Roles of Deregulation on Banking Sector
What roles have deregulation, innovation, and globalization played in changing the character of bank management in recent decades? Has the overall outcome of the changes been greater stability in the banking sector? Discuss the respective roles of asset and liability management in modern banking. Deregulation, innovation and globalisation has changed the way banks run from asset management to liability management, as well as the change from ‘mono’ to ‘multi-tasking’ and the increased competition in the sector as well as risk.
The banking system has evolved drastically from the traditional mono-tasking institution to what it is now. This change in roles of asset and liability management could be one of the main reasons behind the global financial crisis of which the aftermath effects are still being felt. In this essay I will analyse these three trends in turn and so to explain the reasons for the change to liability management.
Traditionally, the role of the banks are simple (post war period 1945-60s) there were strict credit controls (or credit rationing) by the state (there were large public sector war debt) to keep repayments obligations on this debt low. The low interest should also be of aid in sustaining a high demand for Gilts (UK government bonds), allowing no competition on the liabilities side of the bank’s balance sheet. The Liabilities side of the bank’s balance sheet is mainly composed of customer deposits (shows passive banking).
They take deposits in, and loans out as the main source of income; this is referred to as ‘mono-tasking’. It should be noted that in more theoretical consensus that regulation in banking has tended to be increasingly destabilizing as the economy has become more dynamic. The process of deregulation changed all this; deregulation came in two forms: first was the removal of self-regulatory restrictions, those were the regulations established in the financial sector to keep away substandard service providers; second was the removal of government restrictions which came in three phases: ) The ending of the traditional/mono-tasking structure of the sector, which is a decisive blow to the traditional framework.
On the asset side, we have the lifting of quantitative controls on bank’s assets (deregulating the use of funds); and on the liabilities side they lifted ceilings on interest rates on deposits (deregulating sources of funds) as to promote more competition. The UK began deregulating much earlier than the US; this is because the US is more tightly regulated than Europe (due to the large amounts of bankruptcy and anti-monopolistic view).
The US lifted its “regulation Q” act in 1980 (which limited interest rate payable on deposits) but by that time they deregulated many banks moved to Europe where it has been deregulated for a long time. The UK Heath government (1970s) lifted credit restrictions and enabling banks to expand liabilities competitively. In the 1970s the UK was increasingly allowed to use variable rate lending (e. g. LIBOR) instead of sticking to with an unprofitable loan rate when interest rates were volatile; this endowment gave banks higher profit margins.
Later on in 1980s the Thatcher government ended all credit and FX exchange controls. This promoted the change from asset management to liability management, variable rate lending meant stock of loans could be determined by demand, and effective those who want a loan gets a loan. This was explained by the Net interest margins (NIM=interest revenue on assets-interest revenue on liabilitiesinterest earning assets). This differential actually improves the bank’s profitability.
Banks therefore actively create liabilities (borrow from other banks) in ‘money markets’ and thus switch to ‘liability management’ trying to maximise sources of funds. The asset management of the past where loans was seen as a ‘person to person’ management no longer existed, as banks greatly expanded their balance sheet they reduced their capital to asset ratios (high gearing) and mortgages are bundled and not monitored, consequently the risk exposures of banks began to increase (complexity of bundling was a factor which led to the current crisis). )
The second phase sees the ending of the sharp distinction between banks and NBFIs (non-banking financial institutions). In the 1980s, banks were given the right to compete in the mortgage market and building societies allowed to compete in the market for consumer credit; i. e. both allowed in each other’s markets. Whereas in US, banks were not allowed to compete in the field of investment banking and insurance until 1999. 3) The third phase allowed increased competition within the financial sector and from outside it.
NBFIS and other new kinds of financial institutions attached to other financial operations provided new kinds of services such as online banking (within the financial sector). Firms from outside the financial sector also entered the financial services market including Tesco, Marks and Spencer (UK), and GM and GE in the US (General electric’s financial arm makes 1/3 of its profits! ). The three phases of deregulation is the main driving force for banks and NBFIs to compete aggressively and take on excessive risk (through actively searching out liabilities) to gain higher profit margins.
By expanding their balance sheet through liabilities, they increase exposure to credit risk and become highly sensitive to the state of the economy i. e. more defaults during downturns of the economy. Apart from deregulation, financial innovation also played a role in the shift to liability management. Since the 1970s, there has been great instability in the financial environment; there were unpredictable swings in interest rates, exchange rates and inflation; there’s increased demand for NEW financial instruments to hedge against this risk.
This lead to the development of all sorts of exotic instruments such as currency options/options/exchange contracts, interest rate swaps and credit default swaps. It is no longer adequate for banks to look at averages over time, investment banks now trade at massive quantities (high-frequency trading) to profit from the narrowest margins. The development of ever more complex instruments is also the solution for the ever increasing sophistication of regulation, as to find loopholes. US banks started to branch out to off shore operations in order to exploit the loosely regulated markets.
This is one of the effects which is interconnected to globalisation (discussed later on) Financial innovation also includes technological developments which includes the computerisation of banking, telecommunications and customer’s files. The introduction of electronic payments (credit cards) and ATMs also saw unit transaction costs fall. More importantly, there is a growth in automated trading services, allowing banks to process high volume trading comparing to traditional banking. Lastly we have the factor of Globalisation in the shift to liability management.
It follows on the things discussed earlier in the essay; the UK started deregulating far earlier than the US and this became a pull factor; so this is great motivation for the US firms to expand into the European market (funding is restricted by regulation Q which as a push factor), a more profitable and a larger Eurodollar market. This in general shows globalisation in the financial system and the growth of MNCs in general. Securitisation has also increased pace of globalisation of banking.
This refers to pooling contractual debt (mortgages/car loans) and selling these in the form of bonds or Asset backed securities. Eventually this lead to the fragility of the bank’s balance sheet; if much of the bank’s assets is no longer ‘mediated’ why should you trust another bank? This lead to the financial crisis we have today, where the fall in house prices in the US lead to the fall in securities (the Asset backed securities) damaging financial institutions globally and created insolvency issues.
The collapse of big financial institutions eventually lead to the biggest bailout ever in US history; deregulation, financial innovation and globalisation all played a part in this crisis. Based upon the discussion of the three common trends in the banking sector that led to a shift from asset management to liability management above, I will now focus on how these contributed to the expansion of bank’s balance sheets. Interlinking deregulation, innovation and globalization, we see banks fighting harder to compete amongst one another and with NBFIs as well.
As more and more major conglomerates start offering financial intermediation services, it is no wonder banks have been driven to expand their balance sheets to remain competitive. Where this was previously unattainable due to strict regulations in the banking industry, the deregulation that has taken place now creates a great incentive for banks to take on more risks in order to expand their balance sheets. Furthermore, the absolution of the Glenn Seagal Act in the UK has led to a
Banks finance their expansion by borrowing from the inter-bank loan markets, hence leading to the huge increase in financial sector debt over the last 3 decades. This has become a cause of worry, as increased risk taking and declining liquidity of banks have led to the financial crises of 2008 that has persisted until today, as the European economy becomes increasingly volatile. Due to increased competition created by the deregulation process, banks have now become more aggressive in trying to win market share by expanding their balance sheets and providing loans or mortgages at high risks.
The decreasing number of credit-worthy borrowers has lefts banks with no choice but to lower their underwriting standards and issue mortgages to high-risk individuals, resulting in a leap in subprime lending that led to the global financial crisis of 2008. Essentially, investment banks and hedge funds used financial innovation to enable large wagers to be made, far beyond the actual value of the underlying mortgage loans, using derivatives called credit default swaps, CDO and synthetic CDO.
As long as derivative buyers could be matched with sellers, the theoretical amount that could be wagered was infinite. Conclusively, the transition from banks focusing on asset management to liability management today, coupled with the various effects of globalization, financial innovation and globalization has led to banks expanding their balance sheets with high risk mortgages and various other risky ventures, resulting in a massive surge of debt held by the financial sector.
As deregulation decreased interest rates in the US and people demanded more loans, banks started providing loans to credit-unworthy individuals, resulting in a spike in bad debts and eventually bringing about the burst of the housing bubble in 2006/2007 which, when coupled with the fact that banks were borrowing from one another to finance risky ventures whilst maintaining a very minimal liquidity requirement has led to a vulnerability of the banking system that resulted in the global financial crisis in 2008.
Economists have argued that the trend of deregulation has not kept up with the pace of financial innovation that now allowed banks to onduct various unmonitored activities that could lead to an increased vulnerability of the banking system. To prevent a future crisis, the US authorities have to re-evaluate their deregulation trends (introduction of BASEL III) and ensure that sufficient changes are made to ensure that they keep up with the pace of financial innovation. Briefly discuss how the concepts of the equity multiplier and the convexity of pay-off to holders of equity may be relevant to some current debates regarding the rewards structure in the financial sector
The reward structure in the financial sector has been affected in recent years by the changing banking/financial sector especially the excessive risks that the banks are taking for more profit. In this essay I will explore the concepts of the equity multiplier and the convexity of payoffs and affects the reward structure of the financial sector. The high risk aspect of the banking sector could be described by the extremely high gearing banks engage in lending: typically over 95% of funds sourced from debt with less than 5% from equity; if we compare those figures with non-financial institutions with 70% equity funded.
The asset management side is also full of risk, how do we screen for loan borrowers? If we increase r, then we get a large mix of high risk borrowers. Borrowers also have more information (private hidden actions/intentions) than the lenders, so there will be asymmetric information. Adverse selection refers to problem where those most likely to be a credit risk are most eager to be selected for a loan; Moral hazard describes the problem where after a loan is approved, the borrower has the incentive to engage in more risky activities which in turn increases the risk of default.
This can be solved by “Information-producing”, that is filling forms that filters people with bad credit scores; or they can build long-term customer relationship that could be mutually beneficial, such that banks knows about the customer and customer knows that the bank knows about their situation. This is known as the “know your customer” (KYC) procedure within financial institutions, which is carried out to allow better assessment of level of risk taken. There are four main motives for banks to take on excessive risk: First, it is the pressure on the bank’s profits.
Banks used to be mainly asset management based, however since the phases of deregulation and innovation and the introduction of NBFIs into the competition drove down profits of the banks. Banks expanded the liabilities side of the balance sheets, and hedging management instruments replaced asset management, so in effective customers’ deposits form a quite small proportion of the liabilities. Assets were transformed from the short-term funds (deposits) to long term, less liquid, high yielding assets. Risks involved changed from low to how.
All of these are aimed to increase the yield and to increase the returns on assets. Second, it is on the capital adequacy management and the equity management. There is a trade-off between safety and return on equity (low risk/high risk). The return on equity (ROE) is defined as the Net profits/Equity Capital. If the bank wants to increase their ROE, they have the incentive to reduce equity capital. Recall that Equity Multiplier = Assets/Equity. The increase in ROE holding net profits constant will increase equity multiplier.
We make an assumption that retained earnings are 0, which is the entire bank capital is equity capital. Then: A low capital bank with E:A ratio of 4% will have an Equity multiplier (A/E) = (100/4) = 25 A high capital bank with E:A ratio of 10% will have an Equity multiplier of (100/10) = 10 This means, that as we increase the equity multiplier, we also decrease the equity asset ratio, which in turn increases risk of insolvency. A higher equity multiplier implies higher financial leverage, and this will mean the financial instate has to rely more on debts to finance its assets.
The third motive involves the analysis of the convexity of returns to holders of equity ? = min (L, Y) is the payout to debt holders. The function is concave: line between any two points on the curve lies beneath it. ? = max (0, Y- L) is the payoff to shareholders. The function is convex: line between any two points on the curve lies above it. The idea is that risk transfers value from debt holders to equity holders and the bigger the spread, the bigger the transfer of value.
This model of convexity represents the principle-agent problem, when the manager takes on excessive risk and could be beneficial to the shareholders, but due to limit liability, shareholder bares little to no risk. The last motive is the reward structure in the financial sector. Managers typically take a performance bonus (e. g. 20%) of excess return on funds. This creates a rather large problem, managers can take on a huge ‘tail risk’ (or a huge bet) that is hidden from others, and also managers receives his reward/bonus long before the fund gets hit.
This is especially damaging not to one self but also the institution. For example the rogue trader at Barings lost $1. 3billion speculating that brought down the bank that was founded over 2 centuries ago. Another rouge trader at Societe Generale lost 4. 9billion Euros, severely weakening the French bank; he claimed that his superiors knew of his trading activities and it was common practice to take huge gambles for large profits, this is especially worrying.
Conclusively, all of the factors discussed above have driven the financial sector to take on larger risks that has rendered the banking system vulnerable to shocks and prone to insolvency, which is exactly what happened in the 2008 global financial crisis. Steps that can be taken to improve upon this include introducing a new rewards structure in the financial sector that ties management’s gains to the firm’s long-run performance to minimize risk-taking.
Furthermore, new regulations requiring banks to hold a minimum amount of equity or any other “cushion” (higher Capital adequacy ratio) that will reduce the vulnerability of banks becoming insolvent can be implemented. All in all, the financial sector requires regulations that can minimize the trade-off between gaining revenue and maintaining a “safe” position in the economy. Although many such actions have been taken in the US after the 2008 crisis, it is still not enough to eliminate the high debts that have plagued the country for the past few years.