Financial Crisis Essay

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  • Global financial crisis and changes to financial regulations

‘Global Financial Crisis and Changes to Financial Regulations’

The objective of this essay is to demonstrate global financial crisis and changes to financial regulations. The focus of this essay is to clearly explain the proposed area of changes to financial regulation and supervision in the US, EU and UK after the global financial crisis. The fundamental issues to be considered in reforming the financial regulations and supervision are also highlighted. The essay spotlights on what would be the likely implications of the regulatory reform for the financial sector, in general, and banking sector, in particular.

The economy of the world has been hit by severe financial crisis since the Great Depression. This financial crisis spread so quickly which lead to dip of economic growth and jobs all around the world. The failure of the banking sector was mainly responsible for the global financial crisis. There were quite a few firms in UK which have failed mainly because of poor management decisions relating to acquisitions, too much dependence on extensive money supply or extreme leverage and risk taking. (Ref 1, pg3)

There was financial instability in the global economy by July 2007. In September 2008, financial turbulence in the global economy grew more rapidly due to the fall down of Lehman Brothers, an investment bank in US. This global financial crisis can be explained in three phrases. The first phrase arose as the market liquidity dried up. It happened because the prices of the securities fell down in the market as the investors misjudged the risk of those securities which were linked to the US subprime mortgages. The loss on these subprime mortgages was to be estimated to $200bn. The second phrase, losses started being reported by financial institution regarding the holding of impaired assets which bought about uncertainty amongst the investors. This uncertainty plus the slowdown of economy lead to banks responding by hoarding capital. The third phrase, the collapse of Northern Rock and Lehman Brothers crumpled the confidence of the entire global economy. The total losses in the global financial crisis have reached $4 trillion according to the latest IMF estimation. (Ref 1, pg 27-28)

Due to this worldwide recession, many shareholders all around the world had lost their huge amount of money. This crisis also led to bank run on Northern Rock and the break-up of Bradford and Bingley. The government took actions to restore stability in the financial system so that to ensure the protection of the depositors, continuations of lending by the banks and strengthening of the financial system. The government set up pounds 50 billion for the recapitalisation of Royal Bank Of Scotland (RBS) group, Lloyds TSB and the HBOS group. Credit Guarantee Scheme (CGS) was established by the government of up to pounds 250 billion. It was done to grant banks with guaranteed source of supplying funds which will eventually help in improving the flow of credit to the financial system and economy. The government used the Asset Protection Scheme for providing capital protection to the banks by protecting against any future credit losses on certain assets. The government also funded pounds 200 billion under the Banks of England’s Special Liquidity Scheme. (Ref 1, pg 4-5)

The governments from all over the world are reforming their financial regulatory structure on the road to deal with the financial crisis. Supervisors in US and from other part of the world are presently reconsidering the supervisory approaches to slot in the message of the crisis. Many financial regulators like Federal Reserve have played an important role in re-evaluating the financial regulations. Federal Reserve has been putting a lot of efforts to ensure that large financial institutions seize higher worthy capital, improve on their risk-management practices and employ reimbursement structure. There are already changes made to strengthen the regulatory standards. Many firms in US, EU and UK did not have sufficient capital and liquidity to secure themselves during the financial crisis. This required an international response which was fulfilled by Federal Reserve by working with organizations like Basel Committee on bank supervision and the Financial Stability Board. From this we can say that Federal Reserve has been actively supporting Basel Committee’s choice to strengthen capital requirement for securitisations and business activities. U.S supervisors took many important steps which were led by Federal Reserve to ensure that the banks have a sufficient amount of high quality capital with them. As major number of firms had faced problems in liquidity management during financial crisis, Federal Reserve lend a hand to Basel Committee’s decision to correct the development of liquidity risk management. From this we can presume that even during the time of market volatility, all the international firms can fund themselves. Faulty compensation practices and inadequate capital were also chipped in reasons for the crisis.

There was a major need for reforming the banking regulation after the crisis, especially in UK. The government has taken significant actions for reforming the banking regulation. Some of those actions already taken by the government were bringing change in the corporate governance of the banking sector, revolutionize the need of capital by the firm and trim down their leverage. The government was given temporary power to save the failing banks by the banking (special provision) act in February 2008. This act was used to aid Northern Rock, Bradford and Bingley and two Icelandic banks. (Ref 1, p5)

The fundamental principles to be considered in reforming the financial regulations and supervisions are:

  1. Greater emphasis should be on good quality forms of capital by the regulatory form of capital. Common equity should comprise majorly of a banking firm’s Tier 1 capital, and Tier 1 should comprise majorly of a banking firm’s total regulatory capital during good economic conditions.(Ref 4, p5)
  2. Banking firms should be subject to risk free based leverage restraint. There will be a lot of weakness in risk-based capital framework. A simple leverage constraint helps in financial stability by avoiding misjudgements about risk from official sectors, making regulatory system more healthy and add in macro-prudential benefits.(Ref 4, p10)
  3. Banking firms should be subject to explicit liquidity regulation system. These banking firms carry out surplus funding of long-term illiquidity assets with short term debt can contribute to firm’s failure. Banking firms should design the liquidity regulation to reduce longer-term asset-liability maturity mismatch.(Ref4, p11-12)

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