The Financial Crisis of 2007-2010 - Essay Example

1. The financial crisis of 2007-2010 impacted financial institutions as the inability of the banking sector to maintain the required capital base created a liquidity crunch. The impact could have been marginalized if banks would have adopted the Basel III Tier 1 capital. To maintain the required capital base banks have to make adjustments in the capital and retained earnings and have to keep aside more funds to ensure better liquidity. This would have helped to fill the necessity of capital requirements and would have provided the framework through which banks would have been able to maintain the required capital requirements. During the period of the financial crisis of 2007-10 banks found it difficult to raise the required finance which created a liquidity crunch in the banking sector. This was aided by the role of government as the mechanism of monitoring was weak. As a result of it banks didn’t maintain the required capital base thereby affecting their liquidity. It was clearly witnessed that the capital base of the banks were compromised which affected the liquidity position of the banks. The impact was so severe that it led towards bank failures and clearly brings forward the positive relationship which exists between capital base of banks and the financial crisis. The period of financial crisis was one where banks compromised on the level of equity capital which made them difficult to mobilize the funds through the process of deposits and loan. The period also showed that debtors didn’t pay their money on time and were defaulting on bank payments which impacted the manner in which banks mobilize their funds (Berger and Christa, 2009). This had a drastic impact on the overall liquidity and banks found it difficult to pay people as people fearing the risk of a bank failure started to withdraw the money they had deposited. This created a situation where debt started to increase and liquidity fell. This led towards increased bank failures as banks were unable to pay the required money to its depositors. At the same time the banks found it difficult to create new investments which thereby impacted their capital reserves that banks held. The impact was so severe that banks found it difficult to ensure the same money supply leading towards a reduction in the money supply within the system. This situation clearly highlights that lower capital reserves resulted in the deepening of the financial crisis. The inefficiency of banks to maintain a high quality capital base had an impact on the capital reserve and led towards bank failures. In addition to it banks were unable to build the required capital base as investors were not willing to invest along with the fact that bad debts on the loans had started to rise at an alarming rate. The banks were not able to maintain the required capital base which was prescribed by the Basel committee which resulted in bank failures. Having a high capital base helps banks during crisis as they are able to maintain the required liquidity through which the daily operations of the banking sector can be carried out. Having a high capital base ensures that banks are able to improve their chances of sustaining the financial crisis, improve their market share and increase their profitability over a longer period of time (Berger, 1995). The lack of efforts on the parts of the bank to maintain the require capital base led towards bank failure. An example in the same direction is the Lehman Brothers who were unable to maintain the required capital base and ultimately led towards its failure. In addition to it the lack of efforts from the different governing body with relaxation of rules had an impact on the overall liquidity and impacted the banking system drastically. The relationship between the capital base of banks and the financial crisis is clearly evident as after the crisis the different regulatory bodies looked towards framing new rules and regulations which would increase the equity and retained holdings that banks have. This will help to maintain liquidity and ensure that banks are better prepared to deal with the financial crisis. Further having a strong capital base would have provided an opportunity through which the banking sector would have been able to maintain the required liquidity as a strong capital base would ensure that banks have a buffer and can finance their daily activities through it. This thereby helps to maintain the required financial liquidity and provides the required directives through which the banks are able to drive and conduct business in the most positive manner. The overall impact and banks failure could have been greatly averted through higher capital base and having the sufficient liquidity which would have helped them to deal with the different financial shocks that the financial crisis provided showing a positive relationship which exists between banks capital base and financial crisis. 2. Capital requirements is the central part of the banking system as having adequate capital ensures that the severity of the financial crisis can be reduced. The prime reason to have cyclical buffer is to ensure that banks have the desired capital requirements which will help to maintain the required liquidity during a financial crisis. The capital requirements at the present moment are very static and determine the level of capital that banks will have to maintain. Since, the systematic risk changes over time so it is imperative that the capital requirements of the banks undergo changes. This has resulted in the generation of counter cyclical buffer which aims towards making alterations in the capital needs of banks from time to time so that the banking sector is able maintain the required capital base which will help them to maintain liquidity and deal with the financial crisis if it arises (Drehmann, Borio and Tsatsaronis, 2011). The Basel III framework has determined and introduced the time varying capital requirements which is up and above the minimum capital requirements which banks have to maintain and is called the counter cyclical buffer that banks maintain. The requirements of the counter cyclical buffer will be gradually phased from 2016 to 2019. The prime purpose of counter cyclical buffer is to ensure that the banking system is able to maintain the required capital requirements so that proper liquidity can be ensured within the system (Acharya, Engle and Richardson, 2012). At times when the systematic risks are continuously increasing that counter cyclical buffer will be used as a method through which the banks are able to maintain the required capital needs. In case of a crisis banks will look towards reducing the process of credit creation and will use the counter cyclical buffer to finance the daily needs of the banking sector. This will thereby help to deal with the positive aspect of the crisis and will help to maintain the required liquidity within the system. The process of counter cyclical buffer will depend on each country each country based on the risk they face will decide the counter cyclical buffer that has to be kept aside. The banks will thereby be affected by the credit limits which have been prescribed by the domestic authority. Banks which are exposed to foreign countries will have to maintain the counter cyclical buffer in accordance with the domestic and international requirements. The buffer limit has been decided and prescribed by different authorities and aims towards reducing the overall level of risk for banks. The counter cyclical buffer is thereby a strong tool which will help the banking sector to maintain the required liquidity even in difficult situation like a financial crisis (Brunnermeier, Crockett, Goodhart, Persaud and Shin, 2009). Counter cyclical buffer will thereby act as a reserve which will be used to finance the activities and will have to reduce the reliance on outside bodies during the financial crisis. This is a critical aspect which needs to be analyzed and will ensure that the economy won’t have to undergo the difficulty of dealing with a banking crisis. This will require that the prudential authority which is developed understands the time when the crisis will take place and the different risk which is arising. The overall impact will thereby help to bring about a change in the capital liquidity requirements and ensure that a buffer is created through which liquidity is maintained within the system. Counter cyclical buffer is thereby a process which will help to have additional capital buffer but needs to lay down the required percentage up and above the capital needs that banks have to maintain based on different systematic risk. This will help banks and the economy to be well placed and ensure that they have a buffer which can be used in case of a financial crisis and will provide an opportunity through which the chances of bank failures reduce. The process will help to further strengthen the Basel III capital requirements and will provide an opportunity through which the banking system will be able to maintain sufficient liquidity within the system. This will prevent the chances of bank failure and will multiply the overall effectiveness through which the banking sector needs to work so that proper liquidity is maintained within the banking system. 3. The financial crisis of 2007 – 2010 showed the manner in which the off balance sheet items and leverage ratio had an impact on the liquidity position of banks leading to bank failures. Banks are often seen to build up a high leverage while at the same time ensuring that strong capital ratios are maintained. During the financial crisis the leverage for the banks starts to reduce which decreases the price of assets leading to bank failures and reduction of credit. The Basel III reforms have thereby introduced a non-risk based leverage ratio which helps to determine the capital needs requirements. The inclusion of leverage ratio helps the banking sector be provide different dimensions and looks towards achieving the following Have the required leverage so that banks are able to maintain and highlight the different assets and liabilities clearly so that business decisions based on it is correct. This will also tend to include the different off balance sheet item and will provide an opportunity to have the required leverage It will help to reinforce the risk based requirements through a simple process which will be aimed at developing measures through which better liquidity is maintained within the banking sector Including both the leverage ratio and off balance sheet items will help to identify the risk based capital framework and will provide the necessary dimensions through which the banking sector will be able to meet the different capital measurement requirements. A properly developed leverage ratio will also provide the different users with complete information pertaining to the on and off balance sheet items. This will thereby help to understand whether the bank has been able to meet the different capital requirements and will provide the framework through which liquidity is ensured within the financial system. The implementation of the leverage ratio has already started from January 1, 2013 with bank level reporting aimed at bring forward the off balance sheet items so that better transparency is ensured. Using the off balance sheet items while calculating the different leverage ratios will ensure that the user of the financial statement will be able to understand the financial position in a better way. The off balance sheet items which needs to be included are commitments, unconditionally cancellable commitments, direct credit substitutes, acceptance, letter of credit, failed transaction and unsettled securities. Since, off balance sheet items form a substantial part of the total capital requirements it is imperative that it is included in the calculation of the leverage ratios. This will help to ensure that the minimum capital requirements are correctly identified and will help to determine the manner in which the banking sector will be able to maintain the required liquidity. The Basel committee has further recognized that off balance sheet items have a potential significant leverage and thereby needs to be included. The banks need to ensure that the off balance sheet items is included at a uniform 100% credit conversion factor. This will help to understand the leverage of the banking sector and will help to determine the minimum capital requirements that have to be maintained. Banks through the process of highlighting the off balance sheet item will be in a position where they are able to bring forward the actual assets and liabilities that banks have. This will facilitate in the calculation of different leverage ratios and using the Basel III requirements at these dimensions will help to understand whether banks have to increase or decrease their capital and retained earnings holdings. This will also act as a method through which the process of monitoring will improve as the regulatory bodies will be in a position through which they are able to understand the different financial needs. The process will also lead towards strengthening the process through which banks work as it will lay down the basic guidelines and ensure that all banks are treated in a similar manner. This will reduce banks failure as being able to understand the actual and correct financial position of the banks will provide an opportunity where steps can be taken at the correct juncture so that liquidity s maintained. This will thereby help the banking sector by providing additional time through which ramifications and changes can be made in the capital requirements. This will reduce the overall risk and provide an opportunity through which the banks will be able to maintain better liquidity. Thus, the process of including both leverage ratios and off balance sheet items will help to ensure that the capital requirements is identified correctly and the chances of bank failure will reduce. The process will also help to reduce the chances of a banking crisis and will strengthen the Basel III reforms which has been developed thereby ensuring that the capital needs and requirements are better managed. 4. Counterparty risk is the risk to each party of the contract which arises in case the other party doesn’t lives up to the contractual obligations. Counterpart risk is thereby very close to performance risk as one party depends on the other and if the contractual agreement is not honoured by the other party it results in failure and will multiply the overall risk aspect (Servigny and Renault, 2004). This is an important consideration from the banking sector point of view as being able to determine the mechanism through which counterparty risk can be managed will help the banking sector to reduce the chances of default. The different dimensions through which counterparty risk can be reduced are as Counterparty initiation: is a situation which takes place when a company enters into a proposed transaction for the first time. To reduce the counterparty risk the credit department for the banks will review all the public information which is available, the credit agency report and counterparty financials before entering into a contract (Servigny and Renault, 2004). The financial status of counterparty needs to be continuously monitored so that the different factors which have an impact on counterparty risk can be examined. This will help the banking sector to be able to deal with the risk associated with counterparty risk and will help to reduce the overall risk for the banking sector. Contracting Standards: is the type of contract which is entered between the different counterparty. The different contracts which are entered needs to be standardized and customized based on the different parties (Saunders and Linda, 2002). The contracts should be developed in such a manner that it looks at considering the different aspect through which the risk for the banking sector reduces. This will help the banking sector to be well placed and provide a framework through which the risk reduces. Credit limit: is the amount of credit which will be provided to the counter party based on the risk taking ability and disk dimensions which has been identified. This will require the help of credit rating agencies where they provide ratings to the counterparty based on their risk appetite and financial conditions (Saunders and Linda, 2002). This will help to determine the risk of the counterparty and will ensure that the banks provide credit based on the credit limit of each party. The process will ensure that banks provide loans and other credit to different parties based on their financial condition and will thereby reduce the risk associated with repayments and interest on loan. The Basel III norms has already looked at working on the same direction and has identified the different dimensions through which the credit limit determines the process through which credit limits will be assigned for different parties. Credit authorities: is the ability of the trader to enter into a transaction with the counterparty regarding the current and future impact the credit will have. Different banking institutions determine the credit based on future risk exposure while other banks look to work on the current risk exposure while determining the credit limit for different counterparty (Saunders and Linda, 2002). This at times helps to determine a portfolio so that the risk gets dispersed and helps to provide a framework which will help the banking sector to disperse the risk and multiply the opportunity to be able to reduce the chances of bad debts on the loans. Transactions approval: is a process which refers at ensuring that all the requirements of the transactions are adequately met before entering into a transaction. This will require working on the different dimensions, terms of contract, credit limit, credit rating and others which will help to ensure that the transactions passes off easily (Saunders and Linda, 2002). This will help the banking sector to reduce the overall risk for the business and will multiply the opportunity through which the banking sector will be able to use the funds in the most positive manner. Credit risk reporting: aims at addressing the credit risk across the entire firm and should look at treasury, procurement or sales. The risk reporting should be such that it considers the economic scenario and other conditions which have an impact on the credit risk capability (Saunders and Linda, 2002). This will ensure that the banking sector is able to understand and identify the different dimensions through which the risk for the banks reduces. Reserving policy: is aimed towards having a certain buffer so that in case the credit limits which have been determined goes wrong that the bank doesn’t fall into a financial contagion (Saunders and Linda, 2002). This will help to thereby address the risk associated with counterparty and will provide a mechanism through which risks gets controlled. The Basel III reforms have been developed and moulded in such a manner that it looks at analyzing the different factors through which the risk for the banking sector reduces. This will help to find out a mechanism through which the counterparty risk is reduced and the banking sector is able to ensure that the chances of bad debts on the loan reduces. This will also help the banking sector to understand the different parties to whom loan has to be provided and will help to develop counter strategies through which the risk reduces. The overall productivity will thereby improve and will contribute positively in bringing a change through which the finances within the banking system is maintained. 5. The Basel committee has made significant changes to ensure that the liquidity ratios allows banks to use a wider range of liquid assets so that the banking sector is able to develop and manage a good liquidity buffer which helps them to ensure that banks are able to find out the cash flows correctly. The revised framework provides an opportunity through which banks during period of stress may lower their liquidity requirements. The Basel committee furthers states that the process of liquidity rations will be phased from January 1, 2015 (Liquidity. 2013). The Basel committee has laid down the reforms which act as an important denominator through which the liquidity ratios for banks are determined. The Basel committee requires that they have high end assets exceeds 100% of its total cash flow over a period of 30 days (Liquidity. 2013). Maintaining the required liquidity ratios helps to ensure that banks maintain the required liquidity through which the banking system is able to manage liquidity and ensure that the banks are able to work according to their role within the organization. The calculation of liquidity ratios needs to include different things like withdraws by customers which includes both retail and wholesale customers, short term functioning and financing, the need to have external credit ratings and credit and liquidity facilities. The prime objective of having liquidity ratios for banks is to ensure that banks have encumbered high quality liquid assets which can be easily converted into cash so that the liquidity needs of the business can be met for 30 days. This helps to ensure liquidity within the banking system and provides the laws and rules which governs the banking system. The period of 30 days has been chosen and it will provide an opportunity where the management and regulatory authorities will be in a position to take corrective measures so that the banking system is able to perform in a normal manner. This ratio helps banks to understand and maintain the contingent liquidity events so that the banking sector is able to bring a change in the process managing liquidity within the system. The calculation also requires that at no point the liquidity coverage ratio should be below 100% as it would otherwise have a negative impact on the capital composition and will make it difficult for the banking sector to maintain the required liquidity. It is imperative that the liquidity ratios have high end assets which will help the banking institution to meet the liquidity requirements for 30 days. The Basel committee has also prescribed assets which can be considered as high end assets. An asset which can be quickly converted into liquid cash with little or no loss in its value will be termed as high end assets (Basel, 2010). It is important to consider the fact that at time of stress the assets are sold at lower the value because of the fact that the person in the trap has no point other than allowing the process of selling to get through. This thereby results in a monetary loss and cannot be deemed as a high end asset. High end assets further have a lower risk and a high market share which thereby enables and provides an opportunity to be converted into liquid cash quickly. The valuation of such assets are easy as information is readily available and the information supplied is true and correct and ensures that the assets can be easily and quickly converted into cash. The assets are further listed to ensure transparency and should not be correlated with risky assets which have higher returns as high end assets have high returns. The increasing financial crisis and the manner in which financial crisis dries up the liquidity within the economy has made it imperative that the banking sector looks at having proper reforms and regulations which includes the liquidity ratio so that it helps the banking sector to maintain the required liquidity and provides an opportunity through which the banks are able to carry out their functions efficiently (Basel, 2010). The growing need of the banking sector to perform in a manner where they look into the liquidity needs has increased the growing importance of having proper liquidity coverage ratios. This ratios helps to maintain the required liquidity within the system and ensures that the banking sector is able to develop rules which will reduce the chances of failure. The Basel committee has worked in this direction and has already taken and developed steps which aim towards fostering a strong reform in this direction. This will help to ensure that the banking sector demonstrates better liquidity and is able to determine the manner in which the future performance will be governed. 6. The Basel III reforms requires that the domestic regulations supplement the reforms as the domestic economy on their part will have to take the necessary steps through which the implementation of Basel III becomes better. The domestic economy will have to develop special step and measures which helps in the implementation of Basel III reforms. The overall perspective should be such that Basel III should be considered as a standard which prescribes the minimum capital requirements that banks have to keep so that liquidity is ensured. The domestic regulators based on the international standards need to develop process and methods which will help them to maintain the needs and requirements of Basel III. The role of domestic economy is imperative at this point as it will help to ensure proper monitoring and will help to carry out the function effectively. The process will ensure that the minimum capital and other requirements which have been prescribed by the Basel III norms are easily achieved. The overall framework will need the interference of the local government as it is not possible for the international regulatory bodies to monitor the progress of each and every economy and will require the support from the domestic regulators to ensure better implementation of Basel III. In addition to it the needs and requirements of economies vary based on the different strategic risk which they face. This requires active participation from the domestic regulators so that better control can be exercised and the process of implementation of Basel III becomes easier. The role of domestic regulators increases further as the domestic regulators controls the banking sector of their economy. Despite the applicability of Basel III domestic regulators have other rules laid down by them which the banks need to follow. Increasing the role of the domestic economy at this place will ensure that the banks are further pressurized to maintain the required liquidity. This will thereby help to achieve the required capital requirements and multiply the effectiveness through which the banking sector works. It is also witnessed that certain economies haven’t implemented the Basel III reforms as part of their process of managing the different assets and capital requirements. This is due to the fact that economies have looked towards having their own stringent rules than provided by Basel III (Kashyap, Raghuram and Stein, 2002). The requirements have been developed based on the domestic needs of the economy and will help to ensure that banks are able to maintain the required liquidity within the system. The economies which have not implemented the Basel III reforms is primarily due to the fact that the domestic regulators are strong and have better rules which will help to maintain the required capital needs. Having rules which govern their banking system also ensures that the domestic banking sector is strong and has the required infrastructure through which risk for the business can be reduced and chances of growth can be ensured and liquidity can be maintained. The role of government is very important at this juncture as it will help to ensure that the banking sector has the required momentum and will be able to achieve the different capital requirements. This will help to ensure that the implementation of different banking needs becomes easy. The domestic economy requires that government monitors the process by having a strong capital base would have provided an opportunity through which the banking sector would have been able to maintain the required liquidity as a strong capital base ensures that banks have a buffer and can finance their daily activities through it (Mishkin, 2000). This thereby helps to maintain the required financial liquidity and provides the required directives through which the banks are able to drive and conduct business in the most positive manner. This will ensure that the Basel III reforms will be able to achieve its objectives and will be able to chalk out a plan through which the long term success of the banking sector will be ensured. The overall process will thereby help to maintain the required liquidity and will also ensure that the capital structure of the banking sector is developed in such a manner that financial risk reduces. This will reduce the chances of bank failure and ensure that the banking sector is able to grow. References Acharya, V., Engle, R., and Richardson, M., (2012). Capital Shortfall: A New Approach to Ranking and Regulating Systemic Risks. American Economic Review, 102 (3), 59-64. Berger, N. (1995). The relationship between capital and earnings in banking, Journal of Money, Credit and Banking 27, 432-456 Berger, N., and Christa H. (2009). Bank liquidity creation, Review of Financial Studies 22: 3779- 3837 Basel. 2010. Basel III: International Framework for Liquidity Risk measurement, standard and monitoring. Banks for International Settlement. Brunnermeier, M., Crockett, A., Goodhart, C., Persaud, A., and Shin, H., (2009). The Fundamental Principles of Financial Regulation. London, Centre for Economic Policy Research Drehmann, M., Borio, C., and Tsatsaronis, K., (2011). Anchoring Countercyclical Buffers: the Role of Credit Aggregates. BIS Working Paper No. 355 Kashyap, K., Raghuram G. and Stein, C. (2002). Banks as liquidity providers: an explanation for the coexistence of lending and deposit-taking, Journal of Finance 57: 33-73. Liquidity. 2013. Basel Committee Revises Basel III Liquidity Coverage Ratio. Banks for International Settlement Mishkin, F. (2000). The economics of money, banking and financial markets (6th edition), Addison Wesley, New York Saunders, A. and Linda, A. (2002). Credit Risk Measurement: New Approaches to Value at Risk and Other Paradigms. 2nd ed. New York: Wiley Servigny, A. and Renault, O. (2004). Measuring and Managing Credit Risk. New York: McGraw-Hill, 2004 Read More