The Darwinian Economy - Essay Example

? The Darwinian Economy THE DARWINIAN ECONOMY Introduction After the financial crisis, the initial drafts chronicling its history contended that, after financial institutions were de-regulated after 1980, financiers went on a roll with banks blowing up and needing to be bailed out, thus, had to be fettered again (Ferguson, 2012: p1). This paper seeks to argue against the total regulation of banks and the above statement. Regulation concerns the bureaucratic rules and laws that seek to govern the banking sector. An example of bank regulations is capital requirements, as well as interest rates limits. During a House Financial Services Committee hearing, it was put across that the simplest way to frame regulation was capital. Capital informs the amount of risk that financial institutions can take overall. It assures that the institutions have cushions that can absorb extreme shocks. Capital requirements are designed so as, given the uncertainty about the future and ignorance that there is concerning some elements of risk, it will ensure a greater cushion for absorption of loss and save bankers from consequences of judgment mistakes, as well as global uncertainty. The debate on whether to regulate or not to regulate has a great deal at stake. The global financial systems and their stability are dependent on adequate and effective capital requirements for these institutions with the 2008 crisis revealing vital problems with requirements as they currently stand (Ferguson, 2012: p1). However, economic recovery prospects, in Britain, the EU, and the US are heavily dependent on a steady credit flow, as well as lending. In addition, the available evidence is suggestive of the fact that over the top increment of capital requirements, in deed, will cause a credit crunch. Therefore, while financial institutions do require some level of regulation, they should not be over-regulated. Regulatory Failure Regulatory requirements of capital are not equally effective in their totality, especially because of two essential pitfalls that they are susceptible to; discretionary recognition of loss by regulators and bankers and discretionary bailouts by their governments (Barth et al, 2010: p34). Discretionary loss recognition refers to the use of practices of accounting that act to alter the meaning of capital. Instead of utilizing market based concepts, such as bank stock prices, so as to measure risk, as well as establish capital needs, regulators are reliant on concepts of accounting. They check on the bank’s books, rather than on the market assessments of the firm’s held value. Regulatory capital, therefore, is referred to as accounting residual, i.e. the difference between asset accounting value and debt accounting value (Barth et al, 2010: p34). Accountants, book value, of course, are subject strict requirements of law. However, these requirements provide the regulators and bankers with discretion, especially concerning timing, which allows them to delay the acknowledgement of problems, as well as acting on these problems (Barth et al, 2010: p36). In addition, neither regulators nor bankers tend to recognize losses fully during poor economic conditions. The bankers will usually prefer to use delay tactics, such as ever greening, i.e. re-lending of money to the delinquent borrowers in order for these borrowers to pay back ballooning costs of debt service using even more debt to mask their problems. Bank regulators, on their part, always crave system stability, especially forbearance, to avoid worsening or precipitating a crisis. Therefore, they find ways to utilize their allotted discretion so as to downplay the size of losses in order for the banks not to require lost capital replacement (Barth et al, 2010: p34). When the above-mentioned practices are done on a large scale, they can have disastrous results. In the preceding events of the 2008 financial crisis, for instance, their combination caused a failure in the replacement of bank capital in time, which led to an intensification of the eventual meltdown (Calem, 2012: p320). The major financial institutions that failed or needed to be bailed out did not see depletion of their capital overnight. Months had passed between the first crisis shocks with troubled revelations in mid-2007; the bail out of bear Stems in March 2008 and the collapse of systems in September of 2008. The capital raising markets were also not closed during this period. In the year leading up to collapse of the systems, international financial institutions raised approximately $450 billion worth of capital. Clearly, global capital markets were still open with many investors with hedge and private equity funds, as well as moneyed individuals, willing to be investors in banks. However, majority of the financial institutions that were greatly affected by the financial crisis before September 2008, in spite of significant and persistent market value declines of equity in relation to their assets, elected not raise any more sufficient capital (Calem, 2012: p321). The reason that they were able to avoid this had to do with the fact that accounting values of their assets and values did not fall too sharply. For example, Citibank that eventually got a hefty government bail out possessed a capital ratio of 11.8% at its approximate low point in late 2008 at the point that Citibank’s holding company, stock market capitalization was roughly 2% of the bank’s total assets (Calem, 2012: p323). Every one of the banks that needed bailouts during the crisis reported high and exaggerated capital levels in the period prior to the intervention. A senior executive at an institution troubled by the crisis confessed that in the summer of 2008, in spite of the need for the replacement of lost equity, the prices of their stock were at such a low point that it was impossible to think of offering the markets new equity. The issuance of significant equity in mid 2008 would have significantly led to the dilution of existing stockholders, for instance management, lowering that value of shares as the new stock was issued, as well as priced, by the markets. Therefore, they preferred to chill it out, making the assumption that the conditions would either improve leading to a rise in asset prices or that the government would have to take responsibility if the situation deteriorated too much (Calem, 2012: p324). The best strategy, therefore, on balance, was to wait out the issues and wish for the best. A constant challenge that faces regulators has to do with forbearance temptations, who normally find that they are subjected to political pressure in order to delay recognition of bank loss (Barth et al, 2010: p210). The pressure usually causes the regulators to play for time, rather than attempt to enforce requirements of capital adequacy. The Financial Services Authority in Britain that was for a lengthy time, considered as a study in efficiency and forward looking for regulators around the world gave an especially egregious instance of forbearance in the oversight of Northern Rock, which collapsed during the initial stages of the financial crisis of 2007. A few months following the collapse of Northern Rock, its supervisors authorized it to use the approach of advanced measurements in mortgage weight risking (Barth et al, 2010: p211). This led to a reduction of 30% in its required capital. In addition, recent activity in Japan, allowing for a decade of stagnation for the economy that was exacerbated by Japan’s banks delaying loss recognition, show that the political players will always pressure the regulator to forbear in instances where there is a political advantage in the short term (Barth et al, 2010: p213). Japan, in an effort towards assisting the banks in 2008, passed legislation that required bank delinquent laws to other firms did not require to be viewed as delinquent for purposes of regulatory accounting –avoiding lost capital recognition- as long as the company in delinquency possessed a way to cure them of the delinquency. This law, in 2009, was revised to allow for forbearance on loans of a delinquent nature as long as the borrowers possessed a plan. Beyond mutual and explicit decisions made by regulators and bankers in the understatement of losses, bankers can also be innovative when it comes to the manner in which they use complex transactions to camouflage security loss (Barth et al, 2010: p214). Supervisors of regulation come up against serious challenges in the detection and prevention of the manipulation of book values via what they call gains trading, which is a common practice that recognizes gains in capital held at book value at the same time deferring loss recognition. Lehmann Brothers and their legendary bankruptcy revealed yet another way for circumventing measures of adequacy measures. This was the Repo 108 or Repo 105 transactions, which disguised agreements of repurchase as asset removal. Repurchase agreements are a loan whereby the borrower sells the security to the lender and agrees to buy it back for a higher price later (Barth et al, 2010: p215). This was a way to report loans as asset sales, which, in turn, saw a reduction in the balance sheet size, as well as in the level of counted assets, in the ratio of capital to assets. Banks possess huge financial incentives as they engage in this sort of gimmickry with their agility in their activity making it unlikely that the regulators will ever be a step ahead of them or even keep up (Barth et al, 2010: p217). Therefore, while it is essential to have capital requirements, design tends to matter a lot. The regulators, therefore, need to come up with ways that structure the requirements in order for them to minimize incentives for avoiding loss recognition, as well as the creation of powerful incentives against the system of gaming. The Costs of Regulation In the regulation of financial institutions, capital requirements that are effectively designed need to overcome the inadequate nature of existing rules, as well as take into account social costs that are involved in raising the set requirements, as well as means of minimizing them (Peek & Rosengren, 2011: p683). Higher capital requirement costs come, essentially, in the form of reduced activity of banking, particularly reduced lending, or credit crunch, which can be because of huge and sudden increase of capital requirements. Capital requirement, after all, is a capital to assets ratio that means that higher ratios can be attained by increasing the amount of capital in the ratio’s numerator and the reduction of asset quantity in the denominator by reduced lending. It has been argued that banks do not forego profitable lending because to meet higher requirements of capital ratio. This argument begins by stating that activities of a firm need to be invariant to the structure of financing. Regardless of the manner in which a bank is financed, its lending degree needs to be driven by its comprehension of market incentives and conditions. Therefore, it should not matter to the banks whether they raise capital through the issuance of debt of stocks. The theorem, of course, requires qualification when equity and debt finance are taken differently for purposes of taxation since equity finance costs more than debt finance, resulting from deductibility of interest on debt (Peek & Rosengren, 2011: p684). However, different treatment during taxation is not the only reason that the above theorem is inaccurate. The theorem assumes that those investors, who are in debt, as well as in equity, could observe the riskiness and activity of the bank’s assets (Peek & Rosengren, 2011: p684). However, the past thirty years of evidence and theory with regards to banks’ financial structure have indicated that the assumption is not accurate. Equity finance is at a relative disadvantage because of the fact that it is hard for investors to assess a bank’s value properly; this makes it difficult for the bank to sell equity compared to raising debt finance. A fundamental consequence of this is that, the banks will tend to have a higher response to required capital ratios through curtailing their lending activities instead of raising new capital. Therefore, in spite of the benefits to the stability of the banking system that may come with increased capital requirements; and thus, higher regulation, there are downsides in the contraction, in bank credit supply (Peek & Rosengren, 2011: p685). There have been recent studies that have exploited features of the regulatory regimes of United Kingdom and Spain, using individual bank data, in the identification of how the banks react to changes in capital requirements that are bank specific. British bank, like banks in other countries, are subject to approximately 8% of assets weighted against risks for minimum capital ratio requirements (Peek & Rosengren, 2011: p687). However, in order to ensure that there is an adequate buffer against credit risk related to losses, regulators in Britain have added further capital requirements in relation to perception of risk exposures of interest rates and operational risks for individual banks like poor practices of management. This has caused a significant variant in requirements of capital ratio that are above the level of 8% among the majority of banks in Britain (Peek & Rosengren, 2011: p687). Conclusion The implications of this argument are that increased regulation in terms of capital requirements, even when done carefully and as efficiently as possible, are not entirely cost-free. However, this should not imply that there capital requirements and, in turn, increased regulation, should be avoided altogether. There is evidence from the financial crisis that allowing the banks to operate sans adequate capital is more costly in the limitation of growth of bank credit compared, to increasing capital ratio requirements. Undercapitalized banking, coupled to government protection, results in excessive taking of risks and systemic collapse of the banking sector. The combination has far worse consequences for credit supply and economic growth the more predictable and modest credit contractions resulting from requirements of adequate capital through regulation. Therefore, the key is to comprehend the nature of costs of credit supply of increasing regulation in order for policy decisions concerning the timing and structure of capital requirements upgrading can take into account these costs. References Barth, J., Caprio, G., & Levine, R., 2010. Rethinking bank regulation : till angels govern. Cambridge: Cambridge Univ. Press. Barth, J., Caprio, G., & Levine, R., 2010. Bank regulation and supervision: what works best? Journal of Financial Intermediation , 205–248. Calem, P. & Rob, R., 2012. The Impact of Capital-Based Regulation on Bank Risk-Taking. Journal of Financial Intermediation , 317–352. Ferguson, N., 2012, June 26. The Darwinian Economy. Retrieved April 22, 2013, from BBC Radio: http://www.bbc.co.uk/programmes/b01jmxqp/features/transcript Peek, J. & Rosengren, E., 2011. Bank regulation and the credit crunch. Journal of Banking & Finance , 679–692. Read More