Discuss about the Global Issues For The Finance Professional for Microeconomic Concerns.
The regulation of banks arise from the microeconomic concerns over the banks creditor’s (depositors) ability to monitor the risks emerging on the lending side as well as from micro as well as macroeconomic concerns over the banking system’s ability in the case of banks crises. Besides the administrative and statutory regulatory provisions the banking industry has been subjected to widespread ‘informal’ regulation (Danielsson 2013). The government has for example, used its discretion and external formalized legislation to dictate the outcome of the banking sector by bailing out the insolvent banks, maintaining the essential State ownership as well as deciding on the merger of the banks. Banks have been subjected to numerous regulatory provision but in this paper the focus will be on capital-adequacy requirements.
Over the recent past, the banking regulation has become less pervasive and subsequently shifted from the structural regulation to other increased market-oriented regulatory forms. Accordingly, the competition has since played a key role in the credit allocation as well as in the financial service improvement. The established capital framework in the Basel Committee developed stronger competition in banking. It remains unquestionable that globally, banks currently face increased competition from both emerging entrants in the banking industry as well as other financial institutions (Comitato di Basilea per la vigilanza bancaria 2004). The identification and evaluation of arguments both in favor of as well as against capital requirement for banking sector is performed in this paper by considering the particular capital requirement, the cost-benefit trade-offs linked to regulation of banking, the business model of commercial and investment banks as well as the impact of banking decision on systemic risks.
Capital adequacy remains a key instrument restricting the excessive risk taking of banks owners with constrained liability and, hence, enhancing optimal risk sharing between depositors and owners of banks. Again, capital adequacy is perceived as a buffer against bankruptcy crises, restricting the financial distress cost through a reduction of the likelihood of banks’ insolvency. Accordingly, there is a general contention that higher capital endowed banks with high liquidity buffers remain better to support businesses as well as households in crises as buffers promote the banks’ capacity to absorb losses and, hence maintain lending during the crises (Rojas 2011).
The revised framework (Basel 2) issued in 2004 by the Basel Committee on Banking Supervision has been very instrumental in measuring the capital adequacy as well as in the identification of new minimum capital requirements for banks (pillar 1) (Comitato di Basilea per la vigilanza bancaria 2004). The new framework has encouraged the banks to undertake the effective development of their individual in-house risk management systems helpful in the computation of their minimum capital requirement in a much more sophisticated and precise manner with the supervisory oversight being manifested in the endorsing the system adequacy (Van Roy 2003).
The pillar 2 has also introduced a continuous dialogue between the banks together with their supervisor to follow as well as accommodate the changing alongside the evolving business practices. Pillar 3 has also been instrumental in calling for the improvement of the information flow to the public on the banks financial conditions thereby making it increasingly easy for market discipline to exercise a key role in the reduction of excessive risk in the activities of the banks.
The capital requirement has also undertook to significantly address the concerns over the safety as well as the stability of financial institutions, and the payment system (Danielsson and Zigrand 2015). The capital requirement has helped banks to avoid the highly adverse consequence for the economy widespread of banks failure. This can be explained from the perspective of systemic dangers of the bank failure and the need for security and stability in the systems of payment. The capital requirement focuses the argument on the possibility of systemic or system-wide consequence of a given bank failure. Simply put, the likelihood that the failure of a given bank could result in the failure of other banks.
Since systemic risks to the banking system remain adverse risks for the whole nation, the capital requirement has been the magic to protect the public for certain decision that banks would otherwise take to safeguard their individual solvency without taking adequate consideration of the adverse effects to the nation resulting from the systemic failure. Without the capital requirement regulation, banks left themselves will involve in more risk than is optimal from the perspective of systemic (Danielsson and Zigrand 2015). This dilemma, therefore, describes the basic case for the government regulation of the banking sector and its activities as well as the creation of the capital requirement.
The failure of a given bank due to the absence of capital requirement can be shown to affect another bank as well as other non-banks businesses through possible distinct mechanisms. On one hand, where one banks fails, it can trigger a decrease in the value of the assets adequate to provoke another banks failure through ‘consequent failure’ which would otherwise have been avoided by the capital requirement (Danielsson and Zigrand 2015). On the other hand, a failure by a given bank can lead to the failure of another completely solvent institution via certain contagion mechanism and hence the ‘contagion failure.’
The capital adequacy requirement is supported since it takes different forms which can be a minimum level of required capital or an absolute amount and beyond this level there is also the need to maintain certain capital or solvency ratio which is a minimum ration between capital and the entire balance sheet magnitude hence enhancing the stability of the banks.
It is increasingly difficulty to design the capital-adequacy requirement in a satisfactorily sophisticated manner. For instance, despite the 1988 Basel guidelines on capital adequacy for banks classifies assets as well as assigned a ‘risk-weighing’ unavoidably variations in risks remained disregarded between distinct assets (Gudmundsson, Ngoka-Kisinguh and Odongo, 2013). Consequently, banks continued to look for most risky assets within a risk class thereby promoting ‘banks to move upwards the yield curve in quest of return on capital (CEPR’s Policy Portal 2015).’ These led to the re-emergence of the moral hazard problem within the constraints of individual regulatory risk class.
Scholars argue that harsh capital requirement comes at a severe cost. Imposing high capital requirements make banks constrain banks to certain degrees by through competitive pressures. Such pressures occur as a result of competition on deposits, debt and equity investment sources as well as loans. Accordingly, banks will probably lend less and charge more for loans as well as pay less on deposits (Gudmundsson, Ngoka-Kisinguh and Odongo 2013). Banks take such actions as a mechanism to reinstate an acceptable return on large capital base. Continuous constrain on banks hamper their ability to enlarge credit as well as contribute to the growth of economy during the nominal periods. Imposing higher capital requirement hinder competition when it acts as a barrier to entry for new banks hence harshly prohibitive for small banks to undertake their operations.
Capital –adequacy requirement may also trigger a specific problem with the inter-bank lending. In case the inter-bank lending is favorably treated for the capital-adequacy requirement purpose to enhance liquidity on the market, the financial institutions specifically banks could perversely, be provided incentives to lend other banking institutions in difficulty thereby augmenting the risk of contagion as well as eliminating one of the significant ‘catch up’ on the risk-taking bank (CEPR’s Policy Portal 2015).
Another problem associated with the capital- adequacy requirement relates to the technological advancement which has escalated the financial product innovation rapidly. The capital-adequacy requirement, in contrast, could be altered not adequately frequently and merely ‘catch up’ with present developments (Yudistira 2002). In certain cases, the new financial product adoption would be delayed by the lagging capital-adequacy requirement development, thereby stalling as well as stifling the innovation pace in the banking industry.
There is also a dangerous misconception heating up in the public debate regarding bank safety yet it is true that increased capital requirements would come at a price. The argument that banks can be made much safer by increased capital requirement through having shareholders supplying far more of the funding with matching less funds arising from the debtholders and depositors at essentially no economic cost is misguiding (Miles, Yang and Marcheggiano 2011). This view is a misconception since there would be a great economic cost and hence the need to center the debate on scrutinizing the trade-offs. The cost would definitely overweigh the benefits and this can best be understood when analysts and policymakers focus the debate on the trade-offs (CEPR’s Policy Portal 2015).
It has been shown that the main reason for increasing the capital requirement is to boots the stability of the banks by strengthening institutional structures as well as improving the banking industry resilience. These banks are perceived to have augmented ability to withstand financial turbulence and hence raise banking industry stability. Banks are also expected to benefit from the economies of scale as well as lower their cost of transaction, decrease rates of lending as well as raise the competition of banks with eventual promotion of the financial inclusion. However, opponents have opposed this move by arguing that with the saturated banking sector, raising the capital requirement will further merely establish more saturation and cartels as the small banks risk undercapitalization.
CEPR’s Policy Portal, 7 August 2015; available at: www.voxeu.org/article/systemic-risk-research-and-policy-agenda
Comitato di Basilea per la vigilanza bancaria, 2004. International convergence of capital measurement and capital standards: a revised framework. Bank for International Settlements.
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