Incentives to Bank Managers to Spur Risk-Taking - Essay Example

Banking Incentives to bank managers to spur risk-taking in different regulatory environments Banking regulations a premised on microeconomic concerns with regard to banks’ abilities to monitor the risks arising from their lending side as from micro and macro-economic concerns with regard to banking system stability in instances where there is a crisis. Nonetheless, other than statutory and administrative regulations, banks are subjected to other “informal” regulations, for instance, the government may use its discretion, out of formal regulatory frameworks, to influence the outcomes of the banking sector (Baltensperger, 2007). Such moves may include bailing out insolvent banks, and involving itself in banking merger decisions. It is typical of regulatory environments to offer incentives to managers as way of spurring increased risk taking by the banks for the benefit of the larger population. Typical provisions found in different regulatory frameworks include branching and new entry restrictions, pricing restrictions (interest rate regulation and other prices/fees controls, restrictions to the line of business, ownership linkages regulation between financial institutions bank portfolio asset’s restriction, compulsory insurance deposits, and capital-adequacy requirements, reserve requirements, and requirements to direct credit to favored sectors or enterprises, among others (Claessens & Laeven, 2005). Branching regulations Different regulatory environments may from time to time ease on the regulations as a form of incentive to bank managers and hence spur increased risk taking by banks. One way through which incentives may put forth is with regard to branching regulations. In order to increase the rate at which the larger population embraces banking, regulatory environment may be eased to allow banks to open more branches and hence reach out to the population more closely (Baltensperger, 2007). Such a move allows bank managers an incentive that will motivate them to expand their operations. This is definitely an increased risk to the bank. While some banking regulations dictate the number of customers to warrant opening a new branch, in such instances, the regulation can be eased to allow a bank to open a new branch without attaining the mandatory number of clients. Special rules concerning mergers Mergers are often regulated. However in special circumstances, the rules guiding mergers can be eased as an incentive to secure banking customers. Banking system specialty from stability perspective is widely recognized and studied. However, not much literature has looked at the implications is special statuses which may be accorded in special circumstances. In cases of failing banks, the regulations on mergers are often eased to facilitate stabilization of the failing bank. More often than not, such a move is often meant to protect failing bank’s clients from possible loss of savings and investments. For instance, to encourage a larger bank to merge with a failing bank and hence save the failing, restriction on monopoly and acquisitions as well as taxation regulations can be shelved as an incentive to facilitate the merger (Baltensperger, 2007). Additionally, where the merger will spur economic growth and uptake of banking products within the market, governments may offer funds through banks which attain a specific level of capitalization and hence promote mergers. Market volatility and credit dry-up risks The Australian Banking System has been facing by substantial changes in dealing with market volatility and the resulting credit market dry-ups in late 2011, more especially due to the European sovereign debt problems. In comparison to the period before the crisis, industry analysts observe that the Australian banks better positioned to cope with market volatility disruption considering the previous improvements they had made to their capital and funding status over the past few years (Bryant, 2012). In the period of crisis, bank deposits had shown increased growth potential in deposits as compared to credits as well as shrinkage in bank sizes. Consequently, to encourage more uptake of credit, banks increased reach to clients through subsidiaries while government also lowered its rates which was translated to the banks as a motivating factor for the banks to further venture out and seek credit-taking clients. This meant increased risk to the banks as they had to loosen loan issuing requirements. Additionally, thanks to this scenario, banks have taken advantage and made substantial inroads into expected yearly wholesale funding requirements, and hence better positioning themselves cope with renewed funding strains, should such occur. In response to these higher funding costs, banks have in the recent past had to waiver interest rates on some loans in relation to cash rate (Bryant, 2012). As a matter of fact, the level of interest partly reflects competitive industry dynamics in recent years. It further reflects concerns with regard to rising interest rates/views with regard to appropriate industry profitability levels. As a matter of fact, the role of regulatory frameworks in the face of banking system’s continuing instability of the banking system remains of major interest in many regulatory environments. Countries that have weak banking systems suffered severe downturn in economic activity as a result of the crisis, notable US and UK. On the other hand, thanks to government incentives, the highly-capitalized and rated Australian banks remained relatively safe. Nonetheless, while Australian banks continue recording robust profits in the latest half-year reporting durations, slow credit growth environs are more likely to lower the pace of future growth in profits, more especially as reductions in bad/doubtful debts that boosted profitability appear to have largely run their course. In such an environment, banks seek to boost profitability through cost-cutting, productivity improvements, and attracting more clients. Empirical findings Empirical results suggest a correlation between profitability and net interest income. As a matter of fact, the existing empirical results show that with declining credit uptake accompanied by reduced interest collections, banks’ profits are likely to decrease as well. In essence, rise in net interest income reflects a slightly larger average net interest margin over the years, alongside a modest growth in interest-earning assets (Federal Bank of Australia, 2012). Additionally, in the near past, banks net interest margins are under pressure from rising cost of funding relative to cash rate and increased liquid asset’s holdings. The diagram below shows the net interest margin trends as the credit uptake decline over the years moving towards 2011. Major Banks’ net interest margins References Baltensperger, E. (2007). The Economic Theory of Banking Regulation. The Economics and Law of Banking Regulation, 1, pp. 9 Bank for International Settlements. (2006). International Convergence of Capital Measurement and Capital Standards: A revised Framework, A Report of the Basel Committee on Banking Supervision Bryant, J. (2012). A model of Reserves, Bank Runs and Deposit Insurance. Journal of Banking and Finance, 43, 749-761, 1980 Claessens, S. & Laeven, L. (2005). Financial Dependence, Banking Sector Competition and Economic Growth. World Bank Policy Research Working Paper 3481 Federal Bank of Australia. (2012).The Australian Financial System. Financial Stability Review Read More