Essay on Financial Market and Risks
At present, the problem of global regulation of financial and economic relations is a subject of interest of specialist in international financial and banking regulation, scientists, and financiers. Attention to these issues has increased significantly due to recent global financial crisis.
The financial crisis that has hit the United States and later other countries in 2008-2009, has shaken the stability of the entire world economic system. It reveled the vulnerability of financial systems, their exposure to risk and insecurity. The causes of the crisis have been studied and continue to be discussed by experts, financiers and economists around the world. One of the issues associated with the emergence of the crisis was the problem of risk in the banking sector, namely the problem of systemic risk and its consequences.
Although over the past two decades, banking system has changed more than in the preceding two centuries, the nature of banking is still fraught with risk. If bankruptcy of one of the banks is perceived as a sign of instability of the banking system, the population may lose confidence in banks in general. Distrust or panic among customers and investors can damage the rest of the banks and lead to their bankruptcy. Therefore, governments try to prevent bank failures and panic among the population. In order financial capital of banks become a powerful stimulus for economic growth and raise living standards, it is necessary to significantly increase their effectiveness as an investment resource. In addressing this challenge the leading role belongs to the management of risks in the banking sector.
In this paper it is necessary to consider the concept of systemic risk in the banking sector and its implications for economic systems; the importance of financial regulation of the financial system; systemically
important financial institutions (SIFI); question of functional separation of banking between retail / commercial banking business and investment banking.
Конец формы
THE GLOBAL FINANCIAL CRISIS
One the causes of global financial crisis 2007-2010 was called behavior of borrowers of mortgages loans, bank customers, bankers and the U.S. government. This led, first, to unpredictable growth of credit derivatives, and secondly, to the mass panic of bank customers, caused by inability of borrowers of mortgage loans to repay their debts in time, and thirdly, to the opposition of the financial authorities and owners of large banks that accelerated the development of the crisis and the resulting large-scale financial intervention of the caller of the U.S. government in the process of its leveling. (Marshal 2010)
Measures of neutralization of the crisis and its consequences have been the subject of discussions at the “anti-crisis” summit “Group of twenty” (G20). The participants agreed on the need for a centralized body of macro-prudential regulation of the global financial system. Also it was agreed that central banks had to tighten banking supervision in accordance with the recommendations of Basel I, Basel II and Basel III. (Marshal 2010) The central banks of many countries in the world, fulfilling the recommendations of the G 20, first stepped introduction of central bank control over the imbalanced liquidity. At the same, time it became apparent that the effectiveness of their activities greatly depend on how the developers of banking policies and practices adequately understand the specifics of the mechanisms of formation of the global financial crises.
One approach to explaining the global financial crisis is the following. When studying the trends in the global economy, financiers USA and UK have put forward and developed the concept of financial stability after the global financial crisis of 2007-2009 got a scientific and practical significance for the global financial science. It should be emphasized that at first it was treated solely as an objective of banking supervision, and after the financial crisis – mostly as an important objective of the global financial and economic regulation. Under the financial stability is understood as the ability of the financial system at the same time effectively perform three key functions:
- Effectively and continuously promote the intertemporal
allocation of resources in the economy from savers to
investors and the allocation of economic resources in general. - Identify the financial risks and evaluate them for the future with reasonable accuracy, as well as control them.
- Eliminate or neutralize the financial and real economic shocks or unexpected events. (Marshal 2010)
In other words, financial stability means stable functioning of financial institutions, markets, and their infrastructure (the financial system). In turn, ensuring financial stability means preventions of violations of financial crises and the efficient resolution of crises in the financial system with minimal losses for her and the economy. (Sorkin 2009)
Further consideration should be given to the concept of financial risk and methods to resolve it.
SYSTEMIC RISK AND FINANCIAL STABILITY
At present, a new but actively developing field of research and practical interest of the central bank is linked to achieving financial stability. In order to ensure financial stability, management of systemic risk is a key task of the central bank, aimed at ensuring reliable and stable operation of banks, payment systems and financial markets. Maintaining of financial stability is aimed at ensuring dynamic development of economy and improving living standards through efficient reallocation of financial resources between different sectors, provision of complex quality financial services to the public.
In securing the financial stability all elements of infrastructure are important, including banking and nonbank financial intermediaries, financial markets and financial infrastructure (payment and settlement systems, stock exchanges, depositories, credit bureaus, collateral registries, rating agencies, etc.). Ensuring the stability of the financial system is connected with elimination of the effects of instability factors, preventing their influence on the economic system, and, as a result, transition to the stage of systemic risk. (Segoviano et al., 2009)
Prevention of systemic risk is a key element in ensuring financial stability and is a function of the central bank. At the same time in the scientific literature there is no common definition of systemic risk in banking sphere. The existing definitions of systemic risk focuses on the emergence of significant system events that adversely affect the systemically important intermediaries, markets and infrastructure. (IIF, 2010)
There is also the definition of systemic risk as the risk of events (shock), which will lead to the loss of economic value or confidence and increasing uncertainty in a fairly large part of the financial system that cause adverse negative effects in the real economy. (IIF, 2010)
In the IMF study, systemic risk is defined as “the risk of disrupting the financial services, that is caused by damage of all parts of the financial system and poses a threat of negative consequences for the real economy.” Systemic risk can be transferred as a result of inter-dependence of financial institutions (the so-called “contagion effect”). Loss of confidence in the major parties can quickly spread to the entire financial system. (IMF 2009)
The complexity of the phenomenon of systemic risk indicate the number of interactions that determine the direction of distribution of systemic risk: it can be distributed both in the horizontal relationships formed at different levels of the financial system (for example, between different financial institutions) and in the vertical, formed in particular between financial institutions and markets, financial system and economy. The distribution of systemic risk will depend on the structure of the payment system: mechanism of calculations, the number of banks, the extent and strength of the relationship between banks, central bank policy on liquidity and payments, as well as information available to participants about the state of the financial market.
The recent financial crisis of 2008 has demonstrated a lack of proper evaluation of the influence of a number of financial intermediaries on the systemic risk and financial stability. The event which marked the beginning of the recession of the global financial market has become bankruptcy of the investment bank Lehman Brothers. Contrary to the expectations of the financial sector that the bank was “too big to fail”, and hopes that The Fed would not allow this to happen, in September 2008 it was decided not to save Lehman Brothers, which caused panic in the international financial markets. (Zhou, 2010)
In world practice there is no single universal model of mega-regulator from the perspective of standards of banking regulation. But the globalization of financial markets poses new problems in the area of supervisory cooperation and information sharing at the international level, which decision should be based on mutual trust and understanding, as well as confidentiality. In this regard, the global financial and economic management, as well as in other areas of the financial market, it is required to develop and implement a series of international standards. Cooperation in the field of banking regulation can be effected by institutional and methodological arrangements. The first means the creation of structural formation (body), within which are mutually agreed approaches, the second includes a set of regulatory tools (instruments, regulations, directives), which contain uniform standards of banking regulation. (Gauthier et al., 2010)
Finally, the global financial crisis has shown that systemically important financial institutions (SIFIs) are subject to special attention to the economies of both developed and developing countries. So it is necessary to consider their role and significance for banking reform and financial regulation.
SYSTEMICALLY IMPORTANT FINANCIAL INSTITUTIONS
The regulation of systemically important financial institutions is an important task for the effective management of financial markets. This question has received special attention during the crisis of 2008 – 2009, when the problems of several large participants in the U.S. financial system triggered instability of the global economy. Therefore, the identification and oversight of systemically important financial institutions are important to enhance macroeconomic stability.
In the literature there are several definitions of systemically important financial institutions. Praet (2010) proposed the following: “The financial company may be considered systemically important if it’s bankruptcy would have significant negative consequences for the financial system.”(Praet, 2010, p.3)
The size of the financial institution is often considered the main criterion of systemic importance. In 2009, the International Monetary Fund (IMF), together with the Bank for International Settlements (BIS) and the Council, including the Financial Stability Board (FSB) conducted a study in order to identify the characteristics which determine the systemic importance of the organization in different countries. The results showed that in the pre-crisis period, the size and the degree of interconnectedness of organizations considered to be the main determining parameters, and after the crisis were added the level of debt and the value of liquidity gaps (difference between assets and liabilities by maturity).
As a result of the crisis 2008 – 2009 the authorities of many countries have paid particular attention to the issue of regulation of systemically important financial institutions. In the report Financial Services Authority (FSA) discussed the concept of an action plan in case of insolvency (“living will”). Banks should have a plan of action for a period of crisis, including finding alternative sources of financing, sale of assets, and plan to increase capital. (FSA 2009)
On the other hand, regulators should also be prepared to address problems in connection with the default of the company in order to reduce losses to creditors and taxpayers. There are various proposals to limit the size and range of systemically important financial institutions.
FUNCTIONAL SEPARATION OF BANKING BETWEEN COMMERCIAL BANKING AND INVESTMENT BANKING
On February 2, 2011 the Financial Crisis Inquiry Commission (FCIC), chaired by Phil Angelides, released a study of the causes of the financial collapse of 2008. The report concluded that the main cause of the crisis was an attempt for the past three decades to get rid of measures to protect citizens, created by Franklin Roosevelt in the mid-twentieth century, including the Glass-Steagall Act. (Financial Crisis Inquiry Commission 2011)
The Commission pointed out two initiatives on Wall Street that contributed to the crisis. First, in November of 1999 was eliminated the Glass-Steagall Act. After the commission’s report, Angelides LaRouche has called for the restoration of Glass-Steagall Act. This proposal was put forward in the Senate but was blocked by Obama and his supporters.
It is therefore important to consider the essence of Glass-Steagall Act, to consider investment and commercial banks, and the problem of their separation in the United States.
Separation of investment banks and commercial appeared in 1933 in the United States according to the Glass-Steagall Act. In order to protect the banking system from the risk of systemic failure caused by failed transactions in the securities market, it was decided on the division of banking into two parts – the activities of investment banks and commercial banks.
The functions of commercial and investment banks in the United States were separated during the economic crisis 1929 – 1933’s., which led to the bankruptcy of many banks. Then it was considered advisable to isolate the long-term loans and financing from short-term credit operations. The separation of commercial and investment banks was due to the view that many commercial banks until 1933 were engaged in underwriting many high-risk securities. If some of these securities could not be sold at the minimum price, these securities just stayed in the asset portfolio of the bank.
It is also necessary to point that separation also means that commercial banks could not carry out some non-professional securities transactions (to invest in corporate securities), which is the main source of risk, as well as certain types of professional activity, which carry an increased risk (for example, dealers).
In 1999, according to the Graham-Leach-Bliley Act, the distinction in the United States was partially canceled, and commercial banks were allowed to open branches and subsidiaries, which could carry out transactions with securities. It should also be noted that in the last decade in the U.S. there is a “blurring” of the boundaries between investment and commercial banks due to certain amendments to the legislation extending the competence of commercial banks, as well as through the introduction of new types of banking operations (particularly financial derivatives) that do not directly fall under the existing restrictions.
In fact, separation of investment and commercial banks in the United States finally ended in 2008, as a result of the crisis, when investment banks were forced to take loans in the U.S. Federal Reserve. Because the loans from the Fed could get only commercial banks, all investment banks have received such a license.
Lets consider the arguments for the separation of banks.
Transactions in securities, as the activities of investment banks, are associated with greater risk than traditional banking. The investment bank could incur significant losses if it can not sell the securities at the price promised by the issuer. That is why investment activities of commercial banks can increase the number of bankruptcies and undermine the stability of the financial system. This problem could rise due to the current federal deposit insurance system. Permission for commercial banks to carry out additional activities related to risk exacerbates the problem of misconduct and false choices. Another argument against operating of commercial banks in the securities market is the possibility of conflicts of interests of commercial banks while underwriting.
The debate on the question of whether to allow banks to conduct securities transactions have not been yet completed. However, the profit motive encourages banks, like other financial institutions, to intrude on the traditional territory of the business activity of each other.
