Banks: Capital Adequacy, Profit and Global Crisis - Essay Example

GLOBAL FINANCIAL CRISIS 0. INTRODUCTION The global financial crisis, which has started on 2007 and is still being experienced by most countries in the world, has caused massive economic devastation to countries across the globe. Its deleterious effect is felt by mass layoffs and closures of corporations and financial institutions, which left the ordinary people struggling and bracing themselves from this shock. The gravity of the financial meltdown has propelled scholars from various fields to come together and look for the root causes of this phenomenal event (Dell’Arriccia et al, 2008; Persaud, 2008; Danielsson, 2008; Bordo, 2008; Reinhart, 2008). In this regard, recognising that global financial crunch is multifactorial (Bordo, 2008; Wellink, 2009), still, it cannot deny the truism that one of the major factors that led to the global financial crisis is brought by banking failures and difficulties (Blundell-Wignall & Atkinson, 2008; Brown & Davis, 2004). Bank capital is a residual item that is calculated as the difference between assets and those other liabilities, which have more prior claims on banks’ revenues and assets. However, this simplistic definition of bank capital have changed overtime due to regulations and other exogenous factors brought by globalisation, national economies and policies. This continuous evolution on the understanding of bank capital has paved for the concept of bank capital adequacy, which is viewed as having a standing conflict with the notion of bank profitability. In light of this context couple with the gargantuan problem global financial crunch, this research will be looking into the conflict between bank capital adequacy and profitability in relation to the global credit crisis. As such, this research will seek to address the question What is the importance of the conflict between bank capital adequacy and profitability in relation to the global credit crisis? This study is significant because not only it presents current concerns of banking systems across the globe but also it shows the conditions with which banking systems are presently working. Moreover, it endeavours to understand old concepts in the light of the new experience of global financial crisis. Hopefully, this can provide help in the apprehending of the global financial crunch as well as in the charting of policies that may help prevent the same financial crisis from happening in the future. It is the hope of the researcher that the study may add to the existing discourse insights that may clarify the conflict between bank capital adequacy and profitability in relation to global credit crisis. 2.0. BANKS: CAPITAL ADEQUACY, PROFIT AND GLOBAL CRISIS Globalisation, known only in the last sixty years, has dramatically changed the way relations among countries especially in the matters of economics, trade, immigration and other similar concerns are transpiring (Soros, 2002). In the face of changes, corporations, businesses, culture and sectors of the society have transformed in order to cope up with the increasing demand and tougher market brought by globalisations (Hamel, 2006; Comite, 2009; Soros, 2002). In this sense, it can be impugned that the banking industry is not immune from change and has adopted to the demands of globalisation. This change is perceptible in the altered nature of the banking industry. According to Nisar (2009), the nature of banks is that it should be seen mainly as a service industry. Being a service industry, the banking industry offers diverse, multi- products ranging from deposits to investments and mortgage. This aspect of the banking system has been greatly transformed in the past thirty years. This is maintained on the supposition that before banks act as the intermediaries between depositors and borrowers. (Acharya & Richardson, 2009) However, currently banks are acting more as intermediaries between investors (rather than depositors) and borrowers. (Acharya & Richardson, 2009; 5). This fact becomes more perceptible in the light of the reality that banks are primarily private corporations protecting the interest of shareholders. Recognising the nature of banks and the current global condition with which they are situated, a global financial architecture has been set by some powerful countries (Armijo, 2001). The international financial architecture is designated to act as a guide or rule that governs or should govern cross-border money and credit transactions of all kinds (Armijo, 2001, p 380). Under this auspices, Basel I which was published in June 1999 and the New Basel Accord (Basel II) published in June 2004, have been created. A very important framework have been introduced by Basel I and II in the concept of bank capital – bank capital adequacy which stipulates a common capital requirements by banking organisations (Jackson et al, 1999). This regulation has been first adopted by G10 and later on by over 100 countries worldwide. The principle behind bank capital adequacy is that it strengthens “the soundness and stability of the international banking system by encouraging international banking organisations to boost their capital positions. While at the same time, the Committee believed that a standard approach applied to internationally active banks in different countries would reduce competitive inequalities”(Jackson et al, 1999, p 1). This principle is concretely applied through the policy wherein “banks are required to meet a minimum regulatory capital ratio of 8% under the Basel I and Basel II regimes” (Foos et al, 2007) and non-compliance involves sanctions. With all these good intentions, the bottom line of regular capital adequacy is that it acts a buffer for banking institutions in the face of threat of bankruptcy. This is made possible by the fact that a lower leverage ratio means that a bank has a lower probability that it will not be able to pay its debts (Barrios & Blanco, 2000) and in reverse it means that a higher leverage ratio means that the bank has a higher probability that it will not be able to pay its debts. In this regard, it can be claimed that bank capital adequacy acts as disincentive for unwarranted risk that the bank may take. This would have been easier implemented if banking were not complex. Unfortunately, it is. Basel I has mandated an 8% capital requirement. Basel II, which also requires such ceiling, has incorporated changes that includes a more sophisticated calculations for credit risk requirements, capital charge for operational risk and market disclosure and an extended scope for supervisory actions. In the face of these demands made by Basel II, what is the actual and real effect of capital adequacy to banks. In order to mitigate the effect of capital adequacy, banks have taken three diverse options. The first option is to decrease lending in order to cover the costs of capital adequacy (Jackson et al,1999; Barrios & Blanco, 2000; Barrell et al, 2009). The second option is to take riskier transactions in order to make up for the costs of capital adequacy Jackson et al,1999; Barrios & Blanco, 2000; Barrell et al, 2009). And the third option is for banks to use capital arbitrage as a strategy (Jackson et al, 1999). How does this work? In the first option, since banks are more prudent in taking risk, they will not be lending to people or corporations, which do not have a solid collateral or means of payment (Fouche et al, 2008; Elsas et al 2010). This has a direct repercussion to the profitability of the bank since lending at a fix rate is a sure income for the bank (Fouche et al, 2008) and in this scenario, the bank foregoes the chance to earn a revenue since there is a high costs in keeping up with the capital adequacy. This is very significant since it creates a ‘capital crunch’ affecting real economy (Jackson et al, 1999). At the same time, during time of economic downturn wherein bank lending place a very important role in pumping up the economy, the banks are stifled in taking radical actions because of the regulation, of increase chances of loan losses and loan defaults (Fouche et al, 2008). On the other hand, the second option for the bank is to take riskier options, in this way it can cover up the costs however, it counters the very essence of Basel I and II. The thirds option is to resort to capital arbitrage wherein banks sell securities at an overvalued rate. Although this concern is already addressed by, Basel II but still it should be noted that the costs for checking capital arbitrage is charge to the capital. Fig 1 Figure 1 shows the contradiction with which the relation of bank capital adequacy and bank profitability has been set. This has become the scenario because for banks to comply with the regulation they are (1) constrained in decreasing lending which yields a decrease in revenue since lending is a definitive source of revenue, (2)or enter in riskier transactions which increases the probability of incurring loss, (3) or use capital arbitrage as a strategy which in the long run is harmful since it lowers the trust of the buyers to the bank in particular and to the banking system in general. Furthermore, in the era free trade and neoliberalisation, this interference can be interpreted as affecting growth. In lieu with this, what is the importance of this conflict in the face of global credit crunch? The conflict plays a very essential role in understanding the global financial crunch and in preventing it from happening in the near future. This position is based on the following claim. First, the conflict can be used in order to curb the interests of banks in acquiring profits using minimal capital requirements by imposing a higher capital adequacy requirement (Wade, 2008). It has been noted earlier that banks as private organizations protects the interest of it shareholders and as such it will go an extra mile in order to gain profit and this is what have been experienced in subprime mortgage crisis. An increase capital adequacy can control bank’s risk taking and profit taking at the expense of the depositors /the public (Wade, 2008; Nisar, 2009; Bordo, 2008) . Second, the conflict highlights the fact that banking is regulated (Barrell et al, 2009; Armijo, 2001). However, the states that are regulating the industry are all coming from the North. This puts into question the motivation for setting the minimum capital ratio to 8% and at the same time casts doubts whether the international financial architecture in the context of globalisation is authentically set to level the playing field for all nations in the global market or is it set to fortify the hold of the developed countries to their current economic status (Armijo, 2001) Third, there have been empirical studies, which show that there is ambivalence regarding the claim that the imposition of capital adequacy pushes banks to decrease profitability (Jackson et al, 1999). Several studies have shown conflicting results regarding this position. For instance, According to Jackson et al (1990) empirical studies conducted by Wagster (1996), Cornett and Tehranian (1994) and Eyssell & Arshadi (1990) have shown variegated responses regarding the effect of capital adequacy requirements on banks share prices. As such, there is no conclusive evidence that can provide to support the claim that capital requirements reduces bank profitability. Fourth, the conflict shows the reality that banking institutions are embedded in real economic scenarios. Its nature is influenced by changes in the economic conditions and situations. This highlights the truism, that as banks turn from business lending into proprietary trading of financial assets, of fees and commissions (Wade, 2008; Nisar, 2009), “Banks and hedge funds became careless because they were acting as intermediaries, not as principals. The credit-rating agencies also became careless because of several conflicts of interest built into their operation” (Wade, 2008, p 32). As such, bank capital adequacy could have been used as means with which banking would be humanely and rationally responsive to moral hazards. But, in effect it even encouraged and “accelerated the change by encouraging banks to shift toward activities that generated fees and commissions, against which they would not have to set aside capital” (Wade, 2008, p 30). Thus, casting doubt on the motivations of Basel I and II and the banks’ claim that capital adequacy reduces bank profitability. Finally, fifth, the conflict between bank capital adequacy and bank profitability in the light of the global credit crisis shows that there is an urgency in coming up with policies that will protect the real interest of the people of the world and not just of the select few. Concrete action must be undertaken in order to remove the current stature of banks wherein they enjoy privatise profits and socialize losses. The recent financial crisis shows how ineffectual is the current banking system. It is cajoled by the existing world economic and political systems. For instance, in the United States of America, the Wall Street Banks were paid a total of $18 billion in the last year during which the financial sector required almost $1 trillion, for its bailout, from the US taxpayers (Marar, Iyer & Brahme 2009). This situation is a shame. In the end, the beauty of humanity is that it learns from its mistakes. And hopefully, the conflict between bank capital adequacy and bank profitability opens the reality that not all contradictions are necessarily in opposition. 3.0. CONCLUSION The conflict between bank capital adequacy and bank profitability cannot be undermined. If the conflict is seen in the context of the contemporary nature of banks, globalisation, current global financial crisis, world economic and political systems and other similar factors, there is an increase probability of not only understanding the authentic nature of the conflict but of coming up with a possible paradigm that can be utilised as a means with which the global credit crisis can be further understood. And the conflict between the two concepts be accepted as a necessary contradiction in the light of the contemporary human condition. The contemporary period has seen the evolution of banks from providing lending service towards becoming intermediaries, traders of financial assets, and more focus on fees and commissions, thereby, gaining profits without using any capital. This situation could have been hampered by the implementation of a higher bank capital adequacy as it forces banks under threat of sanction to maintain a minimum capital requirement that will act as a buffer in the face of bankruptcy and a policy that will not allow banks to circumvent the regulation. The losses in the global credit crisis should not have been shouldered by taxpayers’ money if bank capital adequacy has been enforced in such a way that the insatiable demand for profit in the banking sector is curbed. The conflict is not something that can be understood or resolved just by choosing between bank capital adequacy and/or bank profitability. Banks are embedded in real human context and any misjudgements or misevaluations of the significant role that it plays in the contemporary human society, redounds into real and actual financial difficulties for real people. In this regard, the issue of how can the global community may come up with a holistic and authentic response not only to the conflict between bank capital adequacy and bank profitability but also to the larger concern of global financial crisis is, still unresolved. (2520 words) References Acharya, V.V. & Richardson, M. (2009). “Causes of the financial crisis”, Critical Review,21 (2), pp. 1 – 26. Armijo, L. E. (2001). “The political geography of world financial reform: Who wants what and why?”, Global Governance, 7, pp 379 – 396. Balakrishnan,P. (2003). Globalisation, power and justice, Economic and Political Weekly, pp 3166 – 3170. Barrell, R., Davis, E. P., Fic, T., Holland, D., Kirby, S., & Liadze, I. (2009). Optimal regulation of bank capital and liquidity: How to calibrate new international standards?, Occasional Paper Series 38. Retrieved at www.fsa.org. Accessed on 3 November 2010. Barrios, V. E., & Blanco, J. 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