The Pew Financial Reform Project - Assignment Example

Table of Contents Executive Summary………………………………………………………………….2 Introduction………………………………………………………………………….3 Main Body…………………………………………………………………………...3 Conclusion…………………………………………………………………………..10 References………………………………………………………………………..…11 Executive Summary The paper has been divided in two major parts in which one part explains concepts while the second part finds a solution to the problem. This paper presents information about the systemic risk and what it actually means. The systemically important financial institutions (SIFIs) have also been described briefly. In the first part, the focus is given to the significance of systemic risk and SIFIs in their role in the reforms and regulation of the banking sector. It is seen that the systemic risk, caused by a catastrophe, could disrupt the whole economic setup leading toward a global financial crisis. Therefore, it is needed to be avoided for preventing the future banking crisis. For this purpose, the proposals have been suggested in the second part of the paper. It is suggested that the division of bank into commercial and investment banking has fewer risks and it is a desirable option in contrast to the unified banking which is more risky but fostered more growth of the banks. Introduction The paper is meant to discuss the serious issue of banking crisis and suggest ways to mitigate the chance of future economic crisis globally. For this purpose, the paper covers two major sections in which the first part explains the term systemic risk and systemically important financial institutions. However, the second part describes and evaluates various proposals for introducing banking reforms concerned with the separation of the commercial banking and investment banking sector. Main Body Explain the meaning of ‘systemic risk’ and ‘systemically important financial institutions’ (SIFIs). Explain their significance for banking reform and financial regulation. The systemic risk can be defined as the condition in which the entire financial setup receives a major setback (Cox, & Larsen, 2011). It can be contrasted to the risk of damage done to the one financial aspect only and implies the collapse of a whole financial system. In other words, it is the major financial downfall which results from the various external and internal causes. It has also been described as the financial instability or disruption of a financial system which is generally catastrophic in nature. Hendricks (2009) has defined systemic risk in following words: "A systemic risk is the risk of a phase transition from one equilibrium to another, much less optimal equilibrium, characterized by multiple self-reinforcing feedback mechanisms making it difficult to reverse." The definition given above used theoretical terms to explain the concept of systemic risk and does not include economic terms in it. However, it suggests that systemic risk is the type of risk which can occur when a particular change occurs in terms of a transition from one phase to the other. He considered this type of change irreversible or hard to be undone keeping in view the serious damage it already has created. It is better to discriminate the term systemic with systematic risk because they are often confused with each other. The systemic risk is the major risk factor capable of disrupting the entire financial market as a whole, whereas the systematic risk can be described as the entire market downfall which is usually the result of a systemic risk (Cox, & Larsen, 2011). For instance, a systemic risk can occur in a specific industry which can cause a systematic risk by disrupting the global financial market. The systemically important financial institutions (SIFIs) can be described as the financial institutions of considerable importance to the extent that the failure of one has the potential of creating global economic crisis (Cox, & Larsen, 2011). The significance of such institutions lies in their strong role in the global economy which can suffer by the abrupt failure of a single institution of this sort. Because of the increased importance of these institutions, it is important to prevent the failure of them by various means. If the systemic risk of any such financial institution is not avoided by a proper prevention program, the whole world economy is under great risk. Therefore, it is necessary to establish proposals which could help minimize the systemic risk of systemically important financial institutions. The type of institutions mostly considered as SIFIs have been international banks which secure huge capital in them. There are 29 global banks which are termed as SIFIs according to international regulators’ report (Cox & Larsen, 2011). Due to the strong financial regulation imposed on the global banks regarded as SIFIs, many financial institutions refuse to consider them as SIFIs and urge others not to regard them so. According to researchers, it is important to revise the listing of SIFIs to determine which financial institutions must be considered as SIFIs and which cannot be regarded so (Wyatt, 2011; Dash, 2011). In order to examine the financial institutions for inclusion in SIFIs, the size of the institution is important to take into consideration. It is because the size of the financial institution is an important indicator of measuring the significant role of the particular institution in the world economy. In addition, it can also evaluate the possible risk which the global economy can face on the collapse of a SIFI. The concepts of systemic risk and SIFIs described above are important for establishing banking reforms and undertaking financial regulation (Cox, & Larsen, 2011). The researchers have related the concept of systemic risk to a process which creates cascade effects on the banks. The cascade effects can be related to the influences on the other banks which appear to be negatively affected by the systemic risk of a bank. Due to the link between the banks at global level which are connected chain wise, the systemic risk is bound to greatly influence the other banks that owe money to it. The term ‘bank run’ has been used to explain the process which suggests the interconnection between the banks at international level. In the issue where cascade effects prevail in the global banking system, the financiers begin to look for liquidity in financial institutions, that is, banks. It reduces the buyers’ trust in the banks experiencing systemic risks because they lack liquidity. Because of this mistrust among the buyers, a huge unrest is created in the global market. Therefore, the policymakers need to develop banking reforms effectively in order to avoid systemic risk leading toward a major systematic risk. Since the systemic risk of the systemically important financial institutions seriously impacts the global financial market by either paralyzing the market activity or terminating it completely, it is important to regulate the financial system entirely (de, 2010). Not only the banking reforms are required, but it is also needed to put a close eye on the process and regulations concerning SIFIs. One of the important demands made by the financial institutions for protecting their interests against the occurrence of systemic risk is the delicate nature of the market. However, it is not sufficient to justify the happening of the systemic risk and it is therefore, not given acceptance among the policymakers and banking reformers. It is at times suggested by the reformersof that issue, if insurance is made possible for the buyers in case of bankruptcy or a systemic risk. However, this suggestion cannot be completely implemented because the issue of liquidity is still there which makes it difficult for the banks to pay money to the claimers. The policymakers do claim that such justifications can only weaken the financial institutions making the chance of systemic risk increase. In addition to the banking reforms, the financial regulation of SIFIs is crucial to reduce the systemic risk and consequently protect the global economy from complete disruption. According to various studies conducted by the researchers, it has been found that regulation is essential for making the global financial institutions stable and work effectively (Sánchez, 2011; Dash, 2011). A process named as regulation arbitrage is used to state the regulation in which commerce is transferred from one sector to the other. The sector which transfers its commerce is the one which is subject to regulation whereas the other sector receiving the commerce is mostly unregulated sector. It has been seen in the research that the banks were brought under financial regulation in order to prevent the systemic risk. In such a case, the insurance sector came into scene and took charge of the issue and thus the direction of systemic risk was shifted from one area to the other. Explain and analyze the various proposals for avoiding a future banking crisis that are based on a functional separation of banking between retail / commercial banking business and investment banking. The global financial crisis of 2007 impacted the banking sector specifically and global economy as a whole (Dash, 2011). The impact was severe enough to raise concerns about the need to regulate the banking systems so as to prevent itself from a future shock. It seriously damaged the trust of people across the world on the banking sector and financial institutions completely. It is therefore, the need of the hour to design procedures and introduce the reforms for eliminating the systemic risk in SIFIs. Various researchers have given various proposals in order to present implications for preventing a banking crisis to occur in future (Dash, 2011; Wyatt, 2011). It has been seen that the macro elements are necessary to be carefully looked upon in order to reduce the major imbalances at macro level. Not only the macro imbalances need to be dealt with responsibility but it is also crucial to develop reforms for finding solution to the macro problems. In a study, it has been found that the systemic risk associated with one bank is most of the time only fault of the single financial institution. There are few other factors involved in creating a major financial crisis which is triggered by the systemic risk of a single financial institution. While suggesting practical solutions for dealing with the problem of avoiding the future banking crisis, it is necessary that long terms goals are established instead of focusing on short-term objectives only (Sánchez, 2011). The realization that the whole world is interlinked in the web of global financial institutions is necessary for the policymakers to think seriously about the issue under discussion. The use of financial regulation targeted on both traditional and modern methods are required to develop the effective proposals. Moreover, the issue of narrowing the functions of banks and dividing it into two commercial and investment banking departments is a serious issue which is under the serious consideration by the reformers. The issue is nonetheless, important but the main thing is how to manage the separation of two major divisions of banks. Additional research is needed in this regard as the available information is not sufficient to specify the best proposal. According to the researchers, the Glass-Steagall Act of banking which suggested the separation of the investment banking from commercial or retail banking sector has been seen as a good approach by many financial experts (Pallavi, n.d; Wyatt, 2011). The main benefits it could provide to the consumers are that their interests would be secured. The conflicts which occur between the consumers and the banks can be ended by undertaking the separation of the two major banking systems. However, the diversification in banks has some risks associated with them which make it difficult for banks to invest the money in securities. It has been pointed out by the researchers that the loans have the potential to be risky as compared to other types of securities, such as bonds. Therefore, the risk can be increased for the banks because they are forbidden to put investment in the securities. There has been a lot of evidence against the separation of the major banking functions. The banks without securities have four times the risk of failure as compared to those following the unified banking system. On the other hand, the unified banks also pose threat of a systemic risk by having conflicts of interests within them. It has been proposed by the researchers and financial experts that the future banking crisis caused by a bank run could be prevented by causing the banks to keep their data confidential (MacNeil, 2011). By hiding the type of data that could cause panic in the market, the future banking crisis can be avoided. Another suggestion is encouraging the customers to apply for the term deposits that could not be easily withdrawn. However, there are some drawbacks associated with the inclusion of term deposits in the banking system frequently. The problem is that the banks have to pay huge interests to individual customers in the long run. It is also recommended that the bankers terminate the withdrawal completely for the time being if bank run is expected. However, these suggestions could only be applied in case of individual banks while there are some recommendations which could be given for the whole economic setup as well. It is necessary to include transparency in the financial system entirely so that the banking crisis could be prevented (Wyatt, 2011). It has been noticed that the complexity in banking system created mistrust among people resulting in creation of panic in the market. A study pointed out that in order to better understand the consequences of the separation of the two banking sectors, it was necessary to discuss the individual functions performed by each banking setup (Pallavi, n.d.). The investment banking system was considered to be risk tolerant as compared to the commercial banks because of the business model of investment banks. It also fosters less regulation by the government but is increasingly important in its ability to cause panic in the market. By losing the important accounts’ data, it could severely disrupt the market. Another study related the global economic downfall to the unified banking system which used both investment and commercial operations at the same time (MacNeil, 2011). However, the banks are free to choose the way they want to run their investment or retail business operations. The significant benefit of employing unified banking is that it helps the banks run in an effective manner boast its growth and stock. Nevertheless, it has been suggested that the banks should not be allowed to work in combination with both retail and investment operations because it could give the banks the power to create a future banking crisis. In such a case, a systemic risk in SIFI can give the world another shock in the form of a financial downfall (Wyatt, 2011). Conclusion The paper attempted to discuss the meaning of systemic risk and SIFIs by referring to the literature. It was also investigated how a financial crisis could be avoided in future by following the proposal given for and against the separation of the investment and retail banking. References COX, R, & LARSEN, P 2011, A Positive Spin On Too-Big-to-Fail, New York Times, 21 December, Academic Search Complete, EBSCOhost, viewed 12 February 2012. DASH, E. 2011, Fed Casts a wide net in Defining Systemic Risk, New York Times, 9 February, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Hendricks, D. 2009. "Defining Systemic Risk." The Pew Financial Reform Project. MacNeil, I. 2011, Editorial, Law & Financial Markets Review, May, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Oz, A. 2010, The Future of Cross-Border Banking after the Crisis: Facing the Challenges through Regulation and Supervision, European Business Organization Law Review, 11, 4, pp. 575-607, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Pallavi, G. n.d., Lewis: BofA pushed to Merrill deal, USA Today, n.d., Academic Search Complete, EBSCOhost, viewed 12 February 2012. Safer, but not yet safe enough 2011, Economist, 398, 8733, p. 22, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Sánchez, M. 2011, FINANCIAL CRISES: PREVENTION, CORRECTION, AND MONETARY POLICY, CATO Journal, 31, 3, pp. 521-534, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Wyatt, E. 2011, To Cushion Against Losses, Fed Considers Raising Capital Requirements for Banks, New York Times, 4 June, Academic Search Complete, EBSCOhost, viewed 12 February 2012. Read More