Finance Markets and Risk - Essay Example

? . What is meant by ‘systemic risk’ and ‘systemically important financial s’ (SIFIs)? Is separation of banking between retail commercial banking business and investment banking need of the hour?- An Analysis ( Word Count with Heading and references 2555) What is meant by ‘systemic risk’ and ‘systemically important financial institutions’ (SIFIs)? Systemic Risk Systemic risk is ushered by unforeseen incidents that amplify uncertainty unimaginably and damage the liquidity of the market at a rapid phase. Illiquidity results in “prices gaps” in respective markets and in the pricing of a particular asset. The related pressure later extends to the liquidity of funding of financial institutions around the world that are assisting those independent markets. Illiquidity in markets sequentially can result in potentially momentous real economic impacts, thus warrant policy action, particularly by central banks. (Evanoff et al 2009: 7). As per IMF (International Monetary Fund), BIS (Bank for International Settlements) and FSB (Financial Standard Board), systemic financial risk is one, which is associated with the peril of risk of disruption to financial services that (a) is happened by a destruction of whole or parts of the financial system and has the probable to have the worst negative outcome for real economy. During September 2008, AIG borrowed from the Federal Reserve System an $85 billion two-year loan that too at a penalty rate, which has been termed as ever known the rescue of one of the globe’s major insurers. In return for the rescue operation, Fed received a 79.9% of shares in the AIG. At the time, the investment banking arm of AIG witnessed a systemic risk emanating from its credit default swap (CDS) business. (Neave 2010: 397). The failure of one firm may not impact its rivals as is happening in the most sectors of the economy nor does it result in market failures. However, in the financial sector, there is an impending peril that the breakdown of any major financial market or institution may result in the adverse impacts on the whole financial system more likely. In several associated channels, such systemic risk can be in operation, if there is a mishap in a specific financial institution. All the depositors of a bank will be in panic and will rush to get back their deposits when the depositors lose their trust, if a typical bank run occurs. The banking system of a nation as a whole may be in jeopardy if rumour spreads about the fate of the remaining banks of a nation. The bank runs vulnerability can be a reality typically as there will be a maturity mismatch between their assets and liabilities. The banking system might have invested in long-term debts like loans to households and businesses, whereas they might have accepted deposits from their customer on the demand basis. Even a healthy bank may have chance to witness a bank run despite the fact that its assets would have more value than its liabilities, but a credit crunch may occur if there is premature withdrawal of deposits suddenly by bank customers. Thus, even a solvent bank can witness a liquidity crunch, despite the fact that the liquidity issues may mirror concerns about bank’s solvency. However, there are some risk-aversion strategies, which are in place like lender-of-last-resort facilities and deposit insurance, which make the possibility of bank run as a mirage. Short-term deposits are available from one bank to another bank through interbank transactions, and this occupies sizeable quantum of their business transactions. However, at times of liquidity crunch, associations between banks may witness jolts to proliferate through the system. For instance, Barclays bank has provided short-term credit to ANZ bank, then, concerns of default by ANZ bank might jeopardise to the stability of Barclays bank. Such similitude vulnerabilities are regarded to be one of the main causes why the alarm can spread between banks in such scenarios. In such situations, inter-banking lending will come to a halt due to market insecurity about which banks have large pile of bad assets and which not. For instance, due to their stringent collateral needs, liquidity may be exhausting out especially from repo markets, thereby departing banks that have been heavy dependent on short-run funding thereby finding it difficult to refinance their business activities. In subprime mortgage crisis that occurred in 2008, not only depository institutions failed but also there were runs on firms in shadow banking division, particularly Lehman Brothers and Bear Stearns in USA and Northern Rock in UK. Thus, if Barclays bank has invited a trouble by lending short-term funding to ANZ bank, then, to have liquidity, the Barclays bank may engage in “fire-sale” to maintain its liquidity. This will consecutively lower the asset prices due to its large size of holding, and this will automatically end in destabilising of balance sheets of other banks. It is to be observed that though bank runs function on the liability side of the bank’s balance sheet, but, the fire-sale issue commences on the asset side of the bank balance sheet. Thus, though they are unique in nature but underpinning sources causes the systemic risk. (ICB 2010:19). A sound and safe banking system need the efficient control of systematic risk .Systemic risk can also emanate from issues with settlement and payment systems or from certain varieties of financial debacles that stir-up macroeconomic calamities. During the subprime mortgage crisis that occurred in 2008, the markets were exceptionally delicate and buoyancy was very feeble. During this period, UK witnessed systemic risk from the failure of a small institution which in the ordinary situation will not be considered as systemic risk. (UK Parliament 2010:21). As a result of the financial crisis in UK, there had been a merger among banks and bank failures, which resulted in the consolidation in the UK banking sector. Many are worried that this consolidation in the UKs banking sector resulted in the reduction of competition and also adversely impacted consumers also. Consolidation in the UKs banking sector has in fact enhanced the systemic risk by compelling the remaining major banks more systematically significant. (HM Treasury 2010:31). ‘Systemically important financial institutions’ (SIFIs)’ A Systemic Important Financial Institution (SIFI) is identified through the size of their liabilities or assets, their interconnectedness, their significance in the maintenance of financial systems activities like clearing and payment and their lack of willingly accessible alternatives for the services they offer. By identifying and monitoring SIFIs, such institutions can be prevented from becoming too large and by through enhanced supervision, the fall of SIFIs can be averted. Through financial regulation and banking reform, the SIFIs can be supervised and controlled through the following interventions viz. To exert ban on investing and sponsoring in shadow banking funds and on proprietary trading. By fixing a cap on their liabilities / assets. By introducing structural reforms and spiralling of competition. By introducing capital surcharges as recommended by Basel Committee, 2011. By introducing various measures like minimum leverage, liquidity ratios, by fixing capital standards like structure of capital, minimum capital needs, counter-cyclical actions and capital conservation buffers , by fixing ceiling on interconnectedness , by putting limits on vulnerability to shadow banking functions , and by introducing ring fencing and structural separation. (Avgouleas 2011). Is separation of banking between retail / commercial banking business and investment banking need of the hour? Globalisation has introduced a lot of advantages through enhancing the efficiency with free flow capital, technology, know-how transformation across borders, ease of regulations, attaining uniform tariffs, etc. thereby improving the economies around the world. At the same time, globalisation in the financial sector offered vast confronts for regulators, governments & central bank at the national level. To address the banking sectors’ debacle immediately after the subprime mortgage crisis, the London Summit held during April 2009, the G20 devised some principles for dealing internationally with impaired banking assets, to repair the banking financial system and to chalk out progress towards reform. It was proposed to create a new Financial Stability Board as a successor to the failed Financial Stability Forum to make available rules and oversee to all SIFIs, markets and instruments and to buttress the international norms of prudential rules. (UK Parliament 2009:44) There is a widespread rumour haunting in the global financial market that the present EU financial crisis may again lead to another banking crisis in 2012 around the world. To prevent any such banking failures once again within a span of three years, it is necessary to enhance the flexibility of UK financial system, which needs dual approach viz. initiatives to ban excessive risk-bearing incentives and to restrict the harm when failures happen. Vickers Report and Banking Reform in UK The ICB Vickers Report has recommended the following austerity measures in the UKs banking sector viz. The commercial banks in UK should alone be allowed to accept deposits from SMEs and from their retail customers .The access to corporate banking and high net worth individuals should not be covered under private banking. Certain type’s risky investment should not be allowed by ring-fenced banks in UK. Hitherto, giant banks in UK should have a loss-absorbing capital capacity of 17% not only for their UK assets but also assets fall outside UK. It is suggested that all banks in UK should sail through normal banking competitive forces and should function safely without relying on government backup and without placing their critical services at peril. UK government is of the view that all banks both ring-fenced and non-ring fenced banks require to be balanced by a tesolution system that includes financial holding companies and investment banks also. As part of the system, the UK government supports bail-in-debt. As recommended by Vickers committee, UK government supports increased competition in banking services, especially an effective and a robust new UK bank challenger to the largest UK banks. The UK government backs the preference of depositor on balance. (ICB 2011;29) Is it Necessary to Separate Commercial Banks from that of Investment Banks in UK? Sir John Vickers , who is heading the independent Banking Commission(ICB) of UK has set out strategies to prevent another banking crisis in UK by suggesting the ring-fencing of the investment banks from of retail banks and also suggested that banks should have larger capital reserves to escape from any future shocks. The additional capital reserves to be pumped in by the UK banking sector will be around ? 4bn to ?7bn. However, the UK banking sector has estimated the real cost around ?10bn which they claim that they would necessarily pass it on UK banking consumers. So as to avoid another bailout, these reforms have been recommended in UK. (Curtis 2011). ICB has received about 150 suggestions from various stakeholders of UK banking industry about whether to separate the investment banks from commercial banks or not. Those who support the separation are of the view that as there exist a funding subsidy offered by retail deposits, separation of risk and rewarding of banking employees around the globe for venturing deposit holders fund judiciously is essential. Further, a spilt is recommended that the inherent “too big to fail” warrantee is distorting the market. However, critics who argued against split felt that it would have a dire impact as business requires access to a broad variety of complex financial instruments and at the same time, basic financial services and also advocated that a separation may not yield financial stability as forecasted. (ICB 2010) Some of the respondents supported to make ex ante structural division of banks and carrying the risky investment products through a separate subsidy thereby the parent with retail activity would not suffer any damage during any future banking crisis. Some critics disputed that it would minimise the chance for cross-subsidies among the divisions of the banks, but some critics still advocate that there would be synergies that would benefit the banks. Some viewed that the recommendation from Basel III was not adequate, and some saw less robustness due to measures taken with regard to risk-weighted assets. It is advocated that the cost to consumers is likely to increase though liquidity restrictions may enhance the stability. Some respondents expressed concerns for giving super-priority to repo assets. Some of the view that the split would increase the equity whereas some are the view that there would be an advantage of contingent capital, which includes “bail-in” incentives by UK government. (ICB 2010) Some respondents were of the view that proprietary trading by banks had restricted value to the UK economy and suggested that there should be a total ban on banks for such activities or there should be some cap within which banks have to engage in such activities. As opposed to market-making and hedging activity, majority of the respondent were of the view that they witnessed some difficulty in recognising proprietary trading. It has been suggested that there should be more openness as regard to charges and fees for retail customers in the case of specialised derivative instruments and full disclosures about the wholesale market activities by banks in the bank balance sheets are to be disseminated. (ICB 2010) Some respondents considered the Lloyds –HBOS merger had market twisting impacts and however, they opined that the State Aid divestments as adequate to retort to this. Some were of the view that UK still remained competitive despite the fact that the level of competition was high in the UKs retail market. Thus , on going through the various representation and recommendation , ICB has felt that though there is a direct link between competition and stability but the link between the two is not certain and there is also non availability adequate empirical evidence. There had been a view that there was no justification why the two could not exist together as this could be accomplished through transparency and good regulation. (ICB 2010) With the introduction in Glass-Steagall Act as early in 1933, separation between retail banks and investments was first ever introduced in USA. Due to Big Bang, the above act was repealed in 1999, and again commercial banks were allowed to combine investment banking in their business venture in USA. It is to be recalled that the failed UK banks did not have investment banking. For instance, Bradford & Bingley and Northern Rock were engaged in high –street operations and RBS failed due to its unfortunate acquisition of ABN Amro. Until its merger with HBOS, Lloyds bank had excelled its performance both in investment and retail banks. As per Robert Peston of BBC (British Broadcasting Corporation), separation of investment and retail banking would enhance the availability of finance for two significant sectors of economy, companies and consumers that are so small to obtain a loan from markets or investors directly. Further, the splitting up of investment and retail banking would remove the subsidy from investment banking and would make it as less lucrative. Some critics lament that “ring fence” proposal advocated by ICB is not harsh enough and for any ring fencing to be successful, there should be virtual split between investment and commercial banking. However, critics argue that a virtual separation would offer the “vibrant firewall” for retail banking as it would be tremendously costly and the banks would lose all the charms of global banking. Thus, the banking reform in UK should make sure that there should be adequate protection of hard-earned money of consumers and there should be a fool-proof system should be in existence where no taxpayer money will be used to bail out the failed banks at least in the near future. (Cameron 2011). List of References Avgouleas, E. (2011) Regulating the Global Financial Institutions .The Unresolved Challenge. [online] available from < http://denning.law.ox.ac.uk/news/events_files/REGULATING_GLOBAL_FINANCIAL_INSTITUTIONS.pdf>[ accessed 3 February 2012] Cameron, D. (2011) Banking: Will a Firewall Stop Another Crisis? [online] available from [accessed 3 February 2012] Curtis, P. (2011) How Much Did the Banking Crisis cost Taxpayers? [online] available from [accessed 3 February 2012] Evanoff, DD, Hoelscher, DS & Kaufman, GG. (2009) Globalisation and Systemic Risk. London: World Scientific HM Treasury. (2010). Maintaining the Financial Stability of UK Banks. London: TSO. ICB. (2010). Issue Paper Call for Evidence. [online] available from [accessed 2 February 2012] ICB (Independent Commission on Banking). (2010) Response to Issues Paper [Online]available from [Accessed 4 February 2012] Neave, E H. (2010) Bank Runs and Systemic Risk. New York: John Wiley & Sons UK Parliament. (2010) Maintaining Financial Stability of UK banks: Update on the Support Schemes. London: TSO UK Parliament. (2009) Banking Crisis: Regulation and Supervision. London: TSO Read More