1

Money, Banking and Finance

APC312

Prepared by: TRAN THI MAI THANH

Student ID: 119107003/1

Submission Date: 9th

January, 2012

_________________________________________________________________

Number of Words:

Part A: 1,503

Part B: 1,772

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Part A: Differences of Banking Industry

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Table of Contents

Title Page…………………………………………………………………………………………….…2

TABLE OF CONTENTS ..................................................................................................................... 3

INTRODUCTION ................................................................................................................................. 4

I. CHARACTERISTICS OF BANKING INDUSTRY – WHAT MAKE BANK SPECIAL?... 5

1. FUNCTIONS OF BANKS ................................................................................................................ 5

2. NATURES OF BANKS .................................................................................................................... 6

3. COST OF BANKRUPTCY ............................................................................................................... 7

4. RISKS AND RISKS MANAGEMENT ............................................................................................... 8

II. GOVERNMENT REGULATION – BANKS CONTROLLING METHODS ........................ 9

CONCLUSION AND RECOMMENDATION ................................................................................ 10

REFERENCES .................................................................................................................................... 11

APPENDIX A: COST OF SUPPORT PACKAGES AFTER 2008 CRISIS .................................. 12

4

Introduction

Banks are now known as the heart of financial system and playing important roles in

the economy. As the result, bank industry is simply treated differently cause of its

characteristic involve functions in financial system and economic growth, natures, cost of

bankruptcy and risk management.

Be treated differently, bank industry requires more control from government.

Regulations in banks also make this industry different in comparison with other non-financial

industry in term of special safe net for bank and banks‟ customer, as well as the higher cost of

regulation implementation.

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I. Characteristics of Banking Industry – What make bank special?

1. Functions of Banks

Fetz A. – member of the board of directors of Bank Coop (2002) emphasised that:

“All banks were created in order to provide the real economy, at a price, with money to

finance its development”.

There are many opinions state that the functions of bank industry make it special and

different in comparison with other industries. In their articles, Beck, et al. (2010) and

Corrigan (1982 in Kwan, 2011) argue that banks are treated differently purely because of

their special functions in transferring assets through payment system; providing transaction

services and monitoring costs to match the various supply and demand of funds.

Bank industry provides money as goods and funds transferring as services while other

non-financial industries transform inputs into outputs through production (Beck, et al., 2010;

Bureau of Labour Statistics, 2011). The performance of banks has to be based on a broad

payment system in order to reducing the transaction cost. This payment system contributes a

huge importance in any national economy. In fact, the total value of payment in the UK

economy was £89,063bn while a value for all goods and services produced of just £1,190bn

(Howells, 2010, p.14).

Therefore, bank industry has special and important role in order to running financial

systems in term of payment, and national economy growth smoothly (Cocris & Ungureanu,

2007; Mishkin, 2010).

Nevertheless, “bank industry is leading buyer of bond and notes government issue to

finance public facilities” (Rose & Hudgins, 2008, p.3). In other words, banks indirectly help

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government in renovate the economy, improve the country‟s infrastructure and people living

standard.

As the result, in order to protect the economy growth and society benefits, banks

industry is treated differently in comparison with other non-financial industry.

2. Natures of Banks

Otherwise, other views concentrate on the capital structure of bank. Macey and

O‟Hara (2003, p.97) figure out that capital structure distinguishes banks from other firms in

two ways.

While non-financial businesses always try to finance themselves with more equity

than debt, banks do the contrary way. “Banks typically receive 90 percentage or more of their

funding from debt” (Macey and O‟Hara, 2003, p.97). Secondly, banks‟ liabilities are liquid in

form of deposits while it holding illiquid asset that often take form of loans.

However, the fragile capital structure of banks also makes its unique function in the

economy is liquidity production (Flannery, 1994; Diamond and Dybvig, 2000; Macey and

O‟Hara, 2003). Needless to say, because of not only banks‟ vulnerability but also its essential

role in economy liquidity, banks are treated differently through regulation.

Besides, Diamond & Dybvig (2010) concentrate on contagion which is more

important for banks than for other industries because of banks‟ nature of in holding illiquid

assets and liquid liability. Moreover, banks are now heavily involved in interbank lending

market and operating with larger information asymmetries (banks are generally more opaque

than nonfinancial firms), hence the contagion could be the trigger for panic and extreme crisis

(Furtine, 2001; Carletti & Hartmann, 2002; Shyam, 2011a).

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Competition is also a difference between bank industry and others. Unlike other non-

financial industries, competition is restricted in banking industries (Mishkin, 2010). The

reason is that increased competition encourage bank accept the lower profitability, hence the

moral hazard also increase from banks‟ effort to maintain revenue (Keeley, 1990; Hellmann,

Murdock, Stiglitz, 2000).

3. Cost of Bankruptcy

As mentioned above, banks play a critical part in whole payment system and economy

but its activities involve many risks and lack of transparency. The question is that what could

happen if banks fail and become bankrupt?

Although there are some ideas argue that the risk of banks‟ failure is not as high as the

risk of non-financial firms‟ one thanks for government‟s stakes (Cocris & Ungureanu, 2007),

some other economists still consider about the cost of bank‟s bankruptcy. Mahate (1994),

Beck, et al. (2010) and Huertas (2010) emphasize that banks‟ bankruptcy has larger social

cost and negatively affects on not only bank‟s depositors but also other banks, the payment

system, financial and general economic stability.

Beck, et al (2010) argues that “the social cost of a bank‟s bankruptcy is larger than its

private cost”. He also points out the reasons for large social cost are the effects on

uninformed depositors1, loss of sunk investment and negative influence on whole banking

industry through contagion effect cause of banks‟ connectivity.

Nevertheless, contagion through the web of reciprocal obligations not only is limited

to the banking industry, but also leads to the sale of risks to non-banking institutions (Beck, et

1 “Uninformed depositors who do not have the incentives or the means to assess the risk they make. Small

depositors are uninformed because they do not consider their deposit as a financial investment, and they will make deposits without having any information about the riskiness of their bank” (Beck, et al., 2010). Therefore, when their bank fails to make payment, “panic” will be occurred quickly.

8

al, 2010). As the result, costs of supporting the financial system after crisis started from

contagion in baking system could vary widely2.

Needless to say, bank industry is treated differently through government regulation by

setting up a safety net to protect banking system and financial stability.

4. Risks and Risks Management

Beside payment risk as an unique risk to banks cause of their role in the payments

mechanism, banking and other industries have to face with same types of risk in operation:

liquidity and asset risks (Howells & Bain, 2005).

However, banks are especially exposed of those risks because of their deposit

business. While other firms can delay payment for long enough to obtain the funds by

disposing off some other asset, banks do not have this option. (Shyam, 2011b)

The reason is banks‟ role in economy of holding only fractional reserve, and a

liquidity crisis at one bank can cause a systemic failure of the banking system through a

processes of contagion (Shyam, 2011b).

Besides, if banks are forced to sell some of their assets in the market to solve their

liquidity problems, it will put down the price of their own assets. In other words, the liquidity

crisis can turn into an assets crisis with bank becoming insolvent.

Therefore, the risks management (classified in term of liquidity, asset and capital

structure managements) is very important in banking sector. In fact, “banking and other

financial services companies were far more like than other industries to have in place an

enterprise risk management program – 79 percentage compared to the average of 67

percentage”. (Accenture Risk Management, 2010)

2 Refer to Appendix 1, p.12

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II. Government Regulation – Banks Controlling Methods

As mentioned above, role and characteristic of bank industry are so important and

different with other industries in the economy, hence it is treated especially. Besides, Levine

(2003), Cocris & Ungureanu (2007), Beck et al (2010) argues that the strict regulation of

government in banking industry which creates a safety net for banks is also a reason make

bank industry special.

There are four main forms of regulation: regulations on structure and activities of

banks, regulations on banks‟ liquidity, regulations of capital adequacy and regulation on

clarity and accuracy of information to protect consumer (Mishkin, 2010).

Although regulation is needed to protect banks from externalities problem,

asymmetric information (especially its consequence of creating moral hazard) and principal-

agent issues, it is also necessary to consider about cost of regulation (Mishkin, 2010; Zhou,

2011)

These costs includes the possibility of moral hazard, danger of agency capture, the

additional costs imposed on firms and possible creation of barriers to entry (Shyam, 2011a;

BBC, 2011)

Every coin has two sides. Although strict regulation and safety net is created to

protect bank industry and banks‟ customers, it also creates the risk for bank in performance

and higher cost for customers. Therefore, government should use the regulations as a useful

method to control banks effectively in each special situation.

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Conclusion and Recommendation

Banking industry is treated differently comparing with other non-financial industries

in terms of its unique functions in running financial and economy smoothly and liquidity

production, fragile capital structure, severe contagion, restricted competition, high cost of

failure, and strict required risk management.

Bank controlling through regulations to create a safe net for banks and protect its

customer from asymmetric information also a difference of bank. However, it is suggested

that government should use this controlling method carefully in order to manage the cost of

regulation as well as risks of wrong regulation implementation.

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References

1. Accenture Risk Management (2010). Risk Management as a Source of Competitive

Advantage and High Performance in the Banking Industry. Global Risk Management

Point of View in Banking, Industry Report.

2. BBC (2011)Banking Reform: Impact on the UK‟s Biggest Banks [online] Available

at: <http://www.bbc.co.uk/news/business-14879427> [ Accessed 1 January, 2012]

3. Beck, T., et al. (2010) Bailing out the Banks: Reconciling Stability and Competition –

An analysis of state-supported schemes for financial institutions. London: Centre for

Economic Policy Research.

4. Bureau of Labour Statistics, U.S Department of Labour, Career Guide to Industries,

2010-11 Edition. Banking. [online] Available at:<

http://www.bls.gov/oco/cg/cgs027.htm> [ Accessed 29 December 2011]

5. Carletti, E. and Hartmann, P. (2002) Competition and Stability: What’s Special about

Banking?. European Central Bank.

6. Cocris, V. and Ungureanu, M.C. (2007) Why are Bank Special? – An Approach from

the Corporate Governance Perspective. Lasi: Alexandru Ioan Cuze University.

7. Diamon, D.W. and Dybvig, P.H. (2000) Bank Runs, Deposit Insurance, and Liquidity.

Federal Reserve Bank of Minneapolis Quarterly Review, 24(1), pp.14-23

8. Fetz, A. (2002) The Role of Banks in a National Economy: a Political View. Swiss

Banking, Swiss Bankers Association Media Seminar. June 25-26

9. Flannery, M.J. (1994) Debt Maturity Structure and the Deadweight Cost of Leverage:

Optimally Financing Banking Firms. American Economic Review, 84(1) pp.320-331

10. Furfine, C.H. (2001). Banks as Monitors of other Banks: Evidence from the Overnight

Federal Funds Market, Journal of Business, 74, pp.33-57

11. Hellmann, T.F., Murdock, K., Stiglits, J. (2000) Liberalization, Moral Hazard in

Banking and Prudential Regulation: Are Capital Requirement Enough?. American

Economic Review, 90, pp.147-165

12. Howells, P. (2010) Money, Banking and Finance. United Kingdom: University of

Sunderland.

13. Howells, P. and Bain, K.,(2005) The Economics of Money, Banking and Finance. 3rd

Ed. London: Prentice Hall

14. Huertas, T.F (2010) Improving Bank Capital Structures. London: London School of

Economics Financial Markets Group

15. Keeley, M. (1990) Deposit Insurance, Risk and the Market Power in Banking.

American Economic Review, December, pp.1184-1200.

16. Levine, R. (2003) The Corporate Governance of Banks: A Concise Discussion of

Concepts and Evidence.

17. Mahate, A.A. (1994) Contagion Effects of Three Late Nineteenth Century British

Bank Failures. Business and Economic History, 33(1), pp.102-115

18. Mishkin, F.S. (2010) The Economics of Money, Banking and Financial Markets. 9th

Ed. Pearson Education, Inc.

19. Shyam, P. (2011a) Regulation Banking, APC312 Money, Banking and Finance.

University of Sunderland, unpublished.

20. Shyam, P. (2011b). Banking Risks, APC312 Money, Banking and Finance. University

of Sunderland, unpublished.

21. Zhou, T. (2011) Central Banking and Regulation, APC312 Money, Banking and

Finance. University of Sunderland, unpublished.

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Appendix A: Cost of Support Packages after 2008 Crisis

UK US Euro

Central Bank

- Money creation

- Collateral Swaps

0.32

0.30

3.76

0.20

0.98

0.00

Government

- Guarantees

- Insurance

- Capital

0.64

0.33

0.12

2.08

3.74

0.70

>1.68

0.00

0.31

Total (as % GDP) 74% 73% 18%

Table 1: Cost of Support Packages after 2008 Crisis (US$ trillion)

Source: Bank of England (2009)

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Part B: Impact of Recent Crisis on Banking Regulation

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Table of Content

Title page……………………………………………………………………………………………....13

TABLE OF CONTENT ...................................................................................................................... 14

INTRODUCTION ............................................................................................................................... 15

I. CHANGES IN ECONOMY BEFORE CRISIS ....................................................................... 16

II. RECENT CRISIS IMPACTS .................................................................................................... 17

1. REASONS OF CRISIS ................................................................................................................... 17

2. IMPACTS OF RECENT CRISIS ...................................................................................................... 18

2.1. Authority Response Policies .............................................................................................. 18

2.2. Regulation Reforms ........................................................................................................... 19

CONCLUSION ................................................................................................................................... 22

REFERENCES .................................................................................................................................... 23

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Introduction

Recent global economy has witnessed a violent crisis that not seen sine the Great

Depression. The growth of macro imbalance and shadow banking, combining with lax

monetary policy and weak financial regulation has encouraged the housing mortgage loans

and subprime lending and created risks in banking operation. Therefore, the collapse of

housing prise boom had triggered and fuelled a wide and deep global financial crisis.

The impacts of recent crisis on banking regulation showed out clearly through

authority‟s response policies during crisis and the regulation reform after crisis in order to

prevent similar ones in the future.

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I. Changes in Economy Before Crisis

It is argued that a long time after World Was II was a cosy time when banking

industry was well controlled and very few banks failed, but many things changed in recent

years (Dewatripont and Tirole, 1994)

According to Financial Service Authority (2009), macro imbalances had grown

rapidly in the last ten years. There was a large current amount surplus in emerging and

developing nations, especially in oil and commodities exported countries such as Japan,

Germany, China3, while large current amount deficits occur in USA, UK, Ireland and some

other countries (Daianu & Lungu, 2008; Obstfeld and Regoff, 2009; Financial Services

Authority, 2009).

Banking in particular has mixed its traditional credit culture with an equity culture

with a focus on faster share price and profit growth, includes the growth of „shadow banking”

created huge and accompanied appreciated risk (Wignall, Atkinson and Lee, 2008; Financial

Services Authority, 2009).

Before 2007, asset-backed commercial paper became the largest short-term debt

instrument4 in U.S and most of this fund was used to invest in long-term financial assets of

current account deficit countries (Acharya and Schnabl, 2010). In other words, U.S banks

were tanking numerous cumulative liquidity risks that would form a deep global banking

crisis anytime.

Moreover, the analysis of Ahrend et al (2008) and Jickling (2010) figures that U.S

monetary policy was much too lax and credit standard in U.S mortgage lending were

3 Under the influence of monetary accommodation, low real interest rates, the world’s economic growth,

commodity price, especially the price of oil created the growing external surpluses of the oil and other developing commodity exporters. For example, China surplus jumped from 3.6% of GDP in 2004 to 7.2% in 2005, and had risen to 11% of GDP by 2007 (Obstfeld and Regoff, 2009) 4 Asset-backed commercial paper valued at more than $1.2 trillion outstanding in January 2007 in comparison

with only $940 billion Treasury Bills in U.S

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relaxed in the early 2000s. As the result, it was more likely increased risk taking to raise the

revenue up in banking sector and was a key contributor to the asset price bubble.

Besides, home prices in the U.S had been rising steadily for nearly a decade from

1997 to 2001, although there was Asian crisis in 1997-8 but upward trend in U.S. home

prices was not much effected (Obstfeld and Regoff, 2009). According to Federal Reserve

Bank of San Francisco (n.d), “U.S. house prices rose about 10 percentage per year from 2000

to 2006, well outpacing gains in income”.

Moreover, the „American Dream‟ zero equity mortgage proposals became operative

in 2004, followed by imposed greater capital requirements and free balance sheet control in

which banks could create their own ways to treat with low-income mortgages (Wignall,

Atkinson and Lee, 2008).

Needless to say, expectations of housing appreciation with low interest rate,

combining with financial innovation had pushed home price up more rapidly, bank was

taking too much risk when allowed a huge number of mortgage loans and the root of crisis

was formed.

II. Recent Crisis Impacts

1. Reasons of Crisis

In general, a financial crisis occurs when asymmetric information creates adverse

selection and moral hazard problems, entail incapability of financial market in exchange

funds from savers to investors (Mishkin, 2010, p.199).

The financial crisis of 2007-09 was similar to previous crises in that the need for

liquidity by businesses and households was unmet by market-based sources of funding.

However, it differed in that its risk were more concentrated in banking system (Mora, 2010).

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As mentioned above, banks had been taking too many liquidity risks before 2007 by

providing huge short-term debt and investing in long-term financial assets, especially

allowing zero equity mortgage loans for housing bubble cause of lax monetary policy.

Nevertheless, global macroeconomic imbalance encouraged transferring funds from

surplus countries to U.S (current account deficit) also helped stimulate the growth of the

subprime market (European Commission, 2009; Mishkin, 2010).

Therefore, the collapse of housing prise boom had triggered the recent crisis and

collapse of sub-prime bubble in U.S, leaded to losses for many financial institutions, runs on

money market funds and bank failures through contagion, and also fuelled a global financial

crisis through liquidity connection in interbank market (Elmeskov, 2009).

2. Impacts of recent Crisis

As mentioned above, the recent crisis erupted cause of liquidity trouble, lax monetary

policy and weak regulation in banking industry. The impact of recent crisis on banking

regulation simply showed out through authorities‟ policies responded to the liquidity trouble

and the regulation reform.

2.1. Authority Response Policies

The policy responses during 2007-09 were broadly similar to those used in the past

but have been put in place quicker (Laeven and Valencia, 2008, 2010). Liquidity pressures

were contained through liquidity support and guarantees on bank liability, while a wide

array of instruments was used including asset purchase, asset guarantees and equity injections.

In autumn 2007, the Federal Reserve provided short-term funding liquidity by

allowing banks to exchange their holdings of Treasury securities for cash (Cecchetti, 2008).

This policy helped banks solve the liquidity troubles they had outstanding.

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Moreover, in March 2008, the Federal Reserve created two programs to provide short-

term secured loans to primary dealers and discount-window loans provided to banks. In

addition, secured loans to institution in commercial paper market also created in fall of 2008

to help this market function well again (Federal Reserve Bank of San Francisco, n.d.).

Consequently, this action had provided liquidity and stabilization in banking system and

financial market to limit the damage of crisis.

Policymakers in European Union also recognized the impact of crisis and pushed

policy action into higher gear in September 2008, including an aggressive easing of monetary

policy, a ware of debt guarantees, recapitalization and impaired asset relief (European

Commission, 2009)

Although there was the idea that government recapitalization program will throw

money into a black hole (Grauwe, 2008), it still have been widely used with 76 percentage of

fiscal outlays (Laeven and Valencia, 2010)

By the end of 2009, the cost of support packages was 1.71 trillion in U.K. (equal to

74% GDP), 10.48 trillion in U.S. (equal to 73% GDP) and 2.97 trillion in Euro (equal to 18%

GDP) (Bank of England, 2009 in Howells, 2010). Those figures showed out the deep and wide

impact of recent crisis on global economies.

2.2. Regulation Reforms

Because of heavy and broad influences on global economy, the impacts of recent

crisis on banking regulation were continuously pointed out through the regulation reform to

prevent similar crises in the future.

The deregulation on capital requirement was an improvement in macro-prudential

regulating. In 2008, Financial Services Authority (FSA)‟s interim capital regime was already

in place which required UK banks to be able to meet a severe stress over a forward looking

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period exceeding 4% Core Tier 15 at all time (FSA, 2010a). This was a double higher capital

requirement in comparison with 2% as Basel minimum (FSA, 2010a). Besides, the

international agreement on long-term regime also required (FSA, 2009)

Moreover, there are numerous criticisms of Basel II cause of its complexity that

makes it unworkable in crisis time, wrong risk-weighted assets requirements, and it was

assessed as pro-cyclical6 (House of Commons, 2009; Freixas, 2009; Mishkin, 2010). As the

result, recent crisis had required the changes in this international regulation.

In December 2009, the BCBS7 published two consultation papers that enhanced all

three Pillar of the Basel II framework and proposed major changes to the capital and liquidity

requirements for banks8 (Council of Mortgage Lenders, 2010). Those papers had improved

the regulatory treatments on quality to capital: trading book capital, introducing counter-

cyclical capital, gross leverage ratio and liquidity.

Furthermore, in term of reform to liquidity and liquidity risk management, FSA

Consultation Paper (CP08/22) issued in December 2009 provided rules to liquidity regime for

banks, building societies and investment firms (FSA, 2010b). This one is supported by

BCBS‟s Principle for Sound Liquidity Risk Management and Supervision in order to promote

greater consistency of liquidity regulation and supervision for international banking

(Caruana, 2009).

Recent crisis also made regulation-maker consider about risk management of

financial institution and improve the micro-prudential regulation. In January 2009, BCBS

5 The deduction of intangibles such as goodwill.

6 “Basel demands that banks hold less capital when times are good, but more when time are bad, thereby

exacerbating credit cycles” (Mishkin, 2010). But crises develop in different way, and even if following sudden booms like in recent crisis; while Basel II require more capital at exactly the time when capital is most short. As the result, Basel II were inadequate in recent crisis. 7 Basel Committee of Banking Supervisors

8 BCBS 164 Strengthening the Resilience of the banking sector and BCBS 165 International framework for

liquidity risk measurement, standards, and monitoring (Council of Mortgage Lenders, 2010)

21

issued a consultative document aimed to strengthen risk management through Pillar 29

(Caruana, 2009).

The improvement and reform of both micro and macro prudential regulations were the

positive changes after crisis. In addition, it is strongly suggested that the form of regulation

structure should follow its function. In other words, the macro-prudential regulation should

be carried out by Central Bank and micro-prudential regulation by FSA (Wyplosz in Howells,

2010)

9 This focuses on improving firm-wide risk management, managing specific risk area such as firm-wide risk

concentrations, securitizations and reputational risk and also bank stress testing (Caruana, 2009)

22

Conclusion

The impact of recent crisis on banking regulation concentrated on the reaction of

authority during the crisis and deregulation to avoid the similar crises.

Through many fast implemented policies, authority had successfully supported the

financial system during the crisis. However, the cost of supporting packages had showed out

the huge impact of recent crisis on global economy in general and banking industry in

particular.

Moreover, the recent crisis had put the impact on banking regulation and required

regulation maker to create correct and necessary reform. The higher quality and quantity

capital requirement, greater consistency of liquidity regulation as well as stricter micro-

prudential regulation in risk management was the positive impact of crisis in order to improve

the financial stability.

23

References

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24

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