Approaches to banking regulation - Essay Example

? Introduction Over the recent past decades, immense changes and growth in the financial sector across the globe have emerged. It is worth noting that, within the same period, a high number of countries across the world have suffered banking crises, which in some situations have resulted into costly bank failures and by extension severe economic disruption. Current changes in the banking sector, as well as banking crises, have caught the attention of policy makers and industry participants on the most appropriate way and strategy to adopt for banking supervision and regulation. As the search for the best supervision and regulation approaches continues, it is essential for the involved countries to conduct thorough assignments on the fundamental principles to employ in order to attain financial system stability and growth (Barth et. al. 2004, p.208). This paper looks into two banking regulation approaches, which are the ring-fencing and total separation strategies. Approaches to banking regulation Ring-fencing Ring-fencing is a strategy that structurally distinguishes retail banking activities from wholesale and investment bank activities. Ring-fencing mainly focuses on ensuring that provision of services is not interfered with in case of a bank’s failure. Secondly, ring-fencing aims at making it easier and less costly in resolving banks. Thirdly, this approach controls incentives for excessive risk-taking. Apart from the three main objectives of ring-fencing, this approach offers several benefits such as insulating vital UK retail bank services from global financial crises, it allows for an easier monitoring of banks under ring-fencing and in a much transparent way. The other possible benefit is the ability to promote competitiveness because UK retail banking can be made safer (Bertsch 2012, p.2). The ring-fencing approach offers a number of advantages compared to the total separation approach of bank regulation. To begin with, ring-fencing has the potential to preserve diversification benefits because it allows for an efficient use of capital, and probably lower funding costs. The second advantage is that the ring-fencing strategy preserves a higher degree of operational synergies. Thirdly, ring-fencing approach offers the advantage of having reduced legal obstacles in comparison to full separation. In addition, ring-fencing approach can be implemented with the existing European Union framework, which includes foreign banks within UK subsidiary (Independent Commission on Banking 2011, p.35). In 2011, the independent commission on banking recommended retail ring-fencing of UK banks over total separation. The main aim was to isolate banking activities in areas where continuous provision of services is of the essence to the economy and customers at large. Settling on ring-fencing approach would create a scenario of mutual advantageous interaction between various bank operations, which produces a higher effect than when the operations are carried individually (Independent Commission on Banking 2011, p39). Ring-fencing bank regulatory approach offers a number of restrictions to ring-fenced banks. The first restriction is that banks are not permitted to render services that are not offered to customers within the EEA. The other restriction prohibits such banks from offering services that lead to an exposure to a non-ring-fenced banking institution or non-banking financial organization. Moreover, ring-fenced banks are not allowed to offer services that would lead to trading book asset such as investing in stock, and corporate debt securities. Apart from these restrictions, under this regulatory approach, they are restricted from offering services that would influence the necessity to hold regulatory capital against counter-party credit risk or market risk. These risks include the purchase or origination of derivatives. Finally, ring-fenced banks are prohibited from offering services that relate to the secondary market activity (Singh 2007, p.178). In ring-fencing approach, restriction of the above mentioned services comes along with a number of benefits. Through service restriction, it becomes harder or expensive to resolve ring-fenced banks. Secondly, prohibition of mentioned services increases the exposure to international financial markets. In addition, the prohibited services involve risk-taking on the side of the ring-fenced banks. Finally, the prohibited services are not essential for the fulfillment of the mandated services (Barth et. al. 2004, p. 214). Total separation Total separation poses a number of disadvantages when compared to ring-fence. First, total separation is thought to have increased economic cost compared to ring-fencing in relation to efficient intermediation between customer synergies, savings and investment, and risk diversification. Secondly, total separation fails to offer clarity on whether it would offer a substantial financial stability if adopted. In connection to this, total separation is likely to eliminate a route of contagion loss from investment banking to retail banking. On the other hand, total separation would have the potential to preclude support for troubled retail banks from other quotas within the banking groups. The third concern on the total separation approach is the difficulties in enforcing it under the European Union law. This stands out as a serious challenge regardless of the fact that universal banks within other member states would continue to possess UK retail banking operations (Independent Commission on Banking 2011, p.61). Apart from the above mentioned disadvantages, total separation comes with an advantage of maintaining a banks’ ability to operate efficiently through the provision a wide range of financial services to customers. Therefore, total separation is recommended within a banking group to allow for a similar marketing organization in order to meet various customer needs. This move is beneficial to customers given that there is maintenance of diverse business line. There are two key arguments raised in regard to total separation. The first argument concerns the fact that common ownership boosts contagion from the rest of the financial sector to retail banks through increased reputational links. The most notable thing is that banking groups have a tendency to live or die together. This is evidenced by the extent to which banking groups have previously offered support to subsidiaries even in times of absence of legal obligations on the same. Banks usually rely immensely on confidence in order to be in operation. Therefore, it is not likely that a retail bank could conduct continuing operating as normal in the event of failure. In cases of problems within the group, there is a likelihood of failure of the retail (Singh 2007, p.192). The second argument talks of the impossibility to implement rules, which will govern economic links between banking institutions unless they are in different corporate groups. The most notable issue is that common ownership generates incentives for management to attempt utilizing economic links. Thus, comparing ring-fencing and total separation, ring-fencing tends to be more complicated than full separation (Singh 2007, p.195). In conclusion, it is clear that a sound approach to regulate the banking sector is vital for the success of the banking industry. As discussed in this paper, both the ring-fencing and the total separation banking regulation approaches have both strengths and weaknesses. In addition, the two approaches also differ significantly in applicability within the banking sector. In the discussion above, the ring-fencing strategy appears to be of more applicability in the regulation of the banking sector compared to the total separation strategy. For this reason, bodies such as the Independent Commission of Banking support the adoption of ring-fencing strategy over the total separation approach within the UK banking sector. References List Bertsch, C. (2012). Short presentation on the ICB’s ring-fencing proposals, London, London Financial Intermediation Theory Network. pp.2-14. Barth, J. R. Gerad, C. & Levine, R. (2004). Bank regulation and supervision:what works best? Journal of Financial Intermediation 13(1), pp. 205–248. Barth, J. R., Gan, J., & Nolle, D. E. (2004). Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices? [Online] Accessed 21 Feb. 2013. Available online at: http://www.ckgsb.edu.cn/Userfiles/doc/BARTHnolle%20gan_bood.pdf Independent Commission on Banking (2011). Final report recommendation. [Online] Accessed 21 Feb. 2013. Available Online at: http://www.ecgi.org/documents/icb_final_report_12sep2011.pdf Singh, D. (2007). Banking Regulation of UK and Us Financial Markets. New York: Ashgate Publishing. pp.178-195. Read More