Critically examine the future of banks as financial intermediaries - Essay Example

A Critical Examination of the Future of Banks as Financial Intermediaries Introduction 2 Underpinnings 3 Financial Intermediation 4 The Problems 5 Conclusion 7 References 10 Introduction The banking sector represents the backbone of the global and national economic system as they are the repositories of money that is deposited, loaned and provided to fuel business activities. Lending is their primary activity and the means via which financial intermediaries earn a profit. That foundation has come under fire as a result of financial crises that have come in more rapid intervals, and increased depth. Based upon conditions and circumstances, individuals as well as companies borrow funds over the long term in capital markets (Scholtens and van Wensveen, 2000, Pp. 1244-1247). The foregoing is different in money markets where lending or borrowing is on a short-term basis (Scholtens and van Wensveen, 2000, Pp. 1244-1247). Capital markets represent where equity securities and or debt is traded (Osano and Tachibanaki, 2001, P. 4), with money markets representing where short term debt securities as represented by commercial paper, repossessions, treasury bills, banker’s acceptances and negotiable certificates of deposit that have maturities of from 30 days to one year (Lapavitsas, 2003, P. 13). An important distinction that exists in capital markets is that the borrowers tend to represent entities seeking to spend in excess of their present income as represented by those individuals or companies where their present income is in excess of expenditures (Allen and Santomero, 1996, P. 4). Within the capital markets the borrowing and lending functions include the issuance as well as sale of bonds and shares, which is termed as direct financing, and intermediated financing which represents dealing using financial intermediaries which represents the bulk of all transactions made (Matthews and Thompson, 2008, Pr. 35-36). The subject matter of this study has broad scale ramifications as evidenced by the most recent financial crisis that has griped the international community. The free wheeling lending of mortgages to high credit risk home owners started a global meltdown that has run for over two years and created unemployment levels as last seen in the Great Depression. This examination will look into the facets of financial intermediation to expose its weak points and recommend international action that is not a new view, it is one that already has be proposed through the Basel II Accords that are mandatory in Europe. Underpinnings Financial intermediation represents a process entailing surplus units, as represented by individuals and or companies whose current income exceeds present expenditures, to what are termed as deficit units, those individuals or companies who are seeking to spend more than their current income (Matthews and Thompson, 2008, Pr. 35-36). As the current global financial crisis has pointed out, the volatility in capital markets (shares and bonds) has exposed the weaknesses of financial intermediation, especially in the case of banks that were hit by a raft of defaults stemmed from the sub prime meltdown as well as their being over extended in general lending as a result of competitive pressures, along with the need to post higher shareholder returns and performances (Geithner, 2008, P. 2). The foregoing underpinning was a result of nearly a decade of unparalleled growth and stability in financial markets that set the underpinnings to surplus units expending lending to deficit units, underscored by less than credit worthy borrowers in the U.S. housing market (Geithner, 2008, P. 2). Accompanying the foregoing was what Geithner (2008, P. 3) termed as “The proliferation of credit risk transfer instruments was driven in part by an assumption of frictionless, uninterrupted liquidity …” which he went onto explain “ … left credit and funding markets more vulnerable when liquidity receded”. The core of the present liquidity crisis resulted when banks, along with other financial institutions lent out huge amounts based on their thinking that the risk could easily be spread into the liquid global markets (Geithner, 2008, P. 3). Newly crafted credit default derivatives, whose implications were unknown, proliferated in financial markets as a means to diversify risk, which were then split up, repackaged and sold again, sparking more borrowing, and thus further extension of risk underpinnings (Dubofsky and Miller, 2003, Pp. 158-159). The well-known results were that when home loan mortgages based on sub prime borrowers began to default, the underpinnings of the risk fell apart, and banks globally were caught up in the cascade of defaults that swept through the system (Dubofsky and Miller, 2003, P. 311). Financial Intermediation In light of the foregoing, financial intermediaries thus can be distinguished via four criteria (Matthews and Thompson, 2008, Pp. 35-36). The first is represented by liabilities, which are deposits that are specified by a sum that is fixed where the foregoing is not related in terms of portfolio performance (Matthews and Thompson, 2008, Pr. 35-36). Secondly, deposits are usually of a shorter term than assets, with the third criteria represented by a high percentage of liabilities (deposits) being able to be withdrawn on demand (Matthews and Thompson, 2008, Pr. 35-36). The last criteria is that their assets and liabilities are by and large not transferable, with the exceptions being certificates of deposits as well as what is termed as securitisation (Matthews and Thompson, 2008, Pr. 35-36). The last term represents the area that embroiled banks in the subprime meltdown as securitisation represents structured finance whereby risk is distributed by putting the instruments into a pool that then creates new securities that the pool backs (Peterson, 2001, P. 14). Thus, financial intermediaries (banks) that make loans directly and accept deposits represent the importance source in fund flow from the surplus units to the deficit ones (Allen and Santomero, 1996, P. 4). Within the preceding capacity, financial intermediaries have main functions as represented by their brokerage and asset transformation functions (Freixas and Rochet, 1997, Pp. 29-33). The brokerage function represent where banks out together the sides in a transaction, along with providing allied services thus reducing costs (Fisher, 2006, P. 35). Under a bank’s asset transformation function, it issues claims that are more attractive by breaking down large denominations issued by corporations into units and thus spreading availability (Fisher, 2006, P. 35). In addition to the foregoing, financial intermediaries also evaluate credit risk, making the process asymmetrical and thus complicating the process for those outside of the realm in terms of understanding the variables involved (Fisher, 2006, P. 35). The foregoing exploration of the main functions of financial intermediaries has been brought forth to provide a foundation for analyzing the future of financial intermediaries. The Problems Individual governments regulate banks, and herein lies the source of the major problems in financial intermediation as the policies, requirements, restrictions and guideline differ (Anderson, 2006, P. 42). As the preceding indicates, therein lies a major issue in the banking sector as the objective of regulation encompasses rules and regulations to reduce risk exposure in the protection of depositors, minimise misuse as represented by criminal activities, use the resources of the bank to direct credit to the proper sectors, and reduce systematic risk as represented by disruption from trading conditions and multiple banking failures (Anderson, 2006, P. 42). The aforementioned global financial crisis has brought forth the failure of banking regulation on a global scale as represented by the preceding individual governmental approach (Brummer, 2007, P. 24). The result is a hodge podge of regulations that in effect cause a domino effect as evidenced by the subprime meltdown that saw defaulting loans in the United States spread to countries and banks not involved in the lending who became embroiled in loans to purchase credit default derivatives that went under when home loan borrowers defaulted. The problem is that the international community is beset by national banking regulations in a global financial world. Banking has increasingly expanded in terms of crossing national borders, yet the framework remains mired in the past. The Financial Services Authority in the United Kingdom set forth a litany of issues besetting the international banking arena in view of the foregoing (Turner, 2009). The preceding underscored the core issues in financial intermediation that needs a system wide (global) approach in light of the transactional volume of today’s banking. Heading the list is that fundamental changes with regard to bank capital as well as liquidity regulations are needed, along with bank’s publishing accounts (transparency) (Turner, 2009). Banking capital was also brought forth as an issue, citing the need for higher limits as a means to underpin higher risk encountered as a result of trading activity. Other points raised were the need for the creation of a central role to tighten and regulate bank liquidity, international as well as national policies to control excessive risk taking, reforms to constrain high risk cross border activity, and attention to the proliferation of risk instruments (Turner, 2009). The foregoing sentiments were also voiced by the Obama administration under a report titled “Financial Regulatory Reform: A New Foundation: (Mayer – Brown, 2009, P. 2). The subprime mortgage meltdown and ensuing recession in the United States, along with the global credit crunch has forced the Obama administration to look at long standing banking policies in the United States as well as the relationship of the foregoing to the rest of the world. Risk spiraled out of control under the subprime mortgage crisis as a result of seeking to remove it as a component of banking portfolios (Mayer – Brown, 2009, P. 2). The problem with that approach is that risk does not disappear, no matter how many times it is repackaged and sold, in fact it actually multiplies in complexity and amount as it is spread around. With that in mind a series of proposals were put forth that would require the originators and or sponsors of risk to retain it (Mayer – Brown, 2009, P. 2). The report went on to add that the present banking structure in the United States, which is pretty much the case globally, is that loan originators and or sponsors should retain their responsibility for credit risk (Mayer – Brown, 2009, P. 2). The core of the subprime mortgage meltdown resided in the fact that the originating banks sold off their risk from less than credit worthy borrowers, thus removing themselves from the on hand capital requirements banks are required to reserve. The Basel Accords are “…an important feature of international bank regulation” (Brealey et al, 2001, p. xiv) as they compute capital ratios making a formal allowance for risk (Brealey et al, 2001, p. 5). The original Basel Accords were drafted in 1988 and have been revised by the Basel II Accords that represent an upgrade to deal with the new financial variables of today’s rapidly changing markets (Padoa-Schioppa, 2004, p. 8). The Asia Crisis represented an instance that brought forth the need for new banking regulation foundations that increased international reserve holdings to provide what is termed as self insurance in terms of capital flow reverses (Feldstein, 1999). In hindsight, the Asian Crisis represented a warning against the pitfalls of the subprime mortgage meltdown where the preceding occurred, along with other newer and more modern developments that revealed further weaknesses in the global banking system. The aforementioned unregulated credit default derivatives problem was such a development that harkened back to increased international capital reserves. The intertwined basis of the international banking system means that national regulations in the absence of a global standard is outdated. Anderson (2007) helps us to understand the complexities by telling us that “Banks, the traditional lenders, became mere conduits connecting borrowers to the much deeper pockets of the global financial system”. He helps us to understand the preceding further by stating “Loose underwriting standards allowed loans to be made that in retrospect should never have been done based on collateral of questionable value” (Anderson, 2009), The absence of international standards represents a loophole whereby the foregoing was possible. At the heart of the foregoing is the fact that deregulation of the banking sector has caused it to become more competitive. This opened the door to the current problems as the distinction between different types of banks was removed, thus increasing competition and the quest for profits as the primary directive, with risk becoming secondary. Conclusion The preceding segments have pointed out the weaknesses inherent in the international banking system as that unless a uniform and mandatory system is put into place, the future of banks as financial intermediaries looks seriously clouded and fraught with problems that will keep resurfacing. The foundational background on these issues calls out for an approach that addresses these deficiencies. Basel II provides for putting in place capital adequacy levels to ensure stability in the financial sector, however, outside of Europe they are not mandatory (Banco de Espana, 2005). The foundational premise behind the Basel II Accords is that soundness as well as safety in the financial system requires 1. effective internal management, 2. market discipline, and 3. supervision (Banco de Espana, 2005). These elements are not present on the international stage as a uniform set of regulations and rules. The core of the Basel II Accords is that the nature of banking requires internal systems to identify and control risk through information systems that is regulated by compliance. The three tier system devised that places higher capital reserve requirements on those banks with the minimum control levels represents the first such step in the direction of dealing with today’s fast moving markets. Sadly, this is not universal. As the preceding is key in terms of the direction in which the banking sector should move, the following highlights key components. Under minimum capital requirements Basel II sets forth three elements, 1. a definition of regulatory capital, 2. risk weighted assets. 3. minimum ration of capital to risk weighted assets (Banco de Espana, 2005). The above thus represents the means to calculate the capital necessary to be set aside as risk protection that is reviewed by regulators (Banco de Espana, 2005). Supervisory review is the provision to ensure financial services companies retain the needed capital to underwrite the risk they take on and adopt best practices concerning risk management and monitoring for each instrument and other areas. Market principles entail disclosure and enhanced transparency to reveal publicly the risk exposure and other significant policies and actions (Banco de Espana, 2005). The driving factor behind Basel II is the avoidance of bank failures using three key mechanisms. The Basic Indicator is the lowest approach and requires higher capital adequacy ratios thus making it an incentive for banks to achieve either a Standardised Approach or the higher level Advanced Measurement Approach that has the lowest capital adequacy due to heightened risk management and monitoring techniques that limit exposure (Banco de Espana, 2005). This discussion of Basel II has been undertaken as it is at present the most advanced bank regulation system and is the direction that global banking should undertake in order to avoid the pitfalls and financial crises that have befallen the sector in the last two decades. These failures have become increasingly deeper and more risky, as evidenced by the current economic malaise as triggered by the subprime meltdown and ensuing credit crunch. The current problems as indicated in this examination has pointed out the weaknesses and inherent dangers present in the national regulatory approach that has been brought forth through banking deregulation. The quest for higher profits in the face of intensified competition has led banks to pursue more risk at the promise of higher returns as opposed to the provisions of sounder banking policy, decisions and actions. The conferences and pronouncements by the United Kingdom’s Financial Services Authority and the Obama administration are calling for the tenets of Basel II, which as one can foresee is being resisted by none Basel II compliance countries outside of the European Union as the stringent measure harkens back to more regulation, providing those that do not adopt these policies with a competitive advantage in having more capital to lend by not adopting the standards. The foregoing point to the banking sector becoming a more risky environment as transaction totals on a global scale increase, as well as risk factors becoming hidden in newer derivatives that have unknown exposures. The speed at which transaction move on a global scale entails a high degree of trust in the banking sector, which the recent meltdown has shown can be the underlying cause for missteps that impact the entire system. Thus the future of banks as financial intermediaries has already lost considerable luster in the face of frequent bank failures and bailouts that are borne by taxpayers. Unless the sector voluntary moves in the direction of universal regulation, another future crisis will surely surface. Disaster will see the public clamour for more regulation in the face of the dangers posed, with the solution requiring that the major banking centres as represented by Europe, the United States, and Japan leading the way. The emerging economies of Russia, China and India, while not at present in the major banking sector group, are fast approaching that status, thus including them in this universal adoption is needed. A coalition is needed to pull the other nations into line through freezing them out of the major transaction band unless they adopt the measures needed to move toward banking soundness as a result of a universal system. Globalisation and open borders is calling for the recognition that business as usual is a recipe for disaster. References Allen, F., Santomero, A. (1996) The Theory of Financial Intermediation. Financial Institutions Center. Wharton School, University of Pennsylvania. P. 4 Anderson, R. (2006) Rethinking Bank Regulation: Till Angels Govern. Vol. 26. The Cato Journal. P. 42 Anderson, R, Sundaresan, S and Tychon, P (1996) Strategic analysis of contingent claims. Vol. 40. European Economic Review Banco de Espana. (2005) How Individual Capital Requirements Affect Capital Ratios in UK Banks and Building Societies. Document No 0515, Banco de Espana. ISSN: 0213-2710 Brealey, R., Clark, A., Goodhart, C., Healey, J., Hoggarth, G., Llewellyn, D., Shu, C., Sinclair, P., Soussa, F. (2001) Financial Stability and Central Banks: A Global Perspective. Routledge Publishers. London, United Kingdom Brummer, A. 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