Essay: Governance, Regulation & Risk Management In Banking - A Critical Analysis.

Factors that Led to the Global Financial Crisis

Discuss about the Governance, Regulation & Risk Management In Banking?

The global financial crisis changed the scenario of the capital market throughout the globe. Economies of some of the most developed countries came crashing down to the ground. With big names in the banking sector reduced to ashes, it was high time to start from the scratch (Covitz, Liang and Suarez 2013). Banks as financial intermediaries play a pivotal role in the development of the economy of a country.  Banks are separate from other financial intermediaries, as they have a much extended role to play (Flannery, Kwan and Nimalendran 2013). Risk management is an integral part of the banking business and many regulatory and legislative changes have been made in this field since the financial crisis of 2008. These stringent norms have tried to change the manner in which banking business operations are carried out throughout the world. The Basel III accord proposed by the BIS (Bank for International Settlements) is one such example of regulatory measure regarding capital adequacy and risk handling in banks throughout the world (Frankel and Saravelos 2012). This essay attempts to bring out a critical analysis of the notion that regulatory changes have created a fear among the banking professional, which has lead to an increase in professional misconducts – opposite what these regulations intended. In doing so, two articles of The Financial Times have been referred to that speaks about the speech given by the Chief Executive of the UBS bank.

Sergio Ermotti, the Chief Executive of UBS stated that stringent regulatory changes have made banks more risk adverse and this has influenced the business to a great extent. He further suggested that making mistakes by banking professionals would be tolerated as long as they are honest ones. This created a stir within the banking fraternity and has been much criticised, as it will allow executive to make mistakes knowing that they can get away with those mistakes. A sense of getting a pardon for wrongdoings will tend them to take their responsibilities in a much serious manner. From the viewpoint of a shareholder, this irresponsible mentality is a crime that requires a death penalty (Haas and Lelyveld 2014). Shareholders and customers entrust the banks with their hard earned money and if the loose this money due to lack in their sense of responsibility; it turns out to be a total disaster for the stakeholders.

Changes in Regulatory and Legislative Frameworks

Let’s take a look at some of the factors of the global financial crisis. Banks throughout the world engaged too much in hedging and invested most of the money of their investors in bonds and other debt instruments that were secured by faulty commercial and residential mortgages. Too many collaterized debt obligations (CDO) were issued where the underlying assets were not performing (Fratzscher 2012). Banks were busy in making money by selling bonds, derivatives, swaps, and other securities without properly evaluating the status of the underlying assets. Most of these underlying assets were commercial and residential mortgages held by the banks for which advances were also provided by them. Banks were hardly bothered about recovering these loans as long as they were making money by selling securities collateralized by these loans (Haas and Lelyveld 2014). In the absence of a proper follow-up, these loans started to turn out bad and lost their value. The fact that these mortgages were turning bad was undetected due to the fact that the bonds and securities were being sold got AAA ratings from most of the credit rating agencies. As a result, the banks paid much less heed towards proper evaluation and classification of these assets (Covitz, Liang and Suarez 2013).

Gradually, these non-performing assets surfaced and the balance sheet of the banks started eroding. Non-performing assets or NPAs pose a great threat to the banks and are considered to be a real charge on the economy of a country. Banks are required to make provisions for NPAs out of their profits. As the amount of NPAs increased, the provisioning amounts also increased (Chodorow-Reich 2014). As a result, balance sheets of most of the banks started to show negative figures. This financial status brought down the market value of their shares along with the securities issued by them. All these contributed to the overall fall down of the international economies (Kuppuswamy and Villalonga 2015). Following the slow down came an enormous change in the regulatory and legislative frameworks. There was a wind to increase accountability and transparency in the manner business activities are carried out throughout the world. The concept of responsible lending practice became very popular. Responsible lending involved a proper evaluation of the credit worthiness of a potential borrower (Erkens, Hung and Matos 2012). Regulators were attempting to inculcate an environment of better governance and compliance to the regulatory and legislative changes that were made to increase the efficiency of the entire banking system.

Importance of Accountability and Transparency

As mentioned above, the changes made by regulators and the government are meant to bring transparency and accountability among banking professionals. Ethical standards and code of conducts are being formulated and implemented to ensure that banks perform their duty of financial intermediation in a proper manner so as to cater an overall growth of the industry and that of the economy (Collins 2012). Effective internal control and internal check systems are effectively being placed to ensure that the risk of making mistakes are eliminated. In such a scenario, bankers are required to perform their responsibilities in a proper manner and be accountable for such work. This in no way hampers the risk taking ability of banks. It a conventional truth that risk and return are co-related (Kuppuswamy and Villalonga 2015). Effective risk management mechanisms are being used by financial institutions to counter and resolve risks arising out of their banking activities. The regulatory environment in no way wants banks to be risk adverse. Stringent norms are being put in place so that mistakes made by bankers do not cost the stakeholders and the banks valuable financial resources. However, if bankers are thrust in an environment where they know that they can be less accountable, the entire system will fail and it will become impossible to recover from such a situation. The main objective of the implemented codes of ethics and conduct will fail throughout the sector (Shiller 2012). This is what Lucy Kellaway stated in her article (the second article referred for this essay). A banker deals with public money and so being accountable and transparent in their work is one of the pre-requisites of the job. If they are allowed excessive room for errors, they will get in the habit of making errors. Some of these errors are inexcusable such as not adhering to proper documentation requirements, lack of foresightedness in evaluating the credit worthiness of a borrower, lack of seriousness in following-up of the advances made (Mullineux 2012). Errors in these cases might increase the operational risk of the bank that can ultimately lead to non-compliance of important legislative norms. Therefore, it can be said that regulators and legislators are not trying to make banks risk adverse but to take risks in a measured manner by proper evaluating the pros and cons of important investment and financial decisions (Singh 2012). In such a scenario, keeping loose ends internally will result in a total failure of the banking system. Performing financial services according to the applicable rules is the only way the objectives of an organization can be achieved. Lacking a spirit of accountability not only affects the stakeholders of a bank, it also affects the entire financial system of a country and this cannot be tolerated in an form (Collins 2012).

Impact of Regulatory Changes on the Banking Industry

Conclusion

The above discussions point out to a very important fact about the functioning of banks throughout the world and its relation with national and international regulatory and legislative norms. The global financial crisis turned the tables for many developed countries and forced them to revisit their banking systems. In order to recover from the after affects of the crisis, various changes in the legislative front were made. Governments bailed out the economy of some of the worst affected countries of the world (Haas and Lelyveld 2014). The capital market collapsed and so did the securities market. Banks and other financial institutions became bankrupt in an attempt to cut short their losses. The aim of the regulatory reforms was to restructure the entire banking system. The risk taking ability of the banks faced an enormous challenge. Risk management had to be enforced in a new form by implementing an effective risk management mechanism that re-engineered the whole business process of these banks. Managing risk and being accountable was one of the primary objectives of the legislative changes. In such a scenario, if banking professional are allowed to get away with their mistakes, frauds and misconducts will increase rather than providing a proper solution. Therefore, it can be concluded that the objective of stringent norms is to empower the banking institutions to work better and contribute much more to the economic development.

References

Chodorow-Reich, G., 2014. The employment effects of credit market disruptions: Firm-level evidence from the 2008–9 financial crisis. The Quarterly Journal of Economics, 129(1), pp.1-59.

Collins, M., 2012. Money and Banking in the UK: A History (Vol. 6). Routledge.

Covitz, D., Liang, N. and Suarez, G.A., 2013. The Evolution of a Financial Crisis: Collapse of the Asset‐Backed Commercial Paper Market. The Journal of Finance, 68(3), pp.815-848.

Erkens, D.H., Hung, M. and Matos, P., 2012. Corporate governance in the 2007–2008 financial crisis: Evidence from financial institutions worldwide.Journal of Corporate Finance, 18(2), pp.389-411.

Flannery, M.J., Kwan, S.H. and Nimalendran, M., 2013. The 2007–2009 financial crisis and bank opaqueness. Journal of Financial Intermediation,22(1), pp.55-84.

Frankel, J. and Saravelos, G., 2012. Can leading indicators assess country vulnerability? Evidence from the 2008–09 global financial crisis. Journal of International Economics, 87(2), pp.216-231.

Fratzscher, M., 2012. Capital flows, push versus pull factors and the global financial crisis. Journal of International Economics, 88(2), pp.341-356.

Haas, R. and Lelyveld, I., 2014. Multinational banks and the global financial crisis: Weathering the perfect storm?. Journal of Money, Credit and Banking,46(s1), pp.333-364.

Kuppuswamy, V. and Villalonga, B., 2015. Does diversification create value in the presence of external financing constraints? Evidence from the 2007–2009 financial crisis. Management Science.

Mullineux, A., 2012. UK Banking After Deregulation (RLE: Banking & Finance) (Vol. 23). Routledge.

Shiller, R.J., 2012. The subprime solution: How today's global financial crisis happened, and what to do about it. Princeton University Press.

Singh, D., 2012. Banking regulation of UK and US financial markets. Ashgate Publishing, Ltd..