Bank Based Financial System vs Capital Market Based Financial System - Assignment Example

Banking Questions Contents Answer 1 2 Funding liquidity and funding liquidity risk 2 Relationship between fundamental liquidity and market liquidity 3 Answer 2 4 Bank Based Financial System vs. Capital market based financial system 4 Answer 3 5 Competition 6 Financial deregulation 7 Answer 4 7 Regulatory Capital 7 Economic capital 8 Answer 1 Before the global financial crisis shook the world into a deep recession, witnessed after a very long time since the great depression, nobody really bothered about the liquidity risk. However, all this changed post the global financial crisis. A part of this change in view came into effect because many thought that the global financial crisis was a result of the shadow banking system which systematically withdrew liquidity from the system. There are mainly two types of liquidity risks that exist in the modern scenario. Funding liquidity and funding liquidity risk Funding liquidity can be defined as the bank’s ability to settle all its liabilities as soon as they occur. A bank which cannot fulfil the obligations is said to be illiquid. If such a case arises then the bank is said to have defaulted which causes the shareholders and the depositors of the bank to incur heavy losses. Funding liquidity risk on the other hand is defined as the probability that the bank won’t be able to pay its obligation in a certain time period in future. So there exists a major difference between the two concepts of funding liquidity and funding liquidity risk. Funding liquidity has only two possible outcomes, i.e. either the bank would be able to pay its liabilities or the bank won’t be able to pay its liabilities at a particular time in future. Funding liquidity risk on the other hand can have infinite possible outcomes depending on the distribution of future incomes. It is spread over a time period not a particular time. As per the theoretical definition of funding liquidity a bank can be said to be liquid as long as the outflows is less that the inflows and the stock of money held. The market liquidity is a function of three different perspectives. The most popular and crudest measure is the bid-ask spread is called width. A low or narrow bid ask spread is said to be tight and reflects more liquidity in the market. Depth refers to the market’s ability to absorb sale of a position. Another feature of the market liquidity risk is the resilience which refers to the market’s ability to bounce back from temporarily incorrect prices. Relationship between fundamental liquidity and market liquidity In period 2 banks can therefore not only trade in interbank market but also obtain liquidity either from depositors depositing money in the banks or by selling assets. Whereas deposits is considered as the natural hedge against liquidity risk which arises out of the giving out loans, but the problem is that it not always possible for the banks to fetch new deposits by attracting new depositors. So inflow and outflow can be considered to be random events and comprises of liquidity shock for the bank. In this perspective another area which can provide and act as alternate source of liquidity is the sale of assets. It is over here that the concept of market and market liquidity risk comes into picture. There are several models relating to this issue which has shown that there exists a strong relationship between market liquidity risk and funding liquidity. If the aggregate market liquidity is less then there is a chance that interbank market rates would increase. Frictions can often result into the market and funding liquidity falling into a downward spiral. For example if a bank is short on liquidity and is not able to obtain the desired liquidity from interbank market it will go for selling of assets. However if there is friction in the asset market then large scale selling of assets will result in the asset prices going down. So for the bank the outflow increases in comparison to inflow and to remain liquid the bank has to sell higher volume of assets. This in turn further reduces the market prices even further and the downward spiral continues. Thus there exists a strong relationship between funding liquidity and market liquidity. Answer 2 Financial system can be defined as a system that allows for transfer of funds from the savers to the borrowers. In essence a financial system allows and facilitates the transfer of money and fund from the source of funds (the depositor or the investor) to the destination, i.e. those who require the funds (the borrower). The financial systems perform the most important task of channelizing the funds from household or domestic investors to the corporate of businesses that require those funds. The financial system also enables the individuals or domestic investors and the borrowers to share risk. Although the functions of financial systems are universal their form varies from country to country. Financial systems are broadly classified as either being banking based or capital market based. Bank Based Financial System vs. Capital market based financial system In a bank based financial system banks are classified as the most important financial institution. The non banking financial instructions are either nonexistent or are totally dependent on banks for their functioning. In comparison to this in a financial system that is dominated by the capital market, the capital markets are the most important financial institution. The non-banking financial intermediaries are relatively important in a capital market based financial institution. In a bank based financial system the importance of the bank as the most important financial institution implies that savers deposit most of their deposits in Banks or use banks as their preferred and perhaps only investment option. It also implies that funds that the businesses use for their business activities are mostly drawn from either banks or equity. Where as in a capital market based financial system the savers or investors use the capital markets to save their wealth. The firms or corporations also use the funds that they need from the capital markets. In a bank based financial system the relationship between the banks and the borrower is very close and the emphasis is on relationship banking. Banks are perfect examples of universal banks. In comparison to this the relationship between the bank and the customers are close but are always at arm’s length. The universal banks are not the reality or rule but may exist as exception. In the financial system that is dominated by the banks, capital markets are unimportant as a source of fund or as a means of the investors depositing their fund. Whereas in a capital market based financial system the important role in corporate finance or corporate governance is not played by the banks but by capital markets. Most people are of the view that market based financial system are more effective at providing financial services. Some suggest the role and function of financial intermediaries and the advantages of their existence. Among the developed nations Japan and Germany are the prominent examples of bank based financial system where as Europe and America of market based financial system. While comparing between these two financial systems often a comparison is made between the growth prospects of these countries. But all of these countries fall in the category of developed countries with almost similar long term growth prospect. So it is self implied that the type of financial system does not have much impact on the growth prospect and hence a comparison in this line is a futile exercise. To accurately determine which financial system is better the economists need to broaden the scope and include more examples. Answer 3 In the modern era there are lot of factors that contribute to the instability of the banks and leads to the riskiness of the banks. The main risk that arises for the banks is the result of excess greed of the bankers. Another cause of risk for the banks is the result of uninformed depositors. If one lists the causes that lead to the risks for the banks then one find the finds the following factors that are main causes of banking risks. Competition Competition can have negative impact on a bank’s performance. Competition often results in the reduction of bank margin and thus results in instability for the banks. If competition is too much, then it may result in instability for the banks. In fact there is a trade off that is involved between efficiency that is the result of competition and greater instability. The concentration-stability view states that if the banking sector is dominated by a few concentrated banks then it is less prone to risks. On the other hand presence of large no. of banks results in greater risk of instability or bankruptcy. A concentrated banking system may enhance profits and boost bank profits. The high profits that are generated by concentrated banks act as buffer or cushion in the presence of higher risks. The reduction of risks and the high profit levels increases the bank value and thus reducing the incentive for the banks and their willingness to take more risks and thus leads to the reduction in the probability of a systemic distress. The concentration of the banks will also result in more effective supervision of the banks by the regulators. Thus the incidence of crisis is greatly reduced in such a situation. However there is a counter view to the concentration stability view, which is known as the concentration fragility view. This view states that a concentrated banking system leads to greater fragility. The supporters of this view argue that if the banks become concentrated then they can influence the market and thus it boosts the interest rates that they charge to firms. Many researchers in the field find a positive relationship between the concentration of banks and the bank fragility. Since these banks are categorised as too big to fail it incentivises them to take on more risks and hence increase banking system fragility. Financial deregulation The increased state of financial deregulation has allowed the banks to enter into new business areas. This often gives bank the licence to enter into business areas where they have no prior expertise. When new instruments are introduced, the banks normally take new risks without paying much attention to the downside risks of going to failure. Liberalization and removal of entry barriers has resulted in the entry of new players in the banking industry which has led to increased risks. The liberalization with respect of interest rates has led to increased repayment and market risks. Deregulation also leads to change in the ownership structure of the banks. With change in ownership the risk taking appetite of the bank also changes. Answer 4 Economic capital and regulatory capital are two terms that are frequently used that are used in the analysis of the framework for bank capital regulation that are proposed by the Basel committee on banking supervision. This regulation by the Basel committee has been suggested in order to ensure that the banks do not fail in the event of global financial crisis. Although these two terms are used almost simultaneously there exists a difference between the terms. Regulatory Capital Regulatory capital is the minimum capital requirement that the banks must mandatorily maintain as required by the recommendations of the Basel committee. The regulatory capital should be in principal derived from the maximization of the social welfare function while taking into accounted the costs and benefits that arise out of capital regulation. While arriving at the deduction of regulatory, it is required in essence that there is trade off between going in for a cheaper or costly source of capital and the probable aversion of the bank going bankrupt. However while referring to the regulatory capital it is implied the minimum capital requirement that is required to be maintained by the banks. Mainly while taking about the regulator the Basel 2 capital requirement by the banks is referred to by the BASEL committee. According to the Basel Committee the regulatory capital of the bank should be kept at a limit such that it covers losses due to loan defaults. The regulatory capital requirements for the banks as given by the Basel Committee are the leverage ratio should be kept at 4%. The ratio of Tier 1 capital to risk adjusted assets should be kept at 4%. Ratio of the total amount of capital that is the summation of Tier 1 capital and tier to capital to risk adjusted assets should be kept at 8%. Economic capital Economic capital is the capital that the shareholders of the banks may choose when there is capital requirement as defined by the regulators requirements is unavailable. Normally Economic capital can be said as the capital that is minimally required to be maintained in order to cover the bank’s losses at a certain probability or confidence level. This view comes from the appreciation of the fact that the share holders set the minimum capital requirement for the banks such that it maximizes the value of the bank while at same time acknowledging that the bank will be closed if the losses incurred by it exceeds the initial capital that the bank holds. The closure of the bank may happen because the banks will run or close before the equity shareholders has the time to infuse new equity capital. The equity capital in essence can be defined as the estimates of the required capital that the financial institution may use so that they can manage their internal risk and allocate the regulatory capital among different units’ insides the organization. It means there is essentially a trade off between the amount of debt capital and the amount of capital that the banks must use. The equity capital refers to the capital which has higher cost of capital but is associated with less bankruptcy risk. On the other hand debt capital refers to capital which is associated with lower cost of capital but high bankruptcy risk. The choice between these two sources should be guided by what is the risk appetite of the investors, degree of volatility of bank’s earnings. Read More