Banking Regulation and Risks Evaluation - Coursework Example

?BANKING REGULATORY COMMISSION AFFILIATED TO THE CENTRAL BANK INTRODUCTION After the great depression the recent global financial crisis that eruptedin 2007 was an event which had sabotaged the entire world’s financial system. The major effect of the global financial crisis was observed in the USA and Europe. The financial institutions’ credibility also faced serious shocks. Additionally, financial institutions identified certain factors contributing to failure but failed to prioritize that which factors require regulatory changes (Davis, 2011). The banks after the financial crisis have constantly undergone reformation in their regulatory practices. The banks are now on a constant quest to out-wind the effects of the global financial crisis and encounter a new business era. The change in the regulatory framework of banks has been observed globally. The practices of the banks of increased regulatory requirement have are hindered the banks from progressing (Ernst & Young, 2011). Hence, this report aims to highlight the effect of the global financial crisis on the regulatory framework of the banks. It will signify the need for the banks to alter the global banking landscape. This has become mandatory so that the system can run smoothly and performance can be optimized while developing capability to sustain any such economic shocks in future. SECURITIZATION The financial engineering based process of pooling certain types of assets so that they can be converted into interest bearing securities is called securitization. The asset in turn derives interest and principal payment for the individual who has purchased the securities (Jobst, 2006). This concept began in 1970’s in the US. The agencies which were backed by the US government pooled the home mortgages. By the 1980’s other assets which were primarily important for pooling were gathered and since then the market of securitization grew dramatically (Jobst, 2006). There was incremental growth in the residential mortgage funding through residential based mortgage securities (RMBS) in UK moved to ?257 billion from ?13billion (Wainwright, 2010). Following trend was observed across the years: (Wainwright, 2010) With the global financial crisis the stability of this concept was also widely impacted. This impact originated from the credibility of securitization conducted for the sub-prime mortgage loans. The poor credit origination, lack of regulatory efficiencies and inadequate methods of valuation proved to hurt the securitization severely. UK suffered as nearly 70% of the RMBS were given to foreigners who reverted to local markets (Wainwright, 2010) The concept of Securitization is also known as financial innovation. The need for securitization was realized to supply the customers with securitized bonds which were backed by sufficient assets. The surety that such bonds will never be subject to bankruptcy was a major factor which attracted the individuals towards it (Davis, 2011). USEFULNESS OF SECURITIZATION AND THE FINANCIAL CRISIS Businesses adopted securitization as source of funding for business on the basis of assets held by them. Banks also allured to the usefulness of securitization as it reduced the pressure of minimum capital requirement imposed as regulation (Jobst, 2006). Securitization was widely used in the US before the financial crisis. At the time of the global financial crisis it was observed that the asset based securities were primarily in the limelight of the investors’ portfolio. The securitization tool was asset backed and so it was widely used as collateral of the sale and repurchase agreements. The asset based securities were also used for the issuance of the asset backed commercial paper. However, the benefits of securitization were enchased unduly that resulted in the crises. During the financial crisis banks were involved as financial intermediaries. When the banking system collapsed these instruments also collapsed as the banks couldn’t sustain the complex engineering introduced for excessive use of the process. This highlighted the needs for regulating the banks in using the process. . According to an estimate by Securities Industry and Financial Markets Association (SIFMA) that nearly US $ two trillion would be short in meeting the demand for funds globally while Council of Mortgage Lenders (CML) estimated shortage to be UK pound 30 billion (Wainwright, 2010) Securitization has still maintained its usage in the financial market with improved financial modeling from complex to simple ones and more information supported. Further the entire portfolios are now being converted into tranches based on their respective level of risk to imply regulation based on risks (Jobst, 2006). The sample is depicted in following image: (Wainwright, 2010) CURRENT RISK BASED REGULATORY FRAMEWORK Risk based regulation is the process of following a system which regulates the risk subject to the individuals. There have been several suggestions prescribed for mitigating the risk. In the banking and insurance sector the assessment of risk is done by using internal risk models. Some of the widely used models include Value at Risk, Monte Carlo, Stress Testing and other tailored versions for banks. Also combination of quantitative and qualitative models is used. The core purpose of these models is to mitigate the risks which may harm the sustainability of the organizations (Black, 2008). In UK, Financial Service Authority (FSA) was driving the regulation. Its failure in ensuring due trading of risk during financial boom led to the developed watchdog of Financial Conduct Authority (FCA)  (BBC, 2013). Also Prudential Regulation Authority (PRA) now drives the regulatory framework (Clifford Chance, 2013). Following regulatory framework was to be used: (Clifford Chance, 2013) The banks have a proper regulatory framework for this purpose. The regulatory departments ensure that the practices and activities of the banks and parties in transaction with bank are according to the prescribed procedures suggested by the central banks. The suggested regulations are enforced and deployed in accordance with the requirements of the present time and the economic conditions which are prevailing. Regulatory teams operating in banks also make sure that risk is identified beforehand and remedial actions are worked upon on the initial stages. One most commonly used practice for assessing the risk is by allotting scores. The banks have to face certain challenges while implementing the elements of the regulatory framework. They need to find: Simple solutions for complex problems Application of appropriate knowledge Application of framework that offers accuracy, consistency and speedy responses Effective internal compliance system POSSIBLE SHORTCOMINGS After the global financial crisis the banks are constantly striving to omit all the loopholes within the regulatory framework. The holding of a required increased amount of capital has been made mandatory by central banks to avoid bankruptcy. This has increased constraints for banks in generating required profitability. The banks specific tailoring of model may be weak as it may not reflect the economic reality and the risks which the entity faces during its operations (Ho, n.d.). Risk management is also an important aspect which the entities must consider while operating in the industry. Proactive decisions must be taken by the management to reduce the risk within the organization. AREAS OF POTENTIAL CONFLICTS In a risk based regulatory system to avoid potential conflict it must be ensured that several regulatory measures are made compatible with the current economic requirement. The propositions suggest that the banks may maintain a minimum capital balance for capital adequacy. This is important so that the banks have the liquidity for doing business but must also stop them from going bankrupt. This need was realized during the global financial crisis when many banks dissolved due to the lack of availability of funds. This also impacted on the type of securities and the mortgage markets it is operating. Strict Regulatory compliance is made essential by the regulatory body for this purpose and it is being applied for assessing risk and minimizing banks defaults. POSSIBLE ALTERNATIVES It is essential for any system to find alternatives for resolving the problems. The problems are solved by taking appropriate decisions at the right time. The most criticized Basel committee at the time of the financial crisis suggested measures which were essential for regulating the banking structure. The methods proposed in the Basel document suggested instant remedial measures for the banks to avoid bankruptcy.. For instance, one of the most simple remedial can be altering capital adequacy ratio for banks based on the risk level in their portfolio. It can also be applied in changing ratio as the economy booming (Financial Services Commission of Ontario, 2011). SUGGESTIONS FOR IMPROVEMENTS IN BASEL II Overall the Basel II model has been subject to a lot of shortcomings. Several drawbacks of the model were point of debate. This was the reason for the formation of the Basel III. Basel accord was based on a few set of regulations which reformed the banking practices. It comprised reforming the financial and the banking practices internationally. One of the aims of the Basel act is to ensure that the banks maintain a minimum capital limits in the system. In the advent of the global financial crisis the lack of capital and liquidity held by the banks was blamed as the reason for their collapse (Ernst & Young. (2010). The Basel II failed because of the lack of practicality. If all the banks maintain a sufficient rate of liquidity then their existence can become very difficult. Banks earn by lending deposits. Maintaining a sufficient amount of liquidity can affect the operations which can impact the survival of the banks. The current Basel requirement again to increase the capital ratio is declared an attempt to kill the securitization market in Europe. The current alternatives proposed also differ in terms of risk measure choice and asset dynamics where Basel proposed one factor model while alternative required two factor model of Pykhtin-Dev BANKING RISK TO THE UK BANKING INDUSTRY The banking risks in UK were related to proper governance, the market risk, and fixed capital requirements, review of the trading books and proper accounting and assessment of the risk in advance etc. All these were the risks which the banks were facing and the Basel II finalization proved significant in deviation in addressing these factors (Ernst & Young, 2010). Suggestions for improving Basel II are that the banks must be interconnected to support the liquidity position. CONCLUSION In this report a discussion has been presented which highlights the problems which the banking in specific context to UK in relation to global financial crisis. The regulatory practices were enforced to regain the investors’ confidence. During the financial crisis the banks were facing severe liquidity issues. The instruments like securitization were also losing credibility. The banks required to strengthen regulatory framework. The Basel committee proposed regulations improvement but criticized as killer of market.. The suggestions for improving the regulations have also been discussed in this report. Hence, it can be concluded that easier is to determine the regulatory framework but defining one that is compatible to the needs of the banks is challenging job for banking regulators in UK. References BBC. (2013). UK financial regulation overhauled. Available from http://www.bbc.co.uk/news/business-21987829 [Accessed 23 September, 2013] Black, J. (2008). Risk Based Regulation. OCED, Available from http://www.oecd.org/gov/regulatory-policy/44800375.pdf [Accessed 23 September, 2013] Clifford Chance. (2013). A brief overview of the Financial Services Act 2012 and the new UK financial regulation framework. Available from https://onlineservices.cliffordchance.com/online/freeDownload.action?key=OBWIbFgNhLNomwBl%2B33QzdFhRQAhp8D%2BxrIGReI2crGqLnALtlyZe7NckjrpjgUOHpxvSAvxk%2BHp%0D%0A5mt12P8Wnx03DzsaBGwsIB3EVF8XihbSpJa3xHNE7tFeHpEbaeIf&attachmentsize=132856 [Accessed 23 September, 2013] Davis, K. (2011). Regulatory reform post the Global Financial Crisis: An Overview. Available from http://www.apec.org.au/docs/11_CON_GFC/Regulatory%20Reform%20Post%20GFC-%20Overview%20Paper.pdf [Accessed 23 September, 2013] Ernst & Young. (2010). A risk-based approach to segregation of duties. Available from http://www.ey.com/Publication/vwLUAssets/A-risk-based-approach-to-segregation-of-duties-May2010/$FILE/Insights_on_GRC_A_risk_based_approach_to_Segregation_of_duties_AU0529.pdf [Accessed 23 September, 2013] Ernst & Young. (2011). The new era of banking regulation. Available from http://www.ey.com/GL/en/Industries/Financial-Services/Banking---Capital-Markets/CFO-report--the-new-era-of-banking-regulation [Accessed 23 September, 2013] Financial Services Commission of Ontario. (2011). Risk-Based Regulation Framework. Available from http://www.fsco.gov.on.ca/en/pensions/Documents/RBRConsPaper.pdf [Accessed 23 September, 2013] Ho, A. (n.d.). Weaknesses in Regulatory Capital Models and Their Implications. Available from http://www.ermsymposium.org/2012/OtherPapers/Ho-Paper-03-23-12.pdf [Accessed 23 September, 2013] Jobst, A. (2006). What Is Securitization?. IMF, Available from http://www.imf.org/external/pubs/ft/fandd/2008/09/pdf/basics.pdf [Accessed 23 September, 2013] Wainwright, T. (2010). Looking to tomorrow: The past and future roles of securitisation in residential mortgage funding. Small Business Research Centre Kingston University, Available from http://www.nottingham.ac.uk/business/forum/documents/researchreports/paper80.pdf [Accessed 23 September, 2013] . Read More