Regulatory Measures and Reportorial Standards Pertaining to the Financial Services Industry - Research Paper Example

The regulatory measures and reportorial standards pertaining to the banking and financial services industry, in light of the subprime crisis and credit crunch of 2007-2008. Chapter I Introduction and Research Methodology 1.1 Background The external signs of the problem appeared to begin on February 22, 2008. On this date, Hong Kong Shanghai Bank fired the head of its US mortgage lending business as losses in this unit reached a staggering $10.5 billion. At first it was believed to be an isolated case, or at worse the result of rogue trading such as that by Nick Leeson whose unauthorized derivatives trading caused the collapse of Barings Bank in 1995. This was quickly dispelled the following month, as New Century Financial and Accredited Home Lenders Holding, two of the biggest sub-prime lenders in the US, reported huge losses and moved towards bankruptcy. By May, the sub-prime problem showed signs in the UK as sub-prime lender Kensington agreed to a takeover. By June, the first major bank to report financial distress, Bear Stearns, revealed that it had spent $3.2 billion (£1.5 billion) to bail out two of its funds that were invested in the sub-prime market. By July, the UK’s Financial Services Authority (FSA) announced that action would be taken against five brokers selling sub-prime mortgages, claiming that they had offered loans to individuals who were not qualified for them. Sadly, even at this point, independent market analyst Datamonitor forecasted that the UK sub-prime mortgages are expected to grow at a faster pace than the mainstream mortgages, targeting £31.5 billion by 2011. This advisory could not be farther from the truth. In July, the financial markets began to tumble worldwide as the US Federal Reserve Chairman, Ben Bernanke, makes his dire pronouncement that the US sub-prime market may cost $100 billion in losses, triggering the start of the credit crunch and subsequent financial crisis. In the succeeding months, the market had its share of bad news. The most significant development that contributed to the further loss of confidence in the financial system was the collapse of Lehman Brothers, a global financial services firm based in New York and a lead trader in sub-prime mortgage securities, in September 2008. At that time, Barclays PLC extended a successful bid to acquire Lehman, at a price of $1.35 billion or £700 million for the core businesses of the bank. Barclay agreed to absorb $47.4 billion in securities and assume $45.5 billion in trading liabilities (BBC News, 2009). The foregoing historical background at once provides a clue that inadequate regulation and reporting of the activities of financial institutions is at fault. This has sparked the debate on the desirability of government intervention in a free-market economy. It is a given, however, that because of the public interest involved and the lack of ideal free market prerequisites (e.g. perfect knowledge, transparency, etc), reasonable government oversight is necessary to ensure the proper workings of the financial system. It is in this aspect where the guard was let down, as seen from the fact that the failure was not general worldwide where the system is applied, but only in those countries (particularly US and UK) where the regulation was lax. 1.2 Main research question This study seeks to answer the question: How may regulatory measures and reportorial standards be improved in the banking and financial services industry, in light of the subprime crisis and credit crunch of 2007-2008? The question pertains to the regulatory framework of the United States, because it was the source of the crisis, and the United Kingdom, the other country outside of the U.S. which had been heavily hit by the sub-prime crisis. In order to formulate a solution to the principal research question, it shall primarily seek to answer the following sub-questions: 1.3 Related sub-questions 1.3.1 What caused the subprime crisis? 1.3.2 What factors escalated the subprime crisis into a financial crisis? 1.3.3. What implications on regulatory measures may be drawn from the crisis? On reportorial standards? 1.3.4 What revisions may be adopted to address these implications? 1.3.5 What advantages and disadvantages may be associated with the proposed changes in regulation and standards for financial reporting? 1.4 Aims and objectives The solutions to the above-mentioned question and sub-questions intend to accomplish the following objectives: 1.4.1 To create a list of events that traces the developments in the sub-prime crisis, in order to gain an understanding of the factual basis of the crisis; 1.4.2 To examine the conditions that enabled the crisis events to take place; 1.4.3 To identify and study the banks and financial institutions that have been adversely affected by the financial crisis; and 1.4.4 To suggest possible measures by which the financial system may avoid another similar crisis in the future. 1.5 Methodology and Data The study describe and analyse events that had already happened, in an effort to find out how the situation could be improved in the future. Therefore, the historical descriptive method of analysis using the qualitative approach shall be employed. There is a possibility of using quantitative data in the form of financial statements of banks and financial institutions, if such will be made available, although such data will be analysed in support of the qualitative assessment of the banking and financial system. For the most part, qualitative data from the archives and academic literature, institutional reports, news articles and government documentary information shall be relied upon in assessing the regulatory framework and reportorial standards of the financial industry. 1.6 Conceptual Framework The assessment of whether reportorial standards and regulatory measures are adequate and how they could be improved will be conducted according the principles of the CAMELS framework. An earlier system of evaluating banks, the CAMEL, has been recommended, beginning in 1988, by the Basel Committee on Banking Supervision of the Bank of International Settlements (BIS) as an important criteria for determining the fitness of a financial institution (ADB 2002). The sixth element, Sensitivity to market risk, was added in 1997 (Gilbert, Meyer & Vaughan). CAMELS ratings are employed in determining whether or not banks and financial institutions are in good health, a good framework for this study. The acronym stands for: C – Capital Adequacy A – Asset quality M – Management quality E – Earnings L – Liquidity S – Sensitivity to Market Risk The CAMELS framework was developed by US regulatory authorities, comprised of the Federal Reserve Bank, the Comptroller of the Currency, and the Federal Deposit Insurance Corporation. Each of the criteria will be described in the following discussion (Baral, 2005): 1.6.1 Capital Adequacy – This first component aims to determine how capable are financial institutions in absorbing shocks to their balance sheets. It tracks capital adequacy ratios that take into account financial risks, namely foreign exchange, credit, and interest rate risks, by assigning weights to the assets of the institution. Bank capital is classified into Tier I, or primary capital and Tier II, or supplementary capital. 1.6.2 Asset Quality – Credit risk is an important factor that affects the health of financial institutions. The extent of credit risk depends on the quality of the institution holds. A number of measures may be used to indicate asset quality, such as loan concentration by industry, region, borrower and portfolio quality; related party policies and exposure on outstanding loans; the approval process of the loan; and checks and balance of the loan. Also important are the portfolio in arrears, loan loss ratio, and the reserve ratio (ADB, 2002). 1.6.3 Management Quality – It is difficult to measure sound management because of its highly qualitative nature. There are several indicators that may be useful in this effort. Expenses ration, earnings per employee, cost per loan, average loan size and cost per unit of money lent may provide bases for evaluating management quality, but they should be employed carefully and a broad picture must be considered so as not to jump to false conclusions. 1.6.4 Earning Performance – The earning capacity or profitability is a naturally important consideration in ensuring the health of a financial institution. Indicators that are usually resorted to are return on assets, return on equity, interest-spread ratio, earning-spread ratio, gross margin, operating profit margin, and net profit margin. 1.6.5 Liquidity – Liquidity considerations are useful for assessing the risk that threatens the solvency of financial institutions. Commercial banks, for instance, run the risk of liquidity inadequacy when depositors seek to withdraw their money (liability side liquidity risk), or when commitment holders decide to exercise the commitments recorded off the balance sheet (asset side liquidity risk). In such cases, commercial banks would need to run down their cash assets, borrow additional funds, or ultimately sell of some of its assets at distressed prices, thus threatening the bank’s financial health. 1.6.6 Sensitivity to Market Risk – Operations of commercial banks are gradually becoming more diversified and complex, involving lending and borrowing, transacting in foreign exchange, selling off assets pledged for securities, and other activities. These functions are subject to market risks linked to interest rates, foreign exchange rates, financial assets and commodity prices. A financial institution with an aggressive operations strategy may be more sensitive to market conditions than a more conservative one, and this impacts to the health of the financial institution. Chapter 2 Literature Review 2.1. US Subprime Mortgage Crisis The financial crisis finds its roots in the subprime mortgage crisis of 2007. The conditions at the time were characterized by unusually large number of subprime mortgages that originated in 2006 and 2007 that had become delinquent or entered into foreclosure proceedings only a few months after they were contracted. The figures that follow show that the loans contracted during this period were comparatively of poorer quality than those that originated over the earlier years. The years 2006 and 2007 show a higher delinquency rate, both as to actual delinquency and when adjusted for year-for-year variation in various macroeconomic and financial indicators. The figure on the left measures the delinquency rate as the cumulative fraction of loans that were past due for at least 60 days, are foreclosed or have defaulted. The adjusted delinquency rate was arrived at by modifying the actual rate for year-on-year loan-to-value ratios, debt-to-income ratios, documentation levels, percentage of loans with prepayment penalties, mortgage rates, origination amounts, house price appreciation since origination, changes in state unemployment rate since origination, neighbourhood median income, and so on. (Demyanyk & Van Hemert, 2009). From data analyzed by the study, it was determined that all segments of the subprime mortgage market were equally affected. These include the fixed-rate, hybrid, purchase-money, cash-out refinancing, low-documentation, and full-documentation loans. This contradicts earlier speculation that the subprime mortgage crisis was confined to hybrid or low-documentation mortgages (Demyanyk & Van Hemert, 2009). Graphs of delinquency rates for subprime mortgages, per year of origination Source: Demyanyk & Van Hemert, 2009, p. 1 2.2 Overreliance on government guarantee The problems originating in the subprime mortgage market worsened with the aggressive lending pursued by the Federal National Mortgage Association (Fannie Mae) and the Federal Home Loan Mortgage Corporation (Freddie Mac). These institutions are government sponsored enterprises that provide housing loans and secure the mortgages to sectors identified by the U.S. government as priority areas for housing development. They are chartered by Congress and thus were required to fulfil certain targets identified by the economic planning agencies. It must be recalled that Fannie Mae and Freddie Mac had begun as government agencies, and while they have since then been privatized, the implicit government guarantee to answer for any default they may incur still is generally accepted. This is to be expected, because the two mortgage firms still advance the government’s housing programs as government sponsored enterprises (GSEs), fulfilling targets as set by the federal planning agency. Because of this implicit guarantee, mortgages entered into by these firms and subsequently securitized were perceived to have a low risk of default, despite the poor creditworthiness of the borrowers (Reuters.com. 2009) 3. Over-reliance on central bank’s guarantee The banking function works by accepting deposits from savers and lending these out to borrowers. A portion of the funds, however, is mandatorily reserved in the bank as protection for possible defaults and withdrawals. Occasionally, however, there will be liquidity floats as banks borrow from each other to meet short term obligations. Because of this system of fractional reserve banking, there normally develops a network of interlocking obligations among banks, causing banks to be constantly wary of the safety status of other banks. Because of these interlocking obligations and the nature of the banking function, a bank will naturally not be able to meet demands for liquidity should all or a substantial number of its deposits suddenly closed their accounts and withdrew their money, simply because the money is not in the bank but with the borrowers who took out loans. Therefore, a bank run fomented by panicked depositors would threaten the stability of banks linked together, unless there is an institution that would ultimately guarantee all these loans. This is the idea behind the central bank as the lender of last resort (Cooper, 2008). The role of the central bank is performed by the Federal Reserve in the U.S. and the Bank of Englad in the U.K. The guarantee provided by the central bank, however, works to the disadvantage of both banks and borrowers. The tendency would be to disregard the soundness and health of the lending and instead transfer to banks that promised higher interest payments, thereby spurring risky competition among the banks. 4. Exotic derivatives At the time risky loans began accumulate, industry strategists sought new ways of increasing revenues by increasing loans. However, the existence of a large proportion of loans in the balance sheet required the banks to maintain a high level of cash reserves, tying up funds that could be loaned out to earn interest income. In order to free up these reserved, investment bank JP Morgan created the credit default swap (CDS) that packaged loans and contracted swap loans on these securities. The loans required the counterparty to bear the risk of the loan’s default, in exchange for a regular monthly pay-out in the nature of an insurance premium (Philips 2008). In effect, these new types of securities, which were not quite understood by many investors, transferred risk out the banks’ balance sheet to an insuring entity. Later on, when defaults began to take place in greater numbers, the insurers of these CDSs were unable to make good on their obligations to pay, thus creating the chain of losses and defaults throughout the system. 5. Poor bank regulation under Basel II The international standard for performance of banking institutions is embodied in the Basel Accord II. The Basel Accord is built on three pillars of prudential performance: minimum capital requirements, banks supervision actions, and market discipline (Angkinand, 2009). The method by which banks are assessed under Basel II was through the reporting of their risk-based capital (RBC) ratios. These ratios specify a measure of regulatory capital in the numerator, and a measure of total risk in the denominator. Banks have devised a way, however, of manipulating their figures such that prior to reporting, the regulatory capital measure could be enhanced, thus increasing the numerator, or reducing the measure of total risk, reducing the denominator. These artificial manipulations are called “cosmetic” adjustments which do not add to the stability or safety of the bank, but comply with the Basel II requirements on paper (Jones, 2000). 6. Absence of oversight of rating agencies The stability of the banking system depends on the safety of the issued debt, and the assessment of this safety is dependent upon the “gatekeepers,” the ratings agencies. The two most relied upon ratings agencies are Moody’s and Standard and Poor’s, and their job is to screen issued debt and determine how safe they are to invest in. However, both ratings agencies mentioned above suddenly lowered their standards during the period preceding the crisis. One reason for this lies in the shift of the payment scheme for ratings, which used to be defrayed by investors but now is shouldered by the issuers of the securities being rated (White, 2007). This has sorely compromised the objectivity of these firms as arbiters of investment value (Sack & Juris, 2007), and the resulting crisis is proof to the toxicity of assets initially rated by them as top quality “AAA”. In short the fact that investment banks paid for the ratings service implies a likely subjectivity on the part of the ratings agency that compromised investors’ confidence. 7. Repeal of the Glass-Steagall Act During the advent of the stock market crash and the Great Depression in the 1930s, the U.S. Congress passed the Glass-Steagall Act that forbid the combination of traditional commercial banking functions with investment banking; thus, banks were forced to choose which activity their charter shall authorize them to undertake. It was generally accepted that investment (non-traditional) banking functions entail a much higher risk from which investors in commercial banks should be protected against. However, due to the weight of hundreds of millions in lobby funds and campaign contributions by interested parties, the Act was repealed in 1999, after which a spate of mergers of commercial and investment banks created monolithic institutions that combined both functions (Frontline, 2003). When the crisis broke out, pundits noted that no serious shocks occurred in the banking system in the eighty years the Glass-Steagall act was in effect. However, only eight years after its repeal, the most massive financial meltdown in contemporary business history rocked the world economy. This has prompted calls by members of the U.S. House and Senate (in the persons of McCain and Cantwell) to propose a reinstatement of the Glass-Steagall (Vekshin, 2009), together with the breakdown of ultra-large financial institutions that have become “Too Large to Fail.” The foregoing literature review provides a brief overview of the elements that would provide essential considerations in evaluating the regulatory framework of the United States, where the crisis began, and the UK, where the crisis spread. The following discussion will deal with the particular weaknesses of the current regulatory systems in both countries, and how to either prevent the recurrence or the spread of a similar crisis in the future, and implications for national and cross-border regulations. REFERENCES Angkinand, A P 2009 Banking Regulation and the output cost of banking crises. Journal of International Financial Markets, Institutions and Money, vol. 19, pp. 240-257. ADB. 2002.Guidelines for the Financial Governance and Management of Investment Projects Financed by the ADB. Manila: ADB. Baral, K J (2005) Health Check-up of Commercial Banks in the Framework of CAMEL: A Case Study of Joint Venture Banks in Nepal. The Journal of Nepalese Business Studies, vol. II, no. 1, December 2005 Brummer, A. (2008) “Where the credit crash came from”, Management Today. Haymarket Business Publications Ltd, London: May 2008. ps. 34-37 Cooper, G (2008) The Origin of Financial Crises: Central Banks, Credit Bubbles and the Efficient Market Fallacy. Hampshire, Great Britain: Harriman House Ltd Davis, G F 2009 The Rise and Fall of Finance and the End of the Society of Organizations. Academy of Management Perspectives, August, pp. 27- 44 Demyanyk, Y & Hemert, O V 2008 Understanding the Subprime Mortgage Crisis. Unpublished paper, 5 December 2008. Accessed 10 January 2010 from http://ssrn.com/abstract=1020396 Financial Services Authority (FSA) (2006) Principles-based regulation: Focusing on the outcomes that matter. FSA Official Website. Accessed 10 January 2010 from http://www.fsa.gov.uk/pubs/other/principles.pdf Frontline 2003 The Wall Street Fix: The Long Demise of Glass-Steagall. Accessed 10 January 2010 from http://www.pbs.org/wgbh/pages/frontline/shows/wallstreet/weill/demise.html Gieve, J 2008 Learning from the Financial Crisis. European Business School 2008 Europe in the World Lecture Panel Discussion, 19 Nov 2008 Gilbert, R. Alton, Andrew P. Meyer and Mark D.Vaughan. 2000. "The Role of a CAMEL Downgrade Model in Bank Surveillance." Working Paper 2000-021A, The Federal Reserve Bank of St. Louis. Nov. 1, 2005 http://research.stlouisfed.org/wp/2000/2000-021.pdf Jones, D (2000) Emerging problems with the Basel Capital Accord: Regulatory capital arbitrage and related issues. Journal of Banking and Finance, vol. 24, pp. 35-58. McNally, Edward A. . 1996. "Basic Topics in Sound Bank Management." EDI Working Paper, Washington DC: The World Bank. Philips, M. (2008) “The Monster That Ate Wall Street”, Newsweek: Oct. 6, 2008, as seen in http://www.newsweek.com/id/161199. Retrieved 12 January 2010. Rappaport, A 2006 10 Ways to Create Shareholder Value. Harvard Business Review, Sep2006, Vol. 84 Issue 9, p66-77 Sack, J S & Juris, S M (2007) Rating Agencies: Civil Liability Past and Future. New York Law Journal, 5 Nov 2007, Vol. 238, No. 88 Vekshin, A 2009 U.S. Senators Propose Reinstating Glass-Steagall Act. Bloomberg.com, 16 Dec 2009. Accessed January 25, 2010 from http://www.bloomberg.com/apps/news?pid=20601103&sid=aQfRyxBZs5uc White, L J (2007) A New Law for the Bond Rating Industry – For Better or for Worse? New York University Law & Economics Working Papers Read More