The Reform of the Banking System - Essay Example

?The Reform of the Banking System Executive Summary The research report deals with the present situation in the banking system after the effects of the global economic crisis. The reform of the financial system has been taken into account and a comprehensive report on the process of evaluating the reform scenario has been presented. The report focuses on the following major areas of discussion: Logical reasoning of the reform in breaking up the larger banks into smaller units Impacts of the proposed new changes in the capital requirements of banks Discussion on the possibility of preventing future massive crises through breaking up of banks and changing the minimum capital requirements of banks Identification of certain other reforms that are supposed to be more effective than these reforms in preventing any future crisis Table of Contents Executive Summary 2 1.0 Breaking up the Banks 4 1.1 Dismantle of Large Financial Institutions 4 1.2 Banks should not be broken up 5 1.3 Breaking up the Large Banks should be considered 5 2.0 Results of the Changes Proposed to the Banks’ Capital Requirements 6 2.1 Objectives of the Proposed Changes 7 2.2 Anticipated Effects of the Changes 7 3.0 Discussion on the Possibility of Preventing another Financial Crisis by the Two Reforms 8 3.1 Can Financial Reform Prevent another Crisis? 9 3.2 Reasons Identified as to why the Banking Reforms will fail to prevent another Crisis 9 4.0 Identification of Other Important Reforms in Achieving the Goal 10 4.1 Lending Practices Such as the “Teaser Rates” 11 4.2 Strict Penalty on Violation of Standards 12 4.3 Incorporation of Financial Crisis Responsibility Fee 12 References 14 1.0 Breaking up the Banks The research paper is an approach towards the consequences of the banking system reform in the present times. In this section, the policy of breaking up the big banks to avoid their risky performance in the future will be evaluated with reference to the views of various scholars and through analysing those views. A final conclusion whether the banks should be broken up or not will be drawn. 1.1 Dismantle of Large Financial Institutions A report in the Wall Street Journal states that the large financial institutions such as the big banks should be broken up or dismantled because there is a prevalence of risk about their existence that in the future again their performance might lead to economic and financial crisis. According to the President of the Dallas Federal Reserve Bank, Richard Fisher, the pseudo-banks and the large banks are difficult to manage due to their big size that creates problem in its supervision. The President is of the view that the costs that these banks impose are more than the advantages that people or society receives from their existence. The financial institutions which were considered “too big to fall” intensified the crisis in the past few years and had resulted in the fall of potential output and most importantly employment. Moreover, it is better to have several manageable units rather than one big unmanageable unit (Nutting, 2010). 1.2 Banks should not be broken up According to the Confederation of British Industry (CBI), the banks should not be broken up because the splitting policy could harm the role of the UK at the control of global finance. The present public anger should be tackled which is over the bankers’ larger bonuses by ensuring that the banks in the UK can still attract and employ top talents. The Independent Commission on Banking (ICB) was set up in Britain during the year 2010, whose responsibility was to analyse the probable shaking up of the industry after the credit crisis occurred and it found that top lenders such as Lloyds and Royal Bank of Scotland are in need of taxpayer bailout. It is believed by the CBI that breaking up the banks would be a mistake and they need to develop a strong system of banking that would help the economic growth as a whole. The views of the CBI are supportive if observed from the side that during the global financial crisis, many universal banks acted stronger than several “narrow lenders”. The universal banks’ activities ranges from trading to retail banking and those of the small bankers include retail and mortgage activities. The small banks collapsed and finally they had to be nationalised (Kar-Gupta, 2011). 1.3 Breaking up the Large Banks should be considered A report published in the Bloomberg points out the views of Alan Greenspan, a former Federal Reserve Chairman who pointed out that there should be consideration in breaking up the large banks. He is of such view because the implicit subsidy that the banks enjoy which allows them to borrow at a lower cost might pose as a threat to the financial system. The bankers or the lenders enjoy that subsidy as they feel that the government is always there to guarantee their obligations. Taking the example of Standard Oil that was broken up in the year 1911, the former Chairman mentioned that after the splitting, the individual segments proved to be more valuable than the whole. From the views of Greenspan, it can be cited that the banks should be kept apart from enjoying the vast advantages provided by the implied subsidy from the government’s relaxation (McKee & Lanman, 2009). Considering the present economic conditions all over the world with the fact that large banks were ultimately responsible for the global crisis, the decision of splitting the banks seems effective. The past trends as well as the future presumptions should also be taken into consideration for taking up the decision. 2.0 Results of the Changes Proposed to the Banks’ Capital Requirements In this section of the research paper, the effects of the changes that have been proposed to the capital requirements of banks will be evaluated. The evaluation will be done with the identification of objectives set when the changes were proposed along with the evaluation whether the changes will be effective in achieving the desired outcomes. On evaluation of the effects, a conclusion about the success of the proposed changes will be considered. 2.1 Objectives of the Proposed Changes The proposed framework of changes developed the structure that was primarily intended towards: Making regulatory capital more susceptible to variations in the risk profiles among the organizations dealing with banking activities Taking into account the exposures to off-balance-sheet for assessment of capital adequacy Lowering of the disincentives for holding lower risk liquid assets (Jackson, 1999) 2.2 Anticipated Effects of the Changes A strong agreement among the policymakers was that there is a need for maintaining higher minimum capital requirements for banks in order to promote a secured financial system and avoid the recurrence of another financial crisis as the one in recent times. As a result of the reform in the structure of minimum capital requirements for banks, there will be likeliness that banks will have to lend in lesser amounts, charge more amounts for granting loans or increase the rate of interests and pay lesser amount for deposits in their banks. These anticipated actions of the banks are expected as they would try to re-establish such an amount of return on the larger base of capital that they will require to employ. A careful balancing of the steady benefits is necessary for determining the most appropriate amount of minimum capital requirement against the cost related to economic aspect for lending that are less attractive. The higher capital requirements can thus play a significant role in guaranteeing the security to the economy’s financial system. It is possible for gaining the stability at a lower cost in terms of availability of funds and pricing of loan, thus making them worthwhile eminently. There should be changes considering the global scenario and adequate attention should be provided to the necessity of substantial periods of transition (Elliot, 2010). Thus, considering the objective of the reform in the banks’ minimum capital requirements, the anticipated effects are likely to fulfil the expectations. Though no writer has confirmed the likely changes, the analytical issues suggest the success of the reforms. As a result of the reform, there will be likely changes in small proportion in the loan amount that will be due to the necessity of maintaining the minimum capital requirements. The maintenance of minimum capital requirements in the banks’ funds will help the global economy come back on the track after the crisis experienced in the financial meltdown. 3.0 Discussion on the Possibility of Preventing another Financial Crisis by the Two Reforms There have been controversies regarding the consequences of the banking reforms initiated to prevent another financial crisis as that of the one during the period 2007-2009. The democrats are of the view that the effect of the reform will be successful in preventing the impacts depicted by the recession, but there are certain groups who still doubt the success of the reforms. The following section of the research paper will focus on the discussion related to the possible success and failures of the banking reforms undertaken. 3.1 Can Financial Reform Prevent another Crisis? According to a number of faculty members in Wharton, certain features of the reform will be helpful in fulfilling the objective of prevention of financial crisis, yet there will be prevalence of plenty of risk factors. This is because a number of aspects would be left to the regulators’ discretion and the regulators might not be willing to spot the deal on right time pertaining to certain political prudence. Moreover, it is not possible to regulate in the most appropriate manner on presuming the future financial situations. The reforms will be successful if risks can be spotted before it grows rapidly. Along with the spotting of risk, the shutting down of infected financial institutions should also be undertaken before the requirement of taxpayer bailouts. The regulatory reforms have been again criticized on the ground that the financial institutions were allowed to issue certain instruments of swaps that was actually not deserved by them (Knowledge Wharton, 2010). 3.2 Reasons Identified as to why the Banking Reforms will fail to prevent another Crisis Ashkenas (2010) in the Harvard Business Review has identified and presented the reasons behind the belief that the banking reforms will not be able to prevent another financial crisis. The fact is that the combination of market forces and human behaviour is found to be more powerful than that of any regulatory reforms or legislations. Gradually new ways will be found out by the creative mind of the financial engineers that will earn money even in the circumstances of the “reformed” system. The new findings will indeed provide rise to completely unforeseen and new issues and opportunities. Until and unless the government is totally aware of the innovations in the financial engineers’ mind, the economy will be faced with several upcoming financial crises. Another pessimistic view of the effectiveness of the banking reforms is that the reforms do not decreases the regulatory fragmentation and complexity. The complexity in the regulations is one of the most important causes of the current meltdown and several crises in the past years. Moreover, there are several institutions or agencies that play a vital role in the regulation of financial system of an economy. In addition, there are organizations that set standards such as the Financial Accounting Standards Board, agencies that provide ratings such as Moody’s and S&P and also the market organizations such as the Stock exchanges. With these huge numbers of organizations that review different sets of data with different agendas and by varied perspectives, there is high probability that problems will be encountered at various points of time. Disappointingly, the bills of financial reforms fail to simplify the entire system. In fact, the present reforms over the banking system strengthen the complexity by empowering the regulatory bodies along with provision of higher budgets (Ashkens, 2010). 4.0 Identification of Other Important Reforms in Achieving the Goal The reforms that are discussed in this research paper, breaking up of the large banks and proposed changes towards the minimum capital requirements are the most initiated approach towards the fulfilment of the objective of preventing another massive crisis in the future. In this section of the research paper, certain other such reforms will be discussed that can help to prevent the world economies another similar disastrous crisis in the future. 4.1 Lending Practices Such as the “Teaser Rates” The recent crisis that the world economy experienced had been the worst since the Great Depression of the 1930s. The crisis has already brought down around half a dozen of financial companies and large banks. But the major reason of the crises was the selling of loans to several homebuyers at a proportion that the borrowers were even unlikely to afford. In view to these practices, various observers are expecting new measures of regulations that would rein as lending practices. The lending practices would be “teaser rates”, i.e. a lending rate that makes the loans look more attractive to the borrowers. The loan at this rate usually carries a low rate of interest during the first two years that are susceptible to increase at a faster rate after two years. This would act as an incentive for the banks through which the banks would get an assurance that the loan can be repaid by the borrowers (Bollag, 2008). 4.2 Strict Penalty on Violation of Standards The rules of the regulatory bodies regarding the penalties against the banks that violate the standards should be presented in stringent form to the bankers. The policy can be set in which the bankers get paid only for the returns on five to ten years of investment by the people. This will make the bankers to concentrate on the amount of risk when it develops and sells products. There can even be penalties in terms of money for bankers on violation of capital standards. Standards can be set for bankers where they need to maintain a maximum debt-equity ratio of 10:1. On violating this standard of ratio, the banks should be penalised with lose of all their bonuses and stock options. Banks would start regulating themselves on the fear of losing bonuses (Cohan, 2010). 4.3 Incorporation of Financial Crisis Responsibility Fee Financial Crisis Responsibility Fee is incorporated by the government to earn the bailout cost. This is an earning of the government through tax that primarily performs two things. One is that it modifies the behaviour of the banks and the other is that it generates revenue for the government which can be used for reimbursing the taxpayers for bailout cost in the economy’s financial system. The tax would affect the bank behaviour in the sense that tax is more precisely termed as a payment of interest. In this case, it is paid after the occurrence of the disaster rather than before the occurrence. It can also be termed as a loan to the banking industry if the cost of the bailout is paid in full by the banks. They are only charged for certain direct and indirect costs such as the package of stimulus for helping the ruined economy. This arrangement would provide an assurance to the government that in case of occurrence of any financial crisis in the future where the government has to bail the banks out, the banks will not be able to escape payment of certain costs (Thoma, 2010). References Ashkens, R., 2010. Why the Latest Financial Reform Bills Won't Prevent Another Crisis. Harvard Business Review. [Online] Available at: http://blogs.hbr.org/ashkenas/2010/06/why-the-latest-financial-refor.html [Accessed February 23, 2011]. Bollag, B., 2008. How Will Washington Prevent Another Financial Crisis? Special Correspondence. [Online] Available at: http://www.america.gov/st/business-english/2008/October/20080930185854berehellek0.3798029.html [Accessed February 23, 2011]. Cohan, P., 2010. How to Prevent Another Financial Crisis? Make Wall Street Pay. Daily Finance. [Online] Available at: http://www.dailyfinance.com/story/investing/how-to-prevent-another-financial-crisis-make-wall-street-pay/19416782/ [Accessed February 23, 2011]. Elliot, D. J., 2010. A Further Exploration of Bank Capital Requirements: Effects of Competition from Other Financial Sectors and Effects of Size of Bank or Borrower and of Loan Type. The Brookings Institution. [Online] Available at: http://www.brookings.edu/papers/2010/~/media/664E1AD0493E4C77B1178A60FA294773.pdf [Accessed February 23, 2011]. Jackson, P., 1999. Capital Requirements and Bank Behaviour: the Impact of the Basel Accord. Bank for International Settlements. [Online] Available at: http://www.bis.org/publ/bcbs_wp1.pdf [Accessed February 23, 2011]. Kar-Gupta, S., 2011. Banks should not Split says CBI. Reuters. [Online] Available at: http://uk.reuters.com/article/2011/02/04/uk-britain-banks-cbi-urgent-idUKTRE71306420110204 [Accessed February 23, 2011]. Knowledge Wharton, 2010. Regulating the Unknown: Can Financial Reform Prevent Another Crisis? Article pdf. [Online] Available at: http://knowledge.wharton.upenn.edu/articlepdf/2516.pdf?CFID=35069295&CFTOKEN=84603465&jsessionid=a83061cc47942af467c61f652914784b265d [Accessed February 23, 2011]. McKee, M. & Lanman, S., 2009. Greenspan Says U.S. Should Consider Breaking Up Large Banks. Bloomberg. [Online] Available at: http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aJ8HPmNUfchg [Accessed February 23, 2011]. Nutting, R., 2010. Big Banks Should be Broken Up, Fed’s Fisher Says. The Wall Street Journal. [Online] Available at: http://www.marketwatch.com/story/big-banks-should-be-broken-up-feds-fisher-says-2010-04-14 [Accessed February 23, 2011]. Thoma, M., 2010. Will the Administration’s Proposed Bank Tax Create a Moral Hazard Problem? Money Watch. [Online] Available at: http://moneywatch.bnet.com/economic-news/blog/maximum-utility/will-the-administrations-proposed-bank-tax-create-a-moral-hazard-problem/388/ [Accessed February 23, 2011]. Read More