Bank Regulations in Europe - Essay Example

 Bank Regulations in Europe Introduction Technical progress across European banking markets had a similar outcome reducing costs by around 3% per annum from 1989 until 2001. Overall research shows that in the European Bank market, a banks size has a relative effect on the efficiency of reducing banks costs. The larger the branch the more adequate the system for reducing costs tends to be. This does not hold true advantages within the scale economy as smaller and larger Banks in Europe have performed the same throughout past years. With the recent decline of the economy worldwide banks have taken a hit and Europe’s bank market is no exception. There are currently many regulatory transitions underway which will have multifaceted effects on how Banks are run in Europe and the ultimate investments they deem as adequate for progressive growth. The controversy surrounding these regulations stems from past success as well as the impact recent recession ratios have imposed on the market. The question this analysis will attempt to address is whether or not these regulations are necessary for European banks to progress in the years to come. Part I: current regulation, Basel II 
 Basel II is the second of the Basel Accords. These are recommendations set by the Basel Committee on Banking Supervision. The point of these laws is to apply some regulation to the world wide banking system, an international standard by which all banks may abide. These regulations are an attempt to safeguard the Banking Market against many of the risks banks face yearly. They are seen as a safety net for the international banking market in the case that one major bank collapses. The main focus of the regulations is to reduce the amount of risk all banks take on. Through rigorous risk and capital regulations, basel II is able to ensure that Banks are not able to take on more risk than they have solvency to maintain. Despite the ABsel II regulations and their proven success throughout the past years, recent developments in the global economy have pointed to a need for more strict regulations. This can largely be connected to the massive recession that has occurred over the past two years in the global economy. The nature of the European Banking system and its current need for BeselIII regulations is in reaction to the state of the Economy. The State of The Economy The CIA World Factbook notes that the United States of America has the largest economy in the globe. “The recent failure in the U.S. housing and credit markets have resulted in a slowdown in the US economy. 2007 GDP growth was estimated at 2.2% but in 2008 it is projected to be just 0.9%, down from the 10-year average of 2.8% (St Labs, p1).” According to the United States Department of Labor, The Unemployment rate as of September 2009 was 9.8%, which is the result of a progressive growth 8.9% in April 2009. The Banks have followed suite with the hosuing industry as well as many of the corporations g out This effect in the west has impacted the Europes University of Maryland economist Peter Morici declares "we are in a depression (Shinkle, p1)."  He signifies a recession as an economic decline from which an economy can eventually recover but poses that the state the American economy is in today is much worse and can’t be resolved with a quick fix. "My feeling is that . . . if (the president) doesn't fix what's structurally broken, what caused this, we'll be back into this after the federal stimulus has had its effect," says Morici (Shinkle, p1).  Many different aspects of the American economy have come under fire as the cause of this financial crisis, most infamous of these methods to date are credit default swap contracts and short selling. The very first credit default swap contract was constructed in 1997 by JP Morgan and it is given credit for what initiated the market to balloon up to a $45 trillion value in 2007 (Pinsent, p1). In a CDS contract, credit risk from emerging market bonds, mortgage-backed securities, municipal bonds or corporate debt is transferred between two parties.  It is a bilateral contract in that both parties are obligated to carryout their end of the contract.  CDS contracts were designed because as Stephan Teak puts it in his article Did Credit Default Swaps Cause the Financial Market Meltdown?, lenders were encountered with a problem they needed solved.  He best describes the factors leading up to this revelation by lenders when he says, “When a lender provides financing in the form of a loan, it has to keep a certain amount of cash, called capital, on hand to cover any problems with the loans such as defaults. For larger financial institutions like JP Morgan, this meant having huge amounts of money tied up and doing nothing. The credit default swap was designed to deal with this problem (Teak, p1).”  The basic goal of the credit default swap is to free up the unused ‘safety-net capital by selling off the risk of the loan to a third party for a premium.  Once the capital was freed-up it would be available for use to provide another loan. The significant way the housing bubble crashing and so many people defaulting on their loans effected the economy was that it caused all of the banks that relied on CDS contracts to crash as well.  A large number of these banks either merged with larger more stable sectors or they disappeared altogether from the market. “The bankers are on welfare, they call it a bailout, but if you're broke you're on welfare” said Van Jones an African American Yale Law graduate at a recent book signing of his highly acclaimed work The Green Collar Economy:  How one solution can fix your two biggest problems (Pinsent, p1).  He promotes the development of alternative energy as the key solution to the decline of the economy and he is one of the biggest advocates of the President’s stimulus plan. Despite the detrimental effect this financial method has had on the economy, it is not completely viewed as a corrupt tactic by economists.  Many argue that it just needs to be regulated, which is more than can be said for the trading method of short selling which has been equally labeled as the cause of the current economic crisis along with CDS contracts. “The largest and still the most important market in the world, the United States of America’s economy is driven by consumers but is troubled by high debt levels (St Labs, p.1).” One of the main factors causing the financial crisis is short selling. Short selling and its effect on the market work in a more underhanded manner.  The main reason why it is viewed as underhanded is because it is a trading method that works counter to the initial goal of trading which is to find the best stock to buy, and instead is recognized as the act of finding the best stock to sell.  Traders who short sell basically sell stocks they don’t own in the belief that once the stock falls, they will be able to buy the stock in the future and make off with the profits.  They then return the shares to the original owner.   The specific way it works is that if a stock falls the way a trader predicts, they can buy shares of the stock at a lower cost and then replace the borrowed shares they sold to bring the stock down in the first place.  “You short 300 shares at $45 per share. Your broker deposits $13,500 in your account. Two weeks later, the price has fallen to $35 per share. You instruct your broker to “cover” your short or buy 300 shares to replace those you sold (Little, p1).” The most obvious risk of short selling is that if the price of the stock rises you actually lose money.  If there are a large number of short sellers trying to cover their position in a stock it also has the effect of driving the stock up.   The Consumer Price Index, CPI represents the changes in prices of goods and services which are purchased by urban households. Included in these purchases are fees paid by the user of the households like sewer services, water and sales taxes. Income taxes and investments are not included in this estimate. The CPI had a major drop of 7% from June 2009 to July 2009, then increased 4% in August 2009 until it finally rested at 2% September 2009. Another major part of continuous improvement is expansion, and no western corporation better exemplifies and their international investment in European Banks. better proves this than Wal-Mart. Their ability to be the first corporation in a new area, or their international ventures prove they may already be developing the market based on their rules. There are certain instances throughout the past year where Wal-Mart has ventured out of its market base and attempted to bring in a new genre of customers. Throughout the companies history these attempts have continuously resulted in them falling back to their original retail line. This is a testament to the niche they have found in their market, but it also shows their willingness to improve and expand their market base. Analysts have questioned the trade-up strategy, which has thus far failed to invigorate the company's sales or stock price and could alienate its core lower-income customers. Part II: new regulation Basel III Banks organize and classify their investments through a system known as tier placement. Within this system a medium of capital is measured by its ROI, possible return on investment, and thus placed in its respective tier. The Basel III Capital structure requirements have impacted the banking markets tier system in numerous ways. For starters, Tier II investments are being more heavily regulated and no longer deemed as relevant to increasing capital, as noted in the JP Morgan 2010 Equity Research publication, “Under new proposed regulations, Core Tier I will include only ordinary sharesand retained earnings (including other comprehensive income) and no longerinclude preferred shares or preferred securities (Kono, 2010).” In addition to Core Tier I tightening up its share requirements, Core tire II classified capital is being adjusted as well. Investments that were previously considered high return that were placed in the tier I category are now being classified as high tier II and lower tier II is being removed from the model all together. All of these changes are not going to be implemented immediately as there will be transitional periods, but 2010 is the major focus of most international banks and investment agencies, as noted “The Basel Committee on Banking Supervision (BCBS) plans to adjust standards by December 2010 following a quantitative impact study in 1H 2010. We therefore view 2H 2010 as the next focus point. The new regulations are slated for implementation at end-2012, but there are plans for interim measures and a transitional period wherein previous policies may be used(Kono, 2010)” Banks performance is crucial to any one of us who has deposited cash or is using any service or product of the bank, in order to make the decision in which bank to invest; you must know how the bank is performing in order to do that you can use various financial ratio that can help you in rating the performance of any bank (Brigham & Ehrbardt 194, 2004).  A bank’s balance sheet and income statement are the most valuable source of information that can be used in evaluating bank’s performance. The amounts stated on these statements can provide valuable insights into the performance and condition of a bank.  The data from these statements can be used to develop financial ratios to evaluate bank performance. Example of ROE: Bank X has total assets of $50 million, an annual net income of $750 thousand and total equity capital of $3 million (Kunda 2008, 492). Bank Y has total assets of $250 million, net income of $1 million and total equity capital of $15 million.Now the question is if you want to know which bank’s performance is better than the other we can see what the Return on Equity is of both the banks.   Bank X Bank Y Total assets $50 million $250 million Annual net income $750 thousand $1 million Total equity $3 million $15 million   Return on your Equity  ROE can be one of the key indicator’s to know about the performance of the bank (Brigham, Eugene and Ehrhardt, Michael (2004). ROE=Annual Net Income / Total equity Annual Net Income can be extracted from the income statement published by the bank and Total equity can be extracted from the banks balance sheet. Therefore in the above case Bank X ROE=Annual Net Income/ Total Equity=750/3000=25% Bank Y ROE=Annual Net Income/Total Equity=1 / 15= 7% 
Bank  X provides return on equity/investment  of 25% and Bank Y provides 7%       This paper has only taken into account the financial ratios, operational efficiency, services & products provided by the bank can also help in determining the performance of the bank further. As further noted in the text, “A retail bank could lose up to a third of its customer base each year to attrition.” Even the best performers lost 15%. By far the largest attrition occurred in the first year of a banking relationship. A study of banking industry found that 34$ of customers that leave a bank indicate that they did so out of dissatisfaction with steep fees and fee surprises, poor service, and errors.” Relying too heavily on just a few indicators of banks profitability can be misleading. 
  Part III: impacts of the proposals, does the banking sector need such a regulation? The proposal for banks to regulate Tier II assets could potentially mean the demise of Tier II investments as an assets class. The core responsibility of the Tier II market has been to provide support for Tier I investments and maintain healthy ratio. This is better explained by Japan equity research when Kono notes, “Historically one of the reasons why issuers would tap the Lower Tier II market would be that these capital instruments allow issuers to absorb regulatory adjustments and therefore supported Tier I ratios (2010).” In the even that these capitals could no longer absorb the regulatory adjustments of Teir I ratios, there would be no need for Tier II and it might not survive in the market. The questing this poses is what does this mean for the health of the banking industry as a hold and does it need these regulations inhibiting tier II markets in 2010.? Example of ROA (Return on Asset) Return on Asset (ROA) show how well a company is using its asset in order to be profitable. The ratio helps in knowing how the management is using its assets to generate earnings. It is calculated by dividing a company's annual earnings (which is Net Income) by its total assets, ROA is displayed as a percentage. The formula is ROA=Net Income/Total Asset The ROA shows how well the company is converting the money it has to invest into net income (Wood and Sangster, 2008, 134-258). If the percentages are high, it’s the better, because the company is earning more money on less investment. For example, if one company has total assets of $5 million and net income of $1 million, its ROA is 20%; however, if another company earns the same amount but has total assets of $10 million, it has an ROA of 10%. This example illustrates that, the first company is better at converting its investment into profit. Monitoring the Net Income after Taxes The banks Income statement can play a very crucial role in identifying the banks performance (Wood and Sangster, 2008, 134-258). By monitoring the banks Net Income after Taxes we can get a picture of how the bank is performing. We can take the Income statement for 2 or 4 years and then see the Net Income after Taxes if it’s positive it means the bank has been profitable and performing well if its negative it means the banks has been in a loss and is not performing very well and there might be a risk in choosing that bank to invest. The cost/income ratio or efficiency ratio is the standard benchmark of banks efficiency. It measures a bank’s operating costs as a proportion of its total profits. Although it’s widely used, the benchmark is an Unreliable and often inaccurate measure of bank efficiency. The cost/income ratio is dependent on factors like lending, borrowing and other activities it undertakes. Word of mouth can also play a crucial role in evaluating the performance of the bank, the type of service & product the bank provides. The other thing which is very important is to see how much loan the bank is giving out and what is the deposit input .These two inputs (deposit/loan) play a very important role in banks performance.Usualy banks income is through the long term deposit which customer’s deposit, these deposits are further given off as loan or invested in some projects by the bank in order to get interest income. If the bank is giving out too much of loan an is unable to recover the loan it can effect a banks performance as the provision to Loan loses will increase and can also lead a bank to bankruptcy. The recent recession was basically due to this issue; banks and investment houses had given out large loan to customers and were not able to recover those amounts. Therefore we need to keep above mentioned points in mind. LIMITATION This paper has only taken into account the financial ratios, operational efficiency, services & products provided by the bank can also help in determining the performance of the bank further. Relying too heavily on just a few indicators of banks profitability can be misleading. As the regulations for Besel III have been newly passed and their main focus is on the transitional period of the 2010 year, there is no finite way to establish whether or not the European Banking market needs these regulations. Despite this, there are examples within the market of Banks that have maintained their solvency without risky investments and have survived on smaller business models than that of traditional big bank theory. One prime example of this can been seen with the success of Commerce Bank over the past two decades. Commerce Bank has revolutionized the way Banking is handled within its market, setting a benchmark for all small as well as middle sized banks to reach.  This is due to an emphasis they have placed on Customer service.  This strategy has proven to be invaluable in a banking industry that pushes its customer base more and more towards online banking and less personal interaction between branch employees and customers.  The effects of Commerce banks business model can be seen in the bank’s performance throughout the past years.  Background        Commerce Bank was founded in 1973. The goal of the business model was to stand out among its big business competitors. The branches were open from 7:30am until 8:00pm, and when customers opened accounts they were given gifts to commemorate the start of their financial relationship with the branch.  This had a dramatic effect on deposit growth in that Commerce bank saw a deposit growth of over 30% each year from 1996 to 2001, while the average deposit growth for the banking industry was 5%.  Commerce’s management team argued this contrast in growth could be attributed to the fact that Commerce focused on interpersonal communications between branch representatives and the customer verse other industry leaders, which tried to push their customers into online banking. Problem       The problem with the banking industry in the United States has been a depletion of deposit growth and a reliance on revenue from fees placed on transactions. In addition, there has been a void developing within the relationship shared between bank branches and customers.  Commerce Bank has attempted to confront this issue through an aggressive campaign to enhance customer relations, which in turn as combated the concept of the alienated consumer in the bank industry.  Analysis       As noted in the text, “In 2001, the banking industry loaned almost 90% of its deposit base. In addition, growth in both deposits and loans was about 20% over the period of 1998 to 2001 (Frances x. Frei, 2006).” Commerce Bank’s numbers more than double these statistics. In addition, they have had a higher return on investment.  As further noted within the industry there have been many telling trends pointing to its potential collapse.   0 Two important trends in the industry had evolved. The first was a push to increase the “cross-sell” of products—the number of products each customer used. Although the industry did not formally track this number of, on average, customer tended to hold 1.5-2.5 products at an institution.  Most companies had cross-sell goals that were significantly higher than this level. The second trend was towards growing revenues from fees customers paid for certain transactions and functionality. From 1998 to 2001, fee revenue, also known as non-interest income, had increased at 27%, a much higher rate than interest revenue, or interest income, which grew at 11% (Frances x. Frei, 2006) 
 Here we see a large amount of the revenue accrued by banks came from fees applied to transactions. Reliance on these fees arguably poses a detrimental effect to customer relations.  The promotion of products in a chronic manner in turn implies more of a seller to consumer relationship and diminishes trust between both parties involved.  Despite this notion, it can be seen that an increase in both the marketing of products and packages to customers as well as an increase in transaction fees was the increase in the banking industry between 1998 to 2001.  Commerce Bank’s business model counters this trend through a more personal approach, hands on with its customer base which in turn is reflected in the bank’s performance.  Conclusion The Basel Committee on Banking Supervision in their publication “Strengthening the resilience of the banking sector,” they note significance of the banking industry has on the globala economic structure, A strong and resilient banking system is the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors. Moreover, banks provide critical services to consumers, small and medium-sized enterprises, large corporate firms and governments who rely on them to conduct their daily business, both at a domestic and international level. “A strong and resilient banking system is the foundation for sustainable economic growth, as banks are at the centre of the credit intermediation process between savers and investors. Moreover, banks provide critical services to consumers, small and medium-sized enterprises, large corporate firms and governments who rely on them to conduct their daily business, both at a domestic and international level.”   Recommendations        Banks like Commerce Bank have a business model that stresses the importance of customer satisfaction in a market that has recently cut down it’s customers relations. They show that regulations applied to European Banking as well as Banking worldwide is not vital for success within the small bank market. The banking industry is notorious of for applying hefty fees to it’s customers accounts as well as making it inconvenient for customers to make ATM transactions as well as accrue interest through savings.  Commerce Bank has nipped these issue in the bud through use of a more small town bank business model and  more hands on approach to its customer relations. The end result has been and continuous increase in stock growth, as well as reputation for solid trustworthy banking.  The only real recommendation that can be given is for other banks to incorporate this practice, but in the years to come in response to the current economic downturn it might be wise for Commerce Bank to maintain its status as a titan of the private sector. With the current societal disillusionment of Multibillion dollar corporations that claim to be ‘too big too fail’ going belly-up in the market, Commerce Bank could find itself suffering from similar pitfalls if it focuses too much on growth and expansion and not enough on its customer relations like it has up to this point.  In addition to this apparently the middle management as well as the upper management alike seem to enjoy working for the company, as there are Halloween parties, and lengthy, yet still enjoyable, training sessions provided for the staff. This all leads to a family like business model that has proven to be very successful for the company. 
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