This essay discusses the developments in banking regulation that are currently being discussed and put in place on account of the global financial and economic crises. With banks, primarily in the United States but also in other developed nations, being the epicentre of the global banking crisis, recent years have been marked by extreme concern among individuals and organisations across the globe on the causes of the economic crisis, the role of banks in the financial crisis, the reasons behind the collapse of huge and well regarded banks, and the existing and proposed banking regulatory system (Dam, 2010, p 581). This essay investigates the reasons behind the financial crisis, the contribution of banks to the crisis, the regulatory failures and gaps that led to the development and exacerbation of various problems, and the regulatory changes that are underway in order to ensure appropriate safeguarding from such crises in future.
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The study also analyses the merits and demerits of the implemented and proposed changes and suggestions for the improvement of effectiveness of banking regulation in future. The study is structured into sequential sections that take briefly detail the developments leading to the financial crises, the regulatory failures and gaps that facilitated the development of the crises, the changes that are being brought about in the regulatory environment and areas that need to be considered whilst making such regulatory changes.
The sub-prime crisis developed mainly because of the unsuitable and perilous usage of financial processes like securitisation, a method used by commercial and investment banks to club their loans, switch them into saleable assets, and thereafter transfer these loans, irrespective of their risk element, to others (Kling, 2009, p 21). Banks earn substantial money from the interest on their loans but need to tie up their capital for long periods of time in such assets (i.e. interest bearing loans) (Kling, 2009, p 21). Securitisation, widely perceived to be the single most significant financial innovation of contemporary times, enables banks to offload their risk and exponentially enhance their cash flows (Kling, 2009, p 21). The availability of the securitisation route led banks to engage in indiscriminate lending to borrowers with doubtful repayment capabilities (Kling, 2009, p 21). Banks, in order to engage in extensive lending to such people, not only borrowed extensively but also engaged in diverse types of investment banking that concerned the purchase, sale and trade of risks (Kling, 2009, p 21). The collapse of the housing bubble in the United States resulted in erosion of confidence in banks and numerous banking collapses, not just in the fraternity of investment banks whose members had low deposit bases, but also among larger banks that had very substantial capital reserves (Robinson & Nantz, 2009, p 5). Financial experts state that the sub-prime crisis, as also the consequent global financial downturn and economic recession, occurred mainly because of unsupervised and unmonitored financial innovations and an extremely lax regulatory environment (Robinson & Nantz, 2009, p 5)
A prolonged period of economic growth, marked by low default rates, in the 1990s, resulted in greater deregulation and the development of numerous unsupervised and unmonitored financial innovations (Kling, 2009, p 22). Whilst banks and financial institutions developed such innovations to enhance their revenues and profitability, the financial crisis developed essentially on account of an inadequate regulatory system that failed to capture and control the intrinsic unpredictability of free market mechanisms. The development of phenomena like excessive and unnecessary sub-prime lending, as well as market speculation, were no more than symptoms of larger causal mechanisms (Kling, 2009, p 22). Recent years have witnessed an extraordinary increase in the functioning of the financial sector, more so in the developed nations (Yueh, 2009, p 39). The entry of numerous highly educated and intelligent students from top management institutes into the area has also resulted in constant innovative exercises and in the development of numerous new products that promised greater returns in an age of low financial costs (Yueh, 2009, p 39). The intricate nature of several of these original and innovative instruments, along with those of the international markets that grew side by side with them, was so complex that it became progressively difficult for banks, regulators, and investors, to fully understand their many dimensions, more so with regard to associated risks (Yueh, 2009, p 39). The regulatory systems that developed in the years prior to the financial crisis did not keep pace with the alterations and innovations in the financial and banking system (Bullard, et al, 2009, p 403). In fact the inadequacies in the regulatory structure enabled banks to conceal their operations from the scrutiny of regulators through the adoption of methods like (a) development of off-balance sheet organisations, (b) utilisation of offshore financial centres, and (c) use of complex derivative instruments (Bullard, et al, 2009, p 403). The increase in securitisation, along with the usage of credit derivatives and the shift of the financial system to market-centric conditions from bank-centric environments, distinguished financial developments in the 1990s and the early 2000s (Bullard, et al, 2009, p 403). This period also witnessed the development of significant systemic risks in the financial sector. Systemic risks can arise from different types of episodes like, for instance, the negative effect of the failure of an individual firm on other organisations and on the bigger economy (Bullard, et al, 2009, p 404). The most important risk to the financial system prior to the crisis stemmed from counter party risks, namely the probability that organisations may not be able to meet their obligations in financial contracts. Such risks come about because of the development of asymmetric information, i.e., the greater knowledge of individuals and organisations, than of others, of their financial affairs (Bullard, et al, 2009, p 404). Systemic risks tend to be high for financial banks that deal in complex financial contracts (Caprio & College, 2009, p 7). Whilst banks engaging in such contracts can safeguard their interests by asking for collateral, actual market circumstances are so interrelated and complex that the true element and extent of risks are often complicated and difficult to determine (Caprio & College, 2009, p 7). Systemic risks are particularly relevant in the banking sector where banks and investment institutions deal and trade with each other through numerous channels like over the counter derivatives, interbank markets, and mechanisms for wholesale payment, as also for settlement (Bullard, et al, 2009, p 403). Settlement risks, namely the probability of default by a party to a financial contract, even after the occurrence of delivery by the other party, is an important area of concern for large institutions that routinely have exposures worth billions of dollars in such transactions (Bullard, et al, 2009, p 403). The instantaneous implementation of financial transactions that take place in the contemporary environment along with the intricate structures of security firms and banks makes it extraordinarily hard to oversee or monitor the acts of (a) counterparties and (b) counterparties of counterparties (Franklin & Gale, 2006, p 3). It is obvious that in such circumstances the quick failure of an apparently robust bank can easily make its counterparties exposed to significant losses. Such events can also adversely affect third parties (Franklin & Gale, 2006, p 3). The financial sector is specifically vulnerable to systemic risk because of its extraordinary high leverage (Subrahmanyam, 2009, p 32). With banks being geared significantly more than other businesses, the high levels of debt in their capital structure, functions as a double edge sword, providing high returns in good times and leading to significant risks of failure during economic downturns (Subrahmanyam, 2009, p 32). Fannie Mae and Freddie Mac, it is important to note, ran into severe financial problems, primarily because of the extremely high debt in their capital structures vis-a-vis their equity funding (Subrahmanyam, 2009, p 32). The financial sector is again prone to systemic risks because of the tendency of firms in this sector to finance long term illiquid assets with short term debts. Numerous financial businesses finance long term assets with short term debts (Yueh, 2009, p 40). The excessive leverage f these organisations, along with mismatches in maturities of their assets and liabilities make them extremely susceptible to liquidity or interest disturbances (Yueh, 2009, p 40).
Financial experts and academics appear to agree that little was done by regulators to monitor and control excessive leverage in banks, or their embracing of further risk, through the alteration and adaption of regulatory procedures (Schmudde, 2009, p 709). Such organisations were on the other hand supported by regulators and central banks to expand and employ their internal risk appraisal and control processes. Such experts seem to be undivided in their opinion of banking and financial regulation in the pre-crisis era being contradictory, out-of-date, pro-cyclical, deficient, and short on the need to address concerns of banks with regard to liquidity and short-term liabilities (Schmudde, 2009, p 709). Such regulation was furthermore based on fundamentally erroneous premise that market assessment and action for systemic risks could be trusted. Existing regulations were also not able to cope with changes in banking and financial structures, thereby encouraging arbitrage and enabling banks to obscure their behaviour from the purview of regulators through the use of special purpose vehicles (Schmudde, 2009, p 709). The regulation of banks as well as financial institutions in Europe and other western markets has since 2004 been defined by the Basel II accord, which provides recommendations on different banking practices and norms (Schell, 2010, p 1-2). Basel II provides international standards for the use of national banking regulators in issues like capital adequacy and risk management. It fundamentally uses the model of three pillars, which assist ensuring stability in financial systems and markets (Schell, 2010, p 1-2). The first Basel II pillar deals with the estimation of amount of capital required to protect banks from three important types of risks, i.e. which concern credit, markets and operations. The accord provides precise methods for reckoning of diverse risks (Schell, 2010, p 1-2). Credit risks for example can be determined through three methods, namely the standardised approach as well as two sorts of Internal Ratings Based approaches. The second and third pillars of Basel II basically support supervisory assessment of capital adequacy and market discipline through precise disclosure standards (Schell, 2010, p 1-2). The chief objective of Basel II concerned alignment of regulatory bank capital with risks after assessing the progress made in risk measurement and management as also the diverse opportunities provided by such advances for enhanced supervision (Caprio & College, 2009, p 7). The accord aimed to bring regulatory capital closer to economic capital, whose levels influence the decisions of banks on issues of revenues and losses. The progress of the financial crisis however revealed fundamental lacunae and problems in the Basel II approach towards risk management (Caprio & College, 2009, p 7). The banking regulations endorsed by the Basel Committee, with its emphasis on least capital requirements, light supervision and controls, and market regulation, are inherently pro-cyclical, these regulations encourage investors to boost risky investments during upswings in business and decrease investments during economic downturns, thus increasing rather than reducing market and economic volatility (Caprio & College, 2009, p 8). Whilst managements of banks were expected to look out for risks, the risks surfaced from unexpected places, which were not provided for by Basel II.Â Various assumptions about liquidity of instruments like mortgage backed securities that were based on historical performance proved to be untrue, along with the dependability of credit ratings on many of such securities (Caprio & College, 2009, p 8). The crisis also exposed that relationships between banks, as well as relationships between banks and financial institutions, could result in the development of domino outcomes during periods of extraordinary stress (Klaus, 2008, p 62). This could render seemingly safe lenders vulnerable through exposure to counterparties that were less safe than estimated. Regulators also proved to be unable to deal with the liability side issues that stemmed from the helplessness of banks and institutions to roll over short term debt (Klaus, 2008, p 62). The exposure of the gaps in the banking regulatory system and their role in the development of the financial crisis has, as evident, resulted in intense debate and discussion and to action on improvement of global regulatory regimes. President Obama of the US has laid out his plans for banking reforms that reveal a significant shift towards the left in US domestic policy and recognition of public anger towards the financial community for its role in the financial crisis (Clifton, 2011, p 1).Â The new proposals for banking regulation require banks to be banned from owning, running or investing in private equity groups or hedge funds for their own profits and have policies to thwart banking sector consolidation (Clifton, 2011, p 1). The Basel Committee has also proposed new standards for financial regulators that aim to improve global consistency and quality of regulatory capital and to standardise required adjustments and deductions (Barnes, et al, 2010, p 2). Basel III intends that (a) the Tier 1 capital should allow banks to remain going concerns, (b) Tier 2 capital should be re-categorised as a “gone concern” protective reserve to safeguard depositors in the cases of insolvency, and (c) that Tier 3 capital should be abolished (Barnes, et al, 2010, p 2). The Basel III document lists items that must be adjusted for computing common equity, like (a) minority interests in subsidiaries, (b) unrealised losses on assets in balance sheets, (c) reserves for cash flow hedges, (d) goodwill and other intangibles, (e) net tax loss carry forwards, (f) deficits in defined benefit pension funds, (g) investments in unconsolidated subsidiaries and (f) shortfall in loan loss provisions for expected losses (Barnes, et al, 2010, p 3). The document also calls for greater disclosure of calculations about regulatory capital in order to improve transparency and help reconciliations with accounting data (Barnes, et al, 2010, p 3). Regulators appear to have realised the dangers of lack of regulation in the banking sector, not only for the future growth and progress of banks but also for the entire financial sector (DonBrash.com, 2010, p 1-2). The securitisation proposals, for instance, aim to change incentive structures for members of markets, increase transparency, assist in investor due diligence, strengthen the role of credit rating organisations, and reduce reliance on credit ratings The fundamental rationale of regulation is the facilitation of authentic, competitive and lawful business activity and the building and provisioning of protection for the interests of different stakeholders. Such regulation, contemporary financial experts argue, should be principle-based flexible and focused on codes and ethics (DonBrash.com, 2010, p 1-2). Whilst the new proposals for regulation are elaborate and specify increases in capital adequacy requirements, sufficient care will have to be taken to ensure that regulations are inclusive and comprehensive and that consider the role of all institutions, markets and instruments, including off-balance sheet items, tax havens, off-shore centres and hedge funds. Lack of completeness in regulation will result in formation of shadow finance systems, making it hard to thwart regulatory arbitrage and excessive leveraging, both of which were instrumental in the current crisis. All sorts of banking actions will require to be checked, including derivative and underlying securities, as well as securities traded through OTC exchanges and exchange routes.
This essay takes up the analysis of regulatory actions in the banking sector in the wake of the financial crisis. Whilst the banking sector was regulated prior to the development of the sub-prime and the financial crises, both through the availability of international standards like the Basel II norms and through national regulations, such regulatory structures proved to be inadequate in regulating financial misdemeanours, which were furthermore aggravated by lack of transparency of information and inappropriate provisioning of credit ratings to banks by accredited credit rating institutions. Intensive investigation into the policies and working of banks and financial institutions revealed that the organisations took advantage of the lax and market focused regulatory environment to engage in fundamentally risky activities. With the entire banking network being closely interrelated, such actions aggravated the systemic risks in the sector and resulted in the financial collapse of 2008. The aftermath of the financial crisis has witnessed intense soul searching, discussion, and debate by regulators, academics, and members of society. The Basel III committee has recommended new norms for capital adequacy and for bringing about much greater transparency in the functioning of banks and publication of records and statements. The US government is also bringing in proposals restricting the working of banks in a number of risky areas. The lessons of the financial crisis seem to have been learnt well but financial experts stress that governments should take care to ensure that regulatory systems do not get bogged down in excessive rules and are developed on the basis of principles and ethical codes of conduct. Whilst the dismay caused by the banking and financial crises are sure to remain in the collective memory of western nations for some time to come, regulatory caution will have to be constantly exercised in the future, even when the horrors fade into distant memories.
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