Banking regulation and risk - Essay Example

?Banking Regulation and Risk The 2008 financial crisis that started in the United s and immediately spilled over to many economies across the globe highlighted several problems that need to be addressed in the current financial system in order to prevent the same catastrophe from happening again. The gravity of the problem is underscored by the length and the damage wrought by the slump, which some economists called as a recession and financial shock. In the effort of prevention, it is crucial to identify the causes of the financial crisis. Understanding the Slump Technically, it was the collapse of the American subprime lending market that has caused the crisis. But from its manifestation in the year 2007 towards its end in the latter part of 2009, the crisis proved to be an amalgamation of problems that facilitated and aggravated the crisis sparked by the subprime lending market crash. The consensus is that global macro-economic imbalances and financial innovation, which aggravated the excessive credit and liquidity expansion, combined with the failures in regulation, supervision and corporate governance collectively led to the financial crisis that has acquired global proportions. (UK Parliament, p. 7) The specifics of the causes of the financial crisis reveal a multi-faceted financial problem that, unfortunately, all boiled down to the matter of faulty and ineffective financial policymaking, regulation and supervision. For instance, central banks erred in keeping inflation in historic lows because it led to the ease by which credits were made available. Then financial institutions, in their greed to achieve higher returns, took more and more risks by introducing increasingly complex financial products which eventual taxed the long-term stability of financial institutions. September 2008 saw the peak of the crisis as ten large financial institutions failed or nearly failed, triggering a financial panic and resulted in the large contraction of the global economy. (Financial Crisis Inquiry Commission 2011, p. 417) In the early part of 2011, much of the world are still reeling from the financial crunch either recovering, rebuilding or are still in its clutches . The United States is still currently struggling, barely posting positive growth. The legacy of the 2008 financial crisis is undeniable, the current global financial system - its risk-based regulatory framework lacks a kind of efficiency and authority to check each and every element of the financial crisis as we watch them happen helplessly. This should already prompt us to questions existing frameworks and conventions such as the Basel II and the existing risk-based regulatory framework that govern the world financial systems. The Problem with Basel II The second installment to the Basel Accords, Basel II is a compendium of recommendations on banking laws and regulations drafted and implemented by the Basel Committee on Banking Supervision. Basel II is supposed to be a mechanism that would prevent crisis such as what was experienced in 2008 from happening. The idea is to setup an international standard or best practices benchmarks that financial regulators could use in their policy- and decision-making. The standard is anchored on the establishment of risk and capital management requirements that would supposedly force banks to maintain capital reserves according to the risks that a financial institution is exposed to as a result of its banking practices. The problem, wrote Padmalatha (2011), is that Basel II is a quantum leap from Basel I and that those tasked to implement and promote its standards were not ready and skilled, making Basel II problematic for regulators and banks themselves. An important argument is the Basel Committees own admission that risk based capital requirements - a fundamental element of Basel II - could inevitably lead to procyclicality, typified by how banks lend more due to an upbeat economy. Padmalatha stressed that "when business cycles take a downturn, banks downgrade the borrowers due to increased likelihood of default and therefore, have to maintain more capital" finally leading to capital shortage, the restriction of credit and the eventual deterioration of the economy. (p. 348) Current Framework And so, all in all, Basel II highlighted the deficiencies of the current regulatory mechanisms especially those in the area of risk-based framework. According to Hermann (2009), Basel II does not deal at all with the question of adequate or appropriate supervisory powers of national authorities because it has been considered as purely domestic domain covered by national legislations. (p. 27) The author explained that the Basel framework emphasized a type of regulatory framework that focuses on the risk positions of individual institutions and financial groups and less on the systematic interconnections within the international financial market. (p. 27) Presently, under the existing international regulatory framework, bank regulators and supervisors play the mere facilitators of the risk management process and that they also just monitor the statutory framework in which it is undertaken. (Van Greuning & Bratanovic 2009, p. 46) We are still within the pre-crisis situation since reforms are only being initiated as we speak. It is still not unusual for countries to use different organizational structure, regulatory and supervisory standards and mechanisms, which all contribute to the seemingly chaotic process by which the global financial system is struggling to overcome. Solutions An important area of reform for a financial organization such as ours is to immediately implement reforms – those designed to setup risk-based regulatory framework that could effectively address those variables that the existing mechanisms could not cover effectively. Short-term solutions include the creation of a stable and enabling environment. By doing so, a regulator or a supervisor play a pivotal role in changing numerous policies by influencing players and policymakers to act according to the most recent best practices/standards. Basel II should also be improved. Its inadequacies, as cited by this proposal, are serious and some quarters consider them as contributing factors in the 2008 financial crisis. Most importantly, however, is that the purpose of the Basel accord is ideally the best possible solution to the identified problems that brought about the financial crash. By setting up an international standards and best practices guidelines, the global policy networks are ensured to work as one. So what are the areas of improvement? First, modifying Basel II is already a stale proposition because Basel III has already been introduced. This accord is specifically tailored in order to address the issues that caused the 2008 financial crisis as well as those effects that came after. Particularly, the regulatory weaknesses have been given primary attention. The new framework is characterized by some of the following important reforms: Banks capital requirements are tightened; Important financial institutions are required to have a loss absorbing capacity beyond the minimum standards outlined; The requirement for an international harmonized leverage ratio; The establishment of minimum standards for liquidity risks; and, The enhanced standards for bank supervision that address vulnerabilities in risk management, including corporate governance, compensation practices, market discipline and stress testing. (OECD 2011, p. 41) As previously mentioned, Basel II has been a quantum leap in comparison to its predecessor. The second framework would have worked had it been implemented faster. Unfortunately, regulators took time in implementing the old standards, hence, it ended in failure to the point that it contributed to the expansion of the recent financial crisis. This is now the area of interest in this proposal. There is a need to implement the standards of the Basel accord immediately and without delay. The entire framework is specifically designed to avert financial crisis and strengthen the global financial system. The arguments and the new standards are sound and valid. Securitization Another important framework that deserves to be utilized again (especially when the financial crisis originated from a credit bubble) is securitization. Simply put, it is an approach of selling combined diverse kinds of debts such as mortgages and credit card debt. These combined debts are sold as bonds, pass-through securities or collaterals to willing investors. What it does is convert lender-borrower loan relationships into capital market commodities. (Kapil 2010, p. 572) When the debtors (receivables) are sold, assuming the form of securities, liquidity is enhanced. This is an example of effectively managing risks because it separates the loans that will be securitized from the debtor’s balance sheet. The process involve an integration of the market because the gap between the primary and secondary markets are effectively linked for consumer credit. (p. 572) An organization can benefit from this scheme in so many ways. For instance, by making financial markets tradable, securitization: 1) reduces agency costs that result in the more efficient financial market; and, 2) improves liquidity for the underlying financial claims thereby reducing liquidity risk in the financial system. (Fabozzi and Kothari 2008, p. 284) Conclusion The legacy of the 2008 financial crisis would be forever etched on our minds. The causes of the crash are clearly identified and with that knowledge, we are more equipped to deal with it today and in the future. We now know that there is a need to reform regulatory frameworks and to enforce more conservative risk-taking strategies within financial organizations. But as with Basel II, the current initiatives at regulatory reforms may be doomed to fail yet again. There is, hence, a need for contextual framework or a clear understanding as to why and how regulation should exist so that cooperation is easier to achieve. In addition, the regulation should take an international outlook. There should be a mechanism that would reconcile and determine which takes precedence between international and national boundaries in the issue of regulation. References Fabozzi, F. and Kothari, V. (2008). Introduction to securitization. Chichester: John Wiley nd Sons. Financial Crisis Inquiry Commission. (2011). The Final Report of the Financial Crisis Inquiry Report. Cosimo, Inc. Hermann, C. (2009). European Yearbook of International Economic Law 2010. Berlin: Springer. Kapil, S. (2010). Financial Management. New Delhi: Pearson Education. OECD. (2011). OECD Economic Surveys: United Kingdom 2011. Paris: OECD. Padmalatha, S. (2011). Management of banking and financial services. New Delhi: Pearson Education. UK Parliament. (2009). The future of EU financial regulation and supervision. London: Stationery Office. Van Greuning, H. and Bratanovic, S. (2009). Analyzing banking risk: a framework for assessing corporate governance and risk management. Washington, D.C.: World Bank Publications. Read More