International Banking Regulation in the United States - Essay Example

International Banking Regulation Customer’s Name Customer’s ID Grade Course Tutor’s Name (June 19, 2012) Question 1 The world has experiences several global economic crises, which though stemming from advanced economies like the United States, have been felt across the globe. These past crises and the recent crisis in 2008 have exposed the inadequacies of international financial regulation. The limitations that plague existing regulatory frameworks in preventing the occurrence of such crises, or mitigating their effects are a source of significant concern among policy makers and standard setters. In response, the international financial regulation framework is going through e metamorphosis of sorts, with massive changes proposed and expected to take place. Basel II is set to undergo various changes which are set to be implemented through Basel III. The process of modifying Basel II has been undertaken through processes that have had greater emphasis on transparency. The participation of the public has been at a substantially high level, and views from public participants have featured significantly in Basel III. This reflects the realization that international regulation requires significant levels of transparency and accountability, to avoid practices that may plunge the world into other crises of similar or higher magnitude. Basel’s core principles are universally applicable, and set minimum standards and to be complied with in sound financial supervision (Basel Committee on Banking Supervision, 2006). Effective systems of supervision are intended to strengthen the international financial system, and improve the stability of financial systems. The committee’s core principles include; that banks must monitor their credit relationships through a mechanism founded on sound principles and prudent practices, banks must pursue policies, procedures and practices of evaluating assets that are effective in strengthening their financial position and that banks must not concentrate their credit exposure on one or a group of borrowers. Supervision measures must be able to detect such exposures, and also review and assess a bank’s lending policies to ensure compliance with the core principles. The Basel principles also require banks to meet specific capital requirements, and put in place effective mechanisms to manage their risks (Basel Committee on Banking Supervision, 2011). These, among others, are the principles that have undergone further development under Basel III. Proposals under Basel III aim at strengthening the regulation of capital base, and improving the risks that the current capital frameworks cover. Financial institutions are interconnected, and they, therefore, are faced with systemic risks. To strengthen the global capital framework, Basel III proposes to improve various principles in Basel II. For example, quality capital bases are essential in backing banks’ exposures to risk. In addition, disclosure and consistence in regulation practices ensure that the quality of capital is assessed and compared between institutions (Basel Committee on Banking Supervision, 2011). To achieve the above stated aims, Basel III states that retained earnings and common shares must dominate Tier 1 capital. The remainder of the Tier I securities should not possess an incentive to redeem or have a maturity date. Harmonization of Tier 2 securities will take place under Basel III, and those that cover market risks are eliminated. To improve discipline and transparency in financial regulation, banks are required to disclose elements of their capital, which should be reconciled with the accounts that they report (Basel Committee on Banking Supervision, 2011). Secretive dealings and lack of transparency characterized the 2008 and past financial crises. The quality of capital assets held by banks was also questionable, and supervisors were not able to prevent lending to undeserving or unworthy borrowers (Basel Committee on Banking Supervision, 2011). When the crisis happened, banks could not adequately handle their losses because they did not have adequate capital assets. Raising the bar on the quality of capital base that banks must have and requiring increased transparency in their dealings is definitely a positive move. Transparency will assist in reducing financial impropriety incidents, and bolster public confidence in financial institutions. Basel II encouraged and fostered securitization of loans. This led to a situation where major balance sheet risks and exposures were not captured. Consequently, the real extent of banks’ risks and exposure were not apparent to the public or supervisors. This state of affairs contributed to the destabilization during the crises, and this is one of the problems that Basel III seeks to fix. The reforms under the accord in response to this problem are aimed at strengthening the capital framework’s risk coverage. To achieve this, capital requirements for banks are raised, and they are based on a continuous period of 12 months. Stressed inputs must be used by banks to determine counter party risk. Where banks have large and liquid derivative counterparty exposures, then they are required to apply a longer margining period than the standard 12 months. Risk weights to exposures have also been raised. Those affected are exposures to financial institutions. Hopefully, these measures will assist to reduce the systemic risks found within the financial sector. Most economic crises have been characterized by a build up of the balance sheet leverage. Measures that have been used in the past to take care of this problem pressed asset prices down, led to declines in bank capitals and the availability of credit contracted. In addition, they have been proved to hurt economies and financial systems. The principles of Basel II, did, therefore not offer effective solutions to the various regulatory problems which led to the 2008 crisis In response, the Basel committee has introduced new requirements on ratio leverage. These requirements are intended to; mitigate the adverse effects of the deleverage processes by constraining leverage, and supplement risk-based measures of risk to reduce measurement errors and preventing model risks (Basel Committee on Banking Supervision, 2011). The proposed leverage ratio can be adjusted to changing accounting standards across jurisdictions. This new ratio requirement is more credible than the risk based requirement. It is applicable in many jurisdictions ant takes into account differences in accounting methods that may exist in a particular state. It is more transparent and may prove to be effective in reducing measurement errors. It is a simple, independent and transparent way of measuring risk (Basel Committee on Banking Supervision, 2011). Banks have in the past, acted as transmitters of risks into the economy and financial systems. This has often been done through procyclical behaviour, leverage build up and release, holding loans to maturity and margining practices. The proposed measures will bolster banks’ resilience in favourable times, and turn them into shock absorbers and not transmitters of risk. To protect banks from the development of excess credit and erect cushion to absorb shock, Basel III proposes measures to conserve capital (Basel Committee on Banking Supervision, 2011). Among the principles of Basel II under review is that requiring banks to ensure that they remain financially healthy. This can only be done by maintaining adequate amounts of valuable capital assets, and keeping their exposure to unhealthy risks at a minimum. Under new measures proposed in Basel III, banks are required to preserve capital that should be drawn on in times of necessity. Such times may arise when there is a crisis. Preserving capital ensures that banks have buffers to absorb possible losses, and keep them afloat when bad times hit (Basel Committee on Banking Supervision, 2011). These measures are as a result of lessons learnt during the recent economic meltdown. Prior to the crisis, many banks engaged in activities that ate into their capital to ward off an image of weakness. These included; buying back shares, making generous payouts in form of compensations and large dividend distributions. Banks engaged in these activities though they were under severe financial strain. Some managed to continue operating profitably, but not enough to build back their capital reserves. Basel III presents a framework that allows regulators to promote the preservation of capital by the use of stronger tools than those employed under Basel II. Supervisors are also provided with improved tools for supervision. In the past, the Basel committee established that more than 20 different methods of supervision were employed by supervisors. This created disharmony in the supervision process, and loopholes emerged. To counter this, standardized metrics are introduced under the new accord (Brummer, 2012). To begin with, the framework will be implemented through capital conservation standards that will be internationally agreed upon. In addition, its flexibility allows banks and supervisory organs to respond in ways consistent with the standard. These standards and measures attempt to tackle some of the factors that led to the financial crisis. Lack of resilience among banks and buffers when faced with hard times were some of the factors that made them ill prepared to overcome the crisis. The proposed measures are a way of addressing these issues and ensuring that banks prepare for hard times in advance (Brummer, 2012). The regulatory principles under Basel II failed to capture important bank exposures to risk. These included; trading activities of a complex nature, off-balance sheet exposures and re-securitizations. New measures under Basel III call for increased transparency and disclosure. Accounting practices and principles are also set to change. Banks are expected to take an Expected Loss approach in their accounting practices (Brummer, 2012). This proposal under the accord is a positive measure. It will increase the relevance of financial reporting, and make it more useful to regulators and stakeholders. It has the potential to capture actual losses incurred by banks in a more transparent way. The stability of the banking sector significantly depends on strong capital requirements. However, this alone is not adequate to ensure stability among banks. A strong liquidity base is also equally important. These should be accompanied by internationally harmonised standards, which have been absent in international financial regulation. Basel III introduces a harmonised set of international liquidity standards, similar to the capital standards, that set minimum liquidity requirements (Brummer, 2012). Difficulties in proper management of liquidity got many banks into trouble during the crisis. This problem faced even banks that had strong capital bases. As the crisis pressed on, market conditions experienced a reversal and liquidity quickly evaporated. Principles established under Basel III detail the guidelines to follow in liquidity risk management. Guidelines for liquidity management supervision are also provided. These principles carry the promise of sound liquidity and risk management (Brummer, 2012). However, this is only possible if they are implemented by banks and enforced by supervisory authorities. The proposed changes under Basel III are a good attempt to solve problems caused by the crisis, and also assist banks to prepare for such times. The preparation measures proposed manly deal with the maintenance of adequate capital bases and liquidity. The new accord requires banks to hold capital on reserve which is three times that required under Basel II. The failure by a bank to meet these requirements prohibits it from issuing dividends. The implementation of such measures will address many of the issues surrounding the financial meltdown. First of all, banks will have sufficient cushion mechanism against losses that could possibly occur (Brummer, 2012). There is, however, a problem that threatens the success of such measures. Some provisions are not effective until 2015 and 2018. These are to do with credit and liquidity requirements. Though these are meant to give some banks ample time to prepare and get ready to comply with the new rules, it is possible that a crisis may occur before this time and the banks will not be ready to deal with it (Brummer, 2012). This may turn out to be counteractive to the rules set under the accord. Basel III addresses the causes and consequences of the global crisis. However, the measures proposed under the accord may not be adequate to avert financial crises in future. For example, the high capital requirements may be a disaster waiting to happen. It is possible that banks may experience reduced returns on capital. To make up for these deficits, they may be tempted to engage in risky banking practices. This may very well counter the efforts of the Basel accord to reduce such exposure by banks. Question 3 Globalization has changed the nature of business transactions in the world we live in today. The decisions of financial institutions in one part of the world affect individuals and institutions half way across the globe. These cross border practices, though to a certain extent subject to domestic laws of the relevant countries, are mainly regulated by an international body of rules and regulations. These rules are not made by a single state, but by global financial bodies such as the World Bank, IMF, and a few wealthy countries. These rules and regulations made through treaties and international agreements, evolve into the body or laws commonly referred to as International Financial Regulations (Brummer, 2012). International financial regulations have gained prominence over the last two decades, due to myriad factors. The occurrence of global financial crises has been one of the most pressing reasons why this body of regulations has come under scrutiny. The way financial institutions are governed across the world is of significant concern to governments, individuals and other financial bodies (Brummer, 2012). This is because of the chaos and perils that financial mismanagement can cause across the globe. The interconnections among financial institutions, global investments and sound regulation practices highlight the significance of international financial regulations. ‘Soft’ administrative structures characterize international financial regulation. The regulatory organizations are set up by agreements, informal by laws and declarations that lack the formal trappings of international law instruments. The informal charters on which they are based are not ratified by states, and they are easily modified by members at meetings. This gives international financial regulation a lot of flexibility that enables organizations to respond to evolving financial situations. For example, if a crisis occurs, the members just meet and agree on new measures to handle it and forge a way forward. These organizations are sometimes incorporated in countries where they have headquarters for purposes of contracting and carrying out business. Though they lack dispute resolution organs, they have disciplinary mechanisms keep rogue members in check (Brummer, 2012). The international regulation is fragmented, and dominated by regulatory agencies. It is a system that lacks a central governing body or authority to set standards, enforce compliance or settle disputes. Various independent institutions take part in the regulatory process, with none being explicitly vested with authority over others. This being the situation, responsibilities are shared amongst them as they arise. The fragmented nature of international regulation is often a source of criticisms over its clarity. Regulations are found in innumerable documents, most of which are agreements entered into at various meetings. These are sources of the best practices that mark international regulation, but they far reaching and cover a wide range of issues (Brummer, 2012). The regulatory agencies are led by professionals in the financial world. The policy-making process of these organizations is far from democratic. The policymakers come from countries that more often than not, wish to advance the economic agenda of their countries of origin. These agenda are then presented to the other player to follow. The decision makers are mostly from members of the G-20, who also dominate the Financial Stability Board which is central to the operations in international regulation. International financial regulation is, therefore, not a ‘global’ process, as only a few countries really participate in the process. Regulators from less wealthy nations have no choice but to comply with what has been agreed (Brummer, 2012). The agreements entered into by international regulators often lack the force of law. They do not impose legal obligations on the parties to the agreements. This makes their enforceability difficult, as the dilemma over what penalties to impose for noncompliance arises (Brummer, 2012). The fact that an enforcing authority is absent compounds the situation. Since most of the participants seek to further their country’s interests, if some regulations do not favour domestic trade, then those institutions may refuse to honour the agreement. At other times, it may appear that parties have no intention of complying with the regulations. In this case, other members may have no incentive to comply. The success of international financial regulation is, therefore, not always assured or predictable. Global financial institutions such as the World Bank, IMF, a group of wealthy nations (G-20) and international conventions specifically the Basel convention form part of the ‘international governors’ that make the rules in international financial regulation. The agreements they enter into ultimately affect the way banks and other financial entities are run across the globe. Though a body specifically mandated with the enforcement of these regulations does not exist, financial institutions are forced to comply with them by various factors (Brummer, 2012). These include; the costs of not complying such as restrictions on business activities, the need to protect their reputations and the disadvantages of interrupting their services due to noncompliance. The international regulation of financial institutions by global bodies through a body of regulations termed as ‘soft’ law comes under criticism for various reasons. There are arguments that they should not be termed as ‘real laws’, because they do not conform to the usual characteristics of laws. Another criticism is that they do not have a coercive effect, and an enforcing authority is absent. This is contrary to the positivist requirement that laws must be enforceable, and an authority should exist to punish noncompliance. The perceived lack of accountability in these regulations has also been a source of criticism. These are criticisms that have been levelled against most bodies of international laws and regulations. The arguments have always been that the lack of an international ‘government’ to enforce them robs them of legal force, and, therefore, they are really not laws (Brummer, 2012). Attempts to measure the legitimacy of any law essentially have leanings towards the ‘input’ and ‘output’ notions of legitimacy. Input legitimacy connotes the traditionally acceptable forms of legal regimes. These are regimes riddled with democratic connotations, and whose authority derives from the public. The decision makers are given authority to represent and make decisions on behalf of the represented through a democratic process of elections. The consent of the governed is, in this case, expressly given. The transfer of power to make decisions from the governed to the governor bestows legitimacy on the legal regime (Brummer, 2012). Input legitimacy features relatively less, in at all, in international financial regulation. Output legitimacy features prominently, and it assumes or implies the consent of the governed from the success of its implementation. Public participation is almost nonexistent in the regulation of international financial institutions. Regulations made by these institutions are justified in terms of compliance by countries and the achievement of desired results. When countries comply with these international laws, and when this compliance results in desired outcomes, then these are used to justify deviation from democratic processes (Brummer, 2012). Within the context of international regulation, regulations derive legitimacy from positive results for example, positive social impacts or gains of the regulations. The argument advanced in support of this form of regulation is that involving the public is not necessary for regulation to be legitimate. Societal gains bestow legitimacy on the regulations. The legitimacy debate about any legal system concerns itself with the foundation upon which power in the system is based, and upon which it stands. The power of regulators in international regulation stems from informal agreements. These agreements are entered into by un-elected officials. These are mainly the finance professionals and executives. Finance ministers of countries involved are only rubberstamps in the process. Authority in international regulation, therefore, does not stem from the people. The regulation lacks consent-based authority and does not mirror values of input legitimacy. This is one of the primary reasons why international financial regulation is heavily criticized as lacking legitimacy (Brummer, 2012). Sound legal systems must be characterized by laws that are legally binding. Laws must impose duties and obligations, non-compliance with which punishment or sanctions must be prescribed. An enforcing body must also be in existence to enforce compliance with the laws. This is a feature that international financial regulation lacks. Though there are mechanisms which as Brummer (2012) argues, wield more coercive power than traditional international laws, international regulation lacks express provisions on enforcement. Institutions that feel that compliance is likely to jeopardize their interests have no obligations to honour the agreements. Sanctions accompanying violation of the regulations are nonexistent. For these reasons, strong arguments have been advanced to the effect that international financial regulation is not legitimate. The criticisms are based on the source of power for its decision makers, lack of a central controlling authority, sanctions and enforcement body (Brummer, 2012). Accountability of public officials or those wielding power over the governed is one of the characteristics of a ‘proper’ legal system. One of the hallmarks of accountability is transparency in decision making. Stakeholders in financial regulations should be informed about upcoming policy decisions, the considerations used to make decisions and the results of various decisions among others. In analysing transparency in regulation, one may seek answers to questions such as whether information about the agencies’ decisions is readily available to the stakeholders (Brummer, 2012). For example, are minutes accessible by the public? International regulation has often been criticized for removing itself from public scrutiny. Minutes from meetings are not always available, and third parties are not allowed to attend most meetings, even as observers. The amounts of money involved in international financial regulations are astronomical. The issue of amounts involved alone warrants public scrutiny of the regulators’ actions and decisions. However, the regulatory instruments do not expressly provide for means of ensuring that there is transparency in regulation (Brummer, 2012). The fact that outsiders find it hard to learn how decisions were reached and who took which position makes it difficult to hold regulators accountable. This limited accountability, though not meaning absolute lack of authority reduces the credibility of international financial regulation (Brummer, 2012). It leaves it more exposed to criticisms about the accountability of the regulators. This compounds the problem that it has with legitimacy issues. Past regulatory practices have not prevented the occurrence of financial crises that have negatively affected global economies, and almost brought many of them to their knees. This, therefore, is proof that regulators need to think about other options in financial regulation. At present, only a handful of nations are involved in international financial regulation. Regulators should explore the option of expanding the participation of more stakeholders. This has already been attempted in the past, with the expansion of the G-7 to G20. However, this has proved ineffective in ensuring that there is effective regulation (Brummer, 2012). Expanding involvement in regulation to involve more participants may have positive impacts, in that there will be wider consultations and the interests of a wider group of stakeholders are taken into consideration. However, this may also present its own set of problems. Wider consultations may slow down the decision making process and the regulators may be unable to respond to financial calamities swiftly. In addition, it may not necessarily mean the involvement of less wealthy countries, as only wealthy states may be considered suitable to be trendsetters in the regulation process. Other options for consideration may include setting up a single authority to regulate financial activities, or involving finance ministers of member states in decision making. The latter would vest power in elected officials, but this would be problematic since they are only political appointees who may lack the requisite financial skills and know how (Brummer, 2012). The one option that I would subscribe to is the formation of a world body to regulate financial activities globally. This would bring some sanity to regulation, and put in place mechanisms to enforce regulations, resolve disputes and ensure compliance. This would also reduce the undercutting that characterizes the present regulatory framework. This happens since nations seek to advance their national interests at the expense of others. However, this option would not be without its own set of setbacks. A regulatory body would most likely, not enjoy much support globally. This is because of individual economic interests of the countries involved. In addition, it may not present a lasting solution to global financial crises. These are situations that require speedy responses, which may not be possible under such a regulatory body. References Basel Committee on Banking Supervision 2006, Core Principles for Effective Banking Supervision, viewed 19 June 2012, Basel Committee on Banking Supervision 2011, Basel III: A Global Regulatory Framework For More Resilient Banks and Banking Systems, viewed 19 June 2012, Brummer, C 2012, Soft law and the global financial system : rule making in the 21st century, Cambridge University Press, Cambridge. Read More