The Business of Banking

Introduction

The business of banking is fraught with dangers due to the instability in the world economy and like any other enterprise the bank too can face untold events and we should remember that bank failures are not a new issue. They come across many pitfalls in their daily operations for instance unwise investments, lending to countries with poor economies etc. Turbulence in the banking sector can shaken the whole economy as it works on the basis of funds invested by the public at large and hence has serious repercussions on public as they lose confidence and also on international trade. The Banking system in the western world are all interlinked , so when the system collapses it loses its versatility and the only way to keep a check is to have a well designed legal framework to regulate its transactions and impose restrictions on the free entry of firms in the main line of banking business.The major issues that have come upfront are concerning the deposit insurance, prompt corrective action, money market operations by Central Banks, liquidity risk management, procyclicality, boundaries of regulation and supervision.

The world at present is in the midst of severe economic crisis which originated from USA but ultimately spread to Europe and other countries in an unexpected manner. Initially it started of as a limited crisis in US housing mortgage sector which turned into a banking crisis breaking down domestic and international financial markets. Since then every central banks and Governments are trying to frame monetary and fiscal policy to overcome the crisis.

The central purpose of this essay is to discuss the recent crisis, its causes and the various recommendations made by different authorities addressing the crisis and eventually draw a conclusion as to how far the crisis been resolved and what is the future of the world economy with the enactment of new laws and rules. Firstly I shall discuss the crisis and what triggered it, secondly its impact on various countries with the shortcomings in the legal system, thirdly the measures taken to combat the crisis and how far they have been successful.

Bank Crisis

Almost every country has faced banking crisis as risk taking is common in the market and it is evident from past incidents. Such crises dates back from the Victorian period when certain banks in the U.K failed for e.g. “the Overend Gurnery Co.Ltd.” which collapsed and even led to a run on the Bank of England and following it after 24 years was the “Baring Brothers merchant bank” failure which fortunately re-emerged due to assistance from the Bank of England. Therefore we see that the Bank of England had extremely important role to play in the prevention of banking crises. However there was again a massive crisis in 1930-1933 especially in US where miraculously UK had survived in good shape and the main cause of the failure was said to be poor management and lending policies. It was during this period that the FDIC was established. Even then this did not stop US from encountering further crisis for in the 19th century it faced a serious downfall which had the effect of highlighting many supervisory and regulatory failures in UK leading to the introduction of banking laws. Until 1979 in UK, regulation did not have a formal statutory basis and banks then were regulated by the Bank of England on the basis of moral persuasion and with the passage of time this power was ultimately shifted to the Financial Services Authorities.

The outbreak of the US subprime crisis in August 2007 bent the global economy. Initially activities slowed and advanced countries fell into mild recession and despite policy maker’s efforts to sustain market liquidity and capitalization, questions with regard to solvency of financial institutions were raised and the situation deteriorated in September 2008 following the default by a large U.S. investment bank (Lehman Brothers). Major U.S. investment banks and government sponsored enterprises like Fannie Mae played an important role in the expansion of higher-risk lending. At an elementary level the crisis can be credited to the persistence of global imbalances, which was the outcome of loose monetary policies in the advanced countries. For the UK, the US credit crunch was a foreign issue initially, but when in September 2007 Northern Rock requested for financial support from Bank of England, it was known that the crisis had hit Britain. Northern Rock was a mortgage lender based on short term bonds and they were forced to borrow from the Bank of England which led to a short run as most depositors came to withdraw their savings and due to difficulties in funding the Government announced that the bank would be nationalized.

Surveys have shown that there are multiple reasons for the crisis and it is important we know the causes so that effective legal measures can be taken immediately. Indeed the immediate cause was the bursting of the US housing bubble, but easy credit conditions, predatory lending, deregulation, over leveraging, financial innovation, incorrect pricing of risks, collapse of shadow banking system, commodity bubble, rapid financial innovation, systemic crises were some factors which can be attributed to the fall. Also the increased internationalization of trade, finance and investment has served to make the economic recession a global phenomenon in which not only the USA, Europe and Japan, but also, China, India and the other developing countries are very much affected.

In addition to UK the crisis had immense impact on developing countries too for example the Russian stock market had to stop trading twice; the India stock market dropped by 8% and stock markets across the world have all dropped considerably. There is a need to understand the nature of the financial linkages, how they occur and whether anything can be done to minimise contagion. The areas which are likely to get affected are trade, remittances, commercial lending, employment sector, investment sector etc and these needs to be monitored well for these affects the economic development of a country. Thus the developing countries must effectively implement social protection schemes to prevent further disaster. Even the decoupling hypothesis did not work. Talking about India which is considered to be a growing economy, was not much affected as it did not lend in a big way to the subprime borrowers but nevertheless was not invulnerable to the impact of crisis. On a broader scale it was also the overconfidence of people which led to the crisis as they thought home prices would only go up, leading to taking risks completely unaware of the bubble. India too in a way is connected with the similar process of thinking. Hence it equally needs to take up actions and improve the quality of financial markets by expanding regulation, supervision and consumer protection. With the collapse of huge Wall Street banks and the freeze of bank credit flows, there was an immediate worldwide liquidity crunch and this shock was immediately felt in India, with foreign institutional investors withdrawing their money, credit for foreign trade vanishing and loans from foreign banks drying up, even exports had began to decline but the Government and the Reserve Bank were quick enough to respond thereby loosening its monetary policies reversing all anti inflationary tightening.

Resposes:

With the financial turmoil abating, now is the time for policymakers to take action to reduce the severity of the crisis. Supervisors in US are actively reviewing prudential and supervisory approaches to be incorporated in the system and the Federal Reserve is ensuring that the large financial institutions hold more capital, improve risk management, have better liquidity management and deal fairly with the customers. It has also been felt that legislative action is also required to address “too big to fall” perceptions and ensure all financial institutions are subject to effective supervision and establish procedures for winding off failing institutions without damaging the entire economy. The Federal Reserve has worked through organizations like Basel Committee on Bank Supervision and Federal Stability Board to strengthen the regulatory standards to limit risks and establish capital buffers. The US supervisors conducted “The Supervisory Capital Assessment Program” to ensure that the banks hold adequate capital. Internationally the FSB has called for stronger capital standards and the Group twenty has been working to frame rules to bring about stability. Countercyclical standards are also being emphasized by the Federal Reserve. It has issued guidelines which require banking organization to review their compensation practices to avoid those which encourage excessive risks. Further steps are taken to provide consumer protection which will also bring about sound lending practices and uphold public confidence. Supervision which fared poorly in the recent crisis is also being strengthened by way of effective strategies, hence updating the surveillance tools for impromptu response by the authorities and reflecting the mission of the central bank i.e. financial stability. The Federal Reserve is striving to develop more comprehensive and information reporting system to meet the dynamics of the market. In addition regulation is also being strengthened for protection against monopolies, ensuring systemic stability and provides retail clients with protection as market failures are stronger here. Though the emergency steps has helped in partial restoration of the system but even then it did not permit from affecting the global economy and it is against this backdrop the financial regulatory reform agenda is promoted by the EC and co-ordinated through FSF and the governments of G-20 countries to provide number of proposals especially based on capital requirements, new rules on accounting , regulation on credit rating agencies, reinforcement of European supervisory framework and has established a high level group on supervision.

Supervision is a process by which the society monitors the banks compliance to the structured regulations providing remedies for the breach of same which can only be made more efficient when it is risk based. This allows the supervisor to impose sanctions and exercise judgment to evaluate the working strategies of the bank and analyse whether they can withstand the financial strain. Recently the FSA in UK undertook a comprehensive review of its supervisory practices and is now implementing a wide-ranging supervisory enhancement programme that includes both training staffs and recruitment of additional supervisors. The FSA has become more intrusive and intensified the monitoring of the banks and made sure they take corrective actions to raise capital. It is engaged in extensive contingency planning with the Bank of England, the Treasury and the FSCS so that a resolution could be given effect and the other significant step taken is strengthening the resolution regime. One major response was the Turner Review which portrays the causes of the financial crisis and recommends steps that the international community needs to take to enhance regulatory standards, supervisory approaches and international cooperation. According to it the risks involved in carrying out banking functions are very different and hence a systemic approach should be applied for its supervision and regulation and other fundamental changes needed are increasing the quantity and quality of capital, the need for fundamental review, creating capital buffers, offsetting procyclicality in published accounts which means reflecting anticipated future losses in published account figures, using a gross leverage ratio as a backstop and lastly a well designed liquidity risk management . The Bank of England is taking steps to boost money supply and stimulate spending and has also cut its lending rates from 5% to 1%. Not only these even the Reserve Bank of India has taken steps to curb the recession to counter act the situation by initiating liquidity measures, lowering rates, but however every country with current account deficits and strong credit cycles are finding it difficult to bring cost of capital down at present and new measures are not that effective. The Balance of Payment deficit at a time when domestic credit demand are high is resulting in reduced access to liquidity, slowing growth, and increased risk-aversion in the financial system. The IMF too has been active to assess the underlying causes of the turmoil, and to draw lessons to help inform our surveillance and is helping facilitate, promote, and coordinate appropriate national and multilateral responses to the crisis. It is already actively engaged in bilateral surveillance, FSAP assessments, programs and is also actively engaged with other international organizations and standard setters to complement their work and many of these recent efforts have been summarized in “Integrating Financial Sector Issues and FSAP Assessments into Surveillance Progress Report.” There are various recommendations made by the Working Group G20 , emphasizing significantly on systemic wide approach to regulation, oversight of credit rating agencies, transparent assessment , compensation schemes, liquidity management, accountancy, enforcement and technical assistance in the emerging markets and to review resolution regimes and bankruptcy laws in light of recent experience.

Historically crisis has always led to eminent legislation for instance the 1907 fall led to the enactment of Federal Reserve Act 1913, which established the Federal Reserve as the central bank, followed by the Great Depression came the Glass-Steagall Act, which established the Federal Deposit Insurance Corporation and the thrift crisis in the late 1980s led to the enactment of the Federal Deposit Insurance Corporation Improvement Act 1991, mandating prompt resolution of failing banks and new standards of supervision, regulation and capital requirements for banks. Subsequently in 2002 the collapse of Enron and WorldCom gave rise to Sarbanes-Oxley. Now it is expected that the recent crisis will undoubtedly provide us with legislations to respond to the downfall but what must be considered is not how to prevent failures but to set up a credible process so that further crises can be controlled preventing its spread at a worldwide basis. Hence The Banking (Special Provisions) Act 2008 was enacted following the nationalisation of Northern Rock to enable the UK government to nationalise high street banks under emergency circumstance which is now supplemented by the new permanent provisions of the Banking Act 2009, which defines the FSA’s role in deciding upon the need for bank resolution and provides the UK authorities with wide-ranging powers to ensure orderly resolution.

The main objectives of banking regulation are to protect investors and the prevention of bank failures as well as the minimization of the risk of contagion that these may create. There are four acceptable ways to deal with a failing bank: liquidity support, full insurance cover of deposits, public rescue and a special bankruptcy regime. The applicable regulatory framework seemed to prevent the Tripartite Authorities from using any of those techniques effectively during the Northern Rock crisis. As per the critics the tripartite agreement where the FSA was given responsibility to supervise banks was a failure and the FSA was severely criticized on their style of supervision and handling the situation as it failed to act promptly even when it was aware of the decline of share price of Northern Rock in a booming market. Not only them but also the Bank of England was open to criticisms from all sides. An enquiry by the Parliament highlighted the shortcomings in the UK’s banking system, regulation, supervision and the administration of liquidity support arrangements and stressed on the impact due to the absence of special resolution regime. The consequences of the crisis was that the Treasury was vested with additional powers relating to the compulsory acquisition of shares in failing banks and transfer their property when they pose a serious threat to the UK’s financial system. In addition the Tripartite Authorities issued a number of consultation papers suggesting changes in the UK depositor protection and financial stability regimes and the establishment of a permanent SRR for failing banks. Number of banks ever since almost collapsed and in order to avert a total meltdown of their banking systems, very costly public rescue packages emphasising on re-capitalization were adopted.

The global financial crisis has revealed weaknesses in the financial system and the central issue of the problem is the mismatch that exists between the way institutions are organized, operated, regulated, supervised and the way they are resolved in a crisis .It is unrealistic to expect a global regulatory authority or an overarching international insolvency framework for cross-border financial groups in the probable future. The US administration has identified the need to provide tools to resolve financial crises as a top policy. Likewise, the European Commission has called for an acceleration of work to build a comprehensive cross border framework to strengthen the European Union’s financial crisis management systems. In February 2009, a group of financial experts, presented 31 recommendations to strengthen supervision of the EU’s financial institutions like developing common rules for investment funds, capping bankers’ bonuses in line with shareholder interests and establishing a crisis management system. The Commission has already adopted proposals to protect bank depositors, regulate credit rating agencies and revise rules on capital requirements under Basel II to make markets less risky for investors.

Indeed a lot is being done by the regulatory authorities to circumscribe the spread of the crisis but the question here is how far have they achieved? Bank crisis as we discussed earlier is not new then why is it that the authorities act only when it is called for in an emergency? Take for instance Basel I which miserably failed to combat the Asian crisis in 1997 and the countries gobbled up by the crisis are those which were progressing and the factors contributing were the pegged exchange rates and the banking setup was marked by gross mismanagement followed by unchecked lending. Some apprehend that the widespread acceptance of the first Accord was responsible as Basel I encouraged short-term lending consequently effecting rampant short-term loans loaned by international banks to the banks in these countries. Now coming to Basel II which emphasized on market discipline and regulation and establishing comprehensive system to manage risks covering operational risk and focusing on harmonisation, if this was so then why did it fail to foresee the recent crisis and take prompt actions to evade global crash? This clearly shows the lacunas in the regulatory system alongside the legal framework. Another question that crosses our mind is whether we need a new Basel or is the Basel II adequate to secure the financial system back to normalcy? The higher risk sensitivity of Basel II comes at a price as, banks and supervisors incur operational costs to implement the new, complex regulation and it creates new risks about risk assessments. Furthermore, the increased reliance on banks’ internal models has rendered the job of supervisors difficult. Therefore a risk-weighted capital requirements, as proposed under Basel II, remain the most rigorous way to address banks’ tendencies to incur excessive risks and, ultimately, to ensure adequate capital levels. However, there are serious short-comings of the risk-weighted approach which was manifest in the recent crisis indicating for a safeguard to provide the financial system with additional protection. The leverage ratio should be complementary to the risk-weighted approach and banks should meet a minimum requirement. Research has shown that risk-weighted capital ratios and leverage ratios contain complementary information about banks’ condition and the leverage ratio has helped protect the US banking system from even greater calamity. It is not because the leverage ratio encourages more prudent behaviour, but because it ensures a minimal buffer to absorb the negative consequences. Even then this process has negative effects such as the system may direct banks to off-balance-sheet exposures, pro-cyclicality i.e. amplifying the financial cycle, and banks’ profitability meaning capital requirements may require banks to bear more losses but again distortions for safety net is the basis of capital regulation which in turn limits the banks from taking excessive risks.

Need For A Legal Framework

Banks are special because they perform financial services that are deep-seated to the functioning of an economy, therefore its failure affects the whole economy and ordinary bankruptcy procedures are not suited for dealing with financial failures which is why a number of jurisdictions have introduced special resolution regimes for banks as well as other financial sectors. The continued access to essential banking services must be one of the objectives of any bank failure regime. Therefore there is a need to reform resolution framework. A closer coalition between legal form and economic reality could facilitate resolution under the fragmented national supervisory and insolvency frameworks that now exist. Apart from adding transparency and logic to the operation, it would also achieve greater predictability in resolving institutions under national law.

In every survey one reason for the backdrop has also been the lack of an insolvency framework to deal with the failing institutions and most countries now have introduced financial sector safety net but it is not to prevent bank failure and that is why we need a legal framework to deal with insolvent banks. The payment system of every banks must be functional for sound economy and maintaining price stability is important as it can be made difficult if there are bubbles in asset prices, hence it must be ensured that the markets have incentives to assess risks for which there is a need of credible insolvency and resolution framework for banks and other deposit taking institutions. Many countries lacked such regime which was apparent in the recent crisis where emergency measures were taken for banks to maintain stability. A bank failure not only affect the investors or shareholders but also ordinary people causing havoc to living and in systemic crisis, countries need special procedures to expedite corporate debts. Moreover the failure of a bank which is used by other banks as intermediary can have knocking effect on the entire system leading to loss of confidence. This is why banking sector is now the most regulated in the economic system with various safety nets and one amongst them is the central bank being the lender of last resort but again it is not a full proof protection and even if there are depositors protection schemes, its improper implementation will lead to more complicacy. Clearly the State here is more at stake and the financial turbulence have definitely triggered the need for an insolvency regime for the ordinary bankruptcy regime does not sufficiently recognise the need for speed when dealing with banking problems and the techniques normally used, such as a stay on payments, are ill adapted to banks calling for a speedy insolvency procedure with fast pay out to depositors and where banks can be effectively closed at low costs. A legal framework is required to write down shareholders rights and as a part of the resolution process the ability for the Government to take over assets of insolvent institutions. One major impediment to restructuring in the crisis was due to the deficiency in the judicial and legal outline where government was unable to intervene effectively in takeovers. The recession has definitely taught a hard lesson to have a well designed legal process before another downfall.

Some of the legal issues while establishing such regime are the choice of insolvency regime, whether to apply the corporate regime or special regime, who has been empowered to commence the proceedings, the threshold for commencement of the proceedings, clear provisions for accountability and judicial review, nature of liability of the banking authorities in case of negligence or ill motive. In addition to the ones discussed a legal framework must also specify who may appoint or discharge official administrator, the scope of transfer of control, extent of protection of bank’s assets and permit provisions for moratorium in case of administration of banks, while on restructuring the law must be specific on the techniques used, scope of negotiation with prospective investors, transfer of liabilities and on liquidation the law must provide for appointment of liquidator, powers, supervision, accountability, treatment of netting or novation, distribution of proceeds, termination of proceeding etc. It is always a viable option to have a special regime rather than applying the corporate one as the latter system focuses on individual companies so does not address that banks, are vulnerable to loss of confidence, which may lead to runs, contagion and wider systemic consequences, it is not well suited to ensure the continuity of key banking functions, it does not recognise the position of bank depositors whose claims on the bank have a major role in the wider functioning of the economy and the main objective of SRR is to ensure an orderly resolution of a failed bank to preserve financial stability and confidence in the banking system which has been replicated in the UK SRR introduced under the Banking Act.

Conclusion

Bank regulation cannot prevent financial crises, but the regulatory framework that is currently being shaped will influence the development of the banking system for many years to come. Recent measures by governments to purchase impaired assets, recapitalize troubled banks, and inject liquidity into the system, have been applauded. What is most important at the moment is to reform the financial structure and guard it with a legal surrounding. Efforts are being made to redesign the system and number of proposals has also underway such as the Action Plan by FSF, de Larosière report on the basis of which the EU Commission has issued a Communication with regard to regulation. But we cannot stop here as there are plenty of areas which require scrutiny. The recent crisis has highlighted that the regulatory and supervisory system is not suited for the modern financial market and we need a more comprehensive approach to mitigate risks and bring about transparency. Thus we need macro prudential supervision extending to all financial sector and the same should be at pace with the market developments. Not only risk but capital management is also very essential and against this backdrop the proposals of the Basel Committee on reforming the capital adequacy standards is a welcoming step. There is an urgent need for a mechanism at national and international level to deal with such crises so we need more collaboration, coordination and workable rules on cross border transferability of assets, insolvency and nationalization.Moreover the competing interests of banks and public needs to be balanced for which various techniques are being used for instance defining the powers of regulators etc.

Despite some progress it will still takes some time to restore the financial sector to its booming position as unemployment continues and house prices still declining. Indeed, the leverage and interconnectedness of firms and the critical role that financial intermediaries play in modern economies, mean that a malfunction in the financial industry can immediately harm the entire economy which is why governments in every countries have provided extensive support for certain financial firms and markets in periods of high distress. However we still need to wait and see how far the enacted laws and procedures help in reorganizing the failing system. In my opinion having a special resolution regime can prove to be effective for it considers all interests and efficiently provides roles for all authorities to make sure a crisis is well handled.

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