Banking Stability as Financial Regulators' Concern - Essay Example

?Financial stability and resilience of the banking industry are the main current concerns of national and international regulators Discuss Introduction Banking is regarded as the heart of global financial system for the reason banks act as the intermediary for pumping money from those who have it to those who are in need of it. Banks have come to play a prominent role in the global financial system which has evolved over a period of time by sustaining under the belief finance per se has the ability to stimulate spending at the national and global levels which further is believed to be responsible in overcoming the ‘hoarding’ that was seen in the medieval economies. However, when the economies were overheated and an economic boom was witnessed, many governments and monetary authorities lost sight of the fact that unbridled banking would ultimately cause the downfall of the financial system. Consequently, the fact that many of the financial instruments created were short-sighted in nature and dubious in character was lost among the policy makers and political leaders. Such a situation arose out of the fact that many of their activities were uncontrolled in nature. The global financial meltdown of 2007-2009 the impact of which is felt even today among the global economies brought a shock among them which made such leaders and policy makers to wake up from the slumber and meet the harsh reality that global financial system needs a through overhaul and if appropriate and timely measures were not taken the threat to the global prosperity during 21st century would turn out to be a monster which would become entirely uncontrollable. There was a sudden urgency to enact prudential regulations. However, the continued worsening of the world economies reeling under pressures of weakening manufacturing activities, growing unemployment and uncertainties have brought into focus a set of arguments that such prudential regulations should be slowed down. In this context, Caruana1 argues that there should not be any such slowing down and it is time, whatever has been thought, considered and proposed by international regulators, they are implemented. The rest of the paper makes a critical analysis of his proposals. 2. Discussions The rationale advanced by him for such an argument is that, firstly, “the financial stability is about resilience”, secondly, “preserving financial stability involves a wide range of policy areas” and thirdly, “a globalised financial system requires global rules”, fourthly “ global financial regulators should stay focused on the end result they want to achieve, namely, a system characterised by less leverage, better liquidity management, sounder incentives, less moral hazard, stronger oversight and more transparency”2. Towards realizing the above, he has set an agenda which includes reforms and regulations on the bank capital, liquidity, financial products (e.g. OTC derivates,) and among other things micro and macro prudential regulations. Each one of the points averred by him is analyzed below. 2.1. Resilience Caruana equates resilience with financial stability and believes that this is something which the world economies should prepare well in advance in terms of capital, liquidity, infrastructure etc to safeguard themselves from the shocks, external/internal so that there is no repetition of the nasty situation witnessed during the 2007-09 global financial meltdowns. The same view has been advanced by some other scholars. According to Sheehan3, Financial regulations have two sides attached to them, viz, micro and macro prudential regulations. Micro prudential regulations seek to focus themselves towards protecting the interests of smaller savers and borrowers from grey practices of financial institutions while the macro ones engages themselves in the creation and implementation of rules that goes towards promoting the stability of global financial systems and reduction of systemic risks. Whether it is micro or macro, each country creates its own financial regulators and empowers them to operate under sovereign laws. Since this paper is about global financial system it would focus on the ones relevant for that and hence it would deal with micro prudential regulation sparingly, In this regard it is worth noting that there exists a number of regulatory agencies as Securities Exchange Commission, (USA), Securities and Exchange Board of India, Australian National Securities Commission etc. which are meant to take care of micro prudential regulations at respective countries levels. Macro prudential regulations extend their writ to balance sheet performance of mammoth transnational corporations which are considered to be susceptible to systemic risks. Currently, the Bank of International Settlements (BIS) situated at Basle, Switzerland acts as a supra-national agency. The Basal Committee on Banking Supervision (BCBS) is responsible for the formulation and regulation of the activities of financial corporations and the most recent ones in this regard relates to accord reached on Basel 3 in September, 2010. It may be of relevance to state in the context of this paper that these norms are considered to be tougher and perhaps this is what Caruana wants whereas a somewhat slowing down of the grips of Basal Committee is sought by those who believe that the current global slowing down has got something to do with the tightening of the grip by the international regulator which is aimed at bringing about some sense of order to the operations of financial corporations. The global financial institutions have been inventing a plethora of financial products from time to time and one such innovations most often quoted in the financial literature is credit derivatives. For example, in its report, British Bankers’ Association4 points out that credit derivates shot up from $1 trillion in 2001 to $20 trillion and between 2002 and 2006 the growth in leveraged loans had shot up from $0.4 trillion or so to $14 trillion. Without going into the mechanisms as to how credit derivatives work and considering the fact they are designed in a complex manner it can just be said that hedge funds which are major players in this arena have a vested interest in the creation and sustaining of unstable markets and hence they need to be controlled through prudential regulations to bring in resilience to the financial system. However a some what discordant note has been struck by Stiglitz5 according to whom that the global financial system has to be proud in the creation of its most innovative product, viz, ‘credit derivatives’. His proposal calls for modifications in the Basel Capital Accords in the form of ‘time varying capital requirements’, by which what he means the incorporation of provisions in the macro financial regulation providing for increasing/decreasing capital requirements of individual transnational financial corporations depending upon the state in which an economy is placed. Thus such a system if implemented would have an increased capital requirement during a boom and decreasing capital adequacy during a slowing down pace in an economy. In short, he calls for flexible capital requirement which is ‘counter-cyclical in nature. On the other hand his report on imposing capital adequacy norms on transnational corporations which are considered too big to fail (TBTF) should be much more stringent in nature for the reason that in times of crisis they impose severe blows on the tax payers money as governments are faced with the unpalatable choice of bailing out them in the interest of minimising disruptions in national economies and repercussions on the international economies. While in the context of this paper it can be said that there is merit in his proposals yet they do not seem to have the sound economic and financial logic to override the arguments advanced by Caruana for the reasons that in a context where global economies are getting to be integrated financially through capital account mobility, availability of tax heavens for parking of funds etc , varying capital adequacy norms would in reality would be most difficult to be implemented and may not be effective in practice. Evidence towards this is attributed by Arvedlund6 by taking the case of Madoff whose financial fraud had sent shivering shocks across the financial world. In this context, as pointed out by Caruana agreeing on Basel III norms even though is a right step in direction yet practical measures need to be taken which when fully implemented it would go a long way in ensuring capital adequacy norms of the banks are fulfilled as this by ensuring that the banks’ common equity being maintained at 7% of the risk weighted assets would protect the financial system from the shocks which it had witnessed during the last global financial crisis. The rationale behind such a prudential regulation is that financial corporations would be mandated to hold a minimum capital reserve which would serve as a safety margin against unexpected happenings. This can be explained by taking up a hypothetical example of say a Transnational Financial Corporation ‘X” which is produced in Table 1 below Table 1: ‘X’ Financial Group: Risk Weighted Assets Asset category BIS risk Asset value Risk-weighted asset value Comments Cash 0.0 $40 billion 0 - Government bonds 0.0 $110 billion 0 - Inter-bank loans 0.2 $100 billion $20 billion Treated as a risk by BIS Securitised assets 0.2 $100 billion $20 billion -do- Mortgages 0.35 $500 billion $175 billion -do- Ordinary loans 1.0 $150 billion $150 billion -do- Total value $1 trillion $365 billion 1. Prior to 2010 according to the norms of the Basel Committee , it should hold equity of $14.6 billion (i.e.$365 billion x4% or 0.04) whereas post 2010 it should hold $29.2 billion ( $365 billion x 8% or 0.08) However, financial corporations would still find methods to leverage the assets in such a manner that the risk weighted assets are lowered and the others are made higher by shuffling and shifting them and unless or otherwise Basel finds methods to pluck this loophole as otherwise its regulation would be somewhat muted. 2.3. Formulation and implementation of policies to preserve long term financial stability The next argument of Caruana centres towards formulation and implementation of monetary and fiscal policies which are needed for the creation and maintenance of a sound financial structure, bringing in financial discipline through improved levels of transparency in the actions of firms and markets and ultimately ensuring protection of the consumers. All these measures are needed as they are inter-dependant in nature as none of them by itself would be sufficient to bring in the desired changes and above all they should be integrated through introduction and implementation of strong accounting standards. Haldane et al7 have in other words described it in terms of a need towards a newer approach to assess the risks to financial stability which basically boils down to systemic stress testing a technique that would go towards assessing the vulnerabilities financial institutions expose themselves in their pursuit to earn a higher return. This has become important consequent to the distress witnessed in particular in the US sub-prime lending market and mortgage sectors in other countries. A critical factor contributing to such a distressing trend was observed in the balance sheet including in the management of off balance sheet exposures. Perhaps Caruana calls for a much more rigorous assessment of tail-end risks to bring in and preserve long term financial stability. When prudent monetary policies are introduced, implemented and followed at the national and global level, a conducive atmosphere for the banks through an injection of a significant amount of capital and liquidity a sizable buffer could be created which would help them to withstand shocks. An example of this could be found in the formulation of ‘large exposures’ rules’ which is underway in Europe through the European Union-wide review. As and when this becomes a reality, the resilience of the financial system would be improved to an extent that the losses arising out of unexpected financial shocks are minimised. A precondition for accomplishing this is the prevalence of strong capital market because such a market would provide the opportunity for the liquidity starved banks to approach it to access funds in times of dire necessity. The financial market infrastructure has a critical role to play here for the reason the market participants would have to rely on such a well-laid infrastructure to provide the liquidity in normal as well as times of stress, act as a platform for determining optimal portfolio allocation and execute appropriate risk management strategies. In this connection, it needs to be noted that the infrastructure for over-the-counter (OTC) derivatives have not kept pace with the rapid growth the markets, in particular, in the credit sector witnessed in the recent past. On the fiscal front, scholars suggest the aligning of sovereign wealth funds with the monetary authority to stabilize the international financial system. As defined by IMF8, sovereign wealth funds (SWFs) belong to a class of government-owned investment vehicles whose objectives are to invest in long-term overseas investment activities. Such funds which typically represent foreign exchange assets and (commodity) export revenues are estimated to be over $3 trillion by Kern9 and Jen10 which, as opined by them, exceed hedge funds and private equity. However, such funds are not without the risks as they are perceived to bring in negative impact to the world markets at least on account of two reasons, viz, the lowered transparency and secondly the inherent risks the very size of them attract. Nonetheless, research in this direction does not seem to be supporting this perception. In their study, Kotter & Lel11 came to the conclusion that SWFS being in the nature of passive investments do not impact growth and profits of companies as they have a tendency to invest in undervalued stocks. However, transparency appears to be an issue. If transparency related issues could be strengthened then SWFs can become a viable fiscal policy tool, because, they possess the ability to bring in fiscal stability by mitigating risks and promoting investments and in short in the long term macro fiscal management. Nonetheless, a well oiled public financial management system is a prerequisite if SWFs were to be effective and help in providing the long term financial stability. Strong fiscal and monetary policies would provide the inputs for the banking institutions to clean up their balance sheets and keep in pace with market developments which would help in building up a financial system wherein the hall marks are long term financial stability, resilience and transparency. 2.4. Globalised financial system requires global rules The differing accounting methodologies followed by nations have prompted some commentators to comment that it has led to a situation of comparing apples with oranges. This has arisen because of the discrepancies prevailing between GAAP and IFRS systems of accounting which has brought about difficulties in formulating a uniform global standard for capital adequacy the reason for which could be found in comparing American banking institutions with non-American ones. The extent to which the accounting rules differ within nations could be illustrated with these examples. The Japanese have been demanding that the ‘unrealised profits’ should be counted as capital for the reason, as per their domestic accounting rules, their banks are permitted to count such unrealized profits from holdings of equities whereas this has not been acceptable to the US and UK as their banks are not allowed to carry on such a practice under their respective domestic accounting rules. Yet another thorny issue relates to the elimination of ‘deferred tax assets’ that is the past losses the lenders could use to offset tax liabilities that may arise in the future years. While there is no limitation in the usage of these credits in the regulatory capital in the case of Japan, this is not the case in respect of USA, and or Europe. These instances bring out the sharp differences that exist in accounting practices and point out the need for expeditious action to bring forth international harmonisation of accounting practices which extend not just to rules but even at conceptual levels as for instance arriving at definition of capital, credit ratings, risk measurement etc. German policy makers were unhappy with some of the provisions of Basel III on the ground that it would penalize a vast number of saving and cooperative banks which have been financing small and medium enterprises (SMEs) which forms the backbone of German economy. The reason for this is not far to seek. Unlike the private banks which otherwise called as Landesbanks, these cooperative and savings banks have not been exposed to mortgage-backed securities and hence they cannot be compared with the crisis that had happened in the USA which emanated from the sub-prime crisis. However, in so far as the Basel Committee is concerned, they are excluded from banks Tier 1 capital on the ground ‘silent participations’ in themselves do not absolve the banks from absorbing the losses as long as they are in business. Unless or otherwise Basel III accommodates this in their agenda and modify the provisions, the German banks could be forced to raise huge amount of Euros, may be in billions, resulting in the depletion of loans that otherwise be available to the borrowers. On the other hand, the French authorities are sore about the Basel III provisions on the count that they were not affected by the global financial melt down say the way Americans were affected and hence they are against the use of ‘fair value accounting’ on the ground that it is not appropriate to use ‘mark-to-market accounting’ practices. Perhaps, these dissenting voices have resulted in the ‘Global Governance dilemma’ but it has not diluted the strength of the argument globalised financial system requires global rules. However, the construction of global rules has brought in divisions of opinions among the scholars because the term rules bring in differing interpretations when applied in a local and global context. Thus, while interpreting the construction of formal rules, Rawi12 took a legalistic approach to demonstrate that the U.S. Treasury was indifferent to the initiatives to amend the Articles in 1990s because of the compulsions to bow to the pressure of Wall Street which was opposed to such amendments. In the context of global financial governance, the rules cannot be considered purely in an accounting perspective because such isolated treatment would not bring in the desired outcomes. In such a scenario the statement that globalised financial system requires global rules could be interpreted to mean, subject to other things being equal, strong accounting standards would provide the background for improving the analysis of tail-end risks through conduct of systemic stress tests. 2.5. The Focus Caruana has pointed out the need for being focused to achieve the objectives set forth for achieving stable global financial security. The reasons as to why nations should pay more attention to these key factors are discussed in this section. It is postulated that leverage has a tendency to increase the possibility of default which in turn could result in increasing the costs of financing and in this regard Kyotaki and Moore13, opined that this can have the effect of lowering cash flow, investment and ultimately output. Bernanke and Gertler14 further pointed that increases in the corporate leverage could induce slowdown through multiplying the adverse shocks (e.g. demand) on the real economy. Moderation of leverage via appropriate policy measures could on the one hand reduce financial distress and on the other hand boost economic growth. Past experience shows when there is an absence of internationally agreed rules on liquidity, many transnational financial institutions were not subjected to stringent liquidity standards. This could have contributed to the global financial shocks for the reason such an absence of rules and regulation could have encouraged unbridled cross-border lending. As a result Caruana stresses the need to be focused on bringing liquidity standards to promote a more resilient banking system across countries as well as the world. An important incentive in the context of achieving global financial stability could relate to the Net Stable Funding Ratio (NSFR). As an incentive, NSFR is understood to be a method which aims at bringing about long term structural ratios which while on the one hand aims at resolving security mismatches while at the same time and on the other hand also aim at providing the requisite incentives to banks to use stable sources to fund their activities. According to Cecchetti15, the observation period is expected to begin in 2012 and the minimum standard would take place in 2018. Focusing on reducing the moral hazard gathers importance in the context of managing the systemically important financial institutions. Such a focusing is considered critical for the reasons the SIFI could be equated with those too big to fail (TBTF) in that they are prone to failure due their size, complexity and when they fail it causes massive disruption in the larger financial system and economic activities of nations. This results in financial distress as bailing them out calls for the usage of taxpayers’ funds. There is a necessity to concentrate on oversight because it could prove effective in preventing systemic failures. It needs to be kept in mind that the present regulatory environment does not possess adequate instruments to do so which is why this area may need a priority focus. Having said that it also needs to be kept in mind current attempts represents improvements in the exercise of financial supervision. This can be evidenced if one pursues the Report of the High-level Group in the Financial Supervision in the EU wherein the creation of a systemic risk authority has been extensively discussed. The gist of the message in this regard is stressing of creation of a strategy which would regulate the financial system as a whole as against individual components. In this regard suggestions have been appearing from time to time towards creation of one supra authority, viz, a supra central bank which can act as a super macro-prudential authority to supervise all the elements of the financial system. Lack and or poor transparency cause a number of threats to the global financial stability. For instance there have been perennial concerns on the likelihood of the breaking of systemic failures in the credit derivative markets arising out of poor disclosures and transparency and such risks could be alleviated if policy makers have more access to detailed counterparty as well as reference asset-specific transaction information. The importance of transparency in this regard can be amplified by the fact that international financial institutions as IMF have been asking for larger as well as better data on credit derivative transactions. This is especially so in a context where much cannot be seen in the exposure statements provided by the financial institutions. Lack of transparency can lead to regulatory oversight. By way of an example on can cite a form of manipulation wherein the participants with a stake in increasing the cost of debt to a competitor company can manipulate thinly traded markets in CDS with a view to drive up their spreads which in effect influences the actual cost of debt. Further argument towards focusing on transparency could be explained by having a look at the currently prevailing situation wherein there is a lack of clear mandate to regulate trading in the CDs market resulting in lesser surveillance and little enforcement. Finally some of the important challenges or obstacles in the implementation of micro as well as macro prudential regulations would have to be understood. Some of them are: However global in nature these regulations are likely to be, yet a certain amount of political will at national level is needed to put the Basel III norms into operations are required. The time table in this regard is expected to begin on Jan, 1, 2013 and proposed to be completed by Jan, 1, 2019. Given the fact as of 2012 the global economies are still feeling the pangs of 2007-09 global melt down and political changes which indicate a trend towards leftist parties in Europe gaining ascendency (France and Greece), to what extent these national governments would be inclined to co-operate at the global level are something one needs to wait and watch. This is especially important if one considers the fact that macro prudential policies cannot in themselves deliver financial stability. The framework proposed and so far accomplished acts as a trade off between stringent capital norms and the long arm given (2013-19) for achievement of such norms and to that extent it can be said the criticisms against accelerating global financial system by replacing it with slower economic progress is not tenable because on account of the longer time framework the micro as well as macro prudential regulations provided is not likely to hamper modest economic recovery. 3. Conclusions Through out the discussion of bringing about global financial stability, there is one strand that runs across the entire literature which is the one which relates to Basel Capital Adequacy norms and accords. For this reasons it is necessary to pin point in the concluding section the scrutiny it has come gone through among the scholars and practitioners all of whom do not necessarily laud the Basel norms for the following reasons. Regulating capital adequacy cannot be done through soft instruments and for this reason it cannot act as good-goodie for all the players who are affected by it. In a sense regulating capital is like regulating exchange or interest rates and consequently its outcome could benefit some banking institutions while there is a likelihood of others being harmed. For example, certain amount of positive benefits could be seen in respect of large financial institutions, but the smaller banks dealing with small enterprises, home mortgages etc are not likely to be benefitted and in fact harmed because they may not be able to maintain competitiveness (Jude, 1989). Basel accords as and when are fully implemented are believed to contain the potential to bring in unintended consequences which some point out as the costs of Basal Process. One such thing relates to the possible accumulation of undercapitalized financial risks falling outside the banking supervisory framework of Basel. The consequential financial risks that could emerge are likely to be the creation of a ‘shadow banking system’ as the Basel Process could have the tendency to give the market participants incentives to evade regulations and in the process create financial risks. However in this connection it would be erroneous to undermine the importance of Basal Accords. Such accords have acted and are acting as building blocks for accomplishing a certain amount of global financial stability especially in the aftermath of global financial meltdown in the immediate past and the gradual abandonment of Bretton Woods’s system which as a result have created an increasingly unfettered opportunities for the free movement of capital flows across the globe. Under such circumstances, what is needed is not to relegate its importance under the guise of weakening the reform process due to compulsions that exist in the current global economy which still have not recovered from the post 2007-09 situations. Such situations however agonising they may be point the need towards enhancing the global financial stability by resolving structural differences prevailing across the economies in the world , by further accelerating the regulatory practices and bringing in fiscal and monetary harmony to an otherwise fragmented global financial system. Basel Accords should then pluck some of the limitation currently they contain which could contribute to the shadow banking system. One such flaw worthy of mentioning in this regard is the failure of Basel to include certain actors as say Securities and Exchange Commission. One can conclude the paper by stating that the arguments advanced by Caruana and suggestions made by him for the acceleration of regulatory and other measures to obtain stability in the global financial system merit serious consideration and action for reasons when sustained efforts are taken in this regard the banks are likely to be better capitalised, become more liquid, provide larger transparency while achieving limited leverage. On the negative side, one can expect voices of dissent from the banking community who are likely to complain of iron hands in the guise of regulations, which in their opinion may restrict dynamism. This in no way diminishes the importance of what has been argued by Caruana because regulatory framework is a must if one were to take the lessons of financial crisis with the seriousness it deserves. In all likelihood there are short term costs which are not to the liking of everyone, especially those who argue for the weakening of the reform process but given the political will and the availability of economic cohesion, these short term costs could be managed and nations can reap the benefits of a stronger financial system in a long term perspective and such benefits are likely to be there for years to come. Bibliography Abdelal, R. (2007). Capital rules: The construction of global finance. Cambridge: Harvard University Press. Arvedlund, E. (2009). Madoff: The man who stole $65 billion. London: Penguin Books. Bernanke, B. S., & Gertler, M. (January 01, 1995). Inside the Black Box: The Credit Channel of Monetary Policy Transmission. Working Paper Series, 5146. British Bankers' Association. (2006). BBA credit derivatives report 2005/6. London: British Bankers' Association. Cecchetti, S. (2010). Financial reform: a progress report, November 2010, BIS. 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Regulating the Global Financial System – the challenge of the 21st century, Leeds Metropolitan University Steffen Kern, (Sept, 01 2007). “Sovereign Wealth Funds State Investments on the Rise”, Deutsche Bank Research, Stephen Jen, (Sept, 01 2006):“Sovereign Wealth Funds and Official FX Reserves”, Morgan Stanley Research Global Stiglitz and Members of a UN Commission of Financial Experts (2010) The Stiglitz Report – Reforming the International Monetary and Financial Systems in the Wake of the Global Crisis. New York, The New Press. Read More