Banking, Financial System and Regulation Lecture

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Banks play a key role as an intermediary in the financial system as they allow individuals to safely deposit their savings, provide loans to both individuals and organisations, and they are responsible for the payments system. This particular module discusses the role and function of the main financial institutions, including: Commercial Banks, Investment Banks, Insurance Companies, Management Investment Companies and Financial Brokerages. The module discusses the role of the Central Bank and monetary policy.

This module also explores the different risks that are present in the financial markets, including: interest rate risk, liquidity risk, credit risk, operational risk, systematic or market risk, sovereign risk and capital adequacy. Lastly, the module discusses the need for Banking regulation and the Basel requirements (i, ii and iii).

The learning outcomes of the module are:

To understand the role financial institutions play in the economy
To understand the role of the central bank and monetary policy
To understand the different risks that are present in the financial market
To gain an understanding of Banking regulation and the Basel requirements

Main Financial Institutions

Commercial Banks

Commercial banks typically provide a ‘full’ range of services via an extensive branch network (Fight, 2004). Some of the main activities of a commercial bank are taking deposits, making commercial and personal loans, mortgage financing, trade finance, foreign exchange and asset financing. Another important role of commercial banks is to act as payment agents within a country and between nations.

A large part of funding of commercial banks is raised from the public in the form of retail deposits (Fight, 2004), which means that stability in their operations is of paramount importance to both government and depositors. As a consequence, commercial banks are regulated heavily.

Investment Banks

An investment bank is a financial intermediary that performs services for businesses and governments. The range of services offered by an investment bank is considerably small than that offered by commercial banks. There are four main activity areas of an investment bank - asset management, broking, investment banking or corporate finance, and trading. Investment banks manage assets of retail and wholesale investors for fees, which is typically based on volume of assets under management. Investment banks help sellers and buyers of assets, such as stocks and bonds, in completing transactions. Investment banking or corporate finance includes underwriting of shares issued by a company raising funds through a public offering, advisory work, and mergers and acquisitions. Investment banks use their proprietary knowledge and systems to trade in various asset classes. Trading function of investment banks has grown in importance with increase in their resources (Fight, 2004).

Investment banks raise deposits via wholesale deposits for periods varying from one day to a year or more (Fight, 2004). Investment banks are generally less regulated than commercial banks.

Insurance Companies

The main role of an insurance company is to help individuals and organisations manage risk and preserve wealth. Insurance companies collect risk-insurance premiums from individuals and organisations who want to protect themselves against losses, such as fire, floods, illness, accident or death. By insuring a large number of people and companies, insurance companies are able to pay out claims and also aim to generate profits for owners of insurance firms. This is based on the assumption that not all insurance owners will seek claim at the same time.

Management Investment Companies

Management investment companies manage a portfolio of securities on behalf of their investors to achieve their investment objectives. These companies allow their investors to indirectly invest in a large number of companies, and thus benefit from diversification. The two categories of management investment companies are closed-end and open-end.

A closed-end investment company raises money by issuing shares in a one-time public offering. After the public offer, investors can purchase and sell shares of a closed-end investment company on a stock exchange.

An open-end investment company, also known as mutual fund, can continuously issue shares. Investors can purchase and sell shares to an open-end investment company at their net asset value.

Financial Brokerages

The role of a brokerage firm is to act as an intermediary between buyers and sellers of financial securities. A brokerage firm earns revenue by charging commission to buyers and/or sellers. A brokerage firm can be either full service or discount. A full service brokerage firm provides investment advice in addition to brokerage. A discount brokerage firm provides trade execution services only, which allows it to charge lower fees than a full service brokerage firm.

Central Banks - Role and Monetary Policy

Central Bank

“A central bank is a public institution that manages the currency of a country or group of countries and controls the money supply” (ECB, 2016, p. 1). The Bank of England is the central bank of the UK. The European Central Bank is the central bank of member countries in the European Monetary Union.

Roles of the Central Bank

The two important functions of a central bank are monetary stability and financial stability (Mayes and Wood, 2010). The mission of the Bank of England is “to promote the good of the people of the UK by maintaining monetary and financial stability” (BoE, 2016, p. 1). Central banks have gained more autonomy which gives them more independence to them in achieving their objectives without any political intervention.

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Monetary stability

The monetary stability is described as “a low rate of change, invariably zero or above, of some specified measure of the price level” (Mayes and Wood, 2010, p. 147). The key aspect of monetary policy is to limit price increases to small percentages only. The objective of the monetary stability of the Bank of England is to set interest rates with the goal of reaching the 2% inflation target (BoE, 2016).

The monetary stability is achieved with help of monetary policy which is the policy adopted by a central bank or a government to control the supply and cost of money to achieve certain objectives. Monetary policies impact both the demand side and the supply side. The demand side is impacted by causing changes in consumers’ behaviour, and the supply side is influenced by changing abilities of companies to invest.

Many tools are used by central banks to implement monetary policies. For instance, the Reserve Bank of India uses open market operations, interest rate changes, cash held as reserve by banks, and credit control policy to implement monetary policy in the country (Economic Times, 2014).

Interest rate policy

The most important tool is the interest rate policy. Increasing interest rate can negatively impact economic growth by reducing demand for investment and personal expenditure, and vice-versa. However, not all central banks use the interest rate policy as their main tool for signalling their monetary policy position (Ho, 2010).

Exchange rate market intervention

Central banks also use exchange rate policy as part of their monetary policy to influence exchange rate to reduce short-term volatility in the exchange rate, and to bring an exchange rate back onto its fundamental value (Aziz, 2013). Central bank of Hong Kong manages the spot exchange rate as an anchor for its monetary policy (Ho, 2010). The large size of foreign exchange market of large countries implies that direct intervention by central banks of those countries would need enormous resources to make a significant impact on exchange rate. Central banks in large countries use verbal intervention to influence exchange rates (Fratzscher, 2006). The Reserve Bank of India (RBI) takes market actions to avoid excessive volatilities in the exchange rate to maintain stable macroeconomic conditions in India (Patnaik and Shah, 2009). However, academic research finds limited support of the impact of central banks’ intervention exchange rates (Broto, 2013). The impact is likely to be less in countries with higher degree of capital account openness (Adler and Tovar, 2011).

The impacts of monetary policy on macroeconomic parameters are mostly indirect (Bernanke and Kuttner, 2005). A central bank can increase money supply through a reduction in bank reserve ratio which allows bank to increase lending, and thus increase money supply in a country. In an IS-LM curve, an increase in money supply will shift the LM curve to the right as it increases liquidity. The direct impacts of monetary policy are observed on prices of assets through the “wealth effect”. Increase in money supply increases expectation of investors about higher earnings because of more spending power in an economy, and thus results in an increase in share prices of companies.

Financial stability

Financial stability is described “as a state of affairs in which financial instability is unlikely to occur” (Mayes and Wood, 2010, p. 149). Financial stability role of a central bank means that it has the responsibility of ensuring the system runs smoothly and that people can trust financial institutions (BoE, 2016).

The key roles of a central bank are listed below:

Central banks’ role as ‘bank of issue’ means that they are responsible for managing the supply of money and credit. This is because only a central bank can issue banknotes in a country.
Banks can fail through loss of capital or loss of liquidity (Mayes and Wood, 2010). The global financial crisis in 2008 caused a sharp reduction in liquidity for banks, thereby causing central banks to step into their role of the lender of last resort. The Bank of England acts as market maker of last resort at times of financial stress (BoE, 2016). The Bank of England may buy and sell assets to ensure that there is enough liquidity in the financial markets.
Central banks manage the payment systems in a country.

Risks

Risks are uncertainties that can cause adverse variations of profitability or in losses and thus risk management is important to ensure wealth preservation or growth. Financial institutions face risks from a number of sources, which are described and discussed below, along with some of the instruments that can be used to manage those risks.

Interest rate risk

Interest rate risk arises from a change in interest rates, and impacts net asset values due to the mismatch between the interest rate profiles of assets and liabilities. A gap analysis, which is the difference between interest rate sensitive assets and liabilities for a given time interval, can be used to evaluate the exposure of its assets and liabilities to changes in interest rate. The gap is positive if rate sensitive assets are more than rate sensitive liabilities.

A business can use internal and/or external hedging to manage interest rate risk. Internal hedging techniques include duration-matching, which involves matching the maturity of assets and liabilities to minimise the interest rate risk. A positive duration gap means that maturity of assets is longer than liabilities, and thus an increase in interest rate will lower the net asset value, since asset values have an inverse relationship with interest rates. The longer terms of loans make it difficult to reduce duration gap for banks. External interest rate hedging instruments are futures, forwards, swap and options, which can be used to convert variable interest rate liabilities into fixed interest rate liabilities and thus, reduce their interest rate risk.

Liquidity risk

Liquidity risk is the inability of a company to fulfil its payment obligations as they arise, and therefore relates to difficulty in matching cash inflows and cash outflows. For banks and lending financial institutions, liquidity risk arises because of the mismatch between the terms of deposits and loans. “Banks typically provide longer-term (illiquid) customer loans by borrowing the funds via sequences of short-term (liquid) loans” (Getter, 2015, p. 3). A bank may face liquidity risk if more than expected depositors ask for their deposits to be returned.

Credit risk

Credit risk is the risk arising from an unexpected deterioration in the credit quality of the counterparty. Lenders face credit risk when borrowers may not repay the entire principal and interest owed (Getter, 2015). Financial instruments, such as credit default swaps and credit default obligations, are often used to manage credit risk.

Operational risk

It is the direct or indirect loss resulting from inadequate internal processes and unknowable actions by employees or from external events. Operational risk can be high as seen in the loss suffered by the Societe Generale Bank due to a rogue trader in 2008 (Clark and Jolly, 2008). Operational risks can be minimised by proactive and regular testing of internal systems.

Systematic or market risk

Systematic risk is the risk inherent to an entire market segment from a source or sources (Fraixas et al.,2000). An example of systematic risk is interest rate risk because a substantial and unexpected change, especially an increase, will impact the entire market (Chatterjee et al., 2003). Other examples of market risk are currency risk and commodity risk.

Sovereign risk

“Sovereign risk refers to the risk that a host government or sovereign power will default on its payment obligations by unilaterally repudiating its foreign obligations or preventing local firms from honouring their foreign obligations” (Wang, 2009: 389). Sovereign risk is similar to credit risk, but the entity in a sovereign risk is a government. Sovereign risk is higher in case of emerging economies because of their relatively weak financial position. Sovereign risk of a country is analysed with the help of macroeconomic, political and social factors. Credit rating agencies have developed their sovereign rating systems to help investors make decisions about sovereign risks.

Capital adequacy

The stability of the lending and financial trading institutions is vital for economic growth. The credit risk and risk from operations mean that banks should have sufficient capital in order to avoid bankruptcy, as high interactions among banks could turn a single bankruptcy into a systematic risk. National regulators have established capital adequacy norms for banks to ensure that they maintain a minimum amount of capital for the size and type of their assets. Minimum capital requirements work as a buffer in case of losses to prevent a bank from going bankrupt.

Moral hazard, corporate governance and Banking Regulation

Moral Hazard

The ‘moral hazard hypothesis’ created by the too-big-to-fail culture increases greed and it encourages the management of a large financial institution to take higher risks during economic upturns with a hope to generate high returns and therefore, earn higher bonuses (Fisher, 2010). Banking firms rewarded employees on the basis of up-front fees generated which encouraged risk taking take without taking into account the long-term consequences of fee generation methods (Wignall et al., 2008). This incentivised employees to maintain or increase risk through trades that make steady income over years but do have a potential to make very high losses periodically (Taleb, 2009).

Failure of corporate governance

Solomon (2007, p. 13) defines corporate governance as the “process of supervision and control intended to ensure that the company’s management acts in accordance with the interests of shareholders”. The banking crisis in 2008 was a result of the failure of corporate governance systems as they failed to safeguard against excessive risk taking activities by many financial institutions (Kirkpatrick, 2009). Extensive academic and business research has resulted in well-documented corporate governance principles in major economies, but the banking crisis in 2008 showed that many institutions may not have followed corporate governance in spirit as their managements took on excessive leverage to increase earnings, which was also driven by their motivation to increase personal income without fully taking into account the consequences of losses on shareholders.

Banking Regulation and Requirements

Importance of Banking

Banks play an important and vital role in an economy because of their function as financial intermediaries in arranging finance for companies and individuals, thereby implying that the failure of a large bank can cause massive issues for an economy. Businesses depend upon external capital, and commercial banks are the main source of lending to companies. Stability of the banking sector is important for output growth in a country.

Need for banking regulation

The high importance of banks for an economy means that its stability should be maintained either by proactive steps by banks and/or through regulations. The failure of many banks suggests that self-designed control measures have not performed as expected in preventing banks from taking on high risks, and therefore banking regulations are required.

Basel accords

Basel I

Capital acts as a cushion against financial losses and shocks, which if not provided for may lead to insolvency of a bank. The criticality of maintaining adequate capital in the banking system for the stability of an economy resulted in the Basel Committee on Banking Supervision (BCBS) creating the first Basel Capital Accord, Basel I (Getter, 2015). Basel I framework was designed to promote safety standards while “providing an equitable basis of competition for banking institutions in participating countries” (Getter, 2015, p. 4). Without an agreement on capital requirement, banks may be tempted to increase loans-to-capital ratio to earn higher profits, which is dangerous since it also increases the bankruptcy risk if economic conditions worsen and borrowers are unable to repay loans.

Basel I was published in 1988, and defined two types of capital in a bank:

“A Tier 1 capital component made up of mainly common shareholders’ equity (issued and fully paid), disclosed reserves, most retained earnings, and perpetual non-cumulative preferred stock” (Getter, 2015, p. 4).
“A Tier 2 capital component, which includes allowances for loan and lease losses, set aside for anticipated loan losses” (Getter, 2015, p. 4). The allowances for loan and lease losses were included in capital only up to 1.25% of risk-weighted assets of a bank.

Basel I prescribed that banks maintain a minimum capital risk adjusted ratio (CRAR) of 8% of the risk weighted assets (Banerjee, 2012). The CRAR of the UK banks increased after the implementation of Basel I (Jablecki, 2009), which suggests that norms reduced risk in the banking sector.

The main problem with Basel I was in the asset risk weighting system which allowed banks to increase lending-to-capital ratios by reducing risks of their assets. Assigning lower risks to some asset classes helped banks reduce the size of risk-weighted asset, thereby allowing them to increase lending.

Basel I also changed the asset holding pattern in banks in some countries. The implementation of Basel I in Brazil saw banks reducing credit and increasing purchase of government bonds because of their low risk weight (Gottschalk and Sodre, 2005).

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Basel II

Basel II accords were designed to allow banks and financial institutions more flexibility in estimating their capital requirements in line with the risk profile of assets owned by them. Basel II norms allow banks to measure credit risk capital under the standardised approach and internal ratings based (IRB) approach. The standardised approach uses the credit ratings given by credit ratings agencies to assets in determining the capital required by banks for those assets. One of the main features of Basel II was the Internal Ratings Based approach which allowed major banks to use their own ratings system to determine risk of various asset classes. The feature was designed to support banks in their view that they know best about the risk profile of their assets, and therefore should decide the level of security needed to cover losses from assets. The banks estimation of credit risk is subject to supervisory approval, which was designed to act as a risk check mechanism to ensure that banks do not take excessive risk and over leverage their capital when using the IRB approach. To further emphasise the importance of risk management, IRB allows two approaches - Foundation and Advanced. Banks can only estimate the probability of default, but rest of the risk measures are preset in the Foundation approach. In the Advanced approach, banks can estimate all risk parameters itself, which means that regulators put more faith in banks to allow them to calculate their capital requirement. The IRB approach was allowed for large banks only, and is based on the assumption that they will have sophisticated risk measurement systems in place.

The problem under the IRB approach was checking the credibility of credit risk models. Without proper regulation of the credit risk models, a bank runs the risk of under capitalisation if the inputs used in the credit risk model are not accurate. Changes in dynamics and correlations between different asset classes over time means that historic credit risk models may not be useful in the future. Additionally, the financial crisis in 2007-08 showed that the credit risk models failed to capture extreme tail events, and therefore greater capital was required than held by banks. The financial crisis in 2008 stemmed from the high-risk derivatives issued under the subprime mortgage lending process in the U.S. spread across nations, thereby highlighting weaknesses in the global banking system. The global financial crisis also pointed to the weaknesses in the Basel Accord for Banking Regulation. The Basel II had stipulated regulatory capital ratios, but the financial crisis showed that many banks lacked capital of sufficient quality to absorb losses during the crisis (CML, 2013). Banks used their own risk models for the pricing of assets and relied on internal credit ratings to estimate capital required for loan default risks (Admati and Hellwig, 2011). With higher personal motives for management, as seen under the moral hazard hypothesis, banks could stretch the rules to set risk at levels that enabled them to increase leverage by reducing risk exposure on questionable lending (Admati and Hellwig, 2011). It was assumed that higher lending will result in greater income for bank, and thus higher remuneration for bank managers. However, the financial crisis in 2008 showed the weakness of this approach, and suggested that Basel II was inadequate in controlling activities of banks in terms of leverage.

Basel III

Basel III regulatory framework was produced in 2010 by the BCBS at the BIS (Getter, 2015), mainly to overcome shortcomings of the Basel II which resulted in the financial crisis in 2008. The main features of Basel III are to revise the definition of regulatory capital and increase capital requirements of banks (Getter, 2015), thereby reducing insolvency risk of banks. It will help in limiting the negative impacts of credit default by increasing collateral (PwC, 2010).

Another benefit of Basel III is that it will provide a more standard risk adjusted model for calculating capital of banks, thereby allowing investors and regulators to better compare risk-adjusted performance of banks (PwC, 2010).

Banks and other financial institutions have used off balance sheet transactions to increase their exposure, which was one of the causes of the financial crisis in the US in 2008. The treatment of off balance sheet areas under Basel III means that they are converted into credit exposure by using credit conversion factors (Liang, 2011), which will limit the usefulness of off balance sheet transactions to banks in increasing their exposure and hence, reduce risk of banks.

The increase in collateral capital means that banks will either have to raise long-term debt or equity to fund loans or reduce the size of their loan book (Allen et al., 2010). This can reduce economic growth as banks are the main providers of debt to businesses. It may also result in change in balance sheet structure of banks as they may increase lending to more liquid, that is, government bonds, and reduce lending to less liquid long-term assets, such as corporate loans (Allen et al., 2010).

Basel III was designed to be implemented by countries in phases to allow time to their banks to improve their financial position and/or raise external capital. The U.S. authorities adopted Basel III framework in 2013, and are being phased in through 2019 (Mendoza, 2015). Basel III is not mandatory, and countries can make modifications to suit their specific needs.

Another disadvantage of Basel III is that it may lead to more expensive or less available bank credit for borrowers (Mendoza, 2015). This may not happen as many banks held higher capital than required under the Basel II but still managed to give high loans (Mendoza, 2015).

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