Questions in Financial Markets and Risks - Essay Example

?FINANCIAL MARKETS AND RISKS QUESTION The need for maintaining safety and solvency in commercial banks: emphasis on adequate liquidity and capital adequacy. A bank is a place for the “safe-keeping” of funds (Caprio et al, 2006). This means that people and entities send monies to the bank and that means that aside the primary need to continue existing and operating as a going concern, a bank needs to have enough money to satisfy its primary safe-keeping responsibility it owes its customers. Also, due to the sensitivity of the role of banks in society, Central Government regulations and other national laws imposes safety and solvency regulations that makes it imperative to have enough money to run their operations and also have enough money to pay their clients as and when they come to them for their monies (Benston, 1999). These regulations cut across the need for adequate liquidity and capital. “Liquidity is the ability to make payments as the fall due” (Moir, 1999). This implies that liquidity refers to access to money or liquid resources that can be easily transformed into cash in a short time. This is what enables a business to pay for its cost of operations and trading activities. The lack of liquidity will cause a business to fold up. Liquidity is mainly borne out of cash inflows and short term convertibles to cash. These resources are used to fund working capital. A bank, like any other business needs to hold enough liquid resources to fund its operations and existence. It needs to pay its workers, pay for the premises they use for operations as well as working tools like computers, cars and other day-to-day expenses. Without this, a bank will obviously fold up. Due to the nature of banking, there is the need for banks to look beyond working capital for the maintenance of operations. They need to hold enough liquid resources to meet the cash demands of their clients within short notices. This therefore means that a bank needs to have enough cash in its vaults or within reach so that when entities banking with them call for their monies, they will be able to honour their legal obligation to pay customers as and when they come to make demands. This puts the need to hold sufficient cash or cash resources for the payment of clients an inherent part of the working capital structure of commercial banks. However, banks also have the duty of increasing the wealth of people saving with them. A rational person who holds money will want it to increase in value by earning some interest or profits through savings or investments. In the capitalist setting where people have the right to choose when and how to invest their money, banks have an obligation to come up with competitive interests for people who decide to save with them. Higher interest rates offered by commercial banks enables them to get more customers. This means that the commercial banks have the duty to invest the money of people who save with them in ventures that bring sufficient returns that enables them to pay high interests to their customers. Commercial banks therefore need to hold assets that can be used to re-generate revenue and sold for profits to attain the aim of providing high interest for their customers (Matz & Neu, 2007). As these assets generate revenues for the bank, the bank increases the wealth of the clients and earn more money through the sale of the assets. Thus, capitalisation is an important part of retail banking. Though the need to capitalise money deposited by clients is vital, clients also come in from time to time and demand their money. Due to the legal obligation of banks to make funds of their customers available to them when they need it, there is a strong need for banks to draw a balance between liquidity and capitalisation. A bank therefore needs to be careful to ensure that it has a fair balance between the two extremes. Investing too much money will mean shortage of money to pay customers who demand money. Also, failure to invest an adequate amount of money will mean that the bank will rake in lower profits and this will make the bank less attractive to the masses. Thus to remain a liquid and money-generating entity, a bank needs to hold enough cash and also invest sufficient money in capital assets to ensure that it remains a safe place for keeping money and also lives above all the financial crises and remain in business. This is what Hasan & Humtar (2003) describe as the solvency ratio, which is the rational balance between the two extremes of holding too much cash in the commercial bank and investing too much money in capital assets. QUESTION 2 Methods used by Commercial Banks to Manage Liquidity Bartetzky (2008) identifies a number of liquidity risks that banks faces. They include credit risks, which involves the risk of lenders not re-paying their loan, event risk which are legal and political risks in a country as well as business risks like strategic and reputation risks. There are also customer risks, which involves customers requesting for their money, operational risks which involves the organisational structures as well as market price risks which involve interest rate risks and price risks. All these risks come together to create problems and challenges for commercial banks that can cause them to cease operation. It is therefore prudent for commercial banks to outline these risks individually, rate them and find solutions to them based on the specific facts relating to their operations. Thus, basically, a risk management approach to liquidity management is key for practical purposes of controlling and managing risks amongst commercial banks. Basically, the liquidity need of commercial banks has to do with the ability to meet possible deposit withdrawals and unpredicted deposit outflows (Haslem, 2010). Due to this, most commercial banks focus on minimising risks of losing money they invest, invest in the most productive activities and also invest in assets that are highly liquid and can be easily converted to cash in a short period of time. Banks minimise risks of losing money loaned out by taking extra care to check the backgrounds of people they give loans to. This way, they are able to ensure that the customers repay their loans and there is always a flow of money to the bank. Commercial banks also increase loan repayment by spreading its loan portfolio over many borrowers. They diversify their accounts by holding more small accounts in order to spread the risk of major customers coming for their money at times that can jeopardise their liquidity positions. Commercial banks also use best practices to manage their reserve assets. They apportion some of their reserves into short term investments that are easily callable and can be converted into cash within a very short period of time. Some of these highly liquid investments that commercial banks invest in include bills, certificates of deposit and government securities and bonds. In very crucial cases, commercial banks borrow to satisfy pressing liquidity needs (Buckle & Thompson, 2004 & Khanna, 2005). In such cases, banks consider borrowing from overnight funds which are faster but more expensive or longer term funds which take a while to be obtained but have a lower interest rate. Commercial banks therefore use a wide range of aggregation of risks in a given period of time and then draw a plan of how they are going to ensure a balance between liquidity and capitalisation. This policy usually includes careful investment of excess funds, investment in ventures that promise quick liquidity and the diversity of accounts as well as the number of investment portfolios they sink funds into. In extreme situations and conditions, banks borrow from sources like the Central Bank and other institutions that give quick loans to commercial banks. QUESTION 3 The Role of Basel I & II Accords in the Over-Capitalisation of Commercial Banks and the Neglect of important matters that lead to Banking Crises Between 1694 and the early 1980s, the Bank of England guaranteed that commercial banks holding an amount of money could create up to ten times that amount of money in credit (Madura, 2008). This meant that commercial banks had little restrictions and need to hold up cash in assets. All they needed was the right to an amount of money and that was enough to generate ten times that amount of money in credit for members of the public. This guarantee made it easy for banks to get a notional cover that enabled them to generate and re-generate wealth with very little limitations. This way, commercial banks also became important partners for members of the public because they had easy access to money which circulated more liberally in the economy and ensured massive prosperity. The Basel Accords came in to change this trend and it forced commercial banks and central banks to take some kind of control over the ability of banks to loan money to people if they did not have sufficient capital to back their positions. The Basel I Accords was a deliberation of Central Banks mostly from the developed world and members of the then Group of 7 Industrialised nations (Scharfman, 2009). It set a minimal capital requirements for various categories of banks. Now, instead of having just an amount of money to generate 10 times that in credit, banks were to hold a certain amount of capital to be able to grant a certain proportion of credits to members of the public. International banks were to hold 8% capital assets in proportion to the total credit they grant to members of the public. It also categorised banks on the basis of their credit risks and set limits for assets they need to hold before granting specific percentages of loans to members of the public. This effectively sought to promote responsibility amongst banks through regulation. The idea was to get banks not to get too aggressive in the granting of loans and spending. However, in doing this, banks were locking up money in unnecessary assets that were not really giving them much in return. This therefore led to so many cases of limitations that affected the liquidity of many banks around the world. The need for higher capital requirements resulted in reduction in bank lending as so much money that could have been lent to other third parties were locked up in capital assets to meet the obligations set out by the Accord. This affect the profitability of banks and reduces their abilities to regenerate more wealth. The limitations placed on banks by the Basel I Accords forced banks to minimise liquidity and financial inflows and this led to so many instances of off balance sheet financing by banks in order to balance their books and meet the supervisory requirements of Central Banks (Eubanks, 2010). So the inherent problems of the Basel I Accords therefore forced commercial banks to cut corners to meet their targets and requirements. This therefore called for further regulation and supervision. The group of nations and experts therefore came up with the Basel II Accords that ensured that capital allocation was rather based on the risk sensitivity of each bank. Basel II also separated operational risks from credit risks. The economic and regulatory capital were also closely regulated. By extension, Basel II sought to minimise capital requirements for banks, improve supervisory roles of central banks and promote market discipline (Jorion, 2009) The Basel Accords is fingered as the main cause of the credit crunch because it led to so many difficulties and regulations that made it difficult for banks to raise loans for members of the public and this caused limitations in the flow of economic resources around the world. First of all, the Basel Accords depressed economic activities around the globe. This is because it caused demand-driven declines in economies. This can be explained by the fact that entities could not get access to credit and loans from the banks due to the limitation so they produced less and hence could not deliver more inflows to the bank. This led to the contraction of several economies around the world. There was also the supply-driven credit decline that can be attributed to the Basel Accords. This is because the inability of clients to expand their capital base through loans from banks led to little production and this means that their supply of inflows to the bank was drastically limited. On the aggregate, the adoption of the Basel Accords led to a negative impact on loan growth in nations and countries around the world (Velasco, 2004). Due to the fact that modern business thrives on credit, the Basel Accords has succeeded in affecting many businesses around the globe and this can be seen as a major contributor to the recent global credit crunch (Eubanks, 2010). Also, the Basel Accords reduced the sources of funds that were available to businesses because banks are major sources of funds for the private sector in every country. Thus a requirement for banks to save more money in capital assets at the expense of liquid resources like loans caused a major restriction to businesses. They had to use alternative sources to raise money. This caused a serious glut in the money market that made it generally expensive to access capital around the world. Additionally, the 21st Century came with so many inventions and innovations. This added up to the need for more business activities and more investments. This meant that there was the need for more money to be used to fund such activities. However, the limitations placed on banks by the Basel Accords made it difficult for all these new ventures and activities to expand and meet their strategic plans. This therefore led to a high demand for money and the low supply of credit because the laws of nations requires banks to hold up a large amount of their money in capital resources. This inevitably led to undue financial crises. The emphasis on the Basel Accords was on risk. However, Bisgnano et al (2009) point out that the risk measurement system of the Basel Accords were highly simplistic and led to the placement of undue restrictions on banks which led to credit supply contraction. This is because the variables were not clearly defined and this caused some banks that were not really at risk to take up a 'one-size-fits-all' standard that led to an unwanted lock-up of liquid resources in capital which contributed to the credit crunch. Also, some banks in the developing world that genuinely needed to be exempt from the high standards set by the Central Banks of the richer industrialised nations during the Basel Accords contributed to the problem. This is because the targets were way too high for these banks and this caused the credit crises to spread beyond the developed world to less developed nation because of the improper setting of standards for the Accords. 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Scharfman, Jason A (2009) Hedge Fund Operational Due Diligence: Understanding the Risks Sussex: John Wiley & Sons Velasco, Andres (2004) Economia, Fall 2004 Journal of Latin America & Caribbean Economic Association Washington DC: Brookings Institute Press Read More