It is witness to the significance of financial regulation that the nations that are most impacted by the credit crunch still have difficulty putting this behind them nearly 10 years after the crisis in sub-prime mortgages arose in the USA.
The new Financial Stability Board of Regulators of the biggest economies considers that calling for banks to cover an increased amount of loans with so-called TLACs reduces future prospects for expensive bank rescues. But these new regulatory institutions are based on basically flaccid underpinnings.
Too many financial supervisors see regulation as a “de-risk” exercise. They think the risk is limited by forcing a financial company to counter-risk substantial amounts of cash. However, the first rule of thermodynamics has a great amount of risk-energy that cannot be produced or destroyed or simply changed. If we are tax risk successfully in one location, it moves to another, like reciprocal funds. When we locate it and tax it again, it just moves again, maybe to store credit cards, and so on.
Another major problem in contemporary risk management strategy is the idea that the new TLAC standards are based on risk sensitivity. Banks don’t overtake them since they always understood that they were hazardous. They tackle doing things that they were persuaded were safe before they become hazardous. Banks claim additional guarantees, collateral, interest, and repayment reserves against loans they consider riskier.
The Regulation of Liquidity
Regulation on liquidity is a new layer to a regulation adopted in the wake of previous crises. Although almost little scholarly research has been available so far on the impact of liquidity control and its interconnections with capital regulation, it is reasonable to claim that it will assist to alleviate the fire sales issue, since banks have more liquid assets in their portfolios. Therefore, without early liquidation of long-term assets, they are in a better position to absorb cash shocks. Liquidity needs may also have some adverse consequences. Forcing banks to keep more liquid and short-term assets, according to the best Forex brokers online, may decrease banks’ long-term profitability. That may lead bank management to take greater risks in compensating for the loss of profitability and encourage investors to react more rapidly, triggering bank runs based on basic principles. Finally, although capital requirements are mainly aimed at preserving long-term financial stability, they may also constitute a short-term type of loss absorption and therefore interact in a significant manner with liquidity regulation.
The liquidity requirements of Basel III and the related CRD IV package are set in Europe by a Liquidity Coverage and a Net Stable Funding Ratio. The first is a measure of an institution’s capacity in the next 30 days to survive a severe liquidity freeze, while the latter is a longer-term the method intended to identify risks arising from large maturity mixes between assets and liabilities. In contrast to capital requirements, the impact of these additional regulations was evaluated by much less empirical study.
What Are the Challenges?
While the regulatory changes implemented so far obviously address major issues, new difficulties have emerged in the crisis years and post-crisis years to build a suitable regulatory architecture.
One of the most important lessons from the previous crisis was that financial system regulation must adopt an integrated approach and take into account the possible instability of banks with the shadow banks. This would avoid regulatory arbitration and govern the system from a comprehensive perspective. Take money-market mutual funds, for example, that invest in bonds, treasuries, etc., and that possess a liability structure like that of banks. While regulation did not regard money-market funds like banks, thus they could do a lot of things that banks could not do, this has changed recently. This has moved focus to fixed income mutual funds, which invest in bonds of corporate, government, and other kinds and have expanded significantly in the United States lately. They offer most of the liquidity transformation previously supplied by banks alone. Again, this may be a reaction to tighter banking regulation. In the future, authorities should consider integrating such organizations more into the regulatory system.
More broadly, financial innovation is one of the main causes of systemic risk. Financial innovation which enables improved risk management and sharing (for example, by creating new securities, or new kinds of financial intermediaries) may decrease the unusual risk that is evaluated independently by different financial institutions. But it may also lead to an increase in systemic risk as huge sections of the financial system face the same systematic or aggregate risk or it may enhance banks’ desire and ability to take risks. As banks become increasingly similar as a result of risk diversification, the systemic risk rises.
As the financial system becomes more complex and sophisticated, regulation likewise tends to be more complicated. This may fire back. First, the increased complexity of the financial regulation may provide financial firms greater incentives to become more complicated. Secondly, financial firms and investors may perceive the chance to exploit complicated laws governing financial regulation.
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