The Process of Banking Regulation - Essay Example

Banking Regulation Introduction The idea of banking regulation stems from systemic effects of banking operation in the market. Economic stability depends on principles that influence financial market players (Beck, 2011:50). The recession that hit UK and other parts of the world led to revaluation of macro prudential principles with an aim of curbing financial volatility. Critics argue that creating macro prudential principles would eliminate operation, which allow banks to act without evaluating the impact of the action they are yet to take. The financial crisis exposed failures of banks to control financial meltdown. The case pointed out that banks directed their interest at the expense of the common good of the financial markets. Regulation in the sector is an issue that is quite complex because UK has banks which handle domestic and international banking. This paper analyses banking regulation and its effects on the financial market. Argument for and against regulation The argument about the need for bank regulation has divided economists into two groups. The first group feel that banking sector should institute policies, which regulate operation of banks while second group feel that banks are volatile to instability, hence less need for regulation. Economists have observed that unregulated actions lead to greater social marginal costs and less private marginal costs (Slaughter and May. 2011). The effects of social marginal costs influence the overall economy because banks form important units of making public payment. This contrasts to private marginal costs because it belongs to a clique of shareholders of the firm. Turner Review on banking regulation proposed interest policy that should be able to tone down macro stability as well as bubbles in the financial sector. However, during the financial spill it was evident that central banks were unable to control macro stability of the banks. Elaborate regulation influence practices, which influence lending, and borrowing. Complexity in the sector crops whenever banks failed to comply with the regulation because they tend to manipulate the markets to gain profit (Hoose, 2010:136). The challenge is to balance financial market as well as doing business. Serving these interests have often thrown the market into cross roads where financial spiff off is inevitable. However, the mandate of the regulation is to promote common good among the market players in the financial sector (Hardy, 2006:6). Economists for regulation have argued that uninsured depositors would create a financial spill when they acquire information about poor performance of the banks. For instance, Northern Rock bank was a victim of depositors run during the financial crisis in 2007. Many of its depositors were not certain that bank suffered liquidity problem. It means that bank run would create adverse effect to the economy because of loses that banks would incur in its attempt to meet the demands of its depositors. The idea is to equip the banks to handle unstable markets (Independent Commission on Banking. 2011: 23). During the 2008 crisis UK, government shielded the banks from falling because they did not have the capacity to absorb the risks. Early banks had demonstrated their ability to lend without evaluating their capacity to handle the risk. Erosion of bank equity destabilised the financial market because the banks lost the ability to bear loses. Proposal on banking regulation is an issue that committees such as Basel committee have discussed reviewing macro prudential methods of regulating operation in the banking sector. The report charged with reviewing stability in the banking sector identified three areas first, the minimum requirement of capital, second, supervisory on internal bank assessment and third, cushioning public from risks. Basel committee recommended that each loan should command its own capital requirement as opposed to portfolio the loan added. The significance of Basel model was to cushion the banks from running into loses which would influence the social marginal costs. Supervisory recommendation of Basel committee sought to influence activities of banks. Strength and Weaknesses of the Report ICB Report ICB report recommended that an increase in bank equity would influence the ability of the banks to absorb losses (Great Britain: H. M. Treasury. 2011:25). This recommendation is strength because the capacity of the banks to be resilient to shocks depends on equity commanded by the bank. Equity has the capacity to absorb losses that emanate from and post resolution. Capital requirement refers to the value needed by law for a bank to operate. The crisis proved that bank’s ability to absorb losses depended on the equity, which is subject to capital requirement. Adopting this recommendation has the following influences to the financial market. First, increasing capital requirement would discourage lending because many banks will increase the rates of borrowing. This would influence money supply bin the financial market. Second, bank’s leverage would influence the stability of the banks during the financial spill off (Chancellor of the Exchequer. 2011:23). Sensitivity of the equity fluctuates with bank’s leverage. Banks would demonstrate ability to compromise on their equity. Disruption of payment would occur in an event when the banks ceases the power to absorb loses. Financial meltdown would occur when debts influence important banks into insolvency (Hoose, 2010:123). Concomitantly, firms holding debts lack the ability to discipline bank. The situation would trigger loses which moral will dictate that should not influence any side of the divide. Recovery plans in events of financial spill off are crucial because it would revitalise the financial market. The strength of the plan is to cushion the financial market from spilling. Loss-absorbency policy creates an opportunity for the banks to make resolution, which would alter situations, which drag banks into insolvency (Hardy, 2006:16). For instance, struggling bank has a recovery plan, it can avert the situation through sell of asserts, issue new equity, and restrict bonuses and dividends. The witnessed crisis created a condition where banks had little or no asserts to sell, dividends, or bonuses to restrict because they did not precaution their lending. Banks usually use collateral as security in events of defaults. This provision creates an avenue of creating equity in the event of crisis. The same would apply when banks acquire assets, which they can sell whenever they encounter loses. When markets fail to yield to the expectation of the speculating banks, debt levels would increase because the expected sum is missing (Madura, 2008:56). The weakness of the increasing bank equity is that some bank asserts will lie idle instead of performing productive investment (Madura, 2008:67). Critics argue that the above notion is a misconception because high requirement for equity would influence the ability of banks to incur debts. The idea is influence the amount of debts that banks incur. The move taken by the banks to cushion the effect of insolvency to important banks spent the taxpayers’ money in handling issues that banks were able to handle. Equity requirement seems to be expensive for some banks. The essence of the argument is that the adopting of the above policy would dictate banks to direct some of their debts to equity. However, it enhances safety in financial operation of the banks as opposed to the effects that it would on the banks. The idea of cushion the public from the risks of financial spill is not to restrict banking operation, but to create sanity in the sector in event of crisis. Measures used by the banks to handle debts failed to cushion shareholders and other stakeholders in the financial sector (Slaughter and May. 2011). Retail ring-fence is a structural reform in the banking sector, which intends to cushion the economy from incidental factors, which influence financial market (Portfolio Media. Inc.). Players in banking economy are customers whose activities influence the overall economy of the nation. Constraints, which influence banking customers’ activities, would influence the financial performance of the banks. In the event of depression, bank customers suffered due to the insolvency of the banks. Ring fence purpose is to handle the following in the financial market. Cushion vital services offered by the banks, creates easy way of sorting ring-fenced and non-ring fenced firms in the event of the trouble and reduce guarantee offered by the government, which influence public finances (Independent Commission on Banking. 2011:36). The idea of the ring fence is to create straight forwardness in the sector, which would enable monitoring of banks activities. The existing structures banking put financial regulation in the hands of the banks, which compete to achieve their own interest (Bresslaw, 2012:12). It is difficult for an institution that competes in the market to institute policies, which would influence its operation. Ring fence principle defines measures, which would be appropriate in handling various categories of banks. Each bank has mandated services that are critical to economic stability (Hudson & Yorke. 2012). Some services bear critical impact to the economy. Government would show concern when its feels that critical services provided by these banks are set to fail. The essence of ring fence is to ensure continuity of the above services. Customers who lack alternative service providers would suffer in an event of withdrawal. Regulating banking operation within the ring fence would eliminate cases of banks credit facilities to individuals and firms outside the ring fence (Sweet, 2010:4). The idea would discourage credit supply and competition exhibited by credit providers. Speculations of various banks without clear fence, which demarcate their operations, influenced credit supply as evident during the crisis. Bank assets should be able to offset liabilities of the bank (Hudson & Yorke. 2012). The proposed ring fence would eliminate inability of bank to handle their debts. Retail ring fence would promote the safety of the investors because they will the ability to assess the ability of the bank to handle their transactions (Bertsch, 2012:13). Various bank use different definitions to create retail programs. Structural reform through ring fence would create categories within the banking sector. These categories are set to influence retail-banking system with major banks handling financial programs within their capacity. The weakness of ICB report is that ring fence reform prohibits certain banks from performing certain functions in the financial market. The essence of argument in ring fence finds its ground on the Volcker Rule. The rule prohibits the banks from engaging in speculative services, which have little or no benefit to the customers (Bresslaw, 2012:6). Speculative services instigated financial crisis witnessed in 2007-2010. The rule bar commercial bank from propriety trading. Commercial banks used deposits to trade on individual accounts. The effect of the approach was eminent when the banks could not sustain the debts their incurred necessitating government involvement. The commission noted that Volcker Rule could not adequately address ring fencing because of complexity created by wholesale banking. For instance unwinding of investment banks constitute complex procedures, which authorities cannot maintain without acquiring support from taxpayers (Independent Commission on Banking. 2011:36). The idea is to separate the ring fence banks from investment banks. The activities of the ring fence bank should not involve investment banks in mediating economic situation of the nation. The failures observed during financial crisis projected the feeling that marriage between investment bank and ring fenced banks aggravated financial crisis. Prohibition created to investment bank against depositing in ring-fenced banks is a measure geared towards protecting the ring fence banks from the crisis. Financial analysts believe that diversified base for funding cushions ring fence banks from risks of insolvency (Great Britain Parliament. 2009:113). Critics observed that restricting deposits depending on the bank size had the effect of forced withdrawal in an event that an investor attains a certain amount of money beyond the limits of the ring fence banks. Cushioning against instability that over depositing would cause has great harm to the economy over the risks involved in transferring investment to larger banks (Chancellor of the Exchequer. 2011:25). In an event financial crisis the expected is cooperate deposit moving from other banks into ring-fence banks. The idea is to protect ring fence banks from registering the effect of cooperate deposit in the event of the crisis. Critics have demonstrated that curbing the run crisis is through instituting policies influencing capital requirement and stronger liquidity. The control exercised through the ring fence structural reform prohibits lending which are likely to through the market out of balance. I believe that the decision by ICB to restructure the banking sector heads towards grouping a number of UK banks under the ring fence banks. The approach is likely to influence risk management in the sector. Susceptibility to risk influences the financial market by creating instability of financial institution (Schoppmann, et. al. 2008:23). The expected effect would influence resolvability of risks in the financial market. Loaning institutions and individuals would eliminate the risks that necessitate underwriting of debts securities issued. The proposed reforms would influence restructuring the banks, which include increasing cost associated with operation. The idea is to allow banks to undertake their activities with limited risks. In conclusion, I support the recommendations on financial banking intended to cushion the customers, investors and the public from financial crisis that stem from banking operation. Regulations would influence activities of the banks by influencing their mode of operation in the financial market. The committee identified loss-absorbency of banks a factor, which must be under control if the society is not to expect a repetition of the crisis. The idea is that banks must demonstrate the ability to absorb shocks related to debts. A measure to curb such failures include institute policies which influence capital requirement, defining services offered by banks, and grouping banks according to the ability to handle financial matters in the market. Ring fencing would create a distinction between the operation of investment banks and ring fence banks. Cushioning ring fence banks from corporate deposits which a common during financial crisis would protect consumers from facing the challenges of insolvency which threatened banks during the economic crisis. Thus, ring fence banks would be able to cushion the economy from collapsing. Bibliography Beck, T. 2011. The Future of Banking. New Jersey: CEPR. Bertsch, C. 2012. London Financial Intermediation Theory Network. Available from: http://faculty.london.edu/fmalherbe/overview.pdf [Accessed on 11 April 2012] Bresslaw, J. 2012. Banking on change - the impact of the Vickers banking reforms. Available from: http://www.legalweek.com/legal-week/analysis/2141403/banking-change-impact-vickers-banking-reforms [Accessed on 11 April 2012] Chancellor of the Exchequer. 2011. The Government response to independent Commission on Banking. Available from: http://www.official-documents.gov.uk/document/cm82/8252/8252.pdf [Accessed on 11 April 2012] Great Britain Parliament. 2009. 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