Regulatory Modifications to the Banking System

5709 words (23 pages) Essay

8th Feb 2020 Banking Reference this

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Introduction

The economic downturn began in the year 2007, which was embarked with the economic crisis in the primal markets of the security interest and mortgage in the United States (US). The crisis progressively evolved into a global crisis in regard to the banking institutions during the downfall of Lehman Brothers investment in September 2008. Further, the European regions faced a debt crisis in relation to Euro currency. This crisis was further worsened by shadow banking. Shadow banking refers to the intermediary financial institutions that are identical to the traditional commercial banks in terms of normal banking operations. However, they do not follow the regulations and legal set of guidelines followed by the normal traditional banking institutions (Claessens, Ratnovski and Singh, 2012).

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Shadow banking is regarded to be highly responsible for the global recession of the year 2008. Factors like bank runs in the shadow banking were also significant for contributing towards the financial crisis. High leveraged shadow banks encountered the loss spiral effect. These shadow banks comprised of illiquid assets, which were required to be deleveraged in an emphatic manner due to high marginal demands and degrading prices of the assets. The forced deleverages increased the minimal needs and downgrading of asset valuations resulted in raised economical downturns (Holmstrom. 2015).

 Another element termed as the Securitisation also holds a significant place in the era of global financial crisis. Securitisation involves the transmission of a credit risk against intermediation, which is well-secured. It has resulted in the increment of the share prices. Increase in the systematic risk is carried out by the commercial banks in order to reduce the risks on the individualised levels (Valckx et al., 2014). However, the process of securitisation involved substantial levels of complexity that limited the ability of the visitors for risk monitoring. Competitive market offering securitised lending through more than one securitiser has resulted in the downgrading of the banking standards. The crisis of the US sub-prime payable entities was highly affected by the securitised lending (Gorton and Metrick, 2012).

In this regard, the primal focus of this essay is to identify the role and impact of the shadow banking and securitised lending in the global economic crisis of the year 2008.

 The essay also delivers a critical evaluation of the contemporary bank system and the regulatory modifications being incorporated in the bank organisations. The alterations in the legislation post to the financial crisis of 2008 are also analysed in the essay. Further, the essay also provides an analytical discussion over the modern banking system, identifying its strengths and weak areas.Thus, the thesis statement is outlined as, “Whether changes in the modern banking system are supportive to avoid the financial crisis in contemporary banking or not?

Securitised Lending and Shadow Banking in regard to 2008 Financial Crisis

 The system of shadow banking had been rapidly thriving for a certain time period before the occurrence of the year 2008’s financial crisis. However, the financial crisis has become the key aspect because of which more attention has been gained by shadow banking and the more critical investigation was performed for evaluating it (Claessens, Ratnovski and Singh, 2012; Wallison, 2016). The particular aspect concerned with shadow banking which gained significant attention of the involved authorities, has been determined as the credit inter-mediation system involving activities as well as entities outer-side of the system of regular banking because it generated systematic concerns of risk specifically through transformation of liquidity/maturity, flawed and leverage transfer of credit risk as well as concerns for regulatory arbitrage. As the shadow banking led to generate unregulated activities and entities related to the off-balance sheet, this aspect has been proved as a fundamental reason for the financial crises of the year 2008 (BankenVerband, 2014; Nesvetailova,  2017). In addition, it is also revealed that extremely leveraged system of shadow banking with some illiquid possessions or assets hugely experienced the loss spiral consequences due to which they had been enforced for being deleveraged because of needs of higher margin as well as the downfall of costs of assets. Such type of deleveraging inflated the needs of margin as well as minimised the valuations of the asset, thereby, delivering the consequent phase of the spiral of loss. Further, it is argued that shadow banking has posed risks to the entire banking scenario through its non-transparent type nature as well as the unregulated virtue of it (Valckx et al., 2014; Nesvetailova, 2017).

 However, on the different side, it has also been perceived that the institutions of shadow banking did not experience the similar type and level of unpredictable risks as opposed to the regular banks due to the aspect that shadow banks used not to yield or take deposits. The financial crisis occurred in the year 2008, nevertheless, has given the proof of exactly opposite aspect of this belief. In this regard, for addressing the faults as well as preventing the future financial crisis, European Union as well as the United States being the regulatory authorities, have developed shadow banking’s new regulatory framework and are also trying to make constant modifications so as it improve it. At the time of crises, as the appropriate regulation was absent, there were crucial concerns regarding lack of liquidity level’s needs as well as the systematic form of lending as well as investing in the banks (Claessens, Ratnovski and Singh, 2012; Wallison, 2016).

 Moreover, a formal safety in the inter-connective network of the banking organisations was highly reduced by shadow banking. Under the concept of shadow banking, the banking operations such as the credit intermediation were carried out by the financial intermediaries. These operations were different from the legislative framework defined for the legalised banking organisations. A rise in the number of shadow banking was identified in the advancing and emerging economies of the globe (Claessens, Ratnovski and Singh, 2012).

 The narrowly defined measures in the shadow banking have resulted in the stagnation of the economy. Different to it, the broadly defined measures that comprise of the investment funds result in a continued economic growth. The extensive presence of the shadow banking organisations is identified in the emerging economies. In the emerging markets, shadow banks have outcasted the traditional system of banking (Holmstrom. 2015).

 On the different side, it is also identified that the growth of the shadow banking can be identified as advantageous and complementary to the traditional system of banking. The shadow banking institutions have assisted in increasing the approachability towards the credit. It is also crucial for enhancing the support towards market liquidity, transforming the maturity and the sharing of different types of risks. The shadow banking practices in the year 2007-2008 in the US are highly constitutive towards systematic domestic risks. However, the role of the shadow banking towards global recession is not observed in the countries like the United Kingdom and currencies like Euro (Valckx et al., 2014).

     Another key reason for the year 2008’s financial crisis was securitisation. This aspect of securitisation leading crisis has initiated from US market of real estate. However, without any delay, it spread across the globe. It was perceived that assets’ securitisation opened up funding’s new source potentially for the banking sector as well as credit risks on the part of investors. The new phase with the adoption of securitisation led the increment of subprime loans in the banking sector. Such types of loans rely potentially on some security interests; however they have been known as subprime as the loan cannot be guaranteed (Aalbers, 2016; Sornette,  2017). Further, few of the mortgages or security interests had initial rate discounts. Post to the period of discount, most of the recipients or borrowers got defaulted as they were not able to make the loan payment with huge rates of interest. As a consequence, many of the borrowers required to sell out the houses of them. Further, the result was that the costs have fallen down as well as the aspect of bubble raised. Thus, the cause for bubble creation in the housing market of US has been low rates of interest, house ownership’s government policy as well as lending standards’ relaxation (Aalbers, 2016; Sornette,  2017).

  The aspect of securitisation referred the formation as well as insurance of securities of debt whose interest and principal payments potentially generate from specific cash flows derived through assets’ individual or separate pools. Asset-Backed Securitisation (ABS)’s issuer can receive the advantages or profits through the sale of illiquid type assets. It refers that potential issuer needs to convert the cash flows of future into certain situations categorised into levels, potentially with the varied risk of investment. Moreover, the issuers’ portfolio is often diversified as well as all the assets have the distinct type of quality and maturity. Such tranches are considered to be negotiable. The payments are received by ABS investors from the potential issuer that relies on principal payment rate and interest rate.  In practice, it refers that in case the borrower or receiver stop making payment of the liabilities of them, the failure of ABS takes place as well as no extra payment would be received by the investors (Ivashina and Scharfstein, 2010; Beltran, Cordell and Thomas, 2017).

     On the different side, it has been revealed that securitised lending led to the huge increment in mortgage type of credit. For the borrowers, varied loans have been made and these borrowers previously experienced complexities potentially in obtaining security interest or mortgages because of less than average scores of credit. It has been observed that private lenders earned huge amount of money through selling as well as pooling subprime mortgages. However, foreclosure-related risks got increased with credit standards’ relaxation. Although, private mortgage-backed securities facilitated huge amount of required money potentially for mortgages (Gorton and Metrick, 2012; Hanson, 2015; Aalbers, 2016). However, such mortgages received from these private labelled lenders, possessed considerable risk as there was no back up of them from the side of government. It has further been identified that few of the borrowers tried to make short sales particularly for the potential underwater security interests or mortgages of them. However, usually, they found it complex to deal or work with the lenders. Ultimately, it is visualised that securitisation played a crucial role in the crisis of subprime mortgage which is one of the important portion of financial crisis 2008 (Hanson, 2015; Aalbers, 2016).               Revision in the proposal of the security and exchange oriented legislations of the US allowed the securitisation sponsors with an extensive number of applicable choices for properly meeting the needs of risk retention. Under the allowances of sponsors, it is clearly described that about 5% of the credit risk will be retained by them. Therefore, it can be clearly understood that the requirements of the risk retention are directly imposed on sponsors (BankenVerband, 2014).

 The securitisation is recognised as a contributive element towards progressing and enhancing the global financial crisis. The reason behind this is that securitisation disturbs the association between the originator of the loan and risks associated with the loans. Although the securitisation of the assets is regarded as a prominent tool for the recent economies, it has further degraded the economies by financially isolating and securitising the particular assets from the originator. The securitised originator is also capable enough for properly funding the banking operations at a low and effectual rate of interest in comparison to the traditional methods of financing (Senarath, 2017).

 Different from the above, on the basis of the theoretical constructs, securitisation should be capable enough for improving the effectiveness of the capital markets. Capital markets can be flourished by means of the tiering and diversification that is carried out on a geographic basis (Solomon, 2012; Peicuti, 2014).

 On the other hand, the securitisation is also identified to reduce the costs associated with the economic transaction. It also contributes towards reducing the rigidity of the business operations. Securitisation is also capable enough of transferring the risks associated with the banking industry to the investors who have originated from the external locations. Therefore, the financial risks are scattered across the economy. This has allowed the bank institutions to reduce the regulative requirement of the capital (Acharya, Schnabl and Suarez, 2013).

  The long-term adverse implications of the financial crisis compelled regulatory authorities to come up with new solutions capable of preventing reoccurrence of crisis. In this relation, there are a lot of debates concerning the best regulatory regime protecting the financial and banking system from another resembling crash. A substantial attention is given to clearinghouses responsible for settling the trading account, collecting and administering margins, clearing trades, regulating delivery and facilitating trading data. They play the role of third parties in all the options and futures contracts as a buyer or purchaser to all the clearing member seller and also the part of the seller for every clearing buyer (Saunders and Allen, 2010).

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  As per the newly formulated regulations, the risk management houses are required to assure that a trade is accomplished in the situation of a counterparty default and are also expected to take an innovative business over the counter derivatives market. However, a considerable concern in this regard is clearinghouses is that these are too huge to fail as all the transactions involving standardised products are executed through clearing houses. In case a clearinghouse fails then in such a situation all the intermediaries working through clearing houses or along with clearinghouse could be devastating.  In the year 2014, the Financial Stability Board, a group of central bankers and regulators established a sector-specific guidance for the purpose of preventing and tackling crises concerning non-banks as an extensively important norm (Claessens and Kodres, 2014). This will permit regulators to unravel institutions by terminating contracts and writing down creditors on trading platforms. The key idea is to determine a way of dealing with the big firms to prevent the financial system for any form of taxpayer bailouts, which occurred in 2008.

  The latest rules are to be abided by the insurers and clearing houses came into effect from 2017. However, the development of accurate regulations is a cumbersome and difficult task as if rules are excessively right, and it will slow down the process of economic growth.  If the banking institutions increase the sale of their products, the profits will rise, and thus the chance of bankruptcy is going to fall; however, this might be conflicting with stringent regulations. Another crucial issue that emerges is that the innovative nature of regulations cannot be obstructed as bankers keep on adding new dimensions for upgrading and refining existing regulations.

  The Dodd-Frank Act provided measures that required fair consensus including the necessity of stimulated capital requirements for the prominent banks. Moreover, the regulatory reform program was implemented even before the end of the crisis. This program significantly helped in strengthening the liquidity, risk management and capital positions of the leading banks. The prime goal of the newly enforced regulations included an assurance that the large financial institutions are sufficiently robust for maintaining effective functioning as intermediaries, leading to creditworthy and securitised businesses even in the event of economic and financial stress (Tarullo, 2016). Another vital goal is to deal with the issue of too-big-to-fail which denotes that when a certain combination of the portfolios, functions, size and interconnectedness of any financial institution are having the potential to create fear for authorities in terms of endangering the whole financial system. In such scenario, authorities are required to rescue the firm via direct capital injections and adoption of requisite indirect measures for strengthening its solvency. Moreover, other dominant actors in the market will also be willing to lend to such institutions at any premium less than the actual risks suggesting its warranty, an impact that is specifically evident during stress periods (Tarullo, 2016).

 As per the newly incorporated regulations, banks have reconstructed their balances sheets as a response to the financial crisis are significantly safer. Banks have started holding capital, three times more than they held at the time of financial crisis. After full implementation of Basel III, by 2019 they will be highly robust. The implementation is vitally ahead in the UK, and accordingly, the UK-based banks have occupied a leading position in the world. The banks functioning in the UK are significantly prepared for any uncertain crisis in future as now they are required to maintain sufficient liquidity for being able to continue uninterrupted functions during the time when actual funding deteriorates, which some of them witnessed during the year 2007 (BBA, 2014). The banks have already rearranged their balance sheets for reducing exposure to more risky trading assets, and the entire sector is determined to make sure that taxpayer’s money is not be used again for bailing out banks.

 The new Financial Services Compensation Scheme requiring £85,000 of the total deposit of every customer to be kept 100% protected is also a beneficial provision as against £2,000 against 2007. This particular scheme funded by banks safeguards approximately 98% of the total customer base which is a strength of the modern banking system and holds potent to reduce such risky incidences in near future.  Moreover, the new reforms ban financial advisors from accepting any commission in lieu of retail investment products they suggest to customers. This indicates that advisors will propose what is best for their customers instead of the product entitling them with the significant commission (BBA, 2014).

  Another strength of the new banking system is the continual supervision by the Prudential Regulation Authority (PRA) and the Financial Policy Committee (FPC) of the Bank of England for monitoring the risks in the whole financial system. This suggests that macroeconomic supervision is effectively integrated with the micro-prudential monitoring, evoking the financial system’s stability. Additionally, the modern mechanism for banking regulation makes the Financial Conduct Authority (FCA) responsible for governing the conduct of bankers and banks which is again contributory in avoiding any risk business transaction. Now FCA requires entities to consider their customers’ well-being as the central aspect of their business administration thereby promoting efficacious competition and assure market operations with integrity. The contemporary banking provisions require new European supervisory authorities including the European Securities and Markets Authority (ESMA) and European Banking Authority (EBA) trigger the banks’ supervision in Europe (Garicano and Lastra, 2010).

 Global economic downfall resulted in the restructuring of financial regulations and global finances. International Monetary Fund and other financial institutions promoted reforms in the financial sector in order to ensure adequate supervision and proper monitoring of financial operations for stabilising the system and avoiding crisis situations. In the light of the financial crisis, the modern banking sector focused on regulating pertinent factors influencing economic stability; wherein central banks have taken particular initiatives to closely monitor the financial operations with the focus on aspects of shadow banking and lending (Eichengreen et al., 2012; Jordà,  Schularick, and Taylor, 2011). Modern banking system focuses on two prime aspects of establishing a lucrative and healthy financial system along with promoting price stability. It is evident that the financial systems’ soundness is an essential pre-requisite for effective monetary policy and favourable economic developments.  Central banks in the contemporary banking system are directing their attention towards strengthening the efficacy of the overall system via taking into account the risk factors causing financial instability and the macroeconomic factors  (Eichengreen et al., 2012). It is emphasised that close collaboration of financial supervisory agencies and central banks is a cornerstone of fostering secure and profitable financial operations and promoting a robust foundation.

  The United States (US) monetary policies, inadequacies concerning government intervention into financial transactions, systematic risk, flawed corporate governance and flawed individual incentives are some of the weaknesses of the banking sector that aggravated the financial crisis. Hence, specific regulatory and structural changes are introduced to alleviate the risk factors causing financial instability. In this relation, stringent risk-weighted requirements, introducing new guidelines for globally systematically important banks (G-SIBs) and regulations concerning liquidity risk facilitated are some of the major areas of change in banking structure post-financial crisis 2008 (Dabrowski, 2010). Specific attention is paid towards assisting in maintaining a stable structure and fostering resilience of liquidity profiles.  Further, the modern banking system includes a framework and a set of guidelines for resolution and recovery of financial institutions (Reinhart and Rogoff, 2013).

 Several national initiatives are complemented via international regulatory changes; wherein new rules for International Holding Company in the US and restrictions on proprietary landing notable structural changes in the US. Further, macro-prudential policy and the ring-fencing provision for trading books are some of the prominent measures undertaken within the UK. Moreover, it is mentioned that the crisis revealed weak areas of the prudential framework and the banking system that resulted in excessive lending, low focus on securitised lending and risk-taking practices unsupported via liquidity buffers and adequate capital (Borio, 2014). Substantial pre-crisis growth led to the issue of legacy assets that further disrupted the credit allocation activities in various nations. Therefore, a robust banking sector is resumed post-crisis with substantial changes for bringing the balance via keeping bank credit growth low and adjusting risk profiles (Borio, 2014).

  Longer term profitability issues in the modern banking system require the attention of supervisors, central authorities and the banking sector as they indicate the aspects of overcapacity and risk-taking initiatives. Low profitability signifies cyclical factors, but it also reflects resilient balance sheets and higher capitalisation. However, low credit growth and restriction on lending may deprive the banking institutions and the overall market from the crucial sources of credit or fresh capital (Baklanova, Copeland and McCaughrin, 2015).

  With a focus on the stronger banking supervision and building a safe financial system, a robust financial system can be developed across the globe. In this context, the modern banking system requires incorporating specific provisions for resilience and intermediation activities for further generating profits and acquiring capital via retained earnings. It is necessary to access external capital via equity markets as an examination of contemporary banking practices suggest that low equity market create profitability concern among banks. It has been evaluated from consideration to the patterns of bank lending that lending activities were highly uneven in several countries (Borio, 2014). High non-performing loans (NPLs) indicate poor financial structure and ineffective regulations as some of the countries significantly struggled to recover from the crisis while banking systems in the advanced economy continued showing solid loan growth that represents tighter regulations (Baklanova, Copeland and McCaughrin, 2015).

  It has been mentioned that adequate capital is required in the banking sector for dealing with the unanticipated shocks and volatile market conditions for maintaining sufficient buffers. The modern banking system requires consistency in risk management and surveillance for establishing a health and secure financial environment and reducing vulnerabilities concerning excessive counterpart risks, repo transactions and high-risk assets (Jordà, Schularick and Taylor, 2011).

Summary

  It is inferred from the assessment of the role of securitised lending and shadow banking in the global economic downturn 2008 that excessive lending and inadequacies prevailing in the financial structure caused credit crisis. It is summarised from the analysis that unregulated financial transactions and off-balance sheet activities were the prominent reasons for the global economic downfall of 2008. Further, it is deduced that shadow banking posed substantial risks to the banking sector via its unregulated virtue and non-transparent nature of transactions. The absence of regulations created liquidity issues that further intensified the crisis situations, and the frantic approach of lending also increased risk factors, thereby worsening the scenario in the global financial system.

  It is deduced in regard to assets’ securitisation introduced new sources of funding to the financial sector while posing credit risks for the investors that further resulted in the increased degree of subprime loans. Moreover, it is identified that securitisation played a prime role in creating crisis situations relating to the subprime mortgage in 2008. Hence, the long-term negative impacts of the economic downfall brought significant structural and regulatory changes in the banking sector so that risk factors can be minimised and re-occurrence of crisis can be prevented. The modern banking system emphasises on close supervision and monitoring of financial activities under the Financial Policy Committee and the Prudential Regulation for protecting the economy from the crisis situations. Hence, it is concluded that the macroeconomic supervision is properly integrated with the micro-prudential regulations for evoking economic stability. However, there is a need to increase surveillance for ensuring proper implementation of the structural and regulatory changes in the banking system. Thus, the thesis statement can be restated as, “Changes in the modern banking system are supportive to avoid the financial crisis in the contemporary banking, but there is a need for effective supervision and strict implementation of regulatory requirements.”

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