Significance of the Terms to Banking Reforms - Book Report/Review Example

? FMRI  Task: Section one Significance of the terms to banking reforms Systematic risk Systematic risk refers to the prospects of failure of the entire financial sector. The jargon is exceedingly frequent in the banking and investment sector that constitutes a majority of the financial sector. Systematic risk assesses the prospects of failure of bank, investment entities and bodies in the insurance sector. It is imperative to establish the factors that can trigger such a calamity. However, systematic risk is no longer a terminology but a reality since mid 2000 when the financial sector began to crumble. This had distressing implications on the global market since banks are the core pillar of the economy. Additionally, globalization worsened the impacts of the systematic risk since what transpired in any economy influenced other nations (Edwards & Bowen, 2005). Consequently, the global economy is reeling from the impacts of a financial calamity. It is vital that banks manage this risk, as they are weary of repercussions of the meagre management. The systematic risk results from links among the financial organizations. Subsequently, the firms are interdependent. The interdependence and linkage of institution in this sector creates risk. This risk means that the failure of any entity in a series of linked or interdependent entities has undesirable implications on the rest of the institutions. The collapse of key institutions may culminate in the breakdown of the financial sector. Overall, systematic risk denotes the chances of the entire financial sector failing due to the misfortunes of one entity. Therefore, studying this risk would encompass evaluating the interdependence among diverse entities in the sector. Interdependence seems to be the core factor that results in this risk. Apparently, banks are exceedingly sensitive institutions that require regulatory measure. However, such measures in the America resulted in decreased discipline among institutions in this sector. This implies government effort to provide banks with last resort opportunity increased indiscipline among entities in this sector. Therefore, indiscipline results in the upsurge of systematic risk. This is because indiscipline may occur among most firms (Taylor 2009, 3). Systemically important financial institutions Systemically important financial institutions (SIFI) denote a category of entities. The entities are generally in the financial sector. However, some are non-finical organization. There are considerations made in enlisting any institution in to the above category. Fundamentally, the organization must have assets that exceed fifty billion dollars. The above figure represents an enormous worth of assets. Hence, it is imperative to ensure the safety of such amounts that primarily emanates from clientele’s deposits. The enormous value of the assets makes it imperative to designate these entities as SIFIs. Designating entities to this group has generated controversy especially if it concerns a non- financial entity (Dervis, Kawai & Lombardi 2011, 109). Similarly, financial entities are unwilling to join this category. The core reason that has triggered the reluctance is the high liquidity conditions. High liquidity requirement reduces the finances that an entity can invest. Consequently, diminishing an entity’s profitability since it has reduced the proportion of the receipts it can invest. SIFIs have to retain huge amounts of deposits to meet any emergency liquidity demands. Previously, organizations could invest almost the entire funds received from the clientele. This exposed the entity and most importantly the clients’ funds. Reduction in such investments made by these firms would lead to losses of customer funds (Rezaee 2011, 192). This is the risk, which governments wish to eliminate. SIFI institutions entail about thirty organizations globally. Most of the entities are banks with enormous balance sheets. The Basel negotiations found it prudent to limit the investment capabilities of these entities ensuring safety of clientele deposits. This reduced the profitability of such entities due to diminished investments. Overall, designation of SIFI has aimed at protecting the funds of ordinary individuals by targeting the largest bodies that would lead to financial turmoil if they failed. The designation considered factors like interdependence and linkage to other institution (Blundell-Wignall & Atkinson 2010, 5). Significance of systematic risk Regulation and reform were eminent once the financial disorder begun. If entities continued to conduct their undertaking without any change, then the turmoil would have persisted. In the UK, a committee had the mandate of establishing what triggered the financial mayhem. The commission made some proposals on the reforms that authorities should undertake. The two terms are significant in the endeavour to reform banks since they elaborate key factors that triggered financial turmoil. It is imperative for financial entities to establish the systematic risk. Systematic risk elaborates the possibility of total financial failure. Establishing this risk requires an analyst to determine specific parameters. The parameters enable estimation of the preceding risk. The parameters include interdependence and linkage among banks. Interdependence denotes financial institution relying on each other. This normally transpires when there an entity has several subsidiary or associates. Additionally a single bank would provide a vital service to other banks in the sector (Treasury 2009, 77). This interdependence generates risk due to diverse reasons. Initially, banks are exceedingly sensitive entities. Therefore, the caving of one institution in the financial sectors generates effects that implicate other entities adversely. Systematic risk is an integral term in the reform and regulation of banks. The term reveals the adverse effects of interdependence among entities in this sector. Subsequently, reforms ought to guarantee that banks do not establish subsidiaries in the same sector. Additionally, authorities should guarantee that existing subsidiaries operate as independent entities. This would reduce the implications financial misfortunes. Linkage is a term that denotes the countless partnership that businesses undertake. The partnership represents joint ventures that aim at optimizing the incomes of the entities in the partnership. These joint ventures contribute to an entity’s revenues. Linkages are frequent in the current economy especially in the financial industry. The linkages pose an evident risk, as the failure of an entity would have countless implications on other organization. Therefore, systematic risk is relevant to reforms as it details linkage among bank that culminates in risk to the financial sector. Authorities must regulate linkage among banks by barring investment of enormous amounts of funds into such ventures. Additionally, banks should encourage banks to collaborate with nonfinancial entities. This would greatly diminish the risk that emanates from linkage among financial bodies. Linkage is integral in the determination of systematic risk. Therefore, the term is relevant to the financial sector reforms (Vasilev 2011, 29). Significance of SIFIs SIFI denotes entities with enormous assets levels. Consequently, it is imperative to ensure that they never fail. Failure of such entities would have dire consequences on the economy since they are market leaders. Additionally, they have enormous funds belonging to ordinary individuals. Establishment of SIFI is a prudent measure that targets such entities whose failure would have irreparable implications on the economy. Entity designated as SIFI have phenomenal level of assets. Hence, it is imperative to ensure apt management in these entities. It is evident that banks seek to profit from the deposit by reinvesting deposits. However, this generates a risk since the investments may lose value or generate losses jeopardizing the clientele’s money. Additionally, over investment deposits results in liquidity hitches. Subsequently, entities designated as SIFI face higher level of liquidity. This culminates in reduction of amounts that such entities can invest. SIFI will be critical since they will provide guidance on how to eliminate risks in the financial sector. Therefore, the term SIFI has significance in reforming the financial industry, which is fragile. Additionally, SIFI demands discipline in the manner that banking entities undertake their transaction. Government regulations have resulted in additional malpractices as they avail last resort for banking entities that are failing. This has resulted in recklessness among banking executives leading to liquidity issues among banks. The core problem that banks encountered before the crisis was the establishment of equilibrium. The equilibrium between the funds banks should invest and those they should maintain as liquid cash. However, most banks opted to invest thus, the slump in assets’ value resulted in losses. Most bank consequently faced liquidity hitches. Overall, SIFI maintains the discipline of large entities by ensuring they have high liquidity ratios (IMF 2011, 10). Section 2 Reforms in banks Introduction The UK commission on banking made certain observations on ways to resolve the crisis. The commission identified a multifaceted means to resolve this turmoil. The solution would ensure that banks could soak up their losses, reduce risk and reduce cost of restructuring. Before the crisis bank took excessive risk in their investment. Consequently, the resulting losses were enormous. Furthermore, such investments led to accumulation of toxic assets. The bank had no capacity to absorb the losses that resulted from the excessively risky investments. The reform will ensure that banks can resolve such a crisis within the constraints of their resources. Hence, they would not require any stimulus funded by taxpayers’ funds. This would require discipline in banks’ practises. Moreover, the assumption that large entities in this industry cannot fail is questionable. This assumption has allowed certain organization in this sector to undertake exceedingly risky investments. The commission and other authorities recommended various solutions that would ensure stability in this sector. This section will evaluate the proposed solution. The solution will encompass multiple measures that are well coordinated to ensure sound practises. The banking sector is exceedingly fragile. Additionally, it is a key pillar of any economy. Consequently, it is imperative to enact measures that will not have negative implications on its stability. Risk taking emerged as the key cause of the crisis since it culminated in the accumulation of toxic assets. The UK authorities failed to buy the assets but instead insured them. This culminated in the liquidity issues with the entire industry requiring a bailout. Reforming banks The UK commission on banking held countless sessions in attempts to establish how to resolve this crisis. The core solution that emerged was separation of banks into components. The two basic constituents include retail and investment. It is imperative to comprehend the difference between investment and the retailing functionality of banks to understand the proposed solution. Retail banks perform ordinary banking operations. Fundamentally, these banks accept deposits and offer credit to their clientele. Most of the credit is offered to corporations. Additionally, they also offer loans to individuals. The crisis has made it tough to obtain credit since the lending rates have rocketed. These institutions favoured offering credit to corporations. However, the difficult financial circumstance has made lit challenging to offer such services to individuals. Overall, the crisis has affected operations of such banks greatly. The investment banks fundamentally assist various organizations obtain capital. These banks act as advisers in initial public offers (IPO) and other undertakings to boost levels of capital. Additionally, they act as underwriters, which is a critical role that ensures that public offers do not fail. Investment banks also facilitate mergers and consolidation of entities. Evidently, the two banking functions differ hence; the commission found it prudent to separate them. Moreover, the commission recommended monitoring of the two functions. The separation would leave any bank that conduct both as an entity with two brands. Ring fencing of banks is a term that denotes the measures that the government seeks to undertake to ensure separation of the two functionalities. Ring fencing is an enormous undertaking. Consequently, the authorities have adoptable a schedule that will ensure total separation of bank by 2015 (House of Commons Treasury Committee 2009, 94). Banks have become complex due to numerous functions. The diverse functions have resulted in contamination of the basic undertakings with more risky operations. Banks ought to have a narrow structure; as such, it is easy to comprehend their operations. Furthermore, such banks are controllable. This will earn the ordinary people’s trust that these organizations have lost due to the complexity of their operations. The complexities of banks’ operations have resulted in conflict between the functions. Research compared retail banks and investment banks. Retail banks are simple with the central utility of accepting deposits and offering credit. Investment banks are hard to comprehend due to their risky and complex operations (House of Commons Treasury Committee 2009, 95). These findings by the house common outline the core concerns that have led to calls to split banks on their functionalities. The findings divulged that most banks wish to maintain the universal model. Representative of Barclays argued that the model ensured access of credit internationally. This model also ensured that banks remained competitive. Moreover, housing of different functionalities under a single bank ensured that such entities benefit from synergies. However, there were counter arguments to the assertions made by the representatives. Despite the benefits, it was evident that currently the operations of banks are complex necessitating separation. However, the universal model facilitates diversification. Diversification of operations diminishes the risk that non-diversified bank face. The idea of maintaining the universal model emerged as a feasible idea since the narrow banks seemed unsustainable on the long run. Nonetheless, the bank represents scholars and citizens’ aspirations because they are simple. However, managers seem to opt for the universal model of banking that is more profitable and sustainable (House of Commons Treasury Committee 2009, 95). The proposal for narrow banking system would bear counter effects. The narrow model would diminish the incomes of retail banks. Consequently, the banks would seek means to boost their finances. This would result in an increase in rates as the narrow banks seek addition al revenues. This would degenerate into a bad credit market. Such a market would further worsen the crisis since it reduces funds that can assist in reviving economies. Higher rates denote tough economic times. Therefore, this model would have negative implication. In the universal model, other functions of the bank assisted when the retail section failed to realize its targets. Nonetheless, the narrow bank model leaves interest as the key source of revenues. Banks will automatically increase rates to ensure sufficient revenues. High lending rate will diminish individuals that borrow credit leaving corporate clients. Accordingly, retail entities will opt to buy government securities that have minute risk. Alternatively, they can invest in expansion. The crisis resulted primarily due to investment banks. Consequently, ordinary citizens suffered yet they had minimal interests in such sections of banks. This means that the retailing sections of banks were still viable. Nevertheless, the profit generated could not meet the losses that occurred in the investment sections. Therefore, separation aims at ensuring that the retail section of bank remains despite the collapse of the investment segment. This would ensure safety of the depositor funds (Independent commission on banking 2010, 2). Conclusion Overall separation of the banks will lead to narrower banks and further competition. However, it will increase cost and reduce banks’ profitability. Separation will eliminate the universal model in which banks have become too enormous leading to the notion that some cannot fail. Separation will ensure stringent management of such entities. However, separation is encountering massive resistance from institutions in this sector that never failed. The resistance emanates from sound reasoning which opts for the universal model. The model ensures global accessibility of credit. Furthermore, it guarantees spread of risk. Importantly, non-hybrid firm performed relatively dismally compared to banks that embraced the universal model. It is vital that such entities monitor their investment section to avert another crisis among banks under universal model. The investment section has complex undertakings with enormous risks. Nonetheless, it has the capability to generate considerable income. Banks that may remain under this model must monitor the activities undertaken in the investment section. Narrower banks will need to publicize their product aggressively since they have limited revenues sources. This will ensure the sustainability of the model. Conclusively, discipline will be imperative in ensuring end of this financial catastrophe. Banks must avoid making overly unsafe investments. Additionally, they should create means of offsetting investment losses within their financial constraints. Bibliography Blundell-Wignall, R & Atkinson, P 2010, Thinking beyond Basel iii: necessary solutions for capital and liquidity, Financial Market Trends, no. 1, pp.1-24. Dervis, K, Kawai, M & Lombardi, D 2011, Asia and Policymaking for the Global Economy, Brookings Institution Press, Washington.  Edwards, P & Bowen, P 2005, Risk Management in Project Organisations, Taylor & Francis publishing, New York. House of Commons Treasury Committee 2009, Banking Crisis: Dealing With the Failure of the UK Banks, TSO publications, United Kingdom. Independent commission on banking 2010, Resolving the dilemma of British banking, Slaughter and May, Viewed on January 18, 2012, International Monetary Fund (IMF) 2011, United Kingdom: Crisis management and bank resolution technical note, Financial sector assessment program update United Kingdom,Viewed on January 18, 2012, Rezaee, Z 2011, Financial Services Firms: Governance, Regulations, Valuations, Mergers, and..., Wiley publishers, New Jersey. Taylor, J 2009, Systemic risk and the role of government, Federal Reserve bank of Atlanta, Viewed on January 18, 2012 Treasury, H 2009, Reforming markets, TSO publications, United Kingdom. Vasilev, D 2011, Risk management in UK banking - The role of derivatives hedging in particular, Grin Verlag, United Kingdom. Read More