Strategic Banking Issues Regulations and Profitability - Essay Example

Running Head: STRATEGIC BANKING ISSUES Strategic Banking Issues Regulations and Profitability Experts in the banking industry blame failure of regulation as one of the main causes of the 2008 global financial crisis. So there is no surprise that post-crisis world wants to see more regulations. Regulation will bring in benefits by way of financial stability, but it also imposes costs. The crisis was developed in the advanced economies. The post-crisis reforms are being driven by the need to fix the loopholes in those advanced economies (Subbarao, 2011, p.1). There is a strong correlation between financial sector development and economic growth. Economic growth generates demand for financial services and spurs financial sector development. A developed financial sector is very useful in allocating resources and promoting economic development. The world before the crisis had easy liquidity, stable growth, and low inflation. Everyone expected that the things will remain like this forever and the financial sector will continue to pile up profits by sheer financial engineering (Subbarao, 2011, p.2). Now new regulation has been proposed and regulation comes with associated costs. A BIS study estimates that a one percentage point increase in the target ratio of tangible common equity (TCE) to risk-weighted assets (RWA) phased in over a nine year period reduces output by close to 0.2 per cent (Subbarao, 2011, p.2). Noted economist Paul Krugman has said that, the way to reform banking is to make it boring once again (Subbarao, 2011, p.6). In this paper we are going to look at the issue of financial regulations and banking sectors’ response to such regulations to maintain their return on equity. Causes of Global Financial Crisis of 2008 There is a host of ideas about the probable cause of the financial crisis. The classical explanation is very clear. Financial crisis are the result of monetary excesses. Monetary excesses first create boom and then there is a bust. In the crisis of 2008, we had a housing boom and bust, and these in turn led to financial turmoil in the United States and rest of the world (Taylor, 2009, pp. 1-2). The monetary policy was strategically loose. The interest rate setting based on macroeconomic variables had shifted significantly from the rates prescribed by the policy makers. The Federal Reserve said that the interest rates would be low for a considerable period and then would rise at a measured pace. These actions were irregular government interventions to reduce the fear of deflation that Japan had faced in the 1990s (Taylor, 2009, pp. 3-4). There are a few competing explanations for the crisis. One of the arguments is called ‘Global Savings Glut.’ Proponents of this concept argue that the low interest rates in 2002-2004 were caused by global factors and thus monetary authorities have nothing to do. This alternative explanation focuses on global saving. It argues that there was an excess of world saving or a ‘global saving glut’ as they say and it pushed interest rates down in the United States and other countries. But the numbers from the International Monetary Fund says a different story. The numbers tells that the global savings rate as a percentage of world’s GDP in 2002-04 was very low compared to the 1970s and 1980s (Taylor, 2009, pp. 5-6). The crisis started as the fall of subprime lending market. Here the monetary interaction with the subprime mortgage problem needs to be understood. In the summer of 2007, the United States first experienced a striking contraction in wealth. The risk spread increased, and the credit market deteriorated. The 2007 United States sub-prime crisis has its roots in falling housing prices and this led to higher default levels particularly among less credit-worthy borrowers. The impact of these defaults on the financial sector has been largely exaggerated due to the complex bundling of obligations that was thought to spread risk efficiently. Unfortunately, the ensuing tools were extremely nontransparent and became illiquid in the face of falling house prices (Reinhart & Rogoff, 2008, p. 4). The subprime mortgage was characterized by a bizarrely huge portion of subprime mortgages originated in 2006 and 2007 and becoming delinquent or in foreclosure only months later. The meager performance of the vintage 2006 and 2007 loans was not restricted to a particular section of the subprime mortgage market. For example, other markets like ‘fixed-rate, hybrid, purchase-money, cash-out refinancing, low documentation, and full-documentation loans’ originated in 2006 and 2007, all confirmed considerable elevated delinquency rates than the loans which made in the prior five years (Demyanyk & Hemert, 2011, pp. 1848-49). There is no agreement on the precise definition of a subprime mortgage loan. The term subprime has been used to portray certain characteristics of the borrower with a FICO credit score less than 660 or for a lender with specialization in high-cost loans. The common element across definitions of a subprime loan is a high default risk (Demyanyk & Hemert, 2011, p.1853). The source of the subprime lending boom has often been pointed towards the increased demand for privately placed mortgage-backed securities (MBSs) by both domestic and foreign investors. The increased demand for MBS can be understood from the evidence of lower spreads and higher volume. This increased demand spurred the lending boom (Demyanyk & Hemert, 2011, p.1851). The boom started slowly and lasted for several years. The process didn’t reverse itself immediately when interest rates started rising. It was sustained by speculative demand, aided and abetted by ever more aggressive lending practices. As these went hand on hand with more sophisticated ways of securitizing mortgages. Eventually people came to know about the truth when the subprime problem drove New Century Financial Corporation into bankruptcy (Soros, 2008, p. 84). Corporate Governance of Financial Firms and the Financial Crisis of 2008 The crisis has raised serious questions about the corporate governance issues in the financial firms. Erkens at al. find that firms with more independent boards and greater institutional ownership experienced worse stock returns during the crisis period. This may prove to be counter intuitive. The possible explanation given by the authors is that independent directors and institutional shareholders encouraged managers to take greater risk in order to maximize shareholders’ return. Shareholders generally do not consider the social cost of financial institution failure. At the same time, the banks also changed chief executive compensation packages to drive the executives to exploit more opportunities engendered by deregulation and sophistication of debt securitization. The other explanation for the negative association between the stock income and board independence is that independent directors pressured managers into increasing equity capital during the crisis to ensure capital adequacy and reduce bankruptcy risk (Erkens at al. 2012, pp. 1-3). The interaction between banks’ exposure to subprime mortgages and their dependence on short-term borrowing had a considerable impact on the performance of financial firms during the crisis period. As the value of risky assets deteriorated during the crisis period, financial institutions could no longer rely on rolling over short-term loans against these assets. As a result, these institutions were forced to raise capital. Investing heavily in subprime mortgage assets and relying on short-term credit lines for financing was a very lucrative technique before the crisis. This technique proved fatal during the crisis (Erkens at al. 2012, pp. 8-9). While raising equity capital helped reduce bankruptcy risk, it was very costly to existing shareholders during the crisis period. Basel committee On an integrated level the world banking industry has been supervised by the Basel Committee of Bank for International Settlements. Its objective is to improve the understanding of key supervisory issues and enhance the quality of supervision throughout the world. This goal is served by discussion on national supervisory issues, approaches and techniques. The committee member includes Argentina, Australia, Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, Switzerland, Turkey, the United Kingdom and the United States (Bank for International Settlements, 2012). The Basel committee was established by the central-bank governors of the group of ten countries at the end of 1974. “In 1988, the committee decided to introduce the capital measurement system commonly known as the Basel Capital Accord. The system suggested an implementation of a credit risk measurement framework with a minimum capital standard of 8% by end-1992” (BIS, 2011, p. 2). Since 1988, this structure has been gradually introduced not just in member states but also in all other countries which has internationally active banks. In June 1999, the Committee issued a proposal for a revised Capital Adequacy Framework. The proposed capital structure consists of three posts: minimum capital requirements that seek to refine the standardized rules were in the 1988 Accord; supervisory review of an institution's internal evaluation processes and capital adequacy; and effective use of disclosure that would strengthen market discipline. It would complement to supervisory efforts (Bank for International Settlements, 2012). Over the past years, the committee has been more focused on the promotion of sound supervisory standards worldwide. In response to global financial crisis, the committee gas net forth new guidelines which would be collectively known as ‘Basel III’. Basel III Framework The Basel committee is trying to raise the resilience of the banking sector by further developing the three pillars of the Basel II framework. The reforms intend to raise both the quality and quantity of the regulatory capital base and enhance the risk coverage of the capital framework. Finally, the Committee is introducing a number of elements into the capital framework to help in containing systemic risks arising from economic cycle and from the interconnection of the various financial institutions (BIS, 2011, p. 2). Banks’ risk exposures should supported by a high quality capital base. The crisis revealed that credit losses and write downs were managed by retained earnings. Retained earnings are part of banks’ real common equity base. The crisis also revealed the inconsistency in the definition of capital across various jurisdictions. Also the lack of disclosure created hurdle for the market to fully review and evaluate the quality of capital among institutions (BIS, 2011, p. 2). By so far, the major form of Tier 1 capital has been common shares and retained earnings. This standard, through a set of principles, has also been tailored to the context of non-joint stock companies to ensure that they hold comparable levels of high quality Tier 1 capital. Deductions from capital and other prudential filters have been synchronized across the globe. These are generally applied at the level of common equity or its equivalent in the case of non-joint stock companies. The rest of the Tier 1 capital base must be subordinated instruments. These instruments have completely optional noncumulative dividends or coupons and have ‘neither a maturity date nor an incentive to redeem’. Innovative hybrid capital instruments with features such as step-up clauses, currently limited to 15% of the Tier 1 capital base, will be timed out. In addition, Tier 2 capital instruments will be harmonized and so-called Tier 3 capital instruments to cover market risks will be eliminated. Finally, the transparency of the capital base would be improved to help the market discipline by disclosing all elements of capital with a detailed reconciliation to the reported accounts. These changes would be implemented in a manner that reduces the disruption to instruments that are presently outstanding. It also reviews the task that contingent capital should be playing in the regulatory framework (BIS, 2011, pp. 2-3). One of the key takeaways of the crisis is the need to make the risk coverage of the capital framework stronger. A key destabilizing factor during the crisis was the failure to capture major on- and off-balance sheet risks coupled with derivative related exposures. Going forward, banks have to verify their capital requirement for counterparty credit risk under stressed conditions. The approach is similar to that of market risk. It will also promote more integrated management of risks like, market and counterparty credit risk (BIS, 2011, p. 3). Banks will be subject matter to a capital charge for possible mark-to-market losses (credit valuation adjustment – CVA – risk). This is linked with worsening in the credit worthiness of the related counterparty. The Basel II standard points out the risk of a counterparty default; but it does not address such CVA risk. But during the financial crisis there was a greater cause of losses than those which arose from out-and-out defaults (BIS, 2011, p. 3). The standards for collateral management and initial margining are also a matter of concern. Banks having large and illiquid derivative exposures to counterparty will have to apply longer margining periods. This should be done as a basis for fixing the regulatory capital requirement. The systematic risk arising out of the interconnectedness of banks and other financial institutions through derivative markets also needs to be addressed. So the committee is supporting the efforts of Committee on Payments and Settlement Systems (CPSS) and International Organization of Securities Commissions (IOSCO) to set up rigorous standards for financial market infrastructures which will also include central counterparties. A bank’s collateral and mark-to-market exposures to central counterparties will be subject to a low risk weight, currently proposed at 2%. Also the default fund exposures to central counterparties will be subject to risk-sensitive capital requirements (BIS, 2011, pp. 3-4). The most compelling underlying feature of the crisis was the buildup of excessive leverage in the banking system. This leverage was both on and off the balance sheet. As the crisis deepened, the banks were forced to de-leverage. This triggered a downward pressure on the asset prices. The committee, hence, introduced a leverage ratio to constrain leverage in the banking sector to mitigate the risk of destabilizing. Other measures have also been taken to dampen any excess cyclicality of the minimum capital requirement, promote more forward looking provisions and conserve capital to build buffers at individual banks (BIS, 2011, pp. 4-5). Impact of Basel III and Responses It is expected that new regulations will help to build a more stable financial system. Banks will have to adopt tighter credit policy for certain types of businesses. Though full implementation of Basel III is not expected before 2019, banks have to gradually shift towards stricter rules and corporate borrowers need to prepare for more expensive financing terms. In the short to medium term, as banks are compelled to raise their capital ratio by reducing lending, getting loans will be more difficult and borrowing cost will increase (D&B, 2010, p.2). There is another truth that many major banks’ capital ratios are above the Basel III standards. This will probably reduce the shock of the fresh regulation on lending. Another interesting observation is that new rules do not include non-bank financial institutions. So the large companies may look for other ways of financing, like raising equity or issuing debt. As a result, the new regulations will simply push the small and medium enterprises into tougher environment. This is true for small and medium financial institution as well as the non-financial companies (D&B, 2010, p.2). The borrowing costs for these players will be much higher. The planed new regulation is expected to cause considerably elevated trade financing costs and tighter access to conventional trade financing instruments, such as letters of credit. Companies may discover it suitable to employ other types of trade financing, for instance overdraft, factoring, cash-in-advance terms and export credit insurance. As trade financing costs are likely to go up, country risk information and market intelligence will act an ever more vital role for companies to reduce costs and risks while contracting with overseas counterparties (D&B, 2010, p.2). Basel committee’s definition of off-balance sheet items includes standby letters of credit and trade letters of credit. The risk weighting of traditional trade finance instruments has been set to a higher level. The implication is that banks will face a fivefold increase in the cost of trade finance. In such a situation financial institutions will have two options. They will either carry forward the cost onto their customers, or they have to seek for more lucrative behavior that will decrease their trade credit exposure. In either case the trade financing conditions are going to deteriorate. It is expected as letters of credit become more expensive, exporters will prefer open account terms which are less expensive and carry less documentary requirements. Other options are open in terms of unsecured financing, like forfeiting. In such a situation the companies will have to evaluate the counter party and country risks more minutely (D&B, 2010, p.7). There are some opposite arguments as well. One view is that banks will be safer with more capital, at least in principle. Therefore the cost of funding could decrease as a result of higher capital levels (Slovik & Cournède, 2011, p. 12). But there is no doubt about the fact that bank’s profitability will decline. One percent rise in the overall cost of capital can lead to 1.4 percent drop in the return on equity. If the overall Basel III is considered, the fall in the return on equity could be from 1.7 to 5.2 percentage points (Slovik & Cournède, 2011, p. 12). This estimate has an assumption that creditors’ return remains unaffected. In order to maintain its profitability, the banks will take some tactical responses. The tactical responses cover the areas of pricing, funding and asset restructuring. Banks can adjust the lending rates. This will depend on the competition within specific market and importance of that market for the bank. The pricing should be more risk sensitive and performance oriented. Banks have to look for higher value clients and shift to a less risky portfolio containing fewer securitizations and lower trading book exposure. At the same time, the banks have to reduce activities such as derivatives, repos and securities financing. In case of liquid assets, banks have to look for quality. The mix of funding and liquidity reserves should be long term oriented (Auer et al. 2011, pp. 7-8). The strategic response can be in terms of rationalization of branch structures, product rationalization or implementation of shared service model. Other strategic move may include the sale of high risk business units, launch of new product segments or businesses, and outsourcing or off-shoring non-core functions. Banks can also issue new capital in the light of new regulations (Auer et al. 2011, p. 8). All these approaches will help the banks to comply with the new norms and maintain the profitability at the same time. Conclusion Global financial crisis of 2008 showed us a lot of systemic weakness of the world financial system. Financial system is an integral part in the growth of a modern economy. But the financial crisis made the financial system an obstacle to growth and prosperity. Instead of being a shock absorber of the impact, the financial system transmitted the shock throughout the world. As a result there was a systemic failure. There are many reasons for the crisis. From monetary policies framed by the central bankers to the corporate practices of the financial firms has been blamed for such a big catastrophe. Observing all these events the Basel committee has recommended some measures to absorb the shocks of future catastrophes. At the same time, the committee has also focused on the prevention of such events. The main policy prescription is on the capital adequacy side. A major loophole in this policy framing is that it does not include the non-banking financial institutions. So a lot of experts are skeptical about the effectiveness of the proposed measures. Only the banks will have the bear the burden of these regulations and come up with strategic and tactical responses to maintain the profitability. References Auer, M. , Pfoestl, G.V. & Kochanowicz, J. (2011), Basel III and Its Consequences: Confronting a New Regulatory Environment, Accenture, Retrieved on April 16, 2012 URL: http://www.accenture.com/SiteCollectionDocuments/PDF/Accenture_Basel_III_and_its_Consequences.pdf Bank for International Settlements, (2012). About the Basel Committee. Retrieved on April 16, 2012: http://www.bis.org/bcbs/about.htm BIS (2011), Basel III: A global regulatory framework for more resilient banks and banking systems, Retrieved on April 16, 2012: http://www.bis.org/publ/bcbs189.pdf D&B, (2010), The Business Impact of ‘Basel III’, Retrieved on April 16, 2012 URL: http://www.dnbgov.com/pdf/DNBBaselIII.PDF Demyanyk, Y. & Hemert, O. V. (2011), Understanding the Subprime Mortgage Crisis, Review of Financial studies, 24(6), 1848-1880, retrieved on: April 16, 2012: http://rfs.oxfordjournals.org/content/24/6/1848.full.pdf+html Erkens, D.H. , Hung, M. and Pedro Matos (2012), Corporate Governance in the 2007-2008 Financial Crisis: Evidence from Financial Institutions Worldwide, retrieved on April 16, 2012: http://www.darden.virginia.edu/web/uploadedFiles/Darden/Faculty_Research/Directory/Full_time/EHM_CorporateGovernanceCrisis_2012_01_04%20JCF.pdfReinhart, C.M. and Rogoff, K.S. (2008), IS THE 2007 U.S. SUB-PRIME FINANCIAL CRISIS SO DIFFERENT? AN INTERNATIONAL HISTORICAL COMPARISON, NATIONAL BUREAU OF ECONOMIC RESEARCH, Working Paper 13761, retrieved on: April 16, 2012: http://www.nber.org/papers/w13761.pdf Subbarao, D (2011), Financial regulation for growth, equity and stability in the post-crisis world, Bank for International Settlements, BIS working paper no. 62, retrieved on: April 16, 2012: http://www.bis.org/publ/bppdf/bispap62a.pdf Soros, G. (2008), The New Paradigm for Financial Markets: The Credit Crisis of 2008 and What it Means, US: Public Affairs. Taylor, J.B. (2009), THE FINANCIAL CRISIS AND THE POLICY RESPONSES: AN EMPIRICAL ANALYSIS OF WHAT WENT WRONG, Working Paper 14631, retrieved on: April 16, 2012: http://www.nber.org/papers/w14631.pdf Slovik, P. and Cournède, B. (2011), Macroeconomic Impact of Basel III, OECD Economics Department, Working Papers, No. 844, OECD Publishing. 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