cost of his capital. However, in low interest
\nenvironment the interest rate difference between the different ratings is less.
\nHence, leverage buy-outs take precedence. Therefore, during the period of
\ncrisis when the CRAs were responsible for incorrect ratings that affected true
\nrisk assessment and the merger drive based on these ratings would be affected
\nin the following way : <\/p>\n

    \n
  1. Bidders with higher ratings would give low
    \npremiums and vice versa.<\/li>\n
  2. Targets with ratings are appropriately
    \npriced. Hence, no risks associated with underpricing and over valuation. It
    \nshall be reflected at true value, hence, premiums are low in case of rated
    \ntargets as opposed to non-rated ones.\u201d    [102]<\/a><\/li>\n<\/ol>\n

    \u201cThe interpretation of the crisis with the supervisory community that it demonstrated that market monitoring does not work, and therefore that they must step up their efforts, is ill founded. more rules, with little attention to information and enforcement. Instead, the conclusion might be that supervisors should be spending less time on risk management and more time mastering \u2013 and disclosing \u2013 information that is in the market. Thus two further key changes then are suggested. First, whatever regulators and supervisors do, they must face some credible accountability. Finance is dynamic; so too must be its regulation. Most static rules are possible to evade, implying that regulators must be given some discretion to respond. However discretion demands close accountability, otherwise regulators could be become (even more) direct agents for banks, and the poor performance of regulators in crises requires effective monitoring as well.\u201d[103]<\/a><\/p>\n

    As a result of boundary issues (the
    \nability of regulated entities to shift prohibited activities to unregulated
    \ndomains, whether in another part of the financial system or another location),
    \nit is better to think of controls as continuous variables rather than on\/off
    \nswitches, to lessen these concerns.    [104]<\/a><\/p>\n

    \u201cEuropean law comes in two forms.
    \nFirst, there are regulations. These are directly applicable in all EU countries
    \nand provide a truly level playing field for banks. Second, there are
    \ndirectives. These still need to be transposed into national law. This is not a
    \nproblem in itself as long as the differences are rooted in country-specific
    \nrisks. But there are still some unjustified differences; there are some uneven
    \npatches on the playing field. Such patches run counter to the idea of a
    \nEuropean banking union. They prevent the European banking sector from growing
    \ntogether, and they make European banking supervision less efficient.<\/p>\n

    Still, rules must not be carved in stone, of course. Driven by innovation, the banking sector constantly evolves \u2013 new instruments are devised, new risks emerge. The rules must reflect such change. After all, the financial crisis was partly caused by financial innovations that took place outside the regulatory wall.\u201d[105]<\/a><\/p>\n

    Bibliography <\/h2>\n

    Books: <\/h3>\n
      \n
    1. The law of international
      \nfinance\u00a0\u2013\u00a0Andrew McKnight\u00a02008<\/li>\n
    2. Legal risk in the financial
      \nmarkets\u00a0\u2013\u00a0Roger McCormick\u00a02010<\/li>\n
    3. Goode on legal problems of
      \ncredit and security\u00a0\u2013\u00a0Royston Miles Goode,\u00a0Louise
      \nGullifer\u00a02013<\/li>\n<\/ol>\n

      Journals: <\/h3>\n