The Frailties Of Domestic And Global Banking Markets Finance Essay - Free Essay Example

The recent financial crisis has highlighted the frailties of both the domestic and global banking markets, with attention being placed on the need for both more and better regulation. It was felt that no one had responsibility for systemic issues, the Bank of England focussed on monetary policy whilst the Financial Services Authority focussed on the supervision of individual institutions and paid insufficient attention to wider risks[1]. There is also the view that better enforcement of current regulation would be more effective.[2]Such focus on solving the issue should not be discouraged as the financial system is of paramount importance to the economy. Any response does needs to be rational, as more regulation may do little beyond satisfying the calls for something to be done[3], and can be just as damaging as under-regulation.[4] The global nature of the crisis has been highlighted by the European Commission response that; an efficient single market is a key factor to facilitate recovery.[5]They stated that it is imperative; the banking sector is brought back to levels of efficiency, transparency and stability that allow confidence and reliability to be restored, to the benefit of consumers and firms alike.[6]A threat to this is the speed of change; major countries and blocs are enacting new legislation at a pace which would have been unimaginable prior to the crisis.[7]Indeed it is put forward that the big risk of all these regulation changes is to put enormous strain on the plumbing of the traditional system.[8]The fact that the crisis is unlike anything we have had before[9]justifies the international response. As changes are already well under way this article will look at whether they were needed or not, or whether the existing mechanisms could simply have been made to work. The article will begin by looking at the causes of the causes of the crisis. It will then go on to assess where change are being made or could be made to improve the regulatory system. Finally it will assess whether a global regulator is a possibility. Cause of the crisis It was the collapse of Lehman Brothers (one of the worlds largest investment banks) in the United States (US) that sent the crisis global. The De Larosire report[10]succinctly describes the crisis; low US interest rates and an extension of credit to those with poor credit histories played a significant role. Whilst, insufficiently regulated mortgage lending and complex securitisation financing techniques, the complexities of which regulators failed to understand, fuelled the crisis. This was compounded by a number of factors. In the UK the FSA failed to enforce regulation. Both the FSA and the Bank of England failed in ensuring financial stability[11]assessing risk.[12]There was too much focus on the micro-prudential supervision of individual banks and not sufficient focus on the macro-prudential risks of a contagion of correlated shocks.[13] The cause of the failure in the UK was the borrowing from US banks this assisted Northern Rock in increasing its lending 42 billion in the fall of 2003 to 113 billion by the summer of 2007, which left it severely overexposed.[14]Other failings include; the greed of bankers who were taking huge bonuses;[15]the failure to act against massive frauds with civil sanction let alone criminal ones;[16]the disclosure of the intervention of the Bank of England in the case of Northern Rock acting as a distress signal to the public, causing a run on the bank;[17]insufficient advice given by credit rating agencies and other firms outside the scope of financial regulation and their lack of accountability;[18]and finally the global complexities of financial products.[19] Reform of the National Structure An effort has been made to introduce new regulation on the back of the good will that a financial crisis brings. Past efforts have begun too late, by which time the will to act has subsided.[20]Legislators are keen for this not to be the case this time and they have recognised the need to; at the least take the opportunity of the crisis to reinforce institutional mechanisms so that we do not in 10 to 15 years time go through it all again.[21]The use of reinforce is significant, as it would seem to suggest the legislators are not seeking to reform the system with purely regulatory measures. The responses will be split into the failings highlighted above. The FSA and the Bank of England The issue of who should be the regulator is seen a contentious issue in the UK. The coalition government announced on its arrival to power the return of regulatory functions to the Bank of England, a system the Conservatives used prior to Labour winning the 1997 election.[22] The FSAs powers will be dispersed between three agencies; the Financial Policy Committee (FPC), which will be part of the bank; the Prudential Regulation Body (PRA), which will be a subsidiary of the bank; and the Consumer Protection Agency (CPMA), which will be a company limited by guarantee[23]. It is an attempt to bring accountability into the regulatory system.[24] The tripartite system was seen as the key weakness of the FSA, as it was claimed it had failed spectacularly in its mission to ensure financial stability and that failure cost the economy billions.[25]The coalition believes a switch to a single regulator is the answer,[26]meaning power has to return to the Bank due to its role as lender of last resort, which could not be filled by the FSA. Such arguments by the government are countered by the argument that the failure of the tripartite system was a result of the people involved, and it is those same people that will be moved to the Bank of England.[27] By splitting regulation into three agencies, proper attention should be paid to both prudential regulation, an area which was overlooked by the FSA, and consumer protection.[28]The CPMA will boost efficiency and oversight of the financial sector by combining consumer protection and conduct of business issues which were previously split between the FSA and the Office of Fair Trade (OFT). However, the separation of agencies may also cause inefficiencies. A start up bank will now need to gain approval from the PRA and CPMA, and the FPC may have an interest in the process; a bank will be subject to separate inspections by the PRA and the CPMA; and will receive separate communications and inspections from each regulator.[29]To be successful a lot will depend on how the mechanisms of cooperation between CPMA and PRA work in practice. Lessons should be learned from the failure of the memorandum of cooperation between the FSA, Bank of England and the Treasury during the crisis. Another worry is that the transition between regulators will cause a drop in regulation,[30]when it is most needed. The switch to the Bank of England is not without its critics, who suggest that the FSAs failed due to it having to adhere to the light touch approach.[31]A tougher approach was promised after the crisis, as the FSA had been; doing regulation on the cheap.[32]Hector Sants added; people should be very frightened of the FSA.[33]Indeed the FSA have been praised for their approach to the crisis.[34]The FSA have adopted a tougher approach and there was increased action in areas such as insider trading.[35]Thus the criticism by the Turner Report that regulation needed to be more intrusive and more systemic through adopting intensive supervision was already being successfully addressed.[36] Further, the Bank of England has already failed as a regulator, so it is arguable that it is not necessarily a better prospect than the FSA. The Turner review pointed out that the success of a nation to deal with a financial crisis is about as correlated to the choice of structure as it is to the choice of supervisory style.[37]It is suggested that removing regulatory powers from the Bank of England was a good decision.[38]So the decision to hand the powers back makes little sense other than it being a preference of the coalition government, and that perhaps it is seen as removing some of the stigma attached to the regulatory system following the crisis. An independent banking commission chaired by John Vickers (former head of OFT) has been set up to monitor the Bank of England, with the aim of highlighting any failings. It will also report every six months to the treasury on matters such as breaking up the banks, policy objectives to mitigate systemic risk, and consider the competitive advantage of banks being considered too-big-to-fail.[39] Too-big-to-fail The too-big-to-fail ideology has also caused issues for the UK, who during the crisis adopted the practice of bailing out the banks, including Lloyds Banking Group and RBS believing that they posed too big a systemic risk to be allowed to fail. Mervyn King supported this approach of protecting the economy from the banks during the crisis, but adds that it may not seem fair and it is not when other companies, such as Jaguar, had to stand on their own two feet or go to the wall.[40] The US has allowed its banks to fail and in the long term it is thought that this is the best approach otherwise banks will continue to take excessive risks. The FSA has previously stated that; a zero failure regime is neither; achievable in practice or desirable or in principle.[41]So it needs to be asked why they sought to achieve this during the crisis. Mechanisms need to be developed that will allow banks to fail so as to prevent future crisis. It is the banks that need to be made to pay for their risks and not the taxpayer.[42] Bonus culture The bonuses of bank executives and directors is an area which needs to be addressed as prior to the crisis it was uncapped. The Walker report said that it is bonuses which drove the behaviour which lead to the crisis, as bankers are assessed on short term success.[43]Top bankers should be looking at objectives 15 years out and not on short term moves to boost the companys share prices and market cap.[44]The crisis has lead to calls for transparency in executive pay;[45]however there is concern about how difficult it will be to make changes in this area.[46] At national level there is a lack of action, despite the coalition agreement having stated; detailed proposals for robust action to tackle unacceptable bonuses in the financial services sector will be brought forward.[47]This has not occurred, and since bonus rounds are in January many have seen no impact on their bonuses. It appears there will now be no cap on bonus pools and even modest proposals to require greater disclosure of pay and bonuses have been dropped.[48]There is a worry that over-regulation would impair international competitiveness indirectly by encouraging an uncompetitive domestic market, and directly by driving operations to less heavily regulated jurisdictions.[49]So the government are reluctant to act too harshly. There has been some action at EU level and this will be implemented into UK law. The commission amended its 2004 and 2005 guidances on directors remuneration in listed companies[50]so that executive remuneration is aligned with the long term goal of the company. Further it has added a new recommendation on remuneration in the financial services sector that seeks to address perverse incentives and excessive risk-taking.[51]On top of this, the European Parliament has passed new rules to restrict bankers bonuses; this includes deferring 40 to 60 per cent of bonuses for three to five years, and half of any immediate bonuses must be paid in shares or in other securities related to bank performance, meaning bankers can only receive 20 to 30 per cent of any bonus in upfront cash.[52]The enactment of this legislation in Europe does cause a few problems, in particular the risk of talented staff moving to companies in other continents in search of higher cash bonuses which could weaken the UKs financial sector. Further, it does little to curtail excessive bonuses; it just means they have to be paid in a different way. The commission have also proposed limits to the payment of golden parachutes. To achieve this they seek to; limit bonus payments to a fixed term or a fixed amount and only on the basis of the non-variable component of annual remuneration;[53]and if the termination was due to poor performance the payment cannot be made.[54]This would have prevented Adam Applegarth (chief executive officer of Northern Rock) from receiving his 760,000 pay off and 346,000 pension top up.[55] Capital measures There has been a growing realisation that Emergency Liquidity Assistance needs to be carried out in confidence, so as to prevent future runs on banks.[56]As the lending of money to banks tends warn to the public of banks difficulties leading them to panic and remove their money. Also it has been recognised that there is a need for greater restrictions on bank lending, and measure to ensure increased holding of capital. If banks hold more money they can absorb shocks to the market more easily. In the recent crisis banks had a lack of liquid assets. Minimum capital requirements restrain leverage and risk taking and therefore reduce the likelihood of gambling for resurrection and reduce the effects of moral hazard.[57]Basel III will force banks to triple their triple capital reserves they must hold against losses, as well as demanding enough liquid assets to survive the market crisis.[58]Such requirements need to be balanced as increased capital requirements also make it harder for banks to lend during a crisis. The proposal put forward by Basel III will avoid this by ensuring that a banks minimum capital requirement falls in proportion to their losses in a crisis.[59] Agencies previously outside regulation Credit rating agencies which had been hitherto unregulated in the UK and US and there is now plans to regulate them. Their failure to warn of the toxic nature of some collateralised debt obligations was seen as key to the banking crisis.[60]Indeed, Consumer losses to real fraudsters must be small compared to their losses investing in high-tech companies on the advice of or through credit rating agencies.[61]The Turner report reflected this by calling for; more supervision of unregulated activities by regulated groups, and regulated firms exposures to unregulated entities.[62] There is no accountability for the quality of their ratings as there is no contract between the agency and user. The De Larosire report proposes that the direct authorisation of credit rating agencies should come under the newly created Agencies where they have a cross border element.[63]It is also proposed that better enforcement of agency duties may have prevented the credit rating agencies passing on bad information to the customer. Lightly or unregulated hedge and private equity funds also need to be brought under the scope of regulation even though they played little role in the recent crisis as they too could cause systemic risks in the future.[64]The International Monetary Fund (IMF) reflected this in their report.[65]seeing a need to extend the perimeter of regulation to capture firms at the edges and to reduce any systemic risk they pose. Essentially there is a need for a Macro-prudential approach to regulation, all firms that can cause a potential banking crisis need to be scrutinised.[66] Disclosure A lack of disclosure has caused problems. More disclosure would ensure an earlier, more graduated response to potential risks, enabling the regulator to respond before the problem gets excessive.[67]By encouraging more disclosure there would not be less of a need for more regulation as the regulator would be in a better position to mitigate risks. It has been shown that banks which disclose less are generally riskier relative to the capital they hold.[68]Difficulties facing any new system include; increased costs and burden on the banks, and pressure on the government to provide regulatory, analytical and intervention infrastructure.[69] Reform of the International Structure The global nature of todays banking system has caused the call for international regulation. Whilst a global regulator is some way off there are plans afoot for a Pan-European regulator. Proposals for a Pan-European Regulator An issue of the crisis was the regulation of cross border EU-institutions which were poorly regulated; a solution to this is the Pan-European regulator which would be able to monitor home-country and host-country relations. It is hoped it would create a more cohesive global system of regulation by coordinating domestic and European agencies.[70] The introduction of a Pan-European regulator is not really more regulation in itself, as the agencies it will preside over are already in place (albeit in a different form).[71]However, the increased powers of the agencies which it presides over would mean that there would be a need for more legislation for it to succeed. The hierarchy of it and the national systems would need to be clearly defined. A Pan-European regulator could not be granted any control over fiscal policy though unless there is an EU level lender of last resort developed, as Countries would be unlikely to want to cede any more sovereignty to Europe, if they still had to bail out the banks.[72] Basel III will propose more on the need for a Pan-European regulator, as well as the need for separate EU-regulators for banking, insurance and securities markets.[73]These will be useful as there is a need for nations to have a better assessment of macro-prudential risk no longer can big cross border firms be allowed to be regulated solely by national regulators. There needs to be closer inspection of cross border firms which national systems are inadequate to cover. European Agencies The De Larosire report proposed a European Systemic Risk Council (ESRC) who would have responsibility for monitoring and giving advice on systemic risks to the financial system of a whole. Its policies would be responded to by the three new European Supervisory Agencies (ESAs); the European Securities and Markets Agency (ESMA), the European Banking Agency (EBA), and the European Insurance and Occupational Pensions Agency (EIOPA), who replace three similar agencies. These have been implemented as of January 2011 following calls by the European Council, that the European Parliament passes legislation to enact the agencies.[74]Together the agencies have the aim of improving coordination between national supervisory authorities, such as the FSA, and of raising the standards of national supervision across the EU.[75]This will be achieved by further pushing for harmonisation across the EU including an increase in the use of regulations rather than directives as the former is directly appli cable to national law.[76]This has shown that there was a need for more regulation so as to provide more oversight of the industry. However the agencies affects of individual banks will be quite limited as they will have little, as it will be the national regulators that deal with them day to day. The UK in particular was against the ESRC having direct power over national regulators, instead preferring them to just give advice and warnings. The structure does bring about an accountability issue with regard to who answers to whom. Global regulator If anything the current crisis has highlighted a need for new laws and regulation on a wider scale than previously envisaged. Todays banks deal on a global level, to leave regulation on a nation by nation basis is not effective, and even proposals for a Pan-European regulator may not be enough[77]. It is worth remembering the current crisis had its origins in America. What is required is a compressive overhaul of the national and international financial systems requiring ethical considerations to be taken into account.[78]There needs to be a new and decisive approach to regulation which starts the process of reform so as to manage globalisation as a force for good in the medium term.[79] The need for a global regulator has been voiced by the Association of British Insurers who state at the very least there is a need for strong international links, as European wide insight may not be enough.[80] However, the possibility of a global regulator seems a long way off as different countries would be seeking to protect their differing interests. For instance it is unlikely that a growing economy like Chinas is going to want or require the same sort of regulation that an economy like the UKs would require. Further the various international standard setting agencies neither individually, nor collectively have the mandate or budget to fulfil the role or functions of global regulator.[81] Conclusion Whilst there has been a lack of regulation in certain areas of financial services activity, the failures and the crisis have been exacerbated by lax supervision and failings in enforcement.[82]It is supervision not regulation which is often the source of aggravation in a banking crisis.[83]Adequate banking governance incites healthy and sustainable economic development.[84]Not only was there a failure to mitigate the crisis there was an initial failure to act once it arrived. It has been suggested by this article that the decision to give regulatory powers back to the Bank of England makes little sense. Either it amounts to more regulation just for the sake of it, or simply a preference of the coalition government, as there are few compelling arguments for a shift away from the FSA. Whilst it is accepted the new structure will bring some efficiency gains, it is also highlighted it will be less efficient in other ways. Further it is a return to a system which has already failed numerous times. Bankers bonuses are a key area that needs reform, and whilst there has been some at EU level it is looking increasingly likely that there will be none in the UK. The need for more regulation in this area stems from the fact that there is a strong correlation between high bonuses and excessive risk taking. Thus there is a need to act to prevent future crisis. The article has also put forward that there is a need for increased minimum capital requirements so that the banks can be made to bear the costs of any future crisis. The current requirements were too low and Basel III will seek to address this. It is important however that any minimum requirement is not too excessive as it could have a negative impact on the banking industry. Credit Rating Agencies are another area which have been highlighted as an area where the regulation was previously too weak. There is a need for more regulation in order to ensure the quality of their work is improved in the future in order to protect the public and the market. Due to the fact they are currently outside the scope of legislation it will require new legislation and more regulation to achieve this. On the other hand with regards to disclosure it is proposed that it would simply require better enforcement of current regulation. It was the lack of disclosure by the firms which was a problem not the quality of the system by which they disclose. Further any new system for disclosure would come at a high cost and would likely face similar problems to the current system. Banks also need to be allowed to fail otherwise another crisis will emerge. Lessons need to be learned from the recent crisis and new legislation needs to be passed that would allow banks to fail. It has also been suggested that the proposals for a Pan-European regulator and new European agencies should not be viewed as more regulation, rather an attempt to better orchestrate the current European system. Further the bodies themselves will have little day-to-day involvement with the national banks. Further the Pan-European regulator cannot gain any significant powers over national regulators unless it makes a European lender of last resort. Finally it was proposed that a global regulator would be beneficial. However, this article suggests that it is still some way off becoming a reality, as the nations that it would involve all have different interests so it would be hard to reach a consensus. Further it is unlikely that nations would be willing to cede further sovereignty. So then as can be seen the answer to the question is not as simple as there needs to be more regulation, or more effective enforcement of current regulation. Banking regulation is a complex area and each aspect needs to be taken separately and analysed before deciding the course of action. However, what cannot be seen is what the effect of change in one area will have on another, so for that reason it is trial and error. Unfortunately, those errors are generally only highlighted by a crisis. Bibliography Materials used in Coursework Articles Alcock, Alistair Are financial services over-regulated?, (2003) 24 Comp. Law 132 Arora, Anu The 2007-9 banking crisis and the EUs regulatory response, (2010) 21(5) 603 Arora, Anu The global financial crisis a new regulatory order (2010) 8 J.B.L. 670 Catanach, Anthony H. What about effective enforcement of existing regulations? (2009) Strategic Finance, Chiu, Iris H-Y Legislative, regulatory and governance reforms in financial regulation: reflections on the global financial crisis 2010 31(6) Comp. Law 165, 165 Hall, Maximilian J.B. 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