The regulation of the financial service industry has assumed greater importance in the wake of a balanced economic development of the nation. An intrusive regulatory framework is considered very much essential in view of the concern about the safety and soundness of the financial service industry. However the advancement in the information and communication technology, the enlargement in the financial services industry, the ambiguity in the distinction of banking and non-banking financial institutions and the creation and offering of numerous financial service products have put the banking system in a state of perpetual change and instability. Thus the transformation of the industry into a highly competitive and dynamic environment has made the system incompatible with the traditional regulatory frameworks that include deposit insurance, limits on permissible activities and controls exercised in the form of capital and liquidity reserve regulations. The key question remains that whether at all it is possible to adapt the regulatory framework to the increasingly competitive environment of the banking systems. This paper examines the risks that are being faced by the banking and other financial institutions.
What are Financial Services
The basic functions of banks, stockbrokers, insurance companies and other financial service providers comprises of services relating to:
- Collecting the savings of the people with a view to provide them compensation in the form of interest for foregoing the current utility of those savings and
- Providing fiancé to those people, firms and even governments who have the intention of investing the finance so provided which will enable them to pay back the institutions the financing and other service charges in the future.
Another service provided by the financial institutions is the use of money or other financial instruments to realize the payments due on purchases of goods and services on behalf of the customers. In order to perform this function efficiently the banks and the financial institutions have developed instruments like checks, wire transfers, credit and debit cards including smart cards and a host of other instruments which are known as the payment mechanism of the economy.
Yet another addition to the financial services include the provision of guidance to the potential savers on how effectively use their savings to reap a good return on their investment which service is recognized as asset management and treasury management. (The Environment)
The financial services have taken the provision of a fifth service which is the risk management to both the investors and savers. The risk management in its traditional form covered only the insurance of buildings, workers’ lives, and property. But the present day concept of insurance has extended its horizon to cover a wide range of activities including financial derivatives to manage “price, interest rate, exchange rate, and even credit risks apart from covering the property, accidents, and self. Thus the financial services encompass the following mechanisms:
- Mechanisms or instruments that enable the potential savers to park their savings safely and profitably
- Mechanisms which provide the needy investors or borrowers the required funds to fund their projects
- Mechanisms that govern the payments on behalf of the customers and
- Provision of advises to the savers as to the manner of dealing with their financial needs, as well as managing the assets of the investors and savers and
- Mechanisms to protect and manage the life, property, and finances of the constituents (The Environment)
The US financial system consists of an array of financial institutions that provide any of the abovementioned financial services. Despite being the most developed and extensive in the world, the financial service institutions face a number of risks in providing the above services.
Different Kinds of Risks being faced by the Financial Service Institutions
Chapter 7 details the different kinds of risks being faced by the financial service institutions in providing the various services outlined above. It may be noted that these risks are not peculiar to the financial institutions alone but are common to all the business entities in the world.
Interest Rate Risks
The major risk being faced by the banks and the financials institutions is the risk posed by the change in the interest rates. The interest rate risk for the financial institutions emanates from the financial intermediation services being undertaken by them. The risk is caused by the difference in the maturity values of the assets and liabilities of the banks. The interest rate sensitivity differences often expose the equity of the banks and other institutions to changes in the interest rates which ultimately affects the profitability of the institutions. The unexpected changes in the interest rates make the balance sheet hedging activity of the bank which is normally undertaken on the basis of the maturities of assets and liabilities at the expected maturity values shown in the balance sheets of the firms. When there are changes in the interest which affect the valuation of assets and liabilities negatively the banks and other institutions are bound to get a beating of the earnings. The other forms of interest rate risks are the refinancing risk and the reinvestment risks.
Another major risk in the operations of the financial institutions is the market risk which is incurred in trading of the assets and liabilities including derivatives. The example of the market risk can be found in the change in the exchange value of Russian Ruble. The unexpected decline in the manufacturing activities of the country is another market risk being faced by the banks. For instance, the working of the banks and the financial institutions were greatly affected in July 2002 when the Dow Jones Industrial index dropped by 12.5 percent for a period of two weeks.
The shift in the focus of the banks and FIs towards more trading activities away from the traditional banking and financial services also is instrumental in increasing the market risks of these entities. The example of market risk may be found in the heavy loss occurred to the AllFirst Bank, the US subsidiary of the Allied Irish Bank where the action of a rogue trader in manipulating the large trade losses and losses resulted from other frauds involving foreign exchange positions had caused huge losses to the bank. The exposure to market risks had caused the banks to look more increasingly at the concepts of ‘Value at Risk’ (VAR) and ‘Daily Earnings at Risk’ (DEAR) which enables the banks to identify the short term risk possibilities and address them effectively. The banks have also started increasingly to resort to securitization in order to thwart the risks relating to changing liquidity positions of assets and liabilities. (Chapter 7)
The third important risk to which the banks and FIs are exposed is the ‘credit risk’ which results in the failure of cash flows reaching the banks in full at the appointed time. The credit risk may be either firm specific credit risk or a systematic credit risk. Major credit risk the banks and FIs face is the charge off s on the credit card debts that have progressively been increasing during the 1990s and 2000s starting from mid 1980s. There has been a steady increase in the credit card loans and the unused balances in the loans.
Off Balance Sheet Risk
With the changing business scenario there has been an increasing risk being faced by the banks and the financial institutions in the form of risks involved in the letters of credit payments, commitments to other loans and the derivative positions booked by the firms which increase the risk of the banks as the inflated values in the assets due to off balance sheet financing techniques being adopted by the constituents. The speculative activities in which the firms engage by using off-balance sheet items result in the increase of a considerable credit risks for the banks.
Technology and Operational Risk
This risk is being caused by the inadequacies in the internal processes and systems of the banks, inefficiencies of the people involved in the functioning of the banks and the risks associated with the external events that cause losses to the banks and financials institutions. The operational risks associated with the technological innovations of the Automated clearing houses, CHIPS, and Real time interconnection of global FIs through satellite systems have resulted in the increased in the operational risks of the banks. There are other operational risks which are not exclusively technological but which are caused by the fraud and errors committed by the employees. The losses caused by the operational risks affect the reputation of the institutions involved and also the future business potential of the banks and other institutions.
Foreign Exchange Risk
Due to the economic globalization the banks and the financial institutions are exposed to increased foreign exchange risks and the exchange risks result either in net long or net short in terms of the foreign exchange earnings of the institutions in the different currencies that the institutions deal with. The intensity of this risk is enhanced due to the fact that there is no correlation between the home currency rates and the exchange rates of the currencies of different countries. Similarly the undiversified expansion into other countries creates more foreign exchange risks. The banks and the financial institutions are often not able to correlate the returns from the domestic and foreign investments.
Country or Sovereign Risk
As a result of the exposure to different governments imposes the restrictions on repayments to foreigners that enhance the risks of the banks and financial institutions. Due to lack of refined litigation systems the country or sovereign risks could not be mitigated. There are a number of examples for the country risk in what has happened in Argentina, Russia, South Korea, and Thailand. The role of the International Monetary Fund in extending aids to the banks in trouble is to be appreciated. The position of the banks in the absence of the initiatives of IMF would be more precarious.
Liquidity risks relate to the position of the banks or other FIs to borrow excessively or sell off the assets within a short period of time to meet its financial obligations. This may be the result of pricing the financial service products very low. The liquidity risks may result in ‘runs’ on the banks and the runs may the liquidity problems of the banks in to a problem of solvency.
The risk of insolvency implies the risk caused to the financial institutions because of the possession of insufficient capital to make good the sudden decline in the value of assets and liabilities. The position of the Continental Illinois National Bank and Trust is the classic example for the insolvency risk. The insolvency risk may be caused by any or a combination of interest risk, market risk, credit risk, off-balance sheet risk, technological risk, foreign exchange risk, country risk and liquidity risks.
Risks of Financial Intermediation
There are other risks which are caused by the interaction of other risks and discrete risks like the risks caused by war or terrorist activities, market crashes, theft and malfeasance. These risks are also caused by the changes in the regulatory policies.
The macroeconomic risks like increased inflation rate or increase in volatility affects the interest rate risks and increases in unemployment level increase the credit risks.
Approaches to the Regulatory Frameworks
In the traditional protective environment the bankers and regulators working in close association with each other have evolved systems and procedures that have the effect of protecting the financial service institutions and thereby they constituted to the stability of the financial system. For achieving this end, both direct and indirect approaches to regulations were followed by the authorities and the regulators (Boot et al. 2000).
The direct approach by explicitly prescribing and specifying the activities the banks can undertake has reduced the discretion on the part of the banking institutions and the regulators as well. The Glass-Steagall Act that was in force in the US which separated the commercial banks from the investment banks and also distinguished the operations of banks and insurance companies as being followed in many countries, exhibit the direct approach to the financial industry regulations. The indirect approach on the other hand mainly uses the price and non-price incentives which have the effect of inducing the desired behavior of financial institutions. One of the examples to this approach is the ‘risk-based capital’ requirements (Boot et al. 2000).
However, in the light of the existence of a highly competitive environment where the level playing field and the regulatory arbitrage are some of the issues that need to be addressed, the adoption of both direct and indirect approaches to the regulatory frameworks proved to be expensive. More specifically the approach of using direct regulatory measures in a competitive and swiftly changing business scenario seems to be seems to cost heavily. This is so because with the rapid changes the regulatory frameworks appear to be getting out of dated quite constantly making them unusable (Boot et al. 2000).
The emphasis on the direct regulatory approach has been diluted by the enlargement in the scale and scope of the activities of the banking and other financial institutions. On the contrary the incentive based indirect approach of regulatory framework has gained momentum. This shift can be seen from the increased refinement in the risk based capital requirements placed on the banking companies and also the enlargement of other control measures (Boot et al. 2000).
But again in a dynamic and competitive environment it is critically important that the control measures are overhauled periodically to include the current requirements of the industry and this needs a fine-tuning of the control instruments at regular intervals. This is very much required to prevent competitive distortions taking place. Such evaluation and re-adjustment of the control measures does not appear to be happening in the context of the indirect approach and this has made the indirect approach to the control mechanism through regulations also ineffective. As a result both the direct and indirect approaches to the regulatory frameworks have become ineffective. In view of this the banking industry is facing a number of risks which may affect the functioning of the whole system (Boot et al. 2000).
Regulations Concerning the Banks and Financial Institutions
The regulations governing the activities and functioning of the banks and other financial institutions take their root in the broad objectives of the government and the regulatory authorities, in protecting the ultimate sources and users of savings. These regulations normally also cover the prevention of unfair practices such as redlining and other discriminatory actions. The primary role of the regulations is to ensure the soundness of the entire banking and financial system as a whole. However it must be noted that the regulations under direct and indirect approaches incur costs. The regulations also aim at increasing the safety and soundness like the minimum capital requirements. The formation of Guaranty funds like Bank Insurance Fund (BIF), Savings Association Insurance Fund (SAIF) and Securities Investors Protection Fund (SIPC) aim at protecting the interests of the investors and savers. The regulations also are expected to monitor and do surveillance on the safety of the investors’ funds. The other regulations take the form of monetary policy regulation, Credit allocation regulation, and Consumer Protection regulation. The consumer protection regulation includes the Community Reinvestment Act (CRA), and Home Mortgage Disclosure Act (HMDA). The promulgation of Securities Act, 1933, 1934, and the Investment Company Act of 1940 are the key legislation in the investor protection legislation. Such legislation act to protect the investor against abuses like insider trading, lack of disclosure, malfeasance, and breach of fiduciary responsibility. There are entry regulations which include regulations governing the scope of permitted activities through Financial Services Modernization Act of 1999.
Thus the competitive environment and the degree of development of the financial systems largely affect the required design of the regulations. Since the intention of the regulations are to protect the interest of the savers and investors it becomes important that the regulations are updated periodically to cover the rapid changes in the financial service products so that neither the institutions nor the customers are put to hardship.
- Boot W.A. Arnoud, Dezelan Silva and Milbourn T. Todd (2000) ‘ Regulation and the Evolution of the Financial Services Industry’ Web.
- The Environment ‘The Future of Global Financial Services’ Web.