Systemic Risks. FMRI (F) - Book Report/Review Example

? FMRI (F) Systemic Risk Systemic Risks can be described as a succession of cascading effects that can take place under specific conditions in several kinds of complex systems and which ultimately lead to a catastrophic situation. These risks can occur in a group of engineering plants, an arrangement of ecological structures, a set of closely-linked financial institutions and so on. The Organization for Economic Cooperation and Development (OECD) first used the notion of ‘systemic risk’ in one of its reports in 2003. In 2000, a series of systemic risks in United Kingdom’s banking sector had resulted in a major financial crisis in this sector. The systemic series of events usually occur without signaling any prior warning to the system and progress rapidly resulting in a significant deterioration in the existing state of affairs. Once the cascading events start taking place one after another, it becomes very difficult to put a stop to the process. Systemic risks can degrade a stable existing system to an extremely low state, where the latter performs much below its potential level for a considerable period of time. More serious systemic risks and their resulting events can even destroy an established system altogether. Financial analysts believe that the global financial crisis of 2008 was actually triggered by the systemic risks existing in the US banking sector. The international financial regulatory institutions had not been strict about enforcing certain banking regulations like the Basel II norms, which had been formulated to insure the against these risks. As a result, the commercial financial institutions started extending risky business loans which were not properly insured. Ultimately, the international financial system collapsed leading to the large scale global recession of 2008. Once an established system collapses, it usually takes a long time for it to regain its original functioning. However, all systems are not strong enough to recover. Some may permanently deteriorate into a qualitatively worse state or simply fade into extinction altogether (Leiss, 2010, p 2-6). Systemically Important Financial Institutions (SIFI) The global financial crisis of 2008 showed that ensuring the soundness of the individual commercial financial institutions was not sufficient to avert a financial crisis. There must be policies within the international financial system that govern the mutual interactions among the financial institutions and also their functioning in relation to the market. Financial analysts have accepted that the financial crisis of 2008 was an international systemic event. They further recognized that the stabilization of the international financial system required the addressal of two important issues: a) the systemic risk generated from the financial institutions and their various interactions b) formulating appropriate regulations and macro policies to keep a check on the international financial sector In the first stage, international regulators need to identify which financial institutions and markets are systemically important. The International Monetary Fund (IMF) together with the Bank for International Settlements (BIS) and the FSB has developed a framework for evaluating the systemically important financial institutions (SIFI). This framework has described systemic risk as the threat of disturbance of regular financial services. This risk is caused by a de functioning of all or some parts of the financial system and is also potentially dangerous for the real economy resulting in serious adverse effects. Further, the IMF, BIS and the FSB have laid down three criteria for financial institutions to be recognized as SIFIs: a) size: the volume of financial transactions undertaken by the institutions b) substitutability: in case the institution fails, the extent to which its services can be provided by other financial institutions in the system c) interconnectedness: the institution’s linkages with other entities of the financial market It is important to recognize the SIFIs in the economy, as this is the first step towards lowering systemic risk. This also helps in formulating the suitable boundaries of legislation in the financial system (Narain et al, 2010, p.5). Importance of SIFI in Banking Reform and Financial Regulation In March 2009, the G20 Working Group on Regulation and Transparency (G20 WGRT) declared that all the systemically important financial institutions, markets and instruments must be brought under an appropriate amount of regulation and supervision. The operations of the SIFI should regularly be supervised by these legislation which in turn must be proportionate to the SIFI’s local and international systemic importance. Sometimes, a group of financial institutions which are not recognized as SIFI, can also give rise to potential systemic risk. The international regulatory authorities have to be careful about the threat arising from such institutions. They could also formulate some form of regulation for these non-systemically important financial institutions and instruments. In 2009, the IMF agreed that the boundaries of the financial sector regulations need to be extended to encompass a wider spectrum of institutions and markets. In March 2009, a group of countries consisting of Brazil, Russia, China and India (BRICs), called for sufficient regulation and supervision of all financial activities, especially those which were liable to generate systemic risk. They urged for the proper supervision of financial institutions which were included in the shadow banking system. The BRICs further requested for intensifying the regulation of hedge funds and other private accumulation of capital. The participating countries of G20, the FSF and the governments of major nations have extended support for implementing comprehensive regulation in the international financial sector. They have recognized the importance of supervising even the smaller sources of capital such as hedge funds and private equity. In 2008, the European Parliament published a detailed report where it declared that the financial sector required to be comprehensively supervised by adequate legislation. This was essential for maintaining the stability of the European Union. The report was also in favor of regulating the smaller pools of capital and constraining the leverage of hedge funds and private equity. However, financial analysts are of the opinion that the European Parliament’s Report has not proposed sufficient measures for the direct regulation of the smaller sources of capital, which are the key sources of systemic risk (Sundaram, 2011, p. 153-155). Proposals for avoiding a future banking crisis: functional separation between retail / commercial banking business and investment banking During the middle of the 2000 decade, the international financial sector suffered a serious crisis. The situation had reached such a state that taxpayers in many countries had to bear an extra burden of costs to save certain native banks from running into failures. Since then, countries have been trying to reform their financial and banking sectors with the help of adequate reforms, so that such a crisis can be avoided in future. The same is true for the Government of United Kingdom as well. There have been many different proposals for changes in the organization and operation of financial institutions and financial markets, as well as regulatory requirements and how they are enforced in the UK. The UK government has setup an Independent Commission on banking to review the arguments for and against the different proposals and make a recommendation on the best way to achieve financial stability and avoid another banking crisis. Sir John Vickers, Chairman of the Commission, has indicated that one proposal receiving serious consideration for regulating banks’ capital and their corporate structure is to separate universal banks’ retail operations from their investment banking business. The separation could be achieved by the forced break-up of universal banks into completely separate retail and investment banking companies or separately capitalized and ring-fenced subsidiaries. The Independent Commission for Banking (ICB) focused on evaluating the universal banks of UK. According to the Commission, unconstrained combination within these institutions usually results in three kinds of potential problems for the banking sector. These were: 1) a huge effect of bank failure 2) a heightened threat of system failure 3) increased indulgence in risk taking activities In its Interim Report, the ICB declared that UK’s universal banks would be able to deal with all these problems if they were supported by a strong capital base and a sound financial structure. Once this was ensured, the universal banks would continue to function efficiently in UK’s economy. The ICB proposed to achieve this objective by “isolating the UK retail banking activities within a universal bank and placing them into a separately capitalized subsidiary (called a retail ring fence)” (ICB, 2011, p.13). For remaining within the retail ring fence, the banks would need to maintain a minimum 10 per cent of their capital assets within their retail business in UK. Any capital in excess of this level could be shifted internally to the banks’ wholesale/investment banking operations. According to the ICB, the introduction of the retail ring fence in banks would provide solutions to many of the above specified problems of the universal banking sector. The ICB has further declared that though it is presently concentrating on implementing the retail ring fence in the banking sector, it is also in the process of thinking about separating the retail business from the wholesale/investment operations of banks. It is contemplating a complete separation of the commercial retail activities from the investment business functions. (Independent Commission on Banking, 2011, p.13-15) In fact, the Independent Commission of Banking has advocated several structural reform measures to promote financial stability in UK’s banking sector. One of the proposed measures of ICB includes a structural separation of universal banks. Banks that are engaged in various retail, commercial, wholesale and banking activities could be divided into two subsidiary entities: one that undertakes the retail commercial functions and the other conducting the wholesale investment operations. The structural separation of banks could be implemented in different ways: A complete separation of the retail and investment operations of the banks undertaken under two different entities. The legal bench of these two entities would not belong to the same corporate group. Introducing a retail ring fence in banks: the retail banking functions would be isolated from the non-retail functions and they would be positioned under a different capitalized subsidiary Implementing operational subsidiarization The ICB has declared that it has not yet come to a final conclusion regarding which of the structural reform measures would be most suitable for UK’s banking sector. The Commission stated that it was presently considering the ‘retail ring fence’ as the foremost option to be introduced in the banks. This however does not mean that the ICB has ruled out the possibility of a full separation of the banking activities; instead it is very much in the process of considering the pros and cons of implementing this option. According to the Commission, one of the important benefits of full separation of banking activities would be that in the event of a financial crisis, this would ensure the separation of risks associated with the two main types of banking functions (Independent Commission on Banking, 2011, p.13-15). The ICB argues that separating the retail banking business from the wholesale/investment banking operations would have its own share of benefits. Under a financial crisis, the regulatory authorities could deal separately with the retail and the investment banks with the help of adequate resolution instruments or suitable insolvency methods. The bank creditors would be aware of such an arrangement right from the outset of the separation of the banking functions. If the creditors are assured that the regulatory authorities would be better equipped to handle the banking entities separately in the event of a crisis, they would feel a lot more confident in investing their money in UK’s banking sector. It is difficult to predict the onset of a financial crisis. However, if the banking sector is adequately equipped to handle a crisis, then the general people would not remain in fear of diverting their financial resources to this sector. When the banks undertake all their operations under one single head, the trends in one sector is likely to affect the functioning of the other departments. In such integrated banking, a crisis in retail banking is probable to impact the wholesale/investment business of the banks as well. It has often been observed that an emergency situation in one banking sector adversely affects the confidence of the general public which in turn impacts the business in the other sectors. However, in case of a complete separation of the banking activities, the trends in one sector would remain independent of the other banking departments. A crisis in one of the sectors is not likely to affect the citizens’ confidence regarding the functioning of the other independent departments. However, the ICB remains cautious in proposing such a structural separation of the banking operations. According to the Commission, the banks must be provided the liberty of organizing themselves in the most efficient manner, while separating their retail and investment business operations under different entities. The financial regulatory authorities should not impose any additional restrictions on the banks, more than those required for effecting the structural separation. Any extra constraints were likely to affect the efficient functioning of the banking operations. On the other hand, the ICB has also enumerated certain disadvantages that the banking sector may be subject to, owing to a structural separation of its business: Under integrated banking practices, where all the operations are conducted under a single entity, the banks are subject to economies of scale/scope. These are certain advantages accruing to the banking sector, as a result of undertaking its business on a large scale. However, these economies of scale will cease to exist when the banking activities are separated under different entities. Thus, a structural separation would bring an end to the operational advantages of the banks. There are several customers who wish to avail the retail as well as the investment services of the banks. Having all the banking business under a single entity proved to be advantageous for them. Under a structural separation, the citizens would have to go to different entities for fulfilling their financial needs. Therefore, a structural separation could cause inconvenience to the bank customers. One of the reasons for implementing the structural separation is to isolate the banking sectors from the trends prevalent in the other departments. A crisis in one sector would not affect the functioning of the other business. However, this same benefit could turn into a disadvantage. Under an integrated banking system, one sector could always come to the rescue of another sector in an emergency situation. However, if the sectors are managed under different entities, then these intra-banking advantages would not exist anymore. These were the proposals advanced by the Independent Commission on Banking (2011) in UK for undertaking appropriate measures to reform the banking sector of the region. Although the ICB has advanced several proposals, the most important one includes a structural separation of the banking sector. The Commission is considering the separation of the retail commercial banking business from the wholesale/investment operations and placing them under different supervisory heads. However, the ICB is still contemplating on the benefits and disadvantages of such a measure and has not decided anything conclusive on the matter. If such a measure is implemented, it would constitute a path breaking reform in the history of UK’s banking industry. References 1. Evanoff, D. D et al (2009), Globalization and Systemic Risk, Singapore, World Scientific 2. House of Commons (2011), Independent Commission on Banking, UK, The Stationary Office 3. House of Commons, Treasury Committee (2009-10), Too important to fail – too important to ignore, UK, The Stationary Office 4. IMF (2009), Finance and Development, Washington DC, IMF 5. Kowalewisky, K (2010), Budgetary Impact and Subsidy Costs of the Federal Reservezs Actions During the Financial Crisis, USA, Diane Publishing 6. Leiss, W. (2010), The Doom Loop in the Financial Sector: And Other Black Holes of Risk, Canada, University of Ottawa Press 7. Narain, A et al, (2010), Shaping the new Financial System, Washington DC, IMF 8. Sundaram, J.K (2011), Reforming the international financial system for development, USA, Columbia University Press Read More