The Extent to Which Regulation Has a Positive Role to Play in the Retail Financial Services Sector - Coursework Example

Critically Assess the Extent to Which Regulation Has A Positive Role to Play in the Retail Financial Services Sector Table of Contents Critically Assess the Extent to Which Regulation Has A Positive Role to Play in the Retail Financial Services Sector 1 Table of Contents 2 Introduction 3 Impact of Regulation on Retail Financial Service Sector 4 Customers in Retail Finance Service Sector 5 Financial Services Authority (FSA) Towards Consumer Responsibility 6 Example of Northern Rock 8 Positive Role of Regulation in Retail Financial Services Sector 12 Negative Role of Regulation in Retail Financial Service Sector 15 Conclusion 17 Introduction The retail financial service sector is closely related with the economy of UK. This sector accounts for considerable employment generation, exports and also contribute huge amount to the GDP of the UK. Insurance corporations, banks and other financial establishments play important part in converting money of people into industrial investments. The financial crisis of 2007 had made the UK economy susceptible. The retail financial service sector helps to expand the economy and enable citizens to use their services such as loans and insurance products. The financial crisis basically takes place because of lack of regulation in financial service. The financial service companies had failed to cope themselves cautiously and thus the crisis hit the major economies (Crown, 2011). The paper intends to discuss the positive role of regulations in the retail financial services sector. After the global financial meltdown, it was observed that the common similarity in most of the organisations that had to be either bailed out or that became bankrupt did not adhere to the regulations. This paper takes the example of Northern Rock, a leading bank of UK which failed because of certain unjustified risks that the bank initiated beyond regulations. The paper aims to substantiate the fact that if the regulations would have been adhered, such a mess would not have occurred. Ultimately, after the thorough analysis of the paper, it can be said that the regulations have quite a few positive roles to play in the retail financial industry. Impact of Regulation on Retail Financial Service Sector A steady and well-organised financial system has strong impact on a county’s financial growth. It can provide confidence to the end user that a financial institution has the integrity in place. The steadiness and competency of the system has both supply side and demand side which impact on the financial system. Thus, a strong regulatory command contributes to the effectiveness and constancy in the economy. In the financial market, there exists a natural propensity to over–regulation as regulatory and administrative services are not delivered through a market method but are enforced externally. In the retail financial service sector, the basic roles executed by regulatory agencies are: Wise regulation for the protection and reliability of financial organisations Maintaining constancy and honesty of the outflows system Sensible regulation of financial organisations Rules regarding how a retail firm does business with the customers Security net provisions such as credit insurance Liquidity support for efficient stability for solvent financial organisations Managing bankruptcy in financial organisations Finding resolution to financial crisis Resolving problems regarding market integrity (Llewellyn, 2006) Customers in Retail Finance Service Sector In general, the economic capability of the UK is not so high and consumers often are unable to respond in an entirely balanced way with respect to the financial matters. Many consumers are unable to plan sufficiently for retirement or for unanticipated expenditures or for decline in revenue. In the retail market, people do not take passable steps to select products according to requirements; they normally take risks without understanding the impact of their deeds. Psychology plays a vital part in decision making for the retail market consumers in financial services. For example, several consumers concern only for loans to keep expenses down initially, with the objective of settling in future. In case of share, the decision regarding selling is often swayed by the paying rather than the present value of share. They often generate false budget for covering different kinds of expenses and savings. For instance, they often spend regular earnings to purchase a vehicle on a rental purchase loan rather than finance life insurance or pension saving. At times, consumers pull improper references and concentrate on wrong information and also easily get confused by vast information or selection, and at times become over–cautious & abuse the real facts (Financial Services Authority, 2008). Financial Services Authority (FSA) Towards Consumer Responsibility Consumer responsibility is significant for the success of financial service sector. No business can perform efficiently unless consumers are involved within it. The regulation of Financial Services Authority (FSA) takes place of the contradictory levels of information, skill, ability and understanding by taking a distinguished method to the regulation of different kinds of product. The regulatory approach reflects the ability of consumers. Thus, there is need for strong regulation to protect consumers and reduce risks in the financial market. The aspects which are considered by FSA for consumer responsibility are described below: Risk Analysis: FSA seeks to recognise and arrange evolving risks and deliver innovative resolution where appropriate. One apparent method in which FSA tactically deal with the consumer responsibility is through risk analysis. According to research conducted by FSA, it has been found that consumers’ understanding about loans product was quite high and knowledge of risk related with that loan was normally good. However, 10% of consumers have no idea or a general rough idea about interest loan or repaying the loan amount. Thus, it is very important for consumers to know about repaying loan and strategy for repayment of loan amount must be accurate and robust. It is unwise to assume that value of house will increase and loan amount can be repaid because of increased rate as happened in the USA. Administration: FSA knows the responsibility of consumer in the retail financial service market. The administration of financial promotion is a good example about administering the regulations and managing consumer competence in decision making. The objective of these promotions is typically to induce consumers to buy as well as investigate about any financial product. Enforcement: The enforcement strategy is the replication of administration strategy. While seeing the suitability of the enforcement strategy, FSA considers the activities of financial institutions as well as the nature and competences of consumers. FSA considers the degree to which consumers may have funded their individual loss or are unable to take rational steps to keep their own interests. The following diagram shows the future of retail financial sector with relation to consumer, regulation provider and distributor organisations: Fig 1: Future of Financial Sector with Relation to Consumer, Regulator provider and Distributor Organizations. Source: (Financial Services Authority, 2008). Example of Northern Rock Northern Rock is one of the best examples for regulation need in the financial services sector. In the year 2007, the global economy had faced instabilities and almost every bank had taken securitisation strategy for handling the financial problems. The banks became quite ambiguous about the possible revelation of off–balance sheet and engrossed the securitised assets on the balance sheet. As liquidity issues became vital, banks were unable to finance the off-balance sheet and were compelled to roll over the properties on the balance sheet or hold on the properties which they intended to securitize. The banks became indeterminate about liquidity requisite and also worried about the status as their own divisions would become bankrupt or face finance problems in the industry. All those factors caused the progression of re–intermediation. Several aspects had been identified in the centre of financial regulation which is described below. LPHI (Low Probability High Impact) Risk: Northern Rock had a specific business system which was ignored by the regulation authority. This bank provides customers short-term finance requirements with standard conditions. The risk in the lending strategy is related to three risks. First, the bank would be incapable to overturn growing finance, secondly, the cost of such finance would increase relative to the return on debt loans and finally, it would not be securitized with those debt properties. Thus, the risk faced by Northern Rock was that it was incompetent to roll-over the short-term loan in the occasion of severe liquidity congestion. Credit Risk: For many years, banks such as Northern Rocks had developed new strategy to remove the credit risk from the balance sheet. The liquidation remote measures were unable to protect banks from credit risk as they became more anxious regarding status risk. It had made those remote measures default and the prospective liquidity problems involved to such measures were misjudged or not measured at all. Creditworthiness vs. Liquidness: A difference is predictably made between the creditworthiness and liquidness of bank. The Northern Rock stayed officially solvent but actually it was dependent on the finance of Bank of England. Northern Rock was unable to finance the business operation in the market. In the regulation of banking system, the difference between illiquidity and bankruptcy was unclear, and illiquidity is capable to make a solvent financial organisation insolvent. In addition, if depositors are aware that bank is illiquid they will extract all of their savings which will force a bank to sell the properties for paying the depositors. Credit Protection System: One of the major faults in regulation of retail financial service sector is the credit protection system. The protection scheme was incomplete and it was incapable to prevent credit problem for which it was intended for, i.e. it cannot prevent insolvency when people start withdrawal of their reserves as of uncertainty regarding the security of a specific bank. Fundamental Limitations: With regard to the inconsistency in savings protection, there were fundamental restrictions in the regulation. In the G7 countries, they had no superior bank bankruptcy rule and no precise resolution strategy in case a bank fails. It has been seen that the fundamental values of Northern Rock’s business model were followed by several financial institutions. In particular, the hazardous blend of aggressive progression, minimisation of wealth and financial risk to support high degree of return on equity was significant common denominator. According to research of FSA, it has been found that throughout the boom phase the banks tend to raise the total assets more rapidly compared to the liabilities. At that time, the debtors were more enthusiastic to raise the liability, both in absolute conditions and in fraction to their revenue which created the credit of bank extremely ‘Procyclical’. The banks had learnt about advantage of securitisation and pushed the strategy to the limit, by generating distinct drive vehicle and issuance of cover bonds. Fig 2: Northern Rock’s Liquidity Gap at Various Maturities in the year 2007 Source: (Bruni & Llewellyn, 2009). The above graph shows that the liquidity gap in the Northern Rock was above £25 billion within 3 months and it needed to be refunded in almost one year. It can be concluded that the enormous inequality between the amount of aggregate asset and the risk weighted asset was possible because of lack of regulation in the retail finance service sector. According to research of European Central Bank (ECB), it has been found that the capital ratio of the UK banks had high dispersion rate in the period of 2000–2004, which concludes that several banks such as Northern Rock had permitted their capital to overdue the aggregate asset. The investigation of International Monetary Fund (IMF) in the year 2008 had showed that almost 10 major publicly registered banks in the USA and Europe had doubled the total assets to almost €15 trillion, while the amount of risk–weighted asset was €5 trillion. The collapse of Northern Rock was the consequence of the failure of retail financial service industry in the UK. Thus, financial services sector should not be allowed to regulate them. The Northern Rock case shows that regulation was not appropriate in this industry and the business strategy of aggressively growing the business through taking full benefit of the return on equity was a complete failure. It has been argued that ‘Basel’ structure permits individual controller to force financial organisations to make their capital beyond minimum level which was proved to be a very risky business strategy. However, special treatment was not applied by the British regulation. There is need for more than the general law that apply to other finance sector (Bruni & Llewellyn, 2009). Positive Role of Regulation in Retail Financial Services Sector Regulation is needed in retail financial service industry as it can measure the improvement and evaluate the market. Better regulation can deliver clearer reporting and sequestering structure against malfeasance of financial institutions. Strong financial regulation can result in more accurate evaluation of risks and thus higher capital prerequisite can be directed towards right way. The financial system is diverse and vastly complicated (IFASOK, n.d.). According to the perspective of economists the absence of regulation in retail financial market can cause several impacts, for example: Absence Of Strong Regulation In Retail Financial Service Sector Example Overall Financial Market Failure Irregular information with regard to financial product offering and financial product suppliers Increased Risks Lack of information with regard to a company’s financial situation can lead to loss of reserve of consumers in that company Increased Incentive Issues Incentive misalignment can create adverse impression on a financial institution and also it can cause market failure Source: (Oxera, 2006). The failure of Northern Rock, one of the top five lenders of the United Kingdom, once again showed the need of effective regulations in place. Though the bank failed amidst the global financial turmoil of 2007, but it can be said without much doubt that if the bank would have followed regulations by the core, it could have avoided such a fate. This invariably suggests that the regulations do have quite a few positive attributes which could have prevented the failure of the financial houses and could have kept the consumers’ faith upon the financial system intact (Delvin, 2003). The LPHI risk that Northern Rock bore, as described above, was not regulated adequately. The bank had an altogether different mechanism of mitigating the risk in order to ensure higher return. When the sub-prime crisis hit the financial industry, the bank failed to ensure its viability. If the bank would have followed due regulations, such a thing could have surely been avoided. It definitely puts forward the fact that adherence to the regulations are utmost necessary for the organisations especially in the financial industry. Not providing for the credit risks was again against the required regulations. As the sector was booming the bank took numerous measures to have higher profits, but once the crisis incepted, it could not stand the liquidity needs and had to be nationalised. The necessity and the positive impacts of the financial regulations can be aptly understood with the failure of Northern Rock. It can be said that if the bank would have maintained all necessary provisions, it could have still remain a major player in the UK financial industry. In order to keep the trust upon the bank intact, the bank initiated the method of window dressing during the last phase. It was observed that the bank had different values for creditworthiness and liquidity, which are basically same. This was basically done to keep the faith of the customers in place of the bank. This was again a violation of regulation as the bank basically depended upon the finances of the Bank of England. Such violation of regulation further weakened the bank and paved way for the fall. If adhering with the regulations, bank could have addressed the real concerns, it might have be in a better place as it could have provided true and fair view of the financial condition of the bank to its customers and other stakeholders (IIRating, n.d.). From the above arguments, it is pretty clear that the financial regulations have quite a major positive role to play to ensure sustainability of the retail financial industry. As in the retail financial industry, the clients are generally scattered with smaller portion of investment funds in their hand, they basically depend upon the regulatory bodies to take care of their hard earned money. Also, the information flow is not always at par in the retail financial industry and therefore there is high dependence upon the regulations from the client’s end to secure the funds. The financial organisations should focus on the effective adherence and implementation of the regulations so that such crises can be avoided (Goodhart, 1998). Nevertheless, also it has been argued that government needs to allow a slow step of changes in modifying the regulations at times as rules become quite tight after recent breakdown of financial system (The New York Times Company, 2011). Negative Role of Regulation in Retail Financial Service Sector Several issues in the retail financial service sector had put finger on the role of regulation in financial market. For the last 30 years, several financial institutions are actively engaged in wide variety of financial activities internationally and those activities are linked with each other. The regulation was unsuccessful to alleviate the logical risks posed by these multinational financial corporations. The activities of retail financial service segments such as banking, securities, insurance has raised considerably in present times, but no regulation had assessed the risks posed throughout the whole financial system (Slaughter & May, 2011). In recent years, several units have emerged in the retail financial sector such as non bank creditors, hedge funds, credit rating organisations, special drive investment bodies which are ignored by the financial regulation but these units have important contribution in the financial service sector. These unregulated units deliver considerable benefits by delivering information or letting financial institutions to better fulfil the demand of customers, depositors and stakeholders. The regulation was unable to administer their actions. For instance, significant involvement of non bank creditors had contributed to credit lending and to the financial crisis (Jackman, 2004). Another negative role that regulation had played in the financial service sector was the propagation of difficult financial products. In the retail financial market, there are numerous investment products which are very complex. The difficult retail loan products and credit products are beyond understanding of consumers. Regulation was unable to assess the risks for selling loan products to the customers and ensure stability in the market (Mwenda, n.d.). Finally, the globalisation of financial industry has fragmented the regulation structure. Regulation structure was unable to synchronise globally with other supervisory bodies (Dodaro, 2009). Retail Financial Sector Example Of Limitation Of Regulation In Retail Financial Services Sector Size of Retail Financial Market Regulation had lack of authority instrument and ability to alleviate risk Unregulated Units Non bank creditors played important role in credit loan crisis and financial disorder Complex Financial Products Customers have confronted difficulties regarding understanding the aspects and impacts of investment, loan, and credit cards Globalisation of Financial Sector Ordinary retailers and officials confronted problems in dealing with international merging of accounting and auditing principles Source: (Dodaro, 2009). Conclusion The major argument about the regulation of FSA was that the retail financial service sector had experienced a muddling of limitations among banking, securities and insurance. This was caused due to rise of financial corporations. This trend had increased from the first quarter of 1990 and group structures were becoming more complex. In order to improve the financial market in future, there is need to add more systematic risk avoidance features in the regulation so that regulator agencies can assess the problem and accordingly act upon before the risk happens (Smith, n.d.). It has been seen that people who are related to regulatory functions have failed because they are less clever, conversant and knowledgeable compared to other contributors in the financial sector. Regulators should guarantee that auditors make the financial statements on time and maintain the standards such as rational capital liquidity ratio and cost benefit ratio. The regulation was unable to manage the financial companies and ignored their actions. The objective of regulation should be towards protecting the consumers as well as to play active role for improving the future of retail financial market. References Bruni, F. & Llewellyn, D. T., 2009. The Failure of Northern Rock: A Multidimensional Case Study. 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[Online] Available at: http://siteresources.worldbank.org/INTAFRSUMAFTPS/Resources/Legal_Aspects_of_Financial_Sces_Regulations.pdf [Accessed August 12, 2011]. Oxera, 2006. A Framework for Assessing The benefits of Financial Regulation. Oxera Report. [Online] Available at: http://www.fsa.gov.uk/pubs/other/oxera_report_20060622.pdf [Accessed August 12, 2011]. Smith, H., No Date. The Macro and Micro Economic Dimensions of the Credit Crisis. The Future of Financial Services Regulation. [Online] Available at: http://www.herbertsmith.com/NR/rdonlyres/A29D3CAC-B3B7-433B-9529-20A853547AD0/9520/1208finserv1.pdf [Accessed August 12, 2011]. Slaughter & May, 2011. Conduct Regulation of Retail Financial Services – A Supervisory Assault on Traditional Business Models. Media. [Online] Available at: http://www.slaughterandmay.com/media/1526602/conduct-regulation-of-retail-financial-services-a-supervisory-assault-on-traditional-business-models.pdf [Accessed August 12, 2011]. 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