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Mid-Crisis Regulation

Mid-Crisis Regulation

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Published by Henry Black
An assessment of whether the regulatory responses made in the wake of the 2007 collapse, indicated a convergence of financial systems in the Western world
An assessment of whether the regulatory responses made in the wake of the 2007 collapse, indicated a convergence of financial systems in the Western world

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Categories:Types, Business/Law
Published by: Henry Black on Nov 11, 2012
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The Euro Crisis—How it could happen and why it would be horrible p16Computers changing the world of Cancer p32James Murdoch comes up empty, again p36
Issue number 1 November 2011Edited by Henry Black—08066412
Mid-Crisis Regulation
Since the financial crisis of August2007 there have been a number ofproposals to regulate and reformfinancial systems across the globe.But do these this proposals indicatea convergence of financial systemsinternationally? One suspects not.Although there is very much a globalmarket in the twenty-first century,the makeup of one financial systemstill varies from the next. To investi-gate further this article will look atthe latest regulatory proposals of theUK, USA and EU, as these three fi-nancial systems embody the westernworld economy that is currentlyexperiencing one of its worst de-clines in history.
It makes sense to start at home withthe UK. There has been much media,and therefore public, furore regard-ing the operations of the UK’s mar-ket based financial system. Thebanks have suffered the majority ofthis focus through pressure to imple-ment strategies such as ‘ring fencing’and more vehemently, restrictions ofthe pay-outs of bonuses (the latterappearing more of a political rebut-tal than an actual proposal). Thesubject of ring-fencing is investigatedin the ICB’s (Independent Commis-sion on Banking) ‘Final Report’ re-leased in September this year. Ithighlights how ring-fencing could beimplemented. The proposal is toseparate the retail and investmentarms of the banks which should en-sure that the banks retail customersare protected from the riskier, in-vestment activities such as deriva-tives and securities trading.The ICB report goes into detail aboutwhat is and isn’t allowed inside thering-fence whilst also leaving it up tothe banks to decide where certainareas sit. For this it has created threeprinciples describing the types ofservices. The ‘mandated services’ areservices that ‘must be provided byring-fenced banks’ and the‘prohibited services’ are services thatmust not be provided.The third principle is that of ‘ancillaryservices’. This is designed to encap-sulate the activities a ring-fencedbank ‘would need to do in order todeliver those services that theywould be permitted to pro-vide’ (Vickers 2011). The report pro-vides a good example of this. A ring-fenced bank would have to hedgeits interest rate risk but it is not al-lowed to provide this hedge as aservice to its retail customers.(Vickers 2011).Such reform should offer more secu-rity to retail and SME aspects ofbanking, but there are downsides tosuch an approach. A proposed im-plementation date is expected fromthe treasury by the end of the year.The significance of such a proposalindicates a UK inclination towardsthe protection of people’s money.Furthermore, the ICB report pro-poses high equity to RWAs ratios forthe ring-fenced banks (7-10% de-pendant on their RWA to UK GDPratio), reinforcing this need for sta-bility.
Since the crisis of 2007 the DoddFrank Reform has been the onlyproposal approved by Congress(Tropeano, 2011). It has been metwith a lot of criticism from those inthe financial sector, due to the shearsize of it (some 2600 pages). Themain, and most controversial, ele-ments of it are the newly modifiedVolcker Rule on proprietary tradingand the derivatives reform.The Volcker Rule has been put inplace to stop the banks making in-vestments that do not provide bene-fits to their customers i.e. using theirdeposits to create profits only en- joyed by the bank. This has largelybeen translated as a ban on proprie-tary trading for commercial banks.Before the Volker Rule these activi-ties where often shown on the samebalance sheets as their commercialactivities (Tropeano, 2011). In suchinstances, when proprietary tradesmade profits, they went to the bank,but when they made losses, thebanks fell back on the deposit insur-
Contemporary Issues in Finance—U52080With all this talk of regulation, do the proposals signify a convergence of financial systems?
BerlusconiSteps Down
Italian President GiorgioNapolitano was holdingtalks Sunday aimed atforming a new govern-ment following the resig-nation of Italy's PrimeMinister Silvio Berlusconi.Ex-European commis-sioner Mario Monti wasfavourite to replaceBerlusconi in a bid tostave off bankruptcy forEurozone's third-largesteconomy. Last week Foreign Minister FrancoFrattini said he sup-ported an emergencygovernment of nationalunity led by Monti."He has an internationalprofile that no one candeny," Frattini said,according to his pressoffice.The departure of Berlus-coni seemingly brings toan end to a long careerplayed out on center-stage in the country'svolatile political arena.The thrice-elected 75-year-old business mag-nate has said he doesnot intend to stand againif new elections arecalled. Berlusconistepped down just hoursafter the lower house of parliament approvedausterity measuresaimed at restoring confi-dence in Italy's economy.Crowds that had gath-ered outside the presi-dential palace erupted incheers --waving theItalian flag, dancing andsinging the nationalanthem --when news of his resignation broke.Since entering politicsnearly two decades ago,Berlusconi has been oneof his country's greatsurvivors, hanging on...Continued on page 8
Eurozone Crisis -4 page special
From late 2009, fears of asovereign debt crisisdevelopedamonginvestorsconcerning some European states, intensify-ing inearly 2010.
This includedEurozonemembersGreece, Ireland, Italy, Spain and Portugal, and also somenon-EurozoneEuropean Union(EU) countries. Iceland, thecountry which experienced the largestfinancial crisis in2008when its entire international banking system collapsed,has emerged less affected by the sovereign debt crisis. In theEU, especially in countries where sovereign debts have in-creased sharply owing to bank bailouts, a crisis of confidencehas emerged with the widening ofbondyield spreadsandrisk insurance oncredit default swaps…Continued page 42
Continued overleaf...
Mid-Crisis Regulation Continued...
ance provide by the FDIC (Federal DepositInsurance Corporation). The Volcker rulehas placed a ban on such activity, echoingthe Glass-Steagall act of 1933. The Volckerrule again illustrates an emphasis on segre-gating risk.Another major element of the Dodd-Frankact is the derivatives reform. This is thebiggest ever shake up of the derivativesmarkets and as a result the exact rules on itare still being written up a year later. Thereform requires derivatives trading to movefrom over-the-counter trading to exchangesor swap execution facilities. This is intendedto add security through an increased clarityof responsibility. During the 2007 crash itproved very difficult tracing back trades.This resulted in large burdens being placedon single organisations who had irresponsi-ble amounts of exposure. On top of beingmoved to exchanges, derivatives are now‘subject to mandatory clear-ing’ (Huntingdon. D et al, 2010). This en-ables real time public reporting to be madeavailable and further insures that trades areaccurately recorded. Such moves show anemphasis on creating more transparency inthe market and also increasing regulationthrough special repositories that can ‘judgeover the dangers of systemicrisk’ (Tropeano, 2011).
The bank based European Union has illus-trated a quite different approach to postcrisis regulation. For better for worse, regu-lation has tended to be directed at marketbased practices. Proposals such as a finan-cial transaction tax, as well as limits on shortselling have been considered.The financial transactions tax proposal isstill yet to gain traction. At the G20 summit,the tax was once again postponed due tocountries such as the UK who are not inagreement. The tax proposes that ‘trades inbonds and shares would be taxed at 0.1 percent, while more complex derivatives wouldface a 0.01 per cent levy’ (Chaffin, J. 2011).The money raised by the ‘Tobin Tax’ (Tobinbeing the US economist who created theidea in the 1970’s) is intended to raise capi-tal for governments in the European Union.Due to the resistance that the tax has met inthe European Union, Belgium’s finance min-ister has suggested that it could be rolledout to just the Euro zone countries.Much of Europe’s regulatory focus has beenaimed at limits on short selling. Certain EUnations first applied temporary limits toshort selling but as of October have agreedto making these restrictions permanent(Barker, A. 2011). Such legislation, when itcomes in to play, will mean that the shortselling of bonds, shares and credit insurancewill be put under close scrutiny. It is arguedthat holding a short position creates a nega-tive outlook and can ‘amplify market tu-mult’ (Froymovich, R .2011). A particularemphasis has been on banning naked CDS(Credit Default Swaps). A CDS is usually usedas a means of reducing ones risk exposureon their held position. This is done throughpurchasing credit insurance to protectagainst default. But when a CDS becomenaked, the actual investor does not hold theposition they are insuring against. They aretherefore only going to make a profit shouldthat borrower fail. Again this is not condu-cive to moral trading and as a result the EUhas considered a ban necessary. The agree-ment still needs to be processed by theEuropean council and the full EuropeanParliament and is therefore not expected tobe in place until November 2012(Froymovich, R .2011)
Basel III
The third of the Basel accords has beenreleased as a direct result of the 2007 crisisand signifies one of the few multinationalregulatory initiatives. It builds upon thefailing of Basel II through increasing thecapital requirements of banks substantially.The new capital ratio has been set at 4.5 percent which illustrates a significant increasefrom the previous 2 per cent level(Wearden, G . 2011). On top of this bankswould be required to hold a ‘counter cycli-cal’ capital buffer of 2.5 per cent. Shouldthey fall short on this amount they are likelyto find themselves facing bans on payingout dividends to shareholders (Wearden, G .2011). Coupled with this are limits on lever-age, which Avinash Persaud believes is de-signed to ‘curb the enthusiasm of lending atthe top of the economic cycle’ (Persaud, A.2011). These higher capital requirementshave been met with resistance from thebanks due to the current pressure they areunder to increase lending. As a result of thisthe Basel III accord is not expect to be fullyimplemented until January 2019 (FT Al-phaville 2010)
Convergence or Divergence
It appears that the UK, US and EU havequite contrasting proposals for the regula-tion of their Financial Systems. The EU’sfocus has tended to be on reforming themarkets, likely due to its roots as an institu-tion based system. Proposed measures suchas the Financial Transaction tax have beenfirmly opposed by the UK and US. Critics ofthe tax say that it would reduce the com-petitiveness of the market unless it wasrolled out on a global scale. Traders maydecide to move their trading elsewhere toavoid such a tax. The fact that this proposalhas been met with this level of resistanceindicates that these systems vary not onlythrough their regulatory bodies but throughthe member participating in them.The US and UK are more closely aligned,with proposals that have shown a focus onthe segregation of risk. Both the ring-fencing from the Vickers report and theProprietary trading ban from the DoddFrank act are attempts of keeping riskierinvestment away from lower risk ones. Thisindicates a realisation that risk needs to becontained. But even between the UK andthe US there are differences. The DoddFrank reform has shown a huge emphasison the reform of the derivatives marketswhich has not been replicated elsewhere.One thing that the 2007 crisis has taught allfinancial systems is that capital require-ments need to be increased. Basel III re-flects this with substantial increases to thecapital ratio and the UK US and EU havecollectively adopted these. This adoption ofhigher capital requirements shows an agree-ment by all parties that inadequate require-ments had a fundamental part to play in thecrisis. But does this truly show a commonapproach going forward? These require-
Continued overleaf...

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