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Functions that Financial Systems bring to the economy

Financial systems perform essential functions in a market economy, such as transforming savings into productive capital, providing information about users of capital, performing capital allocation functions, providing payment and funds transfer services, reducing agency costs by overseeing management and spreading and pooling risk through derivatives and securitization efficiently. Finance is “the oil that lubricates the wheels of commerce.”6 These ends of finance can be frustrated by exogenous factors

and even by the financial system’s internal operation.7

Banking is one of the most regulated industries in the world. This is due to the central role that banks play in financial intermediation (Santos, 2000). As stated by Spierings (1990) financial regulations fall into two parts:

1. Prudential or micro-economic supervision aimed to protect the interests of depositors and the soundness of the institutions and 2.Monetary or macro-economic supervision, aimed at the control of the money supply, price and exchange stability, balance of payments and other goals of economic policy. Spierings (1990) also states that financial regulations are implemented to ensure the following objectives:

- Promotion of competition between financial intermediaries,

- Maintenance of a sound and safety payment mechanism and the financial system as a whole.

- Prudential protection of depositors and investors of financial services;

- Prevention of concentration of economic power.

The primary purpose for this regulation is to prevent financial crisis, by insuring that the consumers are informed, and to ensure the soundness of the financial systems. Government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to consumers. Asymmetric information can lead to widespread collapse of financial intermediaries, referred to as a financial panic. Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds is sound or not, that may result in having doubts about the overall health of financial intermediaries. The consumers may want to pull out their funds from both sound and unsound institutions. One view is that financial crises are mainly due to panics as argued by Friedman and Schwarz (1963) for the U.S. in the nineteenth and early twentieth centuries. As the seminal theoretical contributions by Bryant (1980) and Diamond and Dybvig (1983) have shown, if everybody believes there will be a panic, then the panic is self-fulfilling. Everybody will find it worthwhile to take their money out of the banking system. However, if everybody believes there will be no panic they will keep their money in. Another view is that crises are caused by the business cycle. If people expect a recession then they will withdraw their money from the banking system in anticipation of loans going sour and the banks being unable to repay them. Gorton (1988) and Calomiris and Gorton (1991) have provided evidence for this view using data from the U.S. in the late nineteenth and early twentieth centuries. A third view is that financial contagion is a fundamental problem and provides a rationale for government intervention. If one financial institution fails then other institutions holding claims on it may also fail. Allen and Gale (2007) consider these and a number of other possible causes of financial crises.

The current structure of banking regulation is a patchwork of measures resulting from

The historical sequence of events rather than the implementation of a clear regulatory design. In the Great Depression, the economic situation was so bad that governments adopted a whole range of measures to stop any kind of problem. In the U.S., legislators passed the Glass-Steagall Act separating investment and commercial banking, they founded the Securities and Exchange Commission (SEC), they put in place all the SEC Acts, and the financial system became heavily regulated. In other countries, regulation was also increased and in some such as France, financial institutions were nationalized. This regulation and government ownership was successful in terms of stopping banking crises. From 1945 until 1971, there were no banking crises, except for one in Brazil in 1962 that occurred together with a currency crisis (Bordo et al. (2001)). So it is possible to stop crises by stopping financial institutions from taking risks. However, the alternative to the private sector taking decisions about risks and the allocation of resources is essentially that the government determines who gets credit. This was done in different ways. In countries like France with nationalized banks, the government directly made decisions. In the U.S., the government introduced so many regulations that banks couldn't take many risks and so low risk industries were allocated credit. As a result, the financial system stopped fulfilling its basic purpose of allocating resources where they are needed. In the 1970s it became clearer how inefficient this was and financial liberalization started in many countries. However, this led to a revival of crises. Since then, there have been crises all around the world (Boyd, De Nicolo, and Loukoianova 2009). This historical evolution has led to a patchwork of regulations designed to stop particular problems rather than a well thought out way of reversing market failures in the financial system.

However, market failures still do happen, and the attention of many economy experts is towards the fact what needs to be done in order to minimize the risk of market failure. Amongst the many aspects of the banking sector that can be regulated, Turner (2009) in his Turner Review suggests that some sectors are more crucial than others, and if the regulation on those sectors is more prudent there will be less room for bank failures and market failures. Those aspects are: Capital Adequacy, Liquidity Adequacy, Risk Management, and Credit Rating Agencies.

2.1. CAPITAL ADEQUACY REGULATION

Regulated financial institutions maintain capital at specified levels, those capital requirements are imposed in order to ensure that firms have a buffer or a “cushion” to absorb unexpected losses. The institution should be able to absorb the loses without threatening the ability to satisfy claims of depositors (Weber 2010). The simplest form of capital requirements, explained by Webber (2010), consists of minimum ratio of capital to include equity, and in some cases products which have equity-like features. Subsequently as a firm’s equity declines, so does its capital ratio, which results in non-compliance the capital adequacy regime and a need to raise new capital. Berger et al. (1995) have distinguished two forms of capital requirements: 1.market capital requirements; and 2.regulatory capital requirements. They define the bank’s market capital ‘requirement’: “as the ratio of equity to assets that maximizes the value of the bank to distinguish it from regulatory capital requirements”. On the other hand the regulatory capital requirements are motivated by two main concerns, first, bailout costs to taxpayers resulting from the moral hazard effects of government safety nets; and second, systemic losses to the broader economy from systemic risks that build up in the financial sector. Capital adequacy regulation for banks may reinforce macroeconomic fluctuations: If negative shocks to aggregate demand reduce the ability of firms to service their debts to banks, this reduction in debt service lowers bank equity, and, because of capital adequacy requirements, this in return reduces bank lending and industry investment (Blum, et al, 1995).

Berger et al (1995) also argue that regulatory capital requirements are a blunt tool for controlling bank risk taking. As they say capital is difficult to “define, measure and monitor”. Both the numerator and the denominator of regulatory capital ratios pose significant measurement problems. The ‘regulator value of equity’ to be used in the numerator depends on the market values of all on – and off-balance sheet assets and liabilities adjusted for limited liability. Because banks specialize in lending and providing guarantees for informationally opaque borrowers, the values of bank assets are difficult to measure and monitor. The denominator of the capital ratio – the variability of the regulatory value of equity – is even more difficult to measure, but some progress is being made. That is why the regulation have changed since that journal was published and capital requirements are more sophisticated under the Basel Accord.

In December of 1974, with world financial markets reeling following the collapse of two major international banks, the central bank governors of the G10 agreed to establish the Basel Committee consisting of central bankers and bank supervisors under the auspices of the BIS, in order to address the immediate problems arising in connection with the 1974 international financial crisis. In the longer term, there was an understanding that the Basel Committee would work to promote some modicum of convergence of banking supervisory practices. In a 1981 report, the Basel Committee indicated its concern with the erosion of bank capital ratios and advocated a greater approximation in the levels of capital employed by large banks. In July of 1988, the Basel Committee published the initial Basel Accord, and is now widely employed throughout the financially developed world, has rightly been applauded for helping to stabilize the international banking system by promoting the linkage of capital requirements to risk, and by forcing banks to hold more and higher quality capital and to focus on rate of return on equity and profitability rather than market share which set a minimum capital-to-risk-weighted assets ratio of 8 percent (Quillin, 2008). The Basel Committee published Basel II in 1996, which is in use at the moment, since then the Basel III was created and is expected to be implemented by 2011-2012. Basel II consists of three Pillars, Pillar 1 specifies the minimum capital requirements for credit risk and operational risk; Pillar 2 concerns the supervisory review; and Pillar 3 sets forth new market disclosure process requirements intended to enhance market discipline alongside regulation and supervision (Basel Committee, 1996, 2005).

More detailed explanation of the Pillar 1 will be given as that is the only one directly connected to the capital adequacy. Pillar 1 allows banks to compute their regulatory capital requirements against credit risk in two ways: (i) a revised standardized approach based on the initial Basel Accord, or (ii) one of two versions of an “internal ratings based” (“IRB”) approach whereby banks are permitted to develop and use their own internal risk ratings. The IRB approaches permit banks meeting certain qualitative and quantitative criteria to set their capital requirements by reference to inputs from their own internal VaR models rather than the Basel Accord’s multipliers.

Specifically, there are two IRB approaches: the foundation approach (“FA”) and the advanced approach (“AA”). Both approaches require banks to categorize their assets according to five categories (sovereign, bank, corporate, retail and equity). The IRB approaches are based on four key input parameters: (1) the probability of default (“PD”);

(ii) the loss given default (“LGD”); (iii) the exposure at default (“EAD”); and (iv) effective maturity (“M”). PD represents the “long-run average of one-year default rate” for a given borrower. LGD measures the anticipated loss, expressed as a percentage, of a total exposure upon the occurrence of a default. EAD measures the total exposure if a default occurred, expressed as an amount. Basel II sets forth elaborate asset class specific computational formulae to be used in calculating the capital requirements based on whether a group is using AA or FA. Thus, the applicable formula differs between e.g., an FA bank’s sovereign exposures and an AA bank’s sovereign exposures, or between an FA bank’s equity exposures and the same FA bank’s corporate exposures (Basel Committee, 2005).

2.2. Liquidity Adequacy

Liquidity Adequacy relates to the ability of a bank to meet its obligation on time, especially in relation in repayment of interbank borrowings and customer deposits. Since the survival of a bank depends on the retention of the confidence of its depositors, the maintenance of a reputation for trustworthiness is critical. Thus, banks must actively manage liquidity. Firstly, they hold a stock of readily marketable liquid assets that can be turned into cash quickly in response to unforeseen needs. Secondly, they identify mismatches between potential receipts and payments in future periods. Thirdly, they respond to potential mismatches by borrowing in the market to smooth out cash flows in particular periods. Regulators may attempt to ensure the continued liquidity of banks by, for example, imposing a required minimum liquidity ratio (a ratio of assets of short maturity to total deposit) and/or by setting limits on mismatches or net positions in particular time bands.

The main issue in relation to the quality of a bank’s assets is the ability of its borrowers to service and repay loans. The poor quality of the loans of many banks has been a central element in the problems faced by the Japanese banking system in recent years. The early identification of problem loans is important if remedial action is to succeed. To this end, banks may employ a grading system that classifies loans in a range from trouble-free to non-performing. Some countries require such ratings to be assigned to individual loans in the attempt to evaluate the quality of bank’s assets. Then, default by only one of two borrowers can cause serious difficulties for the bank. The usual regulatory response is to limit exposure to single borrowers to some proportion of the bank’s capital base. Danger can also arise for banks if deposits come from a narrow range of sources, if individual deposits are large and volatile, if income derives from a small number of transactions or activities, or if a high proportion of loans are made against one particular kind of collateral.

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