Role of Government in the Banking Industry - Book Report/Review Example

?Money and Banking Money and Banking The role of government in the banking industry Government involve in the industrial affairs for many reasons. For instance, its role in the banking industry originates from microeconomic matters over the capability of bank depositors or creditors to monitor the risks brought about by the lending side and from macro and microeconomic concerns. In addition to administrative and statutory regulatory provisions, the banking industry has been subject to pervasive “informal” regulation. The major argument against government’s involvement in this industry has been that the government interrupts private industries. Critics of the bailout programs argue that free markets ought to establish which banks carry on, which fail, how much bankers should be paid, and how banks should lend (Hudgins & Rose, 2012). However, this argument is wrong since banking is not a private sector. Banks are shareholder-owned firms. Government role is important as it has raised competence and lowered costs in the banking sector. Government role in the banking industry can be classified into various categories such as mitigating market failures because of asymmetric and costly information, maintaining the soundness and safety of the banking system, financing socially valuable projects, promoting financial growth, and providing access to competitive financial services to clients from isolated areas. It is significant for the government to involve in this sector. Courtesy of the government charters, banks can take part in a host of federal programs, which is not applicable to regular companies like Apple and McDonald’s. For example, the Federal Deposit Insurance Corp guarantees bank deposits. That is like the government giving a free lifetime guarantee on your iPod, a situation that does not occur in the private sector (Hudgins & Rose, 2012). Federal Reserves can lend money to banks, yet banks can assume the arrears of shareholders on a levy-free basis. They can repurchase stock, issue stock, and do everything more easily than any average corporation can. Further, the government is permitted its rights as a steward and creator of financial system. This allows banks to operate in a private way, and offered a profit incentive. That way, a most efficient credit system is created for the nation. When such a system breaks down, the government can impose reforms in 18 months, which means the banking business is infused with money to keep credit flowing and requesting banks to operate by a short-term set of tightened standards. According to Mishkin, the government can also initiate regulatory reforms in the banking system, which is an important step in stabilizing the financial sector. Regulatory reforms can increase the role of competition, which will in turn spur reduced margins in financial services as well as raising efficiency by forcing the consolidation or exit of comparatively inefficient banks and by encouraging innovation (Mishkin, 2009). Reforms by government in regulations can also contribute to decline in prices for banking systems and productivity growth that is profitable to the whole economy. Reforms too improve the quality, access, and variety of new financial services and instruments. Involvement of the government in the financial sector contributes to improved global allocation of resources because of the removal of the barriers to intercontinental capital flows. All these reasons justify that the government really has to intervene in the daily operations of the banking industry. 2. Investing banking activities Leading cash centers in the United States have accelerated their investment banking activities all over the world in recent years, purchasing corporate debt securities and stock from their business customers and reselling those securities to investors in the open market. This is beneficiary to the organizations, since efficiency can be gained by purchasing stocks that are underperforming, improve their performance, and sell them for a profit. It is also significant to these organizations as it increases their market power. Purchasing stocks and debt securities is a profitable mechanism by which the money centers transfer resources from inefficient managers to ones that are more efficient thus, they take the big catch as reliable brokers. The realization of adequate returns by the target customers prior to the transactions could serve as an indicator of the post-transaction return prospective, which might be an essential selection criterion for the organization. Higher target returns make it possible for the new clients to better service the debt following the transaction (Hudgins & Rose, 2012). By accelerating their investment banking activities, these organizations/banks help their customers to raise funds through equity or debt offering. They can raise funds via an Initial Public Offering, selling shares to classy investors using private placements, offering credit facilities, or selling bonds on the client’s behalf. By doing all these, the banks function as intermediaries but they make a big profit by earning revenue by charging a certain fee. On the other hand, clients gain from the bank’s relationship with the investors, proficiency in valuing assets, and knowledge in executing such transactions (Mishkin, 2009). In most circumstances, these banks will buy debt securities and stocks from the client and try to sell at higher prices to the investors. The process is called underwriting. When a bank underwrites a deal with its customer, it agrees to buy newly issued securities, with the aim of selling it later at a profit. The customer pays a premium to the bank, or rather sells the securities to the bank at a discount with the objective of obtaining capital without seeking for numerous small buyers. The bank, in return to the premium, assumes the risk of holding the lately issued securities. This is a risk to the bank since the securities could lose value and lead to a loss. From these illustrations, the banks are both at risk of getting a loss when they buy securities, but they also gain by reselling the stocks to investors at a higher price and by earning revenue from the fee charged. However, the public is disadvantaged when the banks carry out such activities. They are the last consumers of the services and the stocks, yet they will have to get them at higher prices due to the longer channel. If I were a CEO of a company that had placed large deposits with a bank that engage in these activities, I would definitely be concerned about the risk. This is for the reason that, selling debt securities and stocks to a bank requires a registration process, of which a company will have to submit extensive disclosures and documents to be reviewed. This is a long process, involving the company to engage accountants, lawyers, and auditors. It is expensive too and placing large deposits may ruin most of the company’s operations. Securitization Securitization refers to the practice of taking illiquid assets, and by use of financial engineering, they are transformed into a security. It allows banks to convert assets into liquidity that would otherwise be wasted. With the new funds raised, lending can be increased. With securitization, risk transfer has increased noticeably. In fact, most banks are becoming mere originators of lending and distributors’ risk (Hudgins & Rose2012).This is done through packaging a granted loan with other bundles of mortgages issued a risk management by a rating firm, and selling it through ABS. With this done in the right way, securitization can shape the banking system. Recent commotions in financial markets underscore the significance of understanding asset secularization. It is a process that permits banks to fund their credit development and potentially, to arbitrage capital requirements, and to shed off credit risk. At the same time, recent chaos has indicated that the originate-to-distribute method may contain some wicked incentives for banks to loan and rapidly package those loans and convey the credit peril to third-party investors. Securitization was at the center of the financial crisis of 2008 – 2009. Many leading banks such as Lehman Brothers and other investment banks, hedge funds, the rating agencies, the “shadow” banks, and the commercial banks were involved. Behind the crisis, was a new type of specialized mortgage securitizers and lenders unlimited by regulations controlling traditional securitization and lending. Eager to take gains in an originate-to-distribute loaning model, insistent lenders piled in by giving loans with low open costs, thus attracting first-time home purchasers, who were previously unable to do it (Robinson &McDonald, 2010). These practices drove prices especially in California, Nevada, Florida, and Arizona, which had noticeable land-use environmental controls and regulations. It lowered supply elasticity, thus an increase in demand and higher prices, rather than a great housing supply. This rose beyond the expected rate, and the market collapsed. This revealed some flaws in the model of the sub-prime securitization. Usual standards of diligence broke down unimaginably at each stage of securitization, including the behavior of mortgagors, sponsors, borrowers, originators, credit rating agencies, asset manager, investors, and insurers. It is most probable that there was inadequate supervision and regulation of credit agencies, investment banks, pension funds, banks, and insurance companies. In addition, compensation in the whole procedure of securitization was based on short-term results, rather than suiting the interest of investors (Robinson &McDonald, 2010). For securitization to be beneficial to lending firms, some steps could be followed, and this can help to prevent such a crisis from reoccurring. It is important that investors be confident that the banking system is being supervised and regulated effectively. It is also vital that the incentives of different agents and intermediaries be aligned with the interests of the potential investors. Similar, regulators’ incentives also need to be in line with those of the taxpayers, so that taxpayers do not bring about these risks. Most importantly, transparency should be the guiding principle of banks, where there is free access to all data provided by issuers to agencies that rate credit. This will enable competitors to create independent judgments regarding the value of the securitization. References Hudgins and Rose. (2012). Bank management & financial Services 9th edition. New York, NY: McGraw-Hill. Mishkin. F. (2009).The economics of money, banking, and financial markets, business school Edition, 2nd Ed. New York, NY: Prentice Hall. Robinson, P., & McDonald, L. (2010). A Colossal failure of common sense: The inside story of the collapse of Lehman Brothers. London: Crown Business. Read More