Regulation of Financial Services Post Credit Crunch

Regulation of monetary work Post credit rating C dochINTRODUCTIONThe fiscal system is the system that allows the transfer of property between savers and borrowers, and comprises a set of complex and closely interconnected fiscal institutions, markets, deposes, instruments, work, practices, and transactions (Steven M Sheffrin, 2003). All Financial institutions in any country follow certain commands which atomic number 18 placed by the central monetary authority (e.g. financial service authority) in vow to provide im turn up service to the earthly concern and work in the best interest of the nations. Regulationis controlling human or societal behaviour by rules or restrictions (Bert Jaap Koops 2006). The purpose for regulating the institutions is to reduce the assay of failure and to attain social goals. For example believes are regulated, as they by their really nature are habituated failure, and the costs paid by the public for failure is extremely high compared to the financial costs to regulate the banking system. Regulations should be fair and limited so that they go to banks to develop tonic operate in accordance with the customers demand, bear sure competitions in financial work is strong, maintain the quantity and quality of the service provided to public and break off utilisation of imaginativenesss.Over the last five years, the financial system in the creative activity has gone through its greatest crisis. The financial problems choose appeared at the same time in many different countries which makes it unique from the crisis in past. The everywhereall scotch impact is felt all through the world, which is resulted from the interconnectedness of the world(prenominal) economy. This does non mean that the economic recession which many countries in the world right away face allow be anything like as bad as that of 1929-33(turner 2009). The crisis in 1930s was made worse by the policy in response. But it is clear that effec tive the policy response pukenot prevent the large economic cost of the financial crisis.If we are to prevent or minimise the scale of future crisis on that point is an increased need of policy framework that can begin different factors and the corresponding powers to act compulsively when jeopardys are recognized. Currently Britains existing framework is confuse and the powers and capabilities split awkwardly between competing institutions, which results in nobody identifying the constitutional problems when these institutions are construct up and none of the institutions can act in response to crisis as they do not cave in the authority to do so. In launch to avoid future crisis changes in regulation and supervisory cuddle is needed in order to create a more(prenominal) robust financial system for the future. Our instruction in the research is on banking institutions, and not on an other(a)(prenominal) areas of the financial services constancy.In 2007, Britain experi enced its first bank run of any significance since the reign of Queen Victoria (Reid. m, 2003). The run was on a bank called Northern Rock. Britain was free of such event not by misfortune, but because in early third quarter of nineteenth century the Bank of England developed techniques to avoid them. These techniques were used, in Britain and had worked, and appeared to be trusted. The run of northern didder was triggered by the decision to provide support for troubled institution. That run was brought to a standstill, when the Chancellor of the Exchequer (Alistair Darling2) declared that he would use taxpayers funds to guarantee deposits at Northern Rock. Unlike runs in banking history, it was a run only on that one institution as funds withdrawn from it went only to a weeny amount into cash, and were mostly redeposit in other banks or in building societies.The research has three major objectivesDescribes the role of financial regulations and reviews the literature on role pla yed by the regulations in financial system.To describe and evaluate the banking crisis in United Kingdom in last 5 years and the reasons of the crisis which stirred the banking system.To analysis and evaluate the role and benefits of living wills in context of changes in regulation.This leads to the research questionCan living wills address the perceived failures in the regulation of financial services highlighted by the current credit crisis?LITERATURE REVIEWA literature review is a summary of a subject content that supports the identification of specific research questions (Rowley J Slack F, 2004). Literature review explains the role of financial regulations, discuses the banking crisis in UK in last 5 years (2005-2010), and proposed new regulations which are to counter such failures in the future and at what cost these failures can be averted. The main focus of literatures review is the Banking Industry, proposed new regulations in order to minimise the effect of such crisis.T he functions of financial services industryThe existence of money is taken as for granted in all advanced societies directly so much so that most tidy sum are unaware of the huge contribution that the concept of money, and the industry to manage it, have made to the using of our present way of life. Moneyis anything that is generally accepted aspaymentforgoods and servicesand repayment ofdebts (Mishkin Frederic S, 2007).In earlier civilisations the process of bartering was sufficient for the exchanging goods and services. Barteringis a medium in whichgoodsorservicesare directly exchanged for other goods or services without a common unit of exchange (without the use ofmoney) (OSullivan, Arthur Steven M. Sheffrin, 2003). In modern society, people still produce goods or provide services that they could, in theory, trade with others for exchanging for things they need. Due to complexity of life and the size of some transactions make it impossible for people today to match what they have to unfold against what others can supply to them.What is needed is a commodity that individuals will accept in exchange for any product, which forms a common denominator against which the value of all products can be measured. Money carries out these two important functions. In order to be acceptable as a medium of exchange, money must have certain properties. In extra it must be* Sufficient in quantity* Generally acceptable to all the parties in all transactions* divisible into small units* PortableMoney similarly perform as a store of value, which means it can be saved because it can be used to divide transactions in time received today as payment for work done or for goods sold can be stored in the knowledge that it can be exchanged for goods or services later when required. In order to fulfil these functions, money has to retain its exchange value or purchasing power and the effect of inflations can, of course, affect this function.The financial services industry exists largely to facilitate and to shroud with the management of money. It helps commerce and g everywherenment by channelling money from those who have surplus, and wish to play it to make sugar, to those who wish to borrow it, and are willing to pay for the benefit they acquire of having it. The financial organisations want to make profit from providing such services and, by doing so, they provide the public with products and services that offer, convenience ( e.g. current write ups), means of achieving otherwise difficult objectives (e.g. mortgages) and protection from run a hazard (e.g. insurance).Prior to the 1980s, there were clear and distinct boundaries between different kinds of financial institutions some were retails banks, some wholesale banks, others were life assurance companies or general insurance companies, and some offered two types of insurance and were called composite insurers. Today many of the distinctions have become unclear, if they have not vanished altog ether, increasing numbers of mergers and takeovers have taken place across the boundaries and now even the term banc assurance, which was coined to describe banks that owned insurance companies, is inadequate to describe the complex nature of modern financial management groups. For example one major UK bank offers following range of services* Retail banking services* Mortgage services through a subsidiary that is a building society* Credit cards services* Wealth management services* Financial asset management for institutional customers* Investment banking* Insurance servicesRegulationsBank failures around the world have been common, large and expensive in recent years. It is common to think of banking failure as something that happens in emerging economies and countries with advanced banking system, but there have been some shocking failures of banks and banking system within the developed economies in recent decades. The scale and frequency of the bank failures and banking crises have raised doubts about the efficiency of bank regulation and raised questions as to whether the regulation itself has created an iatrogenic reaction.Regulations for banks and other financial institutions hinge on the coase (1988) argument that unregulated private actions create outcomes whereby social marginal costs greater then(prenominal) private marginal cost. The social marginal costs occur because bank failures has a far greater effect then throughout the economy than, say, failure of a manufacturing concern because of the wide spread use of banks. Nevertheless it should be borne in mind that regulation involves real resource costs. These costs arise from two sources (a) direct restrictive cost, (b) compliance costs bear by the firms regulated. In IMF global financial stability report (2009), it estimates that the ultimate cost to British taxpayers of support for the banking sector will be 9.1% of GDP, or more than 130 billion, that is more than five times the equivalent o f 1.8% of GDP in France and three times the estimated 3.1% of GDP in Germany.The main reason for regulating the banks is firstly consumers lack market power and are prone to exploitation from the noncompetitive behavior of banks. Secondly depositors are uniformed and unable to monitor banks and, therefore, require protection. Finally, governments need regulations to estimate the safety and stability of the banking system.Basel accordBasel military commission for banking supervision a committee for BIS (Bank for Inter subject Settlement) was first established in 1974. This committee operates at international level and the main focus of the committee is to strengthen the chapiter of banks. The rationale reasons for the establishment of the committee were to safeguard the financial stability of the banking system worldwide and to create a level playing field. The first major achievement of the committee was in the form of Basel I. Basel I aimed at1. Promote the co-ordination in the regulatory and capital adequacy standards of the member countries.2. Guard against risk in credit uprightness3. Finally, it suggests for the lower limit capital requirements for the international banking.Since 1988 when the Basel committee introduced the first capital accord Basel I the risk management practices, the banking air and the whole financial market has changed. The hot York Fed President argued that it ebulliently has not kept pace with innovations in the way that banks measure, manage and mitigate risk.(EBSCO, 2002)Although the accord cover fairly relevant issues but it wasnt helpful enough to make a major impact in the industry. in that respectfore in 1999 the initial steps were taken which led to the amended of Basel I. There were several different reasons for the amendments. One of the misunderstandings about Basel I was that it was the only way to the financial stability of a country. The positive results of implementation of Basel I were seen in the G-10 coun tries, as these countries were previously operating their financial industry on mostly the same rules, but still there were many new product introduced and reforms took place which remained unexplained by the accord and resulted in the financial industry either fully collapsed or got taken over by other giants. For example Grupo Financiero Bancomer, a Mexican banking giant was reported as US- ground Citibank has agreed to acquire Mexican banking giant Grupo Financiero Bancomer-Accival (Banacci) for US$12.5 billion (All Business.com, 2001). The initial results blinded the G-10 in the aspects of emerging markets as they got pressurized by the larger financial institutions to follow the same accord.Another failed aspect of Basel I which led to the new accord was that the old accord only concentrate around the credit risk. Basel I did not focused on running(a) risk which also supported the downfall of many financial institutions. As explained by Mohan Bhatia Weather it is a fee-based business, emerging practices or income-based business. A bank is exposed to operational risk.(Bhatia, 2002).Even though Basel I was not written to be applicable for the emerging markets, its functions created distortions in the banking sectors of the industrialized economies. In countries subject to high currency inflation and sovereign default risks, the Basel I accord actually made bestow books riskier by encouraging the movement of both bank and sovereign debt holdings from OECD sources to higher-yielding domestic sources (Balin, 2008).Another problem with the 1988 accord was that it focused more on the type of add rather than the credit status of the borrower. As the bank and large financial institutes saved just 8% for the unseen risks they had more capital left. That was used in form of add and subprime bestow which was later proved to be a real disaster for the financial institutions.Basel I created a gap between the regulatory capital and the economic capital as bank wo uld choose to hold. The commonly know regulatory capital is different to the economic capital. The economic capital aims to fire the value of the investor and is based on the internal risk assessment of the institution. Whereas on the other hand the regulatory capital secures the banking stability and the regulator decides it for the protection of the depositor.Considering the drastic effects of the Basel I accord the committee published the reforms in 2003 namely Basel II. Basel II is a response to the need for the regulatory system governing the global banking industry.(Garside, Bech, 2003) Basel II brought many reforms to the old accord and was based on three newspaper columns. The first pillar was tokenish capital requirement which explained explicit treatment for operational risk in the financial industry. However the market risk remained with the same explanation as from Basel I. The Basel II brought some new method actings of measuring the credit risk by introducing the p ublic and internal ratings which provided good risk mitigation techniques. Furthermore the piece pillar explained the supervisory review of capital adequacy. The basic purpose of this pillar was to keep a check on the financial institution that they hold excess of minimum level of capital required. The regulator can intervene at the initial stage if this requirement was not fulfilled. Finally the third pillar was brought into place to bring a much better market discipline. The market is considered to be the role played by the shareholders, government or employees whether proper capital is maintained or not. With this improvement Basel II was considered to help both the lender and the borrower.Basel II spots the weakness in Basel I and proposed effective risk measurement, mitigation techniques and elaborates valuables for market discipline for good banking system and good financial stability as explained we at the Federal Reserve had even more reasons for the most finely tuned Basel II framework Not only are we the umbrella supervisor over all financial stability companies but, as the nations central bank, we are responsible for maintaining nations financial stability. (Poole, 2005)The fines of Basel II are basically explained by the three pillars of it as the very dexterously explain how and where the accord will be effective. The first pillar of minimum capital requirement was extremely advantageous in providing enhanced risk measurement by helping the large financial institutions and big banks to measure the risk involved in their functions and operations more sophisticatedly. Risk management proposals were efficacious for the capital they require to hold in case of unexpected losses.The new accord proposed different approaches for the measurement of credit risk. The standardised approached being the more or less the same as the old accord was more risk sensitive for the creditworthiness of the customers and improved the requirement which was previously ba sed on type of loan instead of the credit status of the customer. This approach explained the birth of credit rating of individuals but the problem with this approach was that the culture of rating is not popular in every European country and other countries with strong and effective economies. Whereas the internal ratings-based approach was based on the internal key risk drivers and therefore the potentiality for more risk sensitive capital was substantial in a way to mitigate the risk. But the internal ratings-based approach is not enough to sum up the capital required for the risks. The approaches for calculating the risk-weighted assets are intended to provide improved bank assessments of risk and thus to make the resulting capital ratios more meaningful (Pitschke Bone-Winkel, 2006). useable risk which the Basel I failed to examine is a crucial element and was elucidated by Basel II in three operational risk alleviation approaches. The first method called the Basic indicator approach advice the banks to hold capital equal to 15% of average gross income earned by banks in the past three years. The second method named the standardized approach separates every business to hold capital to shield itself against the operational risk. Finally the third method of advance method approach allows the banks to calculate their own capital requirement to protect themselves against the operational risk. A disadvantage of the first pillar was that it allowed the banks to set their own risk assessment techniques. This gave over sanguine reports to reduce the capital required. Furthermore it even maximized the return on equity. For a much better market discipline regulators must approve the requirement. As explained by (Lind, 2006) banks must have methods and systems for risk management which are subject to adequate corporate governance processes throughout the banks.The pillar II of The Basel Accord is based on Supervisory Review. It certifies that the banks should have enough capital to sustain all the unexpected risk in an organization and also provides with much more better techniques to monitor and mitigate those risks. It advises the banks to calculate their risks internally. It requires the regulators to assess the banks risk management processes and capital position to maintain a target level of solvency. Pillar II recognises that national supervisors may have different ways of entering into such discussions and provides flexibility to accommodate those differences (Caruana, 2003). It was helpful in a way to evaluate funding strategies and also gave an insight to the risk mitigation policies to the banks. In total the second pillar had two positive proposals. Firstly, it gave more power to the regulators to keep a check of the minimum capital requirement by banks as calculated in pillar 1. And secondly it alarms the repetition of the financial crises such as in countries like Korea and china by taking early actions and offering rapid remed ial actions. Some of the data submitted by individual institutions was not complete in some cases banks did not have estimates of loss in stress periodsor used estimates that we thought were not sophisticatewhich caused minimum regulatory capital to be underestimated (Bies, 2006). At the same time go the corporate governance is in place the accord gave absolutely no information regarding the liquidity. Banks remained unaware of the true financial conditions of each other which forced them to correspond lending and the State Bank of England was highlighted as the last resort to rescue.Pillar III based on the market discipline helped maintain discipline in the market place by greater disclosure of the banks risk profiles. The pillar III is connected to pillar I and pillar II as it complements the minimum capital requirement and the supervisory review process. Market discipline can contribute to a safe and sound banking environment and supervisors require firms to operate in a safe a nd sound manner (BIS, 2005). The disclosure is important for the benefit of the stakeholders. Therefore a disclosure of market risk, operational risk, interest rate risk and the disclosure of capital structure is required. The information should be disclosed timely. It will fundamentally transform financial reporting for banks by demanding increased depth and width of disclosure (Garside, Bech, 2003).One of the other disadvantages of Basel II is the complexity and potential cost of the framework. It is a defected draft of 450 pages and the cost of implementing it is too high for the banks. Banks were also afraid to lend because of the fear of Basel II as they would operate against the rules of Basel II on certain occasions. According to the Basel book the banks have to meet a certain level of capital reserves and in todays scenario of credit crunch it is difficult. As Peter Spencer explains the Basel system of banking regulations, which determine how much capital banks must raise to keep their books in order, are the root cause of the crunch and were serving to worsen the Citys plight (Conway, 2007).The Basel committee produced the old and new accords which to an extent were successful for the strengthening of the capital of banks and also took into account the risk throughout the procedures. But the new accord did not changed with new reforms in the system which made it just a box to be ticked in a form and had no connection with the reality or implementation. Most of the organizations ticked the boxes and yet carried on with the risky decision which seemed profitable but yet proved out to be wrong such as Northern Rock. These decisions were not even against any of the accords as the Basel committee never updated to the new market.Financial Services Authority (FSA)Regulations of the financial services industry in the UK is a 5 tier process* First level European jurisprudence that impacts on the UK financial industry* Second level the acts of the parliament t hat set out what can and cannot be done.* Third level the regulatory bodies that monitor the regulations and issue rules about how the requirements of the legislation are to be met in practice. The main regulatory body is now the Financial Services Authority (FSA), which has taken over the regulatory responsibilities of the number of other bodies, including the bank of England.* Fourth level the policies and practices of the financial institutions themselves and the internal departments that ensure they operate legally and competently.* Fifth level the arbitration schemes to which consumers complaints can be referred. For most cases, this will now be the financial ombudsman service, which takeover the responsibilities of a number of earlier ombudsman bureaux and arbitration schemesBefore the arrival of the financial services act 1986, the UK financial services industry was self regulating. Standards were maintained by a promise that those in the financial industry had a common set o f values and were able, and willing, to exclude those who violate them. The 1986 act moved the UK to a system which became known as self regulation within a statutory framework. Once authorised, firms and individuals would be regulated by self regulating organisations (SROs), such as IMRO, SFA or PIA. The financial services act 1986 covered investiture activities only. Retail banking, general insurance, Lloyds of London and mortgages were all covered by different acts and codes. When labour party came in power in 1997 it wanted to amend the regulation of financial services. The late 1990s saw more fundamental development of the financial services system with the fusion of most aspects of financial services regulation over a single statutory regulator, the financial services authority (FSA) process took place in two phases. First the bank of Englands responsibilities for banking supervision was shifted to the financial services authority (FSA) as part of the bank of England act 199 8. The second phase of development consisted of a new act covering financial services which would revoke key provisions of the financial services act 1986 and itty-bitty other legislation. All the earlier work on regulation would be swept away and the FSA would regulate investment business, insurance business, banking, building societies, friendly societies, mortgages and Lloyds. On 30 November 2001 the act, the financial services and market act 2000 (FSMA 2000) came to form a system of statutory regulation.The creation of the FSA as the UKs single statutory regulator for the industry brought together regulation of investment, insurance and banking. The FSA took over the responsibilities for prudential supervision of all firms, which involves monitoring the adequacy of their management, financial resources and internal systems and controls, and Conducting of business regulations of those firms doing investment business. This involves overseeing firms dealing with investors to ensur e for example information provided is clear and not misleading. Adair Turner (2009) argued that FSAs regulatory and supervisory approach, before the 2007-2008 crises, was based on a sometimes covert but at times quite obvious philosophy which believed that* Markets in general are self-correcting and disciplined which acts as effective tools than regulation or supervisory oversight to ensure firms strategies are sound and risks contained* Main responsibility for managing risks was of senior management and boards of the firms, who were thought to be at better place to evaluate business risk than bank regulators, and who are better off in qualification appropriate decisions about the balance between risk and return, provided proper systems, procedures and skilled people are in place.* Customers protection cannot ensured by product regulation or direct markets intervention, but by making sure that wholesale markets are loose and transparent as possible, and thats the way in which fir ms conducts business is appropriate.Turner argued that this philosophy in supervisory approach resulted inA focus makes sure that systems and processes were delimitate vigorous instead of challenging the business models and strategies. Risk Mitigation Programs set out after ARROW reviews therefore tended to focus more on organization structures, systems and reporting procedures, than on overall risks in business models.A focus within the FSAs failure to notice of approved persons on checking that there were no issues of reality raised by past conduct, instead of evaluating technical skills, with the assumption that management and boards were in a superior position to assess the appropriateness of particular individuals for particular roles.A balance between business regulation and prudential regulation which, with the benefit of observation, appears biased towards the former. This was not the case in all sectors of the financial industry the FSA for instance introduced in 2002-04 major and very important changes in the prudential supervision of insurance companies which have significantly improved the ability of those companies to face the challenges created by the current crisis. But it was to a degree the case in banking, where a long period of reduced economic volatility, which was attributed by many informed observers to the positive benefits of the securitized credit model, helped foster inadequate focus on system-wide prudential risks.Failure of Current RegulationBased on the Geneva root word, the G30 Report, and the NYU-Stern Report failure of current regulationSystemic riskReports established a point of view that the financial regulatory frameworks around the world pay little consideration to systemic risk. Carmichael and Pomerleano (2002) define systemic risk as systemic instability that arises where failure of one institution to honour its promises leads to a general panic, as individuals fear that similar promises made by other institutions also may be dishonoured. Acharya, Pedersen, Philippon and Richardson (2009) argue that Current financial regulations seek to limit each institutions risk seen in isolation they are not focused on systemic risk. As a result supervisions focus on individual institutions, instead of having it on the whole system, while individual risks are properly dealt with in normal times, the system itself remains, or is encouraged to be, weak and exposed to large macroeconomic shocks This focus was a common feature and a common failing, of bank regulation and supervisory systems in the world. As per the Geneva Report regulations wholly assumes that it can make the system as a whole safe by simply making sure that individual banks are safe which is misleading.Pro-cyclical risk taking Reports also agreed that financial regulations encourage pro-cyclical risking taking which increases the possibility of financial crises and their severity when they occur. Any economic quantity that is positivelycorrelate dwith the overall state of theeconomyis said to be pro-cyclical (Gordy MB and Howells B. 2004). Financial intermediation as a whole is inherently pro-cyclical. Financial activity such as new bond issues and total bank lending tend to increase more during economic booms than during downturns. Higher levels of economic growth lead to higher values of potential collateral, thereby loosening credit constraints and making access to debt financing easier. Another contributing factor to the financial systems pro-cyclicality is that financial market participants behave as if risk is counter-cyclical. For instance, bank loan standards tend to be most lax during economic booms (Lown et al 2000)) and banking supervisors have historically been most vigilant during downturns (Syron (1991)). Regulations lead towards stability and reduce statistical measures of risk and encourage excessive risk taking. In bad times, the pendulum swings back producing excessive risk aversion.Large Complex Financial Institutions (LCFIs) All reports agree that current regulations do not deal effectively with LCFIs, defining LCFIs as financial intermediaries engaged in some combination of commercial banking, investment banking, asset management and insurance, whose failure poses a systemic risk or externality to the financial system as a whole. (Saunders, Smith and Walter, 2009). The growing role of LCFIs poses various challenges.The complexity of these institutions has made it hard for financial analysis and effective supervisors oversight. The linkages among business areas within LCFIs are close which leads to increase of risk contamination from one business area to another as well as across jurisdiction. All reports also insist on the danger induce by implicit Too-Big-To-Fail guarantees. Too big to fail is an expression that refers to the belief that ineconomic regulation, the largest and most interconnected businesses are so big that a government cannot let them to declare bankruptcy for th e reason that said failure would have inglorious consequences on the overall economy. Mervyn King on June 17th, 2009, the governor of theBank of England, called for banks that are too big to fail to be cut down to size, as a radical to the problem of banks having taxpaye