BANKING REGULATION AFTER THE FINANCIAL CRISIS HAVE FAILED TO MAKE BANKS SAFER
Abstract
In December 1930, the New York Bank of United States began to collapse as it could no longer fund withdrawals made by depositors. Its eventual collapse spread viral financial implications across the United States and the world’s economy. This financial tragedy that began as far back in October 1929 is infamously known today as The Great Depression. The lookalike of this devastating financial crisis hit Europe when the Lehman Brothers collapsed in September 2008. Many scholars, legal theorists and political office holders blamed the financial crisis on the poor or ineffective regulatory framework. Thus, many regulatory reforms were initiated during and after the financial crisis. However, some scholars still believe the financial crisis could have been averted and many of the mistakes made by the policy-makers are still being overlooked in the new set of banking regulations in the Eurozone. This paper examines in the overview, the changes made in the regulatory framework and whether these changes have made the banking environment safer than it was. This research work employs statutory instruments, books, journal articles and online resources to understand the current and future risks of relying on the current strict regulatory framework rather than regulatory oversight and accountability from the banks. The paper concludes on resolutions drawn by different scholarly works that have proved that the new regulations would do little to avert another crisis and called for more market discipline and financial accountability.
INTRODUCTION
The Great Depression and the Savings and Loans Crisis left many economies and individuals devastated in its wake. It also left government officials with the responsibility of policy formulation and stakeholders wary of loose financial regulatory systems especially in the banking sector.
Foremost, the international banking system is a complex web of systemic banking services and relationship across national borders. This web provides for a simpler way of moving large quantities of funds across borders and seas rather than moving cash or coins. It also provides the ease of organized payment services for families, friends and employees across the world. More importantly, the international banking system is profitable for business organizations with multiple dealings across several countries. Banks provide the financial guarantee for businesses in their international deals. Other benefits include access to loans, deposit facilities, internet banking, tax efficiency, investment opportunities and many more. These services are provided to individuals, corporations and government of nations around the world.
Given the heavy reliance of the economy of countries on its banking system to ensure smooth running of its financial services, the economy faces great risks of a shutdown once a crisis hits the banking industry. A quick look at the trend of the greatest financial crisis across the world shows the interconnectedness between the failure of banks and collapse of the economy. Banks often get overzealous for profits and neglect the best practices of the industry. Hence, governments have devised regulations and policies to regulate the banking sector to keep banks in check and provide a healthy financial environment for the citizens and economy at large. These regulations are enforced by bank examiners and regulatory bodies with disciplinary powers.
The European financial crisis which began in 2007 is a clear indication of the heavy reliance of the economy on the banking system. After the failure of major banks, more regulations were formulated nationally and regionally at the level of the European Union. The fundamental question is whether these regulations have made banking safer and can weather future financial storms or they are bound to fail remains the subject of debate. This essay will analyse these regulations and their impact in the international banking system.
WHAT IS A FINANCIAL CRISIS?
What has been defined as a financial crisis varies between authors. Barry and Richard define financial crisis as a spreading case of insolvency among debtors and intermediaries which includes a fall in asset prices, and a final result in the incapacity of financial markets to provide needed capital.[1] Investopedia defines it in similar terms as a steep decline in the value of assets, inability of individuals and businesses to fulfill their loan obligations and the eventual liquidity fall in the financial institutions.[2] Claessens and Kose simply define financial crisis it as extreme manifestations of the interactive flow between the economy and the financial sector.[3]
These set of definitions admittedly, focus on the factors or symptoms of financial crisis. They also focus on the role of the financial markets within the economy that is, the collapse of several institutions within the financial framework of the economy such as stockbroking institutions, banks, investment banks, regulatory institutions, etc.
However, this paper will focus more on the role of the banking banks both domestically and internationally and the regulatory frameworks in a financial crisis. This paper examines how the above factors have affected the performance of the financial market within the European economy and the aftermath of banking regulations introduced to prevent like catastrophes in the future. The reason for this focus is that authors and studies into financial markets such as Barry and Richard, Claessens and Kose agree that financial crises are often triggered by bank panics, asset bubbles and loose financial regulatory systems.
For this cause, financial crisis in this essay will be viewed as a period of sharp and steady decline of the economy due to inadequate financial regulatory framework and high debt ratio causing failures within the banking system, liquidity shortfalls, and the eventual scarcity of capital.
OVERVIEW OF THE BANKING REGULATORY FRAMEWORK BEFORE THE FINANCIAL CRISIS IN EUROPE
The European Parliament (EP)
This is the arm of the European Union (EU) that performs legislative functions. It has the duty of passing or rejecting bills drafted by the European Commission.[4] The Parliament was also directly responsible for amending existing legislations within the EU. The laws existing at the time of the financial crisis were those passed by the European Parliament. More so, the EP has the power to appoint the President and the Executive Board of the European Central Bank, thus exercising a supervisory role over the banking industry in the Eurozone.[5]
European Commission (EC)
Tasked with the responsibility of legislative initiative, the European Commission serves as the executive body of the European Union. It has the responsibility to look into areas in the Eurozone such as the banking system and draft bills to be sent to the EU. It is also vested with the authority to implement the legislations and equally uphold the EU treaties. Also, the EC is charged with running the day-to-day affairs of the European Union.[6]
The European Central Bank (ECB)
As it name implies, it is the central bank in the Eurozone charged with the responsibility of formulating and enforcing monetary policies across member states as well as the authority in charge of the Euro. The ECB controls the capital subscription of shareholders and majority of its shares are held by national central banks. The bank also performs regulatory oversight over sovereign debt. It played a major role in the European debt crisis and the bailout funds made accessible.[7]
The Legal Structure within the Financial Industry
The European Union and its institutions functioned mainly by EU treaties. Several EU Treaties were in place before the crisis e.g. The Lisbon Treaty, The Treaty of Nice and so on. The institutions such as the European Central Bank served as the institutional framework for implementing the treaties. The Pre-crisis legal framework in the United States and Europe were criticized as having played a major role in the events leading to the financial crisis. It was largely accused of being too loose and poor regulatory supervision of financial supervision. Since the financial crisis hit the doorsteps of Europe, there have been no less than 50 financial reforms in the Eurozone.[8] Thus, many regulations were amended including the treaties. The existing legal framework for the banking system and financial markets were:
i. The EU Treaties
These foundational legislations served as the ‘constitution’ for regulating the several institutions and procedures within the Eurozone. They are not specific legislations but were designed to provide for models upon which these specific legislations may be enacted.
ii. The Financial Rescue Mechanism
There were two major regulatory frameworks that provided a rescue funding for failing financial firms – European Financial Stability Facility and European Financial Stabilisation Mechanism. These were later replaced by the European Stability Mechanism (ESM) after the Lisbon Treaty was amended.
iii. Growth Policy and Mechanism
The Stability and Growth Pact was created for countries to maintain a fiscal policy on debt and budget deficits. This Pact was later reformed in March 2011 in order to automate the procedure of spending caps and penalties for countries that exceeded the limits.
All these treaties and legislations culminated in the previously existing regulatory framework available in the Eurozone for the banks and financial market.
THE FINANCIAL CRISIS 2007 – 2009
The European financial crisis has been attributed by some authors as the worst financial crisis since the Great Depression.[9] The effects of the crisis were widely experienced in many European countries irrespective of their sovereign wealth or status.[10] The causes of the crisis are still being heavily debated but the events that led to the crisis are crystal clear.
The events building up to the Great European Financial Crisis of 2007 – 2009 also underline the very risks and factors that caused the rapid descent into financial and economic anarchy.
The Lehman Brothers
Widely believed as the immediate cause of the financial crisis, the collapse of the investment bank in U.S. in September 2008 triggered a domino effect that revealed the true state of things in Europe. The crux of the collapse was the housing bubbles and losses in structured mortgage credit in the U.S. The investment bank had wandered off into excessive risk taking and when it was clear that borrowers could not repay the loans, the institution crashed with rippling effects all over Europe.[11]
Sovereign Debt Crisis
Another factor in the turn of event that persisted even after the crisis was the huge debt in the portfolio of governments. States like Spain, Italy, Greece were heavily in debt that could not be repaid. While most of these countries capitalized on inflations to reduce the debts, it was the IMF bailout funds that served as the real lifeline.
High Debt Risks and Insolvency
As a result of the asset bubbles, many businesses and credit worthy individuals obtained loans and lavished it on houses, travelling, and vacations.[12] The banks and their investment counterparts believed the bubbles would last forever. The deflation of the asset overpricing brought in reality but at a terrible cost and when it was too late. Many of the businesses that had taken loan were hit with the reality of insolvency and many of the individuals went bankrupt. This led to the collapse of many financial institutions in the United States, and subsequently in the Eurozone.
Unitary Monetary Policy
The availability of a common currency further aggravated the situation. Southern Nations were overspending with high debt ratios and relied heavily on the inflation to pay back debts. Hence, the common value of the Euro diminished the effect of inflation in debt repayment thus increasing in the bubbles of assets.
Effects of the Crisis
The effects of the crisis were felt in different scales. Some of them are explained below:
Liquidity Shortages
A major distasteful reminder of the financial crisis was the shortfall in cash flow. Consumers and depositors could not retrieve their money from failed banks. The poor regulatory framework provided no remedies to the situation as well leaving many European citizens without access to their life savings.
High Inflation Rates
As with all major financial crises, high inflation rates hit countries such as Ireland, Italy, Spain and the United Kingdom. The Euros was able to withstand the inflation from going beyond limits but the damage had already being done.
Loss of Jobs/High Unemployment Rate
One of the severe impacts of the calamity was a widespread loss of jobs. Many small and medium scale businesses collapsed and many youths were left without a job.[13] For instance, many pubs in Ireland have closed business as a result of the rising cost of beer and fiscal policy clampdown on the beer business.[14]
Emigration
The aftermath of the crisis caused many youths and people to emigrate from affected zones. It is reported that about 3000 Irish residents emigrated from Ireland within a single month.[15]
The major lessons learnt and resolutions from the financial crisis were summarised in four folds by the Financial Stability Board[16]:
- Enabling financial institutions to be more resilient
- Making derivatives markets safer through fiscal and regulatory reforms
- Ending “too-big-to-fail”
- Transforming shadow banking
These lessons formed the foundations upon which the regulatory reforms were moulded and it became the reference point for amendment of existing legislations. We shall now consider the different changes made to the regulatory framework and how they have impacted the procedural banking system and the safety of the financial markets for consumers and the citizenry.
CHANGES IN THE BANKING REGULATORY FRAMEWORK (POST-CRISIS)
One of the common elements that were fingered as a major cause of the Great Financial Crisis was the poor regulatory framework. This prompted sharp responses within each country’s jurisdiction and at the confederation level. The major reforms carried out in the banking and financial services law in the European Union. These reformatory solutions were developed to improve the strength of the banking systems, demand more financial transparency and accountability, increase control over liquidity and quality capital, reduce public subsidies and tighten financial gaps within the financial institutions in order to systematically reduce risks in strategic institutions.[17]
The changes in the financial regulatory framework in the EU can be seen in the following categories:[18]
- Financial Supervision and Risk Management
- Banking Union
- Consumer Financial Services
- Payment Services
- Financial Markets
- Insurance and Pension
- Consumer Reporting and Auditing
Financial Supervision and Risk Management
Several policies were formulated by countries to enforce more regulatory oversight over the banks and significantly assess and reduce the risks involved in credit facilities, investment and assets prices.
Some of these developments were as follows:
Prudential Regulation of Liquidity Risk
At the heart of this policy are two regulatory instruments: the Liquidity Coverage Ratio (LCR) which was developed to strengthen the short term capacity of banks to recover quickly from liquidity shortfalls and the Net Stable Funding Ratio (NSFR) meant to secure a steady fund structure to service the assets and activities excluded from the balance sheet.[19]
Introduction of New Measures for Globally Systemically Important Banks (G-SIBs):
The measures included new requirements for banks to have a more solid capital base, disclosure responsibilities and stiffer conditions for large exposures.[20] This means banks deemed as systemically important, have more financial requirements to follow in order to reduce the risk of failure.
Banking Union
Two major regulations were formulated to subsequently preserve banks from failing or spreading adverse effects on the economy in the event of failure:
The crux of this Directive was to give the European Central Bank and national wide powers to monitor banks and to flag and resolve issues at symptom stages. The largest banks are monitored by the ECB while the national supervisors keep a close watch on the rest of the banks. Two regulations adopted to back up the mechanism were the Council Regulation in 2013[23] and the Regulation[24] to align existing legislations on the European Banking Authority
Shadow Banking Systems
Shadow banking refers to a system of unregistered activities by group(s) of financial intermediaries who broker credit facilities within the financial system but are not subject to the regulatory oversight and requirements applicable to banks. Examples of these systems are unlisted instruments, hedge funds and so on.[25]
The EU moved to restrain and regulate shadow banking practices within the banking system. These intermediaries are capable of involving in high risk credit facilities with less equivalent capital to reinforce the value in real terms. The Basel II.5/III have been reformed to provide for consolidation rules in which off-balance sheet entities and activities are harmonized on to the same balance sheet as these entities are now subject to the Banks Prudential Rules.[26] In a view to properly regulate the sector, the Financial Stability Board had recommended to the EU has also set in motion the Securities Financial Transaction (SFTs) which is set to bring all unregulated entities and activities under regulation.[27]
Financial Markets
The aftermath of the crisis led to significant modifications in the regulation and supervision of the financial market structure and new regulations were introduced to end systemic risks and develop best practices within the sector.
Policy of Making Derivatives Market Safer
- The European Market Infrastructure Regulation (EMIR)
This legislation came into force in July 2012[28] to institute certain kinds of interest rate swaps.[29] The aim was to move a large part of interest rate swaps into central clearing houses known as Central Counterparties (CCPs) as in the United States.[30] The Trade Repositories (TRs) were established to collect data and maintain records of derivatives. The main purpose was to improve transparency in derivative markets and reduce risks to financial stability.[31]
Dodd-Frank Wall Street Reform and Consumer Protection Act (Dodd-Frank)[32]
In the wake of the financial turmoil experienced in Europe, there were many calls for an end to the ‘too-big-to-fail’ policy. This policy gave the central banks the ability to give bailouts to failing financial firms whose failure were predicted to have drastic effects on the economy.[33] The rational for these calls were that taxpayers’ money should not be used to rescue financial firms who engaged in large unprotected risks within the market. With the introduction of this federal law in the United States, a restriction was placed on the central bank on the issue of bailout funds and the financial regulatory system was reorganized.
Markets in Financial Instruments Directive (MiFID)
Driven by the catastrophe of the undisclosed risks and cover ups in the event leading to the financial crisis, the EU responded promptly by promulgating a Directive into force in 2007 which placed focus on Over the Counter (OTC) Transactions. This Directive was to improve the level of financial transparency in EU’s financial and money markets with standard disclosure requirements and procedures on operators of the financial market. The essence of this robust regulatory reform was to protect investors from unscrupulous acts of financial market operators.[34]
Markets in Financial Instruments Directive (MiFID) II
On 3rd January 2018, the European Union rolled out a revised version of the MiFID I. While the original version in 2oo7 focused more on stocks, the current MiFID spreads into almost all areas of financial services in the Eurozone. It does not only deal with OTC Transactions but also covers OTC Trading. This meant almost every product and asset fell under its jurisdiction which made for more regulatory oversight.[35]
ANALYSIS OF THE NEW REGULATIONS
The Post-crisis period has probably been the most delicate part when examining the effects of the catastrophe. Many regulations were birthed as a result of the lessons learnt, the “not too big to fail” notion, political and economic drive, and most importantly, the fears of another devastating meltdown.
But the big question lingers, ‘Have the post-crisis regulations made international banking safer?’ As said earlier in this essay, the strength of the Eurozone lies in the financial regulatory framework developed by the central body responsible for financial dictates – European Central Bank. Having examined the various regulations formulated in the previous heading, many economists and professionals still believe the loopholes have not been taken care of and only few gaps have been covered.
What Mistakes are Being Repeated?
The transition into CCPs from disintegrated clearing houses has created giant strides in financial transparency. But with the large jurisdiction and management, reviews have showed that the largest CCPs have become too-big-to-fail.[36] At the moment, there seem to be no actionable plan and recovery solutions in the event of failure or threat of failure. The FSB Resolution Steering Group in its report states that the “resolution frameworks for CCPs are not well developed”.[37] This is another risk that can trigger ripple failures in the financial market if the CCPs become to exposed to undue risks and
With regard to the Dodd-Frank, there are debates about its effectiveness to deal with the real issue. Viral et al (2010) argue that the Act deals only with the forms of financial institutions rather than the functions they perform. Financial firms are able to escape severe sanctions for taking up overbearing risks while their mistakes are borne by their customers. It is also argued that if bailouts are not issued to financial firms outside the banking sector, failure of these institutions are still not being dealt with as a financial firm large enough to have devastating effects on the economy will still deliver such turmoil upon failure and depositors would suffer more. This Act according to the learned scholars has not fully dealt with the factors of the crisis.
The main arguments against the MiFIDs have been its voluminous rules that are almost incapable of being followed by all firms to the letter and the cost of implementation. There are thousands of financial market operators in the EU. To keep tabs on all of them for the sake of transparency will not only be time consuming but a great investment of personnel and resources.[38] Also, the stress tests for big financial firms will be arduous tasks and sometimes inadequate to solely predict the extent of transparency. This poses the great risk of non-compliance within the industry by many operators. If the EU employed the idea of indirect regulatory systems whereby smaller financial firms are monitored by local regulatory bodies, the regulations would have more grip within the market. Also, the EU financial markets do not exist in isolation and the resultant effect is that the rules will be abandoned in intercontinental transactions.
FUTURE RISKS AND SUGGESTED SOLUTIONS
The implications of continuing with the present regulations following the analysis done above can be predicted.
The Asian counterpart of the European Union neglected the warnings by financial risk specialists after the major debt crisis in Latin America in 1982. The Asians rebutted the predictions that the corporate and savings culture maintained by their citizens made the nations’ economies immune from bankruptcy. However, the sovereign debts kept piling up till the Thailand’s Baht failed woefully the moment it was floated in the international market in 1997. This singular failure triggered the collapse of the financial markets across Asia and the situation was only rescued when the International Monetary fund provided bailout funds to the tune of US$40bn. A year later, a look-alike crisis struck Russia in 1998.
The lesson such manifold obstinacy teaches is to ensure market discipline at all levels. The popular statement credited to Rahm Emanuel, “You never want a serious crisis to go to waste” underlines everything we should do to avert future financial crisis.[39] Market discipline at all levels will imply building business and spending models on financially productive activities that are more realistic than investment in asset bubbles. Financial risks disclosure by banks and larger risks exposure control. It will also involve higher tax rates for big spenders on luxuries especially for loans such as mortgage credit, short and long-term capital loans and so on.
In the spirit of averting another of such major crisis in the world, the Harvard University (Business School) advises that more training programs should be initiated to combat unemployment amongst young Europeans in addition to the eight billion Euros pledged by Germany into job training programs.[40] The paper further proposes that banks should be made to maintain higher level of reserves and the price of assets will be more stable than jumping in bubbles.[41]
With a thorough analysis done on the regulations developed in the wake of the European financial crisis, my submission is that the international banking system in the Eurozone has developed into a more beneficial and trustworthy system than it used to be before the crisis. The basis for drawing this initial submission is the significant improvements made in the financial markets particularly the Markets in Financial Derivatives (MiFID) which has helped to improve financial transparency and disclosure. This has helped to control spending within the nations and systemic risks over the years. The Single Supervisory Regulations have also made bank examiners more critical and powerful in their assessment of bank performance. More so, the end of “Not-too-big-to-fail” policy has improved internal checks and balances within the banking industry which gives more security to customers’ deposits. Mandatory insurance policies have also helped to check the obnoxious practices of overzealous banks who grant ‘un-repayable’ loans to less productive business models and concentrate more on providing value added services to businesses that are built on better models and are more likely to remain solvent.
Nonetheless, there is much room for improvement and to tighten up loose ends. Market discipline orientation and policies must be given priority and enforced across board to ensure the responsibility for financial stability of the economy is not placed on banks alone. The new or modified regulations have not fully addressed the causes of the Financial Crisis; hence, there are still risks and future likelihood of a crisis if the situation is not well managed.
Therefore, I conclude on the basis that while the new regulations have assisted international banking in gaining a stronger foothold after the crisis and reduced the short term risks of another crash, they have not completely dealt with the major risks in the banking system which makes it still prone to failure in the long term. This means that these regulations have only made banking safer to a certain degree and more work needs to be done before the system can be completely relied upon as an ideal model within the European context.
CONCLUSION
This paper has examined the various definitions of a financial crisis by different authors. The focus of this paper is to address the post-crisis regulatory framework in international banking and whether these legislations and modifications have led to a safer environment for customers, citizens and the whole economy.
This paper further went to examine the brief background of the regulatory framework before the financial disaster in 2007 in Europe and the changes made thereto. In analyzing the various laws and instruments formulated after the crisis, the strengths and weaknesses of these new regulations were highlighted.
This paper concludes on the position that these new regulations have strengthened regulatory oversight and stiffer banking procedures but have not guaranteed a safe financial atmosphere. The fear of another financial crisis lurks in the corner as the root issues identified by various investigatory platforms have not been fully dealt with.
It is hoped that the European Union through its relevant institutions would launch a working committee to reassess the causes, effects and aftermath of the crisis and compare with the current financial market structure in order to recommend solutions that will address previous and possible future risks in the banking sector of the Eurozone.
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