FN1024 Principles of Banking and Finance

Section A

Answer

The 2008 financial crisis one of the worst financial crisis in the US history. It caused huge crash in the financial market, destabilizing economies and causing high level of unemployment. The crisis was an outcome of years of bubble in the housing market and busted in 2008 causing global crisis. Many attribute the cause of 2008 financial crisis to be deregulation of the financial history which permitted banks to be engaged in hedge fund trading with derivatives. In such an event bank demanded more mortgages for the purpose of supporting the profitable sale of those derivative instrument. Banks crated interest only loans which was within the reach and buying power of subprime borrowers.

In 2001 the fed anticipated the mild recession in the economy after the dot com bubble and propagated monetary easing which caused the rate of Fed to decline from 6.5% to 1.75%. The said action of the Fed prompted people to take loans at low prime rate and promoted banks to even lend funds to subprime or high-risk consumers though a tighter interest rate lending. The crisis seed was started bursting in 2004 when the Fed increased the rate of interest on these new mortgages reset and the seed began to germinate fully in 2007 when the prices of the asset underlying the derivatives began to fall as the supply outpaced the demand eventually. The fall in prices disrupted the LTV ratio and the houseowners were unable to repay the payment and neither could they sale the property on account of dearth of buyers. Eventually as an outcome of above, the derivative prices fell drastically and the banks stopped lending to each other. Thus created the financial crisis eventually leading to great recession. The securities which destabilized the market were mortgage backed securities.

There is another theory behind the crisis which is in relation to Credit Default Swap. This swap are insurance instruments wherein company proposes to make any loss good in exchange of premium. There were huge CDS issued in the market and when the housing prices began to fall CDS started crystallizing and the insuring companies became bankrupt and ultimately the crisis reached creating huge uproar in the market.

The failure of investment Bank Lehman Brother in 2008 further fueled the economic crisis. The government announced huge bail out packages and other measures to stop the spread of the claims that were filed and eventually tried to protect the economy from falling into recession.

Further the above action of 2008 crisis created severe liquidity crisis in the financial market.

The consequence of above crisis on banks were that many banks shut down and some of them were defended by the government. This caused a series of new reforms to be introduced in the banking sector. encompassing the Dodd- Frank Wall Street Reform and Consumer Protection Act which aimed of not usage of tax payer’s money under bailout package and thorough punishment of wall street and there has been lot of structural change in the form of liquidity norms and Basel Norms were modified.

Discuss the main reasons for regulating the banking system. 

 Answer

Bank is the backbone of financial system and crash or failure of the same can cause economy wide panic and disruption of social and financial order .The banking system is also highly leveraged ,large losses of loan provided from bank end can cause high instability in the financial system .If there is a failure by large bank to meet its loan obligation ,than the value of loan amount it has acquired from another bank may also cause the other bank also to fail. Bank transact with money of common people who does not take part in day to day affairs of the bank. Banks are the means through which government seeks to control inflation and promote economic growth .To prevent another global crisis like 2008 financial crisis .To promote economic development and ensure safety of fund. Further, government has to bail out the bank in case it fails and thus to protect its vested interest government regulates bank and the banking sector. Further to keep the financial system stable and also to keep the banking system safe it is also important to regulate the banking system of an economy ,to address the customer concern and grievances ,if the bank fail huge problem can be created to large scale economy at large.

Discuss to what extent Basel 3 helps to make the banking system more resilient to future financial crises.

Answer

Basel III is a prescribed set of measures which is formed by the Basel Committee on Banking Supervision in response to financial crisis which arise in year 2007-09. The principal aim to set this is to strengthen the regulation involved, risk management of bank and also maintain a proper supervision system. It is an international regulatory accord that formed a set of reforms in order to evade the risk involved within an international banking sector. This require that the bank is supposed to maintain a proper leverage ratio and always keep a defined level of reserve capital in hand so that the bank does not run out of cash.

Base III committee standard are the minimum available requirement that need to be followed and applicable to all internationally active banks. Members are committed to execute and apply relevant standard in their jurisdiction within the time frame created by the committee.

Basel III is a defined set of precautionary measures which are imposed which is imposed on banking system and this is made in order to protect the economy from any financial crisis which is very much similar to that of recent years. Basel III generally ensures that banking system must accept the responsibility for any financial economy that operate within and they also act as a safeguard in order to protect against any future collapse.

Basel III is designed in such form with very wider purpose that strengthen the world’s bank.

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