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Paper submission for BAM 2014 Conference
Proposed title:
Impact of Financial Distress in UK Retail Banking Performance (before, during
and after the crisis period)
Symposia Paper for BAM2014 Conference at Belfast
Keywords: Financial Distress, Bank Performance, Financial Crisis, Predictive Models.
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Abstract
This study considers the controversial issues that arise in testing the performance of
prediction models. Can we actually rely on the accuracy of Multiple Discriminant Analysis
developed by Altman in 1968 without adjusting its variables in predicting financial distress
within the U.K retail banking sector? Or can we bridge this gap? The overall aim of this study
is to attempt the impart of financial distress in UK banking performance before, during and
after the global financial crisis by establishing if any relationship exist between financial
distress and crisis. A set of financial and economic ratios in the context of multiple
discriminant statistical methodology is employed. The data used in this study are limited to
the retail banking sector over a 10 year period (2004-2013). Consistent with Bank
capitalization and Trade-off theories, we find that most banks performed poorly during the
crisis period due to high debt and limited liquidity available to meet up payments.
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Introduction
This section aims at stating a review of literature and the overall aim (s) of this study, putting
it in its historical, social, cultural, philosophical, theoretical, and the main findings related to
the impact of financial distress on bank performance. It also explains why research on the
impact of financial distress in UK retail banking performance before, during and after the
crisis period is significant (important) and places the research in the current academic
context.
Research Aims and Objectives
•
Review the literature in order to establish the relationship if any between financial
distress and financial crisis.
•
Contribute towards Altman’s 1968 original model of financial distress prediction in
the context of UK retail banking sector in order to identify distressed and nondistressed banks.
•
Set up hypotheses in order to test relationships existing between financial distress and
bank performance before, during and after the crisis period. (The essence is to
identify “distressed” and “non-distressed” UK banks during the financial crisis and
why were they affected by the crisis).
Research Questions:
1. Is there any difference between the conceptualisation of financial distress and
financial crisis?
2. Is there a relation between Financial Distress and Banking Performance measured in
terms of standard financial ratios (profitability, liquidity, leverage and stock market)
and customer satisfaction?
3. Does the application of Altman’s 1968 Multiple Discriminant Analysis (MDA)
provide a better method for predicting financial distress in the context of UK retail
banking compared to Richard Taffler 1983 and John Robertson’s 1983 models?
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Literature Review
This section is made up of two main parts; we provide a critical review of the relevant
literature, distinguishing between studies that have examined the performance of UK banks
during crisis periods and studies that have focussed on the models to predict financial distress
in companies. This distinction is drawn here, in the case of the former, to highlight the
evidence of bank performance in relation to profitability, liquidity, return of equity and sales
growth, while the latter deals with models to predict financial distress with respect to the use
of financial ratios analysis. As a result, it is significant to provide research into what
financial ratios and statistical models can be used to accurately predict financially distressed
companies in UK retail banking before, during and after the most recent global financial
crisis.
In the light of the on-going international financial crisis, it is vital to review the performance
of the financial sector to prevent or reduce the occurrence of financial distress in the future.
Assessing financial performance will enable managers: to examine the success or failure of
their managerial decisions that have been occurring before, during and after the crisis; to
understand better their management usefulness and provide them with valuable information
to improve their performance and finally, it helps to measure the success rate of such
decisions compared to their competitors during same period.
It is believed that several attempts to detect financial symptoms of unsuccessful businesses
began in the early 1930s (for example, Fitzpatrick, 1931; and Merwin, 1942). Nevertheless,
prediction of corporate distress events in firms originated in the US and gathered momentum
from 1970 onwards (Altman & Hotchkiss, 2006). It is worth noting that the combination of
financial ratios and statistical techniques have now made it possible to forecast the likelihood
or financial health of companies with some degree of success (Mills & Robertson, 2003:
156). Hence, providing a suitable definition of financial distress in this section is imperative.
The following section attempts defining financial distress or failure.
Financial distress is a subjective phenomenon whereby every individual, company, or project,
even with the same cash flow levels, may have different levels to perceive it, and this is the
most important reason why different literatures offer diverse definitions on financial distress.
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Nevertheless, one must be familiar with and recognize the definition of financial distress
before it can be appropriately be predicted and further more prevented.
Apparently, the term “financial distress” and failure are used in the negative connotation to
imply the financial situation of a company confronted with a temporary lack of liquidity and
with the difficulties that ensure a company to fulfil its financial obligations on a maturity date
(Gordon, 1971, p.349 and Devydenko, 2005, p.2).
Generally, financial distress refers refer to the inability of a company to pay its financial
obligations as they become due (Beaver et al., 2011). In addition to this claim, Beaver (2006)
also identifies a company with large overdraft funds, in which the overdraft is not to pay
dividends or corporate debt, as the company experiences financial distress. Kordestani et al.
(2011) also review a few definitions that are offered in the literature and they declare that
financial distress occurs when the cash outflow outweighs the cash inflow.
Pustylnick
(2012) on the other hand, believes that they are two types of distress, which involves negative
net present value (NPV) and negative cash flow, in which the cash deficit could occur at
anytime due to a rise in operational cost. However, it is imperative to give a clear distinction
between failure and distress. Taffler (1982, p.343) defines failure as receivership, voluntary
liquidation (creditors), and winding up by court order or equivalent. Beaver (1966, p. 71)
states that financial failure is the inability of a firm to pay its financial obligations as they
mature. Altman (1968, p.4) presents a more simplistic definition and highlights four generic
terms that are commonly found in the literature namely, failure, insolvency, default and
bankruptcy.
According to him ‘failure’ means that the realized rate of return on invested
capital, with allowance of risk consideration is significantly and continually lower than the
rates of similar investments.
As a result, Jensen and Meckling (1976) and Myers (1977) argue that firms with a higher
leverage may improve their performance. However, on the other side, a highly leveraged
firm means higher agency costs because of divergent interest between shareholder and debt
holder which increase the total cost of the company, so the leverage may be negatively linked
to performance. A survey of the empirical literature on this debate shows the lack of
agreement on the link between high leverage and corporate performance. Therefore, the
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literature provides a rather disagreement on the relationship between leverage and corporate
performance. As a result, theoretical evidence claims that agency cost resulting from the
conflicts of interest shareholders-debt holders suggest that a higher leverage is correlated with
a lower performance (Laurent Weill, 2007 p.251). It is therefore fundamental to understand
the meaning of leverage in this study.
However, significant efforts in this area of financial distress have been made between the late
1960s and 1980s in developing models to predict bank failure. For example, Beaver, (1966);
Altman (1968, 1983); Ohlson (1980); Taffler et al. (1983) were the first researchers to
develop early-warning models to discriminate between failure and non-failure firms. Altman
sampled 33 US manufacturing firms and used data (significant financial ratios) as the best
predictors of firms’ health and he arrived at an accuracy of 95% for all samples.
Even
though these ratios can reflect firms’ performance, they are subject to manipulations and
window-dressing (Casey & Bartczak, 1985; Lee & Yeh, 2004; Opler & Titman, 1994). Also,
empirical evidence provides the limited ability of financial ratios to detect and/or predict
fundamental reporting (Kaminski et al, 2003).
As mentioned in the beginning of this chapter, this section looks at the background research
with its focus on changes in the UK retail banking industry over time in its structural and
cultural changes. It can be concluded that in recent years, technological changes and the
development of models to predict financial distress has played an important role in the
banking sector. The following section will examine the contribution of this study.
Significance and Importance of this study:
Much research has been conducted on the relationship between corporate performance and
financial distress in banks.
For example, Opler and Titman (1994) insist that highly
leveraged firms lose market share and decline in sales more than firms with low leverage.
These findings are consistent with the view that indirect cost of financial distress is
significant and highly positive (Hotchkiss, (1995); Ahmad and Hamzah (2008); Enlow and
Katchova (2011); Safeiddine and Titman (1999); Jandik and Makhija (2005). It is essentially
the concern of stakeholders to be aware whether a company is performing well or not.
Therefore, a greater impact is felt when the company performs less, for example, fewer
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investment opportunities due to lack of growth, lay-offs, employee restructuring and poor
return on share prices. Nevertheless, it is vital to note that the company still keeps on
meeting its contractual commitment.
This situation gets worst when the company encounters an extreme phase of financial
distress. At that point in time, the company is unable to meet up its contractual payments or
faces difficulties to honour them. This may result in cash shortage to pay lenders, employees,
taxes, and most importantly creditors. Therefore, this study is important since it attempts to
identify, predict, analyse and test the impact of financial distress in UK retail bank
performance before, during and after the crisis period, by applying the models of Altman’s
(1968) MDA using significant traditional financial ratios.
Again, this study is significant since it will attempt to provide further insight on financial
institutions, regulatory authorities and other small and medium-sized enterprises (SMEs) to
strengthen shareholder and investor confidence, minimize distress risks and derive possible
resolutions for better decisions in order to prevent another financial crisis in the future. Less
importantly, to our knowledge most data found in the literature comes from the United States
(Beaver, 1966; Altman, 1968 & 1977. et al). It should also be observed that, there are few or
hardly non-UK examples in the literature.
Therefore, this study will contribute to the
literature by expanding the application of Altman (1968) MDA to the UK retail banking
industry.
In a nutshell, the background of this study has established the impact of financial distress on
UK retail banking performance and the need for prediction models to mitigate future losses.
The above questions shall be developed and answered in the final thesis in order to draw
significant contributions to knowledge in the scope of financial distress and UK retail
banking industry performance before, during and after the crisis. The next section will
attempt a conceptual model which explains relationships between concepts and
variables of this study. The following figure 1.1 is a proposed conceptual model to
underpin the study.
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Fig. 1.1
A Conceptual Framework on the impact of financial distress in UK retail banking
performance before, during and after the crisis period.
Control variables
• High leverage
• Poor management
• Interest rates
A
FC
•
Before (2004-2006)
•
During (2007-2009)
•
After (2010-2013)
B
FD
(+)
•
•
•
Altman’s Z core
model
Taffler’s UK model
Robertson’s
Change Model
(+)
C
BP
1. Financial ratios:
• Profits
• Liquidity
• ROE
• Sales
• Shares
2. Customers perception
Source: Authors; designed for this study.
A=Financial Crisis
B=Financial Distress
C=Bank Performance
Therefore,
Cor (FC/FD)>O
Cor (FD/BP)>O
Cor (FC/BP)>O
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Methodology
To satisfy the purpose of this study, historical financial and non-financial information of UK
retail banking industry will be collected.
The literature has discussed several research
methodologies that were used in previous research (including questionnaires, annual reports
survey, and focused groups among others), the most popular method being survey of annual
reports to measure bank performance. The research will be conducted within UK retail
banking industry with the use traditional financial ratios for secondary data and interviews
and semi-structured questionnaires for primary data. Two main criteria will be used to select
the ratios from a set of all possible combinations of financial statement items. The first
criterion is popularity of certain ratios i.e. frequent appearance in the literature, which reflects
crucial relationships among variables. Second, the ratios performed well with those of the
previous studies. The following section presence the design for the study.
Research Design
For the purpose of this study, the positivist approach will constitute the main paradigm
because it is generally deductive in nature, measurable and utilises quantitative data (Punch,
2000),
unlike
immeasurable.
phenomenological
approach
which
is
believed
unpredictable
and
This study will employ a longitudinal study design, research will be
conducted in the UK, four established UK banks and customers are my targeted population,
methods will include: a pilot study will be conducted using Questionnaires (structured and
unstructured, interviews) for primary data and bank financial reports for secondary data from
2004 to 2013-One-source website from the British Library.
Data Collection
Given the background and nature of the research, I propose to use a Triangulation approach
drawing on quantitative and qualitative methods. Steps that will be taken include a series of
qualitative questionnaires and interviews to identify the issue of financial distress that
impacts both customers and companies within the retail banking industry. However, these
questions will be weighted according to their importance and relevance in the context of bank
and customer relationship. Less importantly, the questionnaire will be piloted, refined and
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Paper submission for BAM 2014 Conference
administered. The final step will be using a case study to test the model of Altman (1968) Z
score of the four main established UK high street retail banks (Lloyds bank, Barclays,
H.S.B.C & RBS) in order to ascertain how accurate and effective the model predict financial
distress in UK context. Statistical techniques will be employed in the case with the use of
SPSS as an analytical tool.
Sampling
This study will examine the four main established UK retail high street banks (namely Lloyds
Bank, H.SB.C, Barclays and RBS) with a common criteria amongst them namely all are high
street established UK banks having a long history in the retail banking industry, they all have
published data and about the same revenue size.
The research will use secondary data i.e. financial statements (Balance sheet, Income
Statement and Cash Flow Statement) of UK retail banks as a source of secondary
information. This is because; financial statements will assist in assessing the financial wellbeing of the overall operations. In addition, information about financial results of each ratio
is important for management decision. Furthermore, from the investor’s point of view,
financial information provides useful information in predicting future earnings, dividends and
free cash flows (Erhardt and Brigham, 2006). The dates of the last set of accounts will range
within a ten-year period i.e. from 1st January, 2004 to 30th December, 2013. The data will be
derived from One-source database available in the British Library which gives sufficient time
period to reflect on the changing UK retail banking environment; before the crisis (20042006), during (2007-2009), after the crisis (2010-2013). Therefore, a ten year period is
chosen in order to give reasonable time-frame for empirical study so as to assess the
performance and predict using Altman (1968) Multiple Discriminant Analysis (MDA) distress models to discriminate between failed and non-failed banks.
This model is
significant in assessing a company’s health (performance) and is required in this study
because; it is a well known financial model with 95% of accuracy and originality in
predicting corporate distress. Statistical Package for Social Science (SPSS) software will be
used to conduct secondary data analysis. Primary data will come from interviews and semistructured questionnaires.
A purposefully selected sample of bank customers and bank
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experts will constitute the population to be interviewed in order to establish new enquiry in to
answering the above research questions. For this to be done effectively, the following section
takes in to account ethical issues.
Ethical Issues
An ethical proposal form has been approved by the ethics committee in respect to the
following aspects: participation of respondent will be done on a voluntarily basis,
respondents must be above 18 years old, collected data will be stored confidentially in
lockers at the University (TSD-London Campus), information provided by respondents will
be reported in summary format only, USB devices and other hard wares, sampled companies
will be notified in advance and their information kept secret. Lastly, all authors and scholars
in my field will be referenced and acknowledged both in text and at the end notes.
Conclusion:
The purpose of this study is to examine the impact of financial distress in UK banking
performance before, during and after the financial crisis period, and will make a contribution
to the literature of the UK retail banking industry. By extending the literature to the UK retail
banking environment, this present study with its limitations and recommendations will make
an important addition to the empirical literature of the retail banking industry with regards to
performance before, during and after the crisis period, by applying and examining the
predictive power of Altman (1968) MDA technique to the retail banking industry. As such,
the data may be of use to provide this sector, managers, regulatory authorities and other stake
holders with crucial information to deduce better decisions and strategies in order to avoid
future crises. Less importantly, this research will enable them to assess and monitor financial
distress over the accounting ratios and predictive models.
.
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