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Banking Sector Fragility Causes

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Published: Tue, 31 Jul 2018

Discuss factors which have decisively contributed to the fragility of the contemporary banking sectors, as revealed in the form of the recent global financial crisis.

Prepared by:

  • Ivan Gnatiuk 37193
  • Artem Zaiets 36981
  • Mark Pohodin 37141

 

Introduction

Firstly, crisis was originally started in US where it was a result of provided social policy. In particular, government allowed, even insisted, on distribution of house mortgages not only among wealthy part of society but also among poor one(so called NINJAs No Income, No Job, no Assets). Second part of this policy was an allowance on sell of ‘sets’ or securitized bundles of mortgages among banks. Market at that time was at the expansion at that time i.e. expectations were positive and market accepted securitized sets of mortgage loans they spread not only among US but also around the whole world. In detail, banks became holders of risky assets in a large quantity that give good return during the expansion but become sources of risk during recession. Second important factor was an asymmetry in information i.e. banks who sold this bundles known all about their debtors and buyer of ‘ securitized’ bundle has no idea about quality or ability to pay of debtors in this bundle. Thus, mortgage bundles were spread around the world with no information about ability of money return just before market fall i.e. with a change in liquidity to very low as a result of negative expectations and following mistrust of banks with respect to each other. As a result, bundles lost their value because of that fact that opportunity of repayment thus value was very low thus collected debt obligations become a worthless and cold be just deleted form asset list of bank they currently situated. Therefore, many not only American but also European banks, pension founds and even insurance companies suffered of recent financial crisis. Moreover, interdependence in euro area only strengthened an effect.

Firstly, securitization is a methodology where mortgages and loans with a different maturity collected into large sets for further sell on the market. The problem of such a way operation provision is an asymmetry in information i.e. only seller know what percent of credits are trustful and have a large opportunity of repayment in the future. In contrast, now, Federal Reserve has a regulation that require keeping a fraction of loans i.e. not to sell all loans given on the financial market that intense banks to be more careful with their debtors.

Main reason of fall was an unpredicted unification of two factors. These factors were fall of housing market not only in one particular city or area but it spreading among the whole country with further fall of financial markets. This effect was accelerated by interdependence of banking system. For example, complicated structure of interbank loans such as credit-default swaps where in case third party default seller agreed to compensate buyer.

Fall of such a large bank as Lechman Brothers created not only panic among creditors but also mistrust among banks. It was one of the most hitting factors. Banks started to keep a large amount of cash. In such situation banking system become ineffective and only damage economy; collecting cash and decreasing overall liquidity i.e. banks become a cash collectors and only reduce money multiplier.

When money demand is inelastic, increase in money supply does not have an effect on liquidity i.e. monetary policy become ineffective i.e. at some point holding of cash become more profitable than any other investment. Thus, central bank loose quantitative instrument of market control. Banks start to buy ‘safe’ government bounds with aim of protection of their capital and limit their credit distribution to reduce risk of not repayment of credits given.

The volatility of banks

In particular, banks play a very important role in determining the crisis. Problems encountered banks were due to great mistrust by customers. That is, the customer confidence in banks declined and that had a great influence on bank returns and stock prices. Stocks are more risky, which in term increase banks stock volatility.

In finance, volatility refers to the standard deviation of continuously compounded by the return of a financial instrument for a certain period of time horizon. Thus, the return fluctuates over time and, therefore, an important determinant for the price of the shares. This is because the volatility shows the standard deviation of stock returns and depends on the risk of these stocks to hold. As a result, an increase in volatility leads to lower stock prices and vice versa.

According to Choi et al. (1992)xi the interest rate variable is important for the valuation of common stocks of financial institutions because the returns and costs of financial institutions are directly dependent on interest rates. Moreover they mention a model which states that three different shocks affect bank’s profit during a given period namely; interest rate, exchange rate and default shocks. Since these three factors have a great influence on the profits of banks, it has also a great influence on its volatility of stocks. The interest rate directly has a great influence on the volatility. Profits of banks are determined by the interest rate. As mentioned, the revenues banks obtain are the interest payments of customers. The costs are the payments made to the customers. So an increase in the interest rate the banks gain will increase the banks’ profits and thus make those banks’ stocks more attractive. Investors can get more dividends on investment but also can earn money by buying low and selling high. So when a bank is doing well, stocks prices will increase and that results in a saver investment. This causes a decrease in the volatility of those stocks. So an increase in the interest rate, at which banks lend, leads to a decline in the stock volatility and on the contrary. The interest rate at which banks ‘borrow’ has another influence on its stocks. A growth in that interest rate will rise banks costs, and thus decrease the banks’ profits. That 13 make the stocks less attractive and causes a decline in its prices. So the growth of that interest rate causes an increase in banks stock volatility and vice versa. Grammatikos et al. (1986)xii investigated the portfolio returns and risk associated with the aggregate foreign currency position of U.S. banks. They found that banks have imperfectly hedged their overall assert position in individual foreign currencies and exposed themselves to exchange rate risk. This fact suggests that exchange rate risk may importantly affect bank stock returns. Thus, it also affects the volatility. To make business internationally you always need to convert your money. That is why it is especially for banks an important factor. Companies dо business with other corporations internationally via banks. Banks hold the foreign currency which investors and companies have to buy in order to invest or do business internationally. Moreover the exchange rate defines also in which country it is attractive to do investments. For example, when the exchange rate is low for Europeans so that the euro/dollar is low, it is attractive for Europeans to make investments in America. It is advantage for European banks because European investors are now buying dollars from the bank. Since investors have to pay fees for that and banks have more money to lend out, the profits are growing which means that the volatility is decline. So an increase in the exchange rate decreases the volatility. Default shocks are according to Choi et al. the last determinant of the banks profit and thus banks stock volatility. Default occurs when a debtor has not met his or her legal obligations according to the debt contract. This can be that he has not made a scheduled payment, or has violated a loan condition of the debt contract. A default is the failure to pay back a loan. Default may appear if the debtor is either unwilling or unable to pay their debt. This can appear with all debt obligations including bonds, mortgages, loans, and promissory notes. So it is an important factor in the banking industry. When huge amount of customers default, the banks have a high bad debt expense. This leads to an increase in the volatility. Furthermore if the risk of default rises, the interest rate rises as well because banks want to be compensated for this risk. As we have seen, an increase in the interest rate means a decline in volatility. So shocks in default mean shocks in volatility. This can be either up or down. When we take a closer look at the determinants of the volatility of banks stocks, we can see that it all depends on the state of the economy. When the economy is healthy, there are a lot of 14 actions in the markets as well as in the banking market. Corporations are investing a lot and thus are borrowing from banks; the housing market is doing well which means a lot of mortgage loan for banks. Overall there is a huge amount of business for banks which means that banks are doing well and thus stock prices are increasing, which indicates low volatility. On the contrary, during economic crises it is the other way around which we will see in the next part.

Banks volatility in crisis

During economic crises, we have seen that the economy in general is depreciating, during these years banks carry a lot of risk that customers are going to default. That is, the risk of having a lot of bad debt expanses rises. That risk causes fluctuation in the volatility of banks. During the last financial crisis, the housing market collapsed which caused a lot of default on mortgage loan. Because of the rise of default the interest rate is increasing and the currency is becoming cheaper. The three factors that affecting the volatility of banks according to Choi et al. were all affected during the last financial crisis, which caused increase in the volatility of banks. Moreover during banking panics, the volatility also increases. A banking panic means a bank run that appears when a huge number of customers withdraw their deposits because they think that the bank is, or might become, bankrupt. As amount of people who withdraw their deposits increases, the likelihood of default increases, and this leads to further withdrawals. This can destabilize the bank and finally lead to bankruptcy. So the bank carriesuncountable amounts of risk at that time. Because of that risk, investors are not willing to buy stocks of that bank and investors holding the stock already, want to sell their stocks. As a result the price of its stocks will decline and eventually be very low. Therefore the volatility will be very high. To sum it up, we have seen that the major determinants of the banks stock volatility are the interest rate, the exchange rate and the default shocks. More importantly, these three factors are all indicators of the state of the economy. When the economy is doing well, the factors influence the volatility negatively. However during financial crises and banking panics, the volatility will rise. So the volatility of banks’ stocks is affected by the health of the economy, which is indicated by the three factors mentioned.

Globalization, as important crisis factor

In this part we would like to reference such sector of banking as regional instability. Since the beginning of 21st century, the fragility of singular unit of the banking system was determined as a factor that affects only this particular institute. With increased globalization and technological progress, we have faced the new problem, which is a result of our own actions.

Everyone loves traveling, but no-one likes to have big amounts of cash, casually lying in their pockets. This is the reason why we use plastic cards. Little do we think that they are a result of hard work and complicated connections between thousands of institutions. Such companies as Visa and MasterCard are offering us freedom of movement, in some way, and since the 90-th they grant us wide range of possibilities which we would never have in other way. We should state that both Visa and MasterCard, went public just recently before financial crisis, in October and may of 2006. This simply means that they became big enough, that there were a need of external financing, so the companies can expand even faster and bring their services to broader audience.

The process of globalization brings us to the point of time, when there will be no more ways of globalizing without bringing any harm to economy of the world or even humans. Willing to expand, “systems” will fight over for the customer. Thus is when we meet the term that was implemented just recently – “reverse globalization”

In the face of great economic risks, a lot of countries have started to implement the policy of protectionism. For example, in 2013, more than 2000 trade restrictions had been implemented by different governments, including United States and China. Another problem is that most companies which have their manufacturing powers abroad, mainly in china, report that their departments there are getting even more profitable. So we see the creation of the link between such countries. If one of them will be affected by the stroke, other one is going to feel the result as well. Banks are also taking part in such policy, or at least they used to. Since 1995 we can observe the steady trend to an increase in number of the foreign banks, from 780 to more then 1300, in 2007. The amount of new foreign banks, entering the market in OECD countries, peaked in 2007 at 132 in a year.

The financial crisis dramatically reduced the number banks, up to the point when for the first time, since 1995, net exit of banks appeared to be bigger than net entrance. With the peak number being 1350, in 2009, it has been reduced to 1272 in 2013. Though this impact was intense, we can see even more radical change in the number of domestic banks. Here the number of facilities fell from 2704 to 2384, in 2007 and 2013 respectively, increasing market share of foreign banks up to 35%, from around 33% previously.

The most interesting effect crisis had on banks of emerging and developing countries. Firstly, the amount of banks there didn`t decrease, but rose by 30. Also significant amount of banks that have been opened in European countries, had an actual headquarters in developing country. So, in regards to regional economy, European banks had the greatest reduction, as 29 foreign banks left the market. Nevertheless, we had an increase of such in Sub-Saharah Africa, where it peaked on the mark of additional 31 bank. The trend of developed countries being in lead, by an annual net entry, had been changed, when emerging and developing countries took this spot, even though developed countries are still shoving positive rates in all years after, except 2013.

Concluding this point, we can assume that increasing amount of banks is not useful for overall health of world economy. Also such actions on the behalf of new banks can create issues for regional economies, as they tend to accumulate resources from citizens and not being effective as allocating institute.

Such point leads us to the point that banks, as institutes which are supposed to be an effective tool for cash flows allocation, can be harmful for small regional economics. They create risks of collapsing and creating systematical problems, through connections between small banks and systems of such institutions. Finalizing all the information above, we would like to mention that banks, as fiscal institutions, are a source of great possibilities, but they may create bigger problems. Analyzing such data we see that market economy is self-efficient in some respect. It naturally clears itself during each crisis peaks. The problem is that banks link different economies, some of which are better and some are not that healthy. That just means that some links must be destroyed and thus operations of such banks are not necessary. In future risks of crisis fluctuations will be higher, as there will be even more banks to create harder connections, and thus world economy will suffer from those “small depressions” even harder with each next starting its action.

Conclusion

To sum it all up, from our research we have seen that crisis of 2007-2008 show us the fragility’s of banking system and the factors, which have decisively contributed to the fragility of banking sectors. We saw that some strengths of banking system in light of global financial crisis become fragilities. Banks volatility increased over the time period of a crisis especially during the last financial crisis. We can say that the volatility of banks increased during the financial crisis of 2008 and that the main driver is the GDP growth rate and that the less important drivers are the interest rate the exchange rate. In addition, we can say that increasing amount of banks is not useful for overall health of world economy. Also such actions on the behalf of new banks can create issues for regional economies.

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