Module Title: Global issues for the finance professional (PAM100-2020-JUL)

Student Reference Number: 200107145

Title: Coursework Assignment (2)

Word Count: 3,998 words

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The world is transitioning by increased economic developments, cross border trading,

technological breakthroughs and constant evolution in online trading of different sorts. All

of this has been possible by the banking system acting the real locomotives hauling the

outright economy behind them. It would not be wrong to claim that the banks evolved first,

making financing possibilities the key, thus enabling other sectors to follow lead.

The backbone of every economy has been the strength of their banking system. Innovation

in the banking sector has now become a dire need to keep fulfilling their role as the

stimulator. Modification in loan packages/customised mortgage deals/complex bonds and

treasury bills today is a continuous process for ensuring the flow of credit in the economy

without halting any operations. Maintaining the money stream is a stipulation for

continuous economic growth.

This excessive burden on the banking sector for devising new credit lines to support newer

projects has resulted in its increased risks exposure. The global financial crisis of 2008 was a

proof to this fact leading to more stringent regulations being introduced in the emergence

of Basel lll as the most recent. These regulations that were created in 2010 are yet to be

implemented however it identified the key areas causing the financial crisis [ CITATION

Ins20 \l 2057 ].

Thus the banking sector exposed to different types of risks aims at minimising those to their

utmost capacity. On the same front they are pressurised by both the shareholders and the

government to increase profits and lending respectively to boost economic growth. Both

elements are at crosshairs because the banks have to work within a very strict regulated

framework that has been designed to protect both the customers and the entire financial

system, so as to not repeat the episodes such as 2008’s. This assignment will look critically

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at the significance of these risks and how banks manage those. It will also look at the

current regulatory system and assess whether the pressure of lending and profits is

realistically achievable within the currently existent regulatory framework.

Credit risk

The studies show that during the economic expansion times the banks tend to lend more to

encourage stability under a background of relaxed regulations which slowly keeps

accumulating risk. In the not so good times when the investments and consumption slows

down and lending facilities reduce, these risks start materialising in the worst economic

outlook [ CITATION Ris08 \l 2057 ].

One of the major threats to the normal functioning of banks arises due to the

unpredictability as regards the solvency of clients (individuals & companies). The possibility

of the loans, made to borrowers, resulting in non-payment or to some extent delayed

payments is known as credit risk. It can be a result of concentration of exposure to one

single entity or a group of entities in a particular economic sector [ CITATION Koz15 \l 2057 ].

Credit risks also increase due to incomplete credit assessment of the prospective

customers, subjective decision making by the management or inadequate monitoring of the

assets’ values over time by the banks themselves [ CITATION Vai20 \l 2057 ].

The profits for banks come majorly from loans in the form of interest payments. For

maximisation of profits the banks involve in different strategies like mortgages, fixed-

income securities, credit cards etc. All these financially packaged products result in added

credit exposure to the banks. For instance up to 1990s mortgage lending US was strictly

limited to borrowers with good credit history and stable income known as prime-borrowers

hence keeping the risk exposure composed. However in the 1990s the very same mortgages

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were extended to not so credit worthy clients leading to the emergence of sub-prime

borrowers. The banks were enjoying such high returns on these sub-prime mortgages on the

whole in the wake of a booming economy that no one paid heed to the discreetly building

default risk. Once these sub-prime borrowing started turning out as sub-prime defaulting

the global financial crisis began to emerge. It is evident today that financial innovations that

are prime motivators for increasing profits and stimulating economy, brings with it added

troubles [ CITATION Arn12 \l 2057 ].

The default mechanism of banks’ operations makes it evident that credit risk cannot be

eliminated. Only option left is for credit risk mitigation.

Credit risk mitigation begins with the client screening first. Prior to their selection it is

imminent to carry out a thorough credit analysis, preferring those with good credit ratings

and repayment history. This acts as a foremost check against default protection [CITATION

Wha19 \l 2057 ]. By establishing an appropriate credit risk environment, the Board of

Directors are responsible for approving and at least periodically reviewing the credit risk

strategy and policies adopted by their bank. The senior management should then ensure the

implementation of those strategies and their compliance. [CITATION Bas00 \l 2057 ].

A collateralised transaction is another basic techniques used by the bank against risk

protection. Here the credit exposure is hedged fully or partly by some sort of collateral

placed by the borrowing party with the bank, against the value of their loan. With such

collaterals the banks are also allowed to reduce the risk exposure when calculating their

minimum capital requirements [ CITATION Ban20 \l 2057 ]. The legal framework requires the

banks to ensure they have the right of acquiring legal possession or liquidating the pledged

asset in a default scenario.

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Securitization is another effective strategy that is a step back from traditional policies of

holding the loans by banks on their balance sheet until maturity date. Instead, the banks

package such loans or other assets together into new securities and further sell them to

interested investors. By packaging and distributing these asset-backed securities (ABS) to

new investors, the banks hedge a considerable amount of their credit as well as liquidity risk

from their asset portfolio. This “originate to distribute” model makes a bank sell its loans &

other ABSs for cash which can further be utilised in initiating new loans. It was reported by

the Bank of England that 70% of commercial loans by major U.K banks were re-originated

within 120days [CITATION Sau10 \l 2057 ]. This led to the financial institution shifting the risk

from their balance sheets off to other customers.

However the shift from the original “originate to hold” model where these loans would be

shown on the balance sheet till maturity had a benefit of banks’ more stringent and active

monitoring of their borrower’s activities. The new shift resulted in banks’ reduced incentive

to keep an eye on their borrowers as the risk had now shifted from their domain. This led to

deterioration in the credit quality over time. One of the build-ups of credit crisis 2007

[ CITATION Sau10 \l 2057 ].

Another option available for default risk mitigation is the Credit Default Swaps (CDSs). It is a

financial derivative that provides a guarantee against high risk municipal bonds, sovereign

debt, mortgage backed securities, collateralized debt obligations etc. These swaps protect

the lenders against the credit risk. However the CDSs were unregulated till 2009 which gave

an incorrect sense of security to their dealers. They indulged in buying riskier debt thinking

to be protected from losses. The ever famous Lehman Brothers case on CDSs was another

important factor leading to the 2008 financial crisis. The Lehman Brothers owed a debt of

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$600 billion. $400 billion of it was covered in swaps sold by American International Group

(AIG) majorly. When Lehman Brothers declared bankruptcy, AIG did not have all that cash

on hand to cover the swap contracts and ultimately Federal Reserve was forced to bail them

out [ CITATION Ama19 \l 2057 ]. The swaps market fell apart and in 2009 Dodd-Frank Wall

Street Reform Act came into existence for regulating the financial markets and protecting its

consumers.

It keeps a vigilant eye on the Wall Street. If, for instance firms increase a lot in size, it will ask

the Federal Reserve to supervise its activities. The Fed in turn can make that bank increase

its reserve requirements to ensure they have enough cash available to deter bankruptcy.

Moreover it stops the banks from gambling with their customers’ money with the help of

Volcker Rule that bans the banks to buy or sell risky derivative instruments/bonds for their

own profits. A lot of banks protested against this rule as it acted as a deterrent to their

competitiveness. However recently in 2019, under the orders of President Donald Trump

some revisions to the Volcker Rule have been made to ease Volcker regulations on the

banks. Banks are still prohibited from proprietary trading but the new proposal does make it

easier for them to trade for market-making i.e. buying and selling as brokers in steady

stream based securities (again not in risky portfolios) [ CITATION Ona19 \l 2057 ].

Liquidity Risk

Commentators argue that along with the credit risk, liquidity risk also goes hand in hand

when discussing the risks banks are exposed too. An occurrence where the depositors

suddenly start claiming their deposits back from the bank and the banks find difficulty in

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meeting these short term obligations is known as a liquidity risk [CITATION Omr17 \l 2057 ].

The difficulty arises because the banks operate by transforming their deposits i.e. short-

term liabilities into long-term assets i.e. loans and are exposed to the bank-run issue in the

likelihood of a crisis leading to immediate withdrawals of cash [ CITATION Top15 \l 2057 ].

Even a slightest rumour of a possible crisis can create enough panic in the public to start

withdrawing all their funds.

FDIC and OCC’s official reports claimed that the majority of the commercial banks failure in

the global financial crisis was a result of both liquidity and credit risk. Liquidity risk denotes a

cost of lower profitability, hence in case of a default emergence, the cash inflow to the bank

decreases hence increasing the liquidity risk. Therefore both these risks are positively

correlated [ CITATION JDe86 \l 2057 ]. This is the reason why recent regulatory efforts mainly

by Basel III framework have put more emphasis on the significance of the management of

the liquidity and credit risks together.

Banks provide liquidity to not only their demand depositors but also by initiating lines of

credit or loan commitments to their borrowers. Both instances are bound to present cash

on demand. The banks thus try to manage their liquidity risk exposure by trying to combine

their demand deposits with loan transactions. If somehow the demand from depositors is

not highly correlated with that of the borrowers, the banks can operate by keeping minimal

cash intact and serve both parties simultaneously. The increase in deposits transactions has

been observed to reduce the liquidity risk exposure emerging from the lending side of bank.

If the banks have a high loan-liquidity risk but does not enjoy huge levels of money deposits,

their exposure to liquidity risk increases. Interestingly during the tight market days, when

the flow of the funds moves from the securities markets to the bank accounts, their risk is

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hedged and the banks have the stronger chances of injecting liquidity in loans form into the

markets where markets normally do not. The reason being today the banks are viewed as

safe havens in cumbersome times [ CITATION Gat09 \l 2057 ].

When the liquidity crisis of 2008 hit the real economy hard, new liquidity risk hedging

propositions were put forth by the Basel Committee on Banking Supervision. Those included

enhanced capital adequacy standards, improved supervisory review process, risk disclosure

and market discipline. These were presented to encourage banks from excessive risk taking

strategies for enhancing their profits by imposing higher costs on them. Meanwhile later in

2013 the same BCBS encouraged the banks towards greater transparency by asking them to

fully disclose their minimum capital requirements as well as by egging the local authorities

to supervise liquidity risks more thoroughly [ CITATION Ami20 \l 2057 ].

An extreme liquidity crisis can also lead to a capitalization crisis in case of a fire sale risk. This

risk is a result of taking large positions in illiquid assets. This can have serious impacts on the

banks’ balance sheets because one is forced to price their assets to the prevalent fire-sale

price. By closely monitoring the ‘liquid assets to total assets’ & ‘liquid liabilities to total

liabilities’ ratios, banks can avoid such conditions [ CITATION JGo09 \l 2057 ].

Furthermore the central banks require the condition of cash reserve requirement amount at

all times to overcome impeding liquidity issues. A bank normally avoids any sort of capital

injection from the governmental bodies since it puts them in their debt, hence why holding

minimum cash deposits helps them in troubled times [CITATION Oli07 \l 2057 ]. Though

today’s modern banks are not much concerned about the liquidity crisis as they know that

with the backing of central banks, in case of a bank run situation, it will deploy all its

resources to help the affected bank and restore its depositors’ confidence [ CITATION Ris08 \l

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2057 ]. Incidentally it also holds true that by increasing the reserves on hand banks lose out

on earnings opportunities as they rely majorly on corporate or wholesale lending. These

loans are floated on long-term basis, in times of slow economy with poor utilization of

resources, the very same loans convert to non-performing loans. This then acts as a leeway

to solid liquidity crisis [ CITATION Ari12 \l 2057 ].

Solvency Risk

‘The solvency risk defines the risk that a bank cannot meet its maturing obligations due its

negative net-worth; that is, the value of its assets are smaller than the amount of its

liabilities’ [ CITATION Alm15 \l 2057 ]. The bank unable to meet its obligation ends up

defaulting and losing their value.

Solvency is dependent upon two factors, buffer of capital available in banks and their

profitability as a result of their activities. Profitability of any institution is linked to the

competition in the same industry. An increase in the competition reduces the profit margins

generally. So it can be implied that competition leads to lower profitability hence lower

solvency.

On the other hand how the very same competition affects the capital position (second

determinant of solvency) of a bank has further two aspects. Firstly, the existing micro

prudential framework clearly defines minimum capital requirements to cover up for

unexpected losses if the provisions have accordingly been provided for. In such a scenario

the capital ratio can simply be treated as a constant (fixed). Thus leading to no effect on the

solvency of the bank [ CITATION Alm15 \l 2057 ].

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However some banks have been observed to hold more buffer capital than required by

regulations since they actively manage their capital requirements on the basis of their credit

risk exposure. The more risky assets in their portfolio, more capital they hold. Therefore an

instance of a rise in competition would lead to reduced profits, reduced retained earnings

hence leading to a need of setting higher capital ratio to hedge against the solvency risk.

There is hence a positive impact of capital adequacy ratio (CAR) on banking stability. Capital

provides a safety net in distressed times by reducing the insolvency possibility. Capital on

assets has been confirmed to be negatively related to banking failures [ CITATION Imb14 \l

2057 ].

Technology & Reputational Risk

The modern banking involves extensive technological use. ‘From the algorithms used in

proprietary trading strategies to the mobile applications customers use to deposit checks

and pay bills, it supports and enhances every move banks and their customers make’

[ CITATION Oli16 \l 2057 ].

Where the banks have enjoyed benefits from various softwares they have also become

more prone to its complementary risks. They are now discovering how the extensive use of

technology affects more than half of their operations for example in the form of breaching

of sensitive customer information online, disruption of processes outsourced to vendors and

cyber-security issues etc. Providing robust cyber-security involves almost 10% of total IT

spending. IT systems today come with increased complexity and vulnerability even for the

banks that are constantly upgrading their system infrastructures. The sensitivity of banks

operations and their usage of technology opens them up for huge possible litigations, court

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proceedings in case of any leakage of high profile data and more over puts their reputation

at risk too [ CITATION Oli16 \l 2057 ].

Regulators are known to penalize banks heavily in cases of any non-compliance and

investors start getting rid of their shares in the rubble of cyber-attack rumours. Hence why

Basel-ll drafts a clear notion on ‘Business disruptions and systems failures’. These were also

the result of huge operational losses that made the Basel committee work towards

developments in Basel ll. The loss of $690million caused by rogue trading activities being

carried out in Allied Irish Bank and similarly in the case of U.Ks oldest Barings Bank where

the losses were reported around $1.3billion, show clearly the scope of these risks and how

they must be managed. Not only the technology risk needs to be factored in here but the

reputational risk of the banking industry was triggered too [ CITATION Dio07 \l 2057 ].

Technological risks can be managed by several methods. Forming an IT Risk Committee at

the board level that interacts with the IT team & senior executives can focus solely on

system failure risks and suggest improvements. The committee can include IT experts as

well as members from the board for stringent results. They can also work towards

increasing transparency of their reporting practices by focussing more on the key risk areas

and performance indicators. Moreover banks can set thresholds for informing Boards of

risky technological crisis such as cyber-crimes or items leading to regulations violations so

that they can try deterring the possible eventualities before it materializes [ CITATION Del18 \l

2057 ].

Moving further the reputation of any bank carries utmost importance for its survival. It is an

intangible asset that leads them to increase business and profitability. If a slightest news hits

the market about any bank’s brow raising activities, such sort of negativity immediately

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impacts their business. For instance JP Morgan, Citi Bank, UBS, RBS and HSBC were fined a

total of $3.3billion in 2014 as a settlement claim to their forex market manipulation, by the

regulators. The Financial Conduct Authority chief executive Martin Wheatley clearly

condemned the act and stated it will not tolerate any such conduct that puts the markets in

jeopardy [ CITATION Gar14 \l 2057 ].

This news made a lot of customers shift their businesses to other banks causing a monetary

as well as a reputational loss to the perpetrators. Their trading dropped significantly lower

than the other market players. External borrowers end up demanding higher risk premium

which again can lead to increased costs of capital for the banks.

Factoring the reputation risk for any industry is quite challenging. Even the Basel ll

framework issued in 2004 and updated again in 2005 specifically excluded the reputational

risk from its guidelines, according to some banking professionals, this is because of the

difficulty of incorporating this risk in the capital adequacy requirements [ CITATION Ecc07 \l

2057 ].

Customer satisfaction, financial performance of a bank, the quality of the internal processes

and social requirements the general public are considered to be the key drivers of

reputational risk. Hence the risk can be measured and quantified on the basis of these very

indicators acting as a basis of structured risk analysis. For instance number of customer

complaints, increase in profitability etc. can be a determinant of assessing the risk. Lastly

bank specific drivers can be assessed case by case [ CITATION Zab19 \l 2057 ].

Current regulatory system

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Why banks default? This question needs to be answered on two fronts. Firstly by

understanding the banks’ failures, it becomes easier for supervisory authorities to define

their role more efficiently. If the problems can be assessed earlier then regulatory actions

can be taken pre-emptively hence reducing the governments’ bail-out costs, or the costs

faced by the shareholders, bondholders etc. Second the failure of one bank results in the

failures of all others related to it hence triggering the contagion effect. We call it the

systemic risk that results in a possible collapse of an entire financial services sector as

happened in 2008 [ CITATION Cer17 \l 2057 ].

In 2010, Basel Committee issued Basel ll the second set of banking regulations defined by

the BCBS. It was an extension to the minimum capital requirements of Basel 1. Three new

pillars in this framework were;

1. Capital Adequacy requirements; 1st Pillar now included operational risk in addition to

the credit risk (Basel l) for calculating the risk-weighted assets (RWA). It now also

required the minimal capital requirements to be 8% of its RWA.

2. Supervisory review; 2nd Pillar for now obligates all the bank to internally assess

capital adequacy in a manner that it covers all possible risks that can materialize in

their future processes. One of the main features being the supervisors ensuring that

banks maintain minimum capital ‘above’ the level defined by Pillar 1.

3. Market discipline; The 3rd Pillar stresses on disclosure of appropriate market

information that enables the users of the financial information to make informed

decisions [ CITATION CFI20 \l 2057 ].

The highlight of Basel ll framework is the funding of minimum capital requirements for the

banks. To determine this, Capital Adequacy Ratio needs to be calculated. This ratio is a

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result of eligible capital divided by Risk Weighted Assets. These RWA link the minimum

capital requirement of the banks with their risk profile of loans. The higher the risk is more

capital is required by BCBS to be kept as a deposit for troubled times [ CITATION APR20 \l 2057

]. Credit, market and operational are three risks whose weights are assigned for the

calculation of total RWAs.

However in Basel lll reformed capital regulation where the risk weighing approach is still

intact, it redefined the risky assets by their behaviour during the financial crisis. Moreover

previously where goodwill was included while calculating the capital adequacy now has to

be removed. It proposes the inclusion of only high loss absorbing capital instruments in the

minimum capital calculations and further increases the minimum requirement threshold.

The capital adequacy ratio has also been changed to a much simpler one that now is free

from the previous complication of assigning risks weights to different assets [ CITATION

Tum13 \l 2057 ].

Many studies show that the additional capital requirements stabilizes the banks financially

by reducing the risk profile of banks’ assets. Moreover during credit crunch better

capitalized banks have turned out as more resistant and lent more money supply. This

improved the banking and economic stability [ CITATION Kli18 \l 2057 ].

Conclusion

The above discussion determines that the nature of today’s banking involves risks

inherently. The pressure from both the shareholders and the government exists together;

more profits and stable economy respectively. Amidst all this the financial crisis of 2008

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cannot be ignored. The building of systemic risk was because banks indulged in dealing with

risky complicated financial products e.g. mortgages, sub-prime mortgages, CDOs, ABSs not

only to increase their profitability but inject more credit lines in the economy to facilitate

development and progression. The result however was witnessed by all.

Today the Basel Committee works towards pre-emptive measures just to avoid the

repetition of 2008 crisis by bringing newer reforms in their supervisory capacity. However

where most banks maintain capital reserves in excess of the Basel limits, an occurrence of a

default that cannot be covered by that buffer capital or profits of the bank will lead to a

contraction in money supply. It does not guarantee an economic stability due to the existent

relationships’ multiplier effects; inter-bank lending, loan to customers from other banks

continue to destabilise the system and can lead to a cascading failure [ CITATION Jac12 \l 2057

].

Where the capital requirements are set to increase liquidity for crisis period, they constrict

lending capacity of banks thus reducing the cash inflow in markets affecting both

consumption and investment in economy. However the BCBS did update the Basel ll by

providing Liquidity Coverage Ratio that ensures banks possessing high quality assets that are

easily cash convertible to meet their own one month cash requirements.

Ultimately we require a flexible regulatory framework. The pro-cyclical effects of Basel

Accords show that we require reduced capital adequacy in booming economies and vice

versa during depression [ CITATION Muh12 \l 2057 ].

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