The Cost of Capital and Risk Taking - Essay Example

?THE COST OF CAPITAL SHOULD MATCH THE COST OF RISK TAKING Basel I and Basel II have pursued to equate capital parameter with the riskiness of bank loaning, but fastidiousness of the established structures of the banking system of government have frustrated these attempts. Let downs of risky IBs are a character of this crisis. These businesses profited from a small charge of capital and consequently, they developed to too large. The rate of capital is less if creditors have confidence that banks are supervised and that they will not disappoint (Blundell-Wignall, Atkinson & Lee 2008, p 3). According to the Basel system, IB’s profited from the low capital weight conferred to them. This acted as a reflection of relation safety therefore making it economical for banks to offer credit as counterparties to IB’s. The role of regulatory oversight for investment banks aided maintain the cost of capital low while at the same time allowing more control. Forth coming strategies need to guarantee that equity and credit principles are not mixed up , and that the capital rules that apply to these risky businesses are targeted efficiently to them and the cost of leverage is sufficiently high to ensure their size and risk taking activities are appropriately contained (Blundell-Wignall, Atkinson & Lee 2008, p 5-6). At the conference, some maintained that this arrangement might still not evade main systemic hitches in the future. This was because banks in the monitoring boundary would continue enjoying counter party relations with IB’s and other high-risk firms outside the fence thus dragging them back to where they were before. The considerable risk opportunities that should be taken are not particular and so is the independence of the cost of capital. If banks are to enter into counter party relationship with the high risk firms it should be done with very clear guidelines in some cases up to full cover in order to protect the banks’ creditworthiness. IB’s and should therefore have a much greater rate of capital in comparison to their status quo. Particularly, no longer would they be in a position to take advantage of the varied banks’ reserves procedure elevating low-cost peripheral capital to apportion to high-risk internal deals. As a result, fewer transactions would be up to the internal rate of return requirements, and control and general risk will be proportionately smaller and so would the size and way of the monetary sector on the economy. However, it was observed that now it is too late to turn the hand of time and as such, the existing strategy in the crisis necessarily should pool the weaker and stronger institutions (Blundell-Wignall, Atkinson & Lee 2008, p 10-11). Another tactic is to work with non- operating holding company structures (NOHC’s). It will split a financial company into its integral parts in which there exists distinct panels and stout firewalls among the subordinate parts. Capital laws can be designed to the riskiness of the actions of the companies, and in an occurrence of a crisis, any subsidiary making losses can easily be handled by administrators while not jeopardizing the whole corporation. To liquidate or sell a challenging IB securities trader can be done with much more ease. For instance, the IB can be a subordinate of the non-operating holding company structure (NOHC) other than an entity at the top most of the structure. In addition, the NOHC configuration is also much more transparent and in its case, it is less taxing to reduce intra-group contacts. It also offers clear and adaptable arrangement for scarcely defined, deposit-taking banking that is superior to having the bank at the top of the group or having the bank as the group itself as in the case of the universal banking in Europe. In other words, NOHC’s would be much more stress-free to regulate. The key general point to note is that high-risk financial undertakings need to pay the accurate market charges of capital without biases caused by the rule and bank structure interface. For example, UBS used its treasury operation to borrow competitively on the capital market from the bank and then allocated cheap funds within itself to high-risk investment banking units. The reformation of the regulatory authority is also important as shown in the Fannie and Freddie analysis. It showed that multiple and overlapping regulations can cause confusion (Blundell-Wignall, Atkinson & Lee 2008, p 13). The Theory of the second best could help streamline the incentive structure The argument of the Reserve Bank conference paper and specifically the argument that sensibility program creators have been dealing with in an organization motivated by many elements that lie outside their purview. As a result, the banking business should model itself on how it responds to incentives from macro liquidity policy, regulation, taxation rules, and policies to make mortgages an element of social policy (Blundell-Wignall, Atkinson & Lee 2008, p 15). The enormous let down in business authority in some of the companies mirrors poor incentive arrangements for decision making that should be regular with supportable corporate progression. It is important for the up-front fees and compensation systems to be founded on recent performance criteria so should the structure of the board, and how they manage risk. Common values and soft rules contained in self-regulation do not seem to be enough. This may necessitate for more effort to implement improved governance. An instance of this would be the tax system being used to nurture slow-vesting share involvement schemes in place of up-front cash bonus payments. The goal is to acquire the varied effects to push operations to the end of the interaction process to positively lower risk activities. Tax, governance, macro policy, remuneration among others need to be supportive of one another and not generating struggles in policy goals (Blundell-Wignall, Atkinson & Lee 2008, p 17). The philosophy second best is very appropriate if market fiascos exist then attempts to advance pieces of the system will not aid and this in fact, will make things even more badly. These contacts are difficult, and it is not by any means clear if altering prudential rules that deal with the main structures of the existing crisis will essentially aid to evade tomorrow’s crises. Summarily, Basel I did much to introduce regulatory harmony and development across international banking system but on the other hand, it allowed banks to interpret rules in their own ways, which was a major blow to implementing its strategies. Basel II brought in limelight factors such as operational, credit and markets risks, regulatory and surveillance measures that brought sanity in banking system. Reference Blundell-Wignall, A., Atkinson, P, & Lee, H, 2008, The Current Financial crisis: Causes and Policy issues. Financial Market Trend, Vol. 1, pp. 1-21. Read More