The Efficiency of the Banking Sector in the US - Case Study Example

The efficiency of the banking sector in a country of your choice. The US banking industry. Summary The performance of financial s in the international market is depended on specific criteria – most commonly the performance of the national economy but also the capital adequacy of these institutions are used as indicators for the estimation of their performance in the future. Current paper focuses on the examination of the efficiency of the banking sector in US. The reference to the global financial crisis and its effects on the current and the future performance of US banks is unavoidable. Up to 2003, the performance of US banks can be characterized as quite satisfactory, a fact also proved by the level of the syndicated lending across the country (Figure 1, Appendix); after the appearance of the current financial crisis the credibility of US banks has being decreased; however, efforts are made towards the improvement of these institutions’ image in the national and the global market. These efforts seem to have achieved their target; signs for the efficiency of the US banks in the future – as analyzed below – are quite encouraging. 1. Background After the September 2008 – beginning of current recession by the collapse of Lehman Brothers – the US government took specific measures to support the banks across the country. These measures have been based on the following initiatives: a) provision of capital in order for the capital efficiency of the US banks to be increased, b) provision of guarantees in order for the banks to continue to have access to funding and c) purchase of assets in order to help banks to avoid extended losses (Panetta et al., 2009, p.1). The above plan of action has been common among Western countries that were severely affected by the global financial crisis – even if the measures taken by governments worldwide have been extensive – see Figure 3, Appendix. In order to measure the efficiency of US banks it is necessary to refer primarily to the reasons that led to the beginning of the financial crisis in the US; the efficiency of the US banks is, in any case, related with their ability to avoid the same mistakes that led to current recession. In accordance with Coffee (2009) two facts should be considered as mostly related with the current financial crisis: ‘a) the excessive reliance on the credit rating agency and b) the shift toward more self-regulatory rules that permitted US investment banks to increase leverage’ (Coffee, 2009, p.1). From a similar point of view, it is supported by Thompson (2009) that the practices of Fannie Mae and Freddie Mac ‘were creating an increasing systemic financial risk’ (Thompson, 2009, 17). This risk was further increased by the fact that ‘Japanese and Chinese central banks were acting as cheap creditors’ (Thompson, 2009, 17, also Figure 2, Appendix). In 2009 the pressure over the US banks has been increased leading many US banks to collapse. In any case, the dependency on the mortgage backed – loans has been one of the most severe faults – in terms of strategic choices – of managers in US banks; but it has to be noted that the exposure of US banks to the relevant risk has been different; the research of Igan et al. (2010) revealed that ‘the banks with rapid loan growth along with high cost-income ratio have been proved to be the most vulnerable’ (Igan et al., 2010, p.1). It should be noted that despite the relevant signs, the appearance of the crisis in 2008 ‘have surprised financiers and regulators’ (Caprio et al., 2008, p.2). The crisis revealed the weaknesses in the structure and the strategic decision process of the US banks; in the literature, the crisis has been also related with the ‘limited information about the character of each counterparty’ (Caprio et al., 2008, p. 5) – referring to the parties of financial contracts developed between the US banks and individuals (or firms); the inability of an effective monitoring on these financial contracts was also another reason for the development of the crisis. The crisis still continues to affect the performance of banks internationally but signs of stabilization can be identified in the markets worldwide (Avdjiev et al., 2009, p.13) 2. Bank competition and efficiency within the US banking sector The strategic choices of US banks up to 2008 have been considered as the main reason for the development of the financial crisis across US. The provision of problematic financial products – referring to the mortgage – backed loans – led to the decrease of the banks’ ability to respond to a crisis – due to the limitation of their capital and the extended losses. In a relevant report it is noted that ‘6-12 months are likely to be required for banks to offset losses via earnings alone, depending on Fed rate cuts and the dividend policy of banks’ (Financial Market Trends, 2008, p. 21). On the other hand, existing US legal framework strongly supports the foreign investment on the country but there are certain conditions that could be regarded as hostile towards the foreign investors. In the context of the legal texts regulating the US banking industry, any ‘foreign bank that buys or opens a US bank becomes a bank holding company under Federal Reserve jurisdiction’ (Grieve et al., 2008, p.9). The above fact has not affected the level of competition in the US banking industry; indeed, the competition in the specific industry has been found to be extremely high – this fact could be possible considered as an advantage for the US banks that could borrow from other banks minimizing their exposure to risk (Dinger et al., 2009, p. 491). At the next level, the efficiency of US banks could be measured by referring to the interaction between the US banking industry and the financial crisis – the role of the US banks in the development of the crisis would help to identify their strengths and weaknesses but also their prospects for the future. It has been proved that the development of the recent financial crisis has been strongly related with the US financial institutions; it seems that the strategies used by these institutions the last decade have increased the chances for the beginning of the recession. Eichengreen et al. (2007) have examined the potential interaction between the US bank policies and the market’s performance (Eichengreen et al, 2007, p.7); through their study it is revealed that the use of the emerging – market bond spreads as an indicator of the market’s performance should be avoided; in fact, it is proved that those spreads could be used for the development of misleading assumptions regarding the performance of the market – referring also to the performance of financial institutions within the specific market. Under these terms the efficiency of US banking industry would be depended on the ability of the US banks to develop effective criteria – referring also to the financial indicators and indexes – for the measurement of their performance – the latter is used as a basis for the measurement of the US banking industry performance. In other words, the efficiency of the US banking industry should not be measured using indicators related only with the overall US market but mostly indicators that show the performance of the US banks. On the other hand, it is noted that ‘the relationship between macroeconomic and financial variables on the one hand and pricing behavior on the other is more stable over time for bank loans than bonds’ (Eichengreen et al., 2000, 37); this means that the financial products used as criteria for the measurement of the performance of the US financial market have to be of specific type. In accordance with the above, the measurement of efficiency of the US banking industry needs to be based on specific principles and criteria. Furthermore, the level of syndicated loans in US could be used in order to understand the characteristics of the US banks’ strategic choices. Syndicated loans ‘allow the sharing of credit risk between various financial institutions without the disclosure and marketing burden that bond issuers face’ (Gadanecz, 2004, p.77); the fact that syndicated loans are well expanded in US (see Figure 1, Appendix) proves that the limitation of risk by the country’s financial institutions has been set as a strategic priority – even if this target was not finally achieved – at least at a satisfactory level – probably because of other strategic failures. In any case, the practices of US government in relation to the regulation of US banks has not been quite effective in the past; the financial crisis revealed that the existing – then – rules regarding the regulation of banks and financial institutions did not cover all aspects of these organizations’ activities; this weaknesses made clear by the crisis’ appearance and its rapid development across the country. Current regulatory and monetary practices of US government have been improved setting limits on the exposure of banks to risk; however, the potentials of these organizations for development are not negatively affected (Farrell, 2009, p.2037). The efficiency of these measures could be increased if relevant measures were developed in the international market – in which US banks have an active presence (Thirkell, 2009, p.689). At the next level, US banks seem to have certain advantages compared to US institutions that operate in different industrial sector – this fact could positively affect the efficiency of banks in periods of severe financial crisis – in opposition to institutions in different industrial sectors that are more exposured to the market risks in periods of recession. In this context, it is noted that ‘bank can alter the risk composition of their assets more quickly than most non-financial industries’ (Levine, 2004, p.3). Another common practice of banks to hide their actual exposure to the market risks – and thus reveal their actual efficiency – is ‘to extend the loan to customers that cannot service previous debt obligations’ (Levine, 2004, p.3). 2a. Bank strategy in US – key environmental factors In accordance with the above, the following environmental factors have been identified as influencing the current strategies of banks in US: a) the level of support available by the state in regard to specific projects, b) the level of the market efficiency – this factor refer to two different sub-factors: 1) the buying potentials of people across US, b) the potentials of financial institutions in US to fund other financial institutions – in the context of inter-market borrowing which is related with less risks for the borrower and c) the trends of the global market – referring mainly to the capital adequacy of banks in the global financial market but also to the performance of the markets as an indicator of the financial recovery in the international community. Efforts have been made by researchers worldwide to identify the potential prospects for the US banks – taking into consideration the current financial crisis but also the current strategic plans of these banks – as analysed above. An indicative study is that of Kosmidou et al. (2008) who used data of US banks (reference is made to the decade 1993 up to 2003) and came to the conclusion that the possibilities of a bank failure could be effectively predicted using ‘a multicriteria decision technique, namely UTilites Additives DIScriminantes (UTADIS)’ (Kosmidou et al., 2008, 26). The efficiency of banks in the future could be also predicted by estimating their equity duration; the specific method is analyzed in the study of Hatemi et al. (2008); after using this method in practice, Hatemi et al. (2008) came to conclusion that ‘banks in the UK had the highest duration followed by those in Australia, Canada and then the US’ (Hatemi et al., 2008, 1173); it has been also proved that ‘among the four countries banks in the US are the most profitable’ (Hatemi et al., 2008, 1173). In other words, US banks have rather low equity duration but they have a high profitability; these assumptions are valuable in order to identify the future prospects for these banks’ efficiency level. 3. Conclusion The efficiency of the US banking industry has been proved to be satisfactory – despite the fact that a high number of banks in US have collapsed since the beginning of the crisis; the failures of banks across the country cannot be measured with reference to their number but rather to their position in the banking industry; this means that the US banking industry is most likely to be affected by the strategies and the performance of large banks than of regional banks – a fact related with the difference in the capital efficiency of these banks. In the future, the prospects of US banks are many; however, it is necessary that appropriate alternations be made on the existing US regulation (Norton, 2010, p. 328) – referring specifically to the legal rules regulating the activities of banks in US. At the next level, it is necessary that the framework on which the strategic choices of US banks are based is changed – in accordance with the issues highlighted above in regard to the key environment factors that influence the strategic decisions of US banks. References Avdjiev, S., Gyntelberg, J., Upper, C., 2009. Highlights of international banking and financial market activity. BIS Quarterly Review, pp.13-28 Caprio, G., Kunt, A., Kane, E., 2008. The 2007 Meltdown in Structured Securitization: Searching for Lessons, not Scapegoats. The World Bank. Policy Research Working Paper, 4756 Coffee, J., 2009. What Went Wrong? An Initial Inquiry into the Causes of the 2008 Financial Crisis. Journal of Corporate Law Studies, 9(1), pp. 1-22 Dinger, V., Hagen, J., 2009. Does Interbank Borrowing Reduce Bank Risk? Journal of Money, Credit and Banking, 41(2-3), pp. 491-506 Eichengreen, B., Mody, A., 2000. Lending booms, reserves and the sustainability of short-term debt: inferences from the pricing of syndicated bank loans. Journal of Development Economics, Vol. 63, pp. 5-44 Farrell, J., 2009. Monetary policy rules in theory and in practice: evidence from the UK and the US. Applied Economics, 41(16), pp. 2037-2046 Financial Market Trends, 2008. The Subprime Crisis: Size, Deleveraging and Some Policy Options, 1, pp. 21-45 Gadanecz, B., 2004. The syndicated loan market: structure, development and implications. BIS Quarterly Review, pp. 75-89 Grieve, C., Plews, T., Pax, T., 2008. Pitfalls for non-US financial institutions undertaking business in the US. Journal of Investment Compliance, 9(4), pp. 9-12 Hatemi, A., Roca, E., 2008. Estimating banks equity duration: a panel cointegration approach. Applied Financial Economics, 18(14), pp. 1173-1180 Igan, D., Pinheiro, M., 2010. Exposure to Real Estate Losses: Evidence from the US Banks. IMF Working Papers, pp. 1-33 Kosmidou, K., Zopounidis, C., 2008. Predicting US commercial bank failures via a multicriteria approach. International Journal of Risk Assessment and Management, 9(1-2), pp. 26-43 Norton, S., 2010. A comparative analysis of US policy initiatives and their implications in a credit crisis: The Depression Era of the 1920s in a twenty-first century context. Journal of Financial Services Marketing, 14(4), pp. 328-345 Panetta, F., Fach, T., Grande, G., Ho, C., King, M., Levy, A., Signoretti, M., Taboga, M., 2009. An assessment of financial sector rescue programmes. BIS Papers, No 48, July 2009 Thirkell, B., 2009. Dealing with the banks: populism and the public interest in the global financial crisis. International Affairs, 85(4), pp. 689-711 Thompson, H., 2009. The Political Origins of the Financial Crisis: The Domestic and International Politics of Fannie Mae and Freddie Mac. The Political Quarterly, 80(1), pp. 17-24 Appendices Figure 1 – Syndicated lending internationally for the years 1993-2003 (source: Gadanecz, 2004, p. 77) Figure 2 – Gross international claims for 2001-2009 (source: Avdjiev et al., 2009, 14) Figure 3 – Measures taken by governments internationally for the support of banks (source: Panetta et al., 2009, 8) Read More