Banking Regulations and the Current Financial Crisis - Essay Example

?Banking Regulations and the current financial crisis Introduction Banking sector is termed as a heavily regulated industry and it has a huge impact on both the local and global economy. So every country feels the need for a stable banking system. Instability prevailing within the banking system can lower down the growth of a country by causing higher uncertainty (Jokipii and Monnin). However such banking regulations proved to be less influential during the occurrence of the current financial crisis. Such banking regulations could not prevent the crisis which resulted from the recent economic downturns and overall global meltdown. Banking regulations failed to bring back the confidence of mutual trust investors and could not prevent the breakdown of short financial transactions (Schmidt-Hebbel). Thus we can say that even a stable banking system with all proper regulations in place failed to stop such a financial crisis from occurring. The paper intends to trace out the reasons behind such a failure with the help of findings and analysis and the relevant steps undertaken for this. Reasons behind failure of banking regulations Economists and policy makers of various countries have tried to find the conditions which led to the crisis. They tried to find out those faulty policies and the incorrect measures taken by the bank that led to its failure of crisis prevention. It was found that at the time of the crisis the interest rate was really low. Financial investors in such a scenario became optimistic regarding the prices of assets along with the underlying risks. The banking regulations directed towards changes in financial landscape led to extension of leverage and this made accurate risk prediction more difficult. Investors transformed into risk lovers and excessive risk taking began in the markets (Caruana). Neither banking regulations nor effective supervision could stop such a phenomenon. The fragmented banking regulation again proved to be wrong. No connection could be traced out in the activities of regulated and non regulated markets. All over the markets and institution there was prevalence of asymmetric information. Some loopholes existing in the legal procedures were also equally responsible (Caruana). The macroeconomic policies implemented during this time were inadequate. The easy liquidity banking policy made structures of debts, especially the heterogeneous ones more incomprehensive. Criticisms have been against the supervisory regulations of bank. Easy loans were given to individuals without careful examination of the underlying default risks (Neuman). Monetary policies were framed in such a way that cash flow becomes easy across the economy. Such an instance is proved by statistical evidence. Table1: Data showing low interest rate policy adopted by the banks Source: Neuman The interest rate considered is for the Euro zone. The data is for short term real interest rate which continued till 2005. Such data shows that banks have adopted a low interest rate policy during the given years. This paved the way for easy liquidity. The banking regulations of 2004 led to significant credit expansion and credits involving high risks became the main reasons for initiating such crisis. It first led to subprime losses in March 2008 with Bear Sterns incurring huge subprime related losses. Ultimately Federal Reserve had to take over the firm. Detoriation of subprime loan holdings eventually culminated into the crisis. Banking sectors have earlier avoided such high risk alerts generated by the economists in 1999 (Nichols, Hendrickson and Griffith). Easy financing act of 2005 became the strategy for banking operations. During this time some big American and European banks even violated banking regulations by setting up companies for such short term financing purpose. Such companies were not disclosed in balance sheets. Banking sectors however did not pay attention to the fact that such a low interest rate policy regime adopted by banks in 2003 after European Central Bank followed suit was slowly increasing asset prices. The rising trend was visible from 2003 onwards in real estate market as well as in stock markets. The situation became worse with such a rise entering credit market in 2005. It had its impact upon mortgage credits and credit card related debts (Neuman). The banking act of 1995 helped the banking sector provide easy housing loans to low income borrowers. This law gave the bank the power of easy lending without quite accessing the underlying default risks. After 1995 banks recklessly carried out such lending and purchase activities and this was one of the major reasons for financial crisis. During the recovery period people failed to repay loans for their mortgaged houses (Nichols, Hendrickson and Griffith). Banks sealed those houses making people homeless but could not recover money. As a result GSE had to step forward in 2005 to purchase more than 52% of the mortgaged houses from the banks. The following figure gives an account of the mortgage performance of GSE for the following years: Source: Nichols, Hendrickson and Griffith Such data shows that GSE has been making mortgage purchases above its target level following the crisis years of 2004, 2005, 2006, 2007. This is a kind of state assistance that was given to the banks in the time of financial crisis. A very serious situation emerged with crisis in financial markets during the classic bank crash in 2008 when transactions totally stopped and liquidity froze. There were rumors of bankruptcy everywhere before it actually took place. This saw a whole line of depositors in a queue to withdraw their cash. Banks were unable to restore the depositor’s confidence and they eventually closed down (Neuman). With the equity capital regulations of banks enforced there was deregulation of commercial as well as investment banking. Under regulation of credit lending as well as that of mortgage regulations, was another story. Enforcing ‘too much regulations’ and monetary policies can also be blamed for the financial crisis. With the emergence of ‘shadow banking’ in 2008 weaker regulations were injected in the banking sector. Problems with securitization also rose up. There is no doubt that such weak regulations accelerated the process of financial crisis. Gradual weakening of the banks consumer protection regulations failed to give sufficient protection to consumer’s interests. As banking has an enormous influence on other sectors such as insurance sector, pensions management companies etc as per the prudential regulations initiated in 1930. Thus a failure in the banking sector actually accelerated the process of financial crisis (Dewatripont, Rochet and Tirole, 3). So it may be said that it was chiefly due to the above reasons that banking regulations could not save the economy from experiencing a crisis. Change in Regulations with Financial Crisis Financial crisis is assumed to be the big lesson learnt by the banks and other such institutions. Banking sector have become more careful and more regulated so as to avoid or at least minimize possibility of such crisis. After identifying the errors in regulations that led to crisis, banks have undergone some changes in regulation. The aim of such a change has been to increase the ability of banks to tackle such crisis and to provide more strength to the central banking system. The new regulations have made an attempt to increase the capacity of banks so that I can inject more liquidity into the economy. Previously less transparency was a cause of crisis which is now taken care of. Efforts are being put now to consolidate the banks. Banking system is pushing hard for risk reduction through reduced fund regulation implemented post crisis since increasing credit risks was one of the major problems it encountered. Weakened Prudential Regulations have been strengthened .The sector is taking the help of some business models that would help to identify those risks involved in monocline insurance companies and off balance sheet vehicles (Caruana). Since mid September 2007 reforms are also underway in the securitization process. Stability has been regained in the lending process. At the same time the banks are also working on the process of re-construction of balance sheets (Schmidt-Hebbel). Along with the new banking regulations mention needs to be made of the GLBA act effective from July 1, 2001. Functions of banking sector have undergone some transformations after enforcement of this act. The act has considerably helped the banks and other industries in the process of mergers and acquisitions. This act has launched a new era in investment banking. It facilitates movement of bank holding companies to investment banking. It just needs to bring under it those companies who are in the business of investment banking. Categorization of financial products as banking, insurance or security products is now possible with the enforcement of this act (Macey). Banks can now be more secured with the relevant information. Monitoring of borrowers has improved within the banking system. This minimizes the default risks. Prevention of crisis The new regulations introduced and the existing regulations are modified to help the banking sector tackle the problem of financial crisis in case of its re-occurrence. However the economy has still not recovered totally from crisis. The banking sector still needs to work on some areas. It has already given attention on credit restriction. But an eye also needs to be kept on the asset prices. Greater flexibility is required by the banking system for liquidity norms. The current crisis was also a result of asymmetric information. Banks need to work out in this area. They need to ensure that the available information helps in accurate risk prediction so that steps may be taken to mitigate such risks. The banking sector will also need the help of effective public policies in case it wants to tackle such crisis. Impact on industries Although new regulations have been imposed with an attempt to improve the market scenario, it has to be admitted that market will surely take some time to gain in confidence and restore the trust of shareholders and investors. There has been a revival of the output growth rate which went down terribly owing to the crisis. The liquidity freeze during the crisis in 2008 is in a process of resolving. An uncertainty has developed within the households with the occurrence of the crisis. They are now making modifications in their spending patterns since September 2007. This has lowered the demand for loans (Schmidt-Hebbel). In the current scenario such a crisis tends to have its effects on output and employment. With the impact of financial crisis in 2001-02 housing markets have collapsed. It was mainly due GSEs expansion of housing purchases as instructed by HUD. An attempt is being made to resolve housing markets trust post crisis (Nichols, Hendrickson, and Griffith). Other than housing and finance industries automobile industries were also badly hit by the crisis. They are also in the process of revival of growth. The figure below presents a scenario of the annual production and growth levels of automobile industries in different countries during the year 2007-2008 after experiencing the crisis (Sturgeon & Biesebroeck). .Figure 2: line diagram showing a fall in production for cars post crisis Source: Sturgeon & Biesebroeck The data shows that production levels have reduced owing to the crisis. We have a downward trend. This is because due to crisis the demand for cars has come down. Consumers are spending less on such goods. Moreover with the new regulations of banks, loans have become more restrictive. Conclusion Financial crisis was a result of breakdown of short term financial transactions which led to overall global meltdown. Housing market collapsed in most of the countries and financial markets were in turmoil. Other than that automobile industries were also hit by this crisis. These industries are in a state of recovery and it would take time because demand has lowered owing to crisis. The banking regulations could not help in preventing such a crisis and high risk lending was the main reason behind it. Currently banks have modified existing regulations and introduced new regulations but it still needs to work on some areas like liquidity flexibility and information in order to be able to tackle financial crisis. References: 1. Jokipii, Tehri and Monnin, Pierre, The impact of banking sector stability on the real economy, Swiss National Bank Working Papers, 2010, November 25 2011 from http://www.voxeu.org/index.php?q=node/5631 2. Schmidt-Hebbel, Klaus. Financial crisis and the Economy, OECD, 2008, November 25 2011 from http://www.oecdobserver.org/news/fullstory.php/aid/2754 3. Caruana, Jaime, Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management, IMF, 2009, November 25 2011 from: http://www.imf.org/external/np/pp/eng/2009/020409.pdf 4. Neuman, Manfred, International Financial Crisis: Consequences Regarding Banking Regulation and Monetary Policy, 2009, November 25 2011 from http://www.progressfoundation.ch/PDF/referate/211_Lecture%20Manfred%20Neumann_12.05.2009.pdf 5. Nichols, Mark W, Hendrickson, Jill M and Griffith, Kevin. Was the financial crisis the result of ineffective policy and too much regulation? An empirical investigation, Journal of Banking Regulation, (2011)12, 236-251 http://www.palgrave-journals.com/jbr/journal/v12/n3/full/jbr20113a.html 6. Dewatripont, Mathias, Rochet, Jeane C, Tribe, Keith and Tirole, Jeane, Balancing the Banks. New Jersey: Princeton University Press, 2010 7. Macey, Jonathan R, The Business of Banking: Before and after Gramm-Leach-Bliley, Journal of Corporation Law, 2000, November 25 2011 from http://digitalcommons.law.yale.edu/cgi/viewcontent.cgi?article=2426&context=fss_papers&sei-redir=1&referer=http%3A%2F%2Fwww.google.co.in%2Furl%3Fsa%3Dt%26rct%3Dj%26q% 8. Sturgeon, Timothy J and Biesebroeck, Johanness V, Effects of the Crisis on the Automotive Industry in Developing Countries: A Global Value Chain Perspective, Policy Research Working Paper, 2010. November 25 2011 from: http://unstats.un.org/unsd/trade/s_geneva2011/refdocs/RDs/Automotive%20Industry%20and%20Crisis%20%28Sturgeon%20-%20Jun%202010%29.pdf Read More