How the Global Financial Crisis Impacted on the Banking Industry - Assignment Example

Answers to Questions Q1. Highlight how the Global Financial Crisis impacted on the Banking Industry? The global financial crisis (GFC) had different impacts on the banking Industry in different countries. In general, many banks went bankrupt while others were in distress because of their sensitivities in terms of their balance sheets, to the financial risks that were increased by the crisis (Eken et al. 2012, p. 269). However, some banks felt the effects of the crisis to a less extent (Eken et al. 2012, p. 269). These details are explained below. The banking industry was severely weakened in countries such as the US, the UK, Japan and many countries in Europe as a result of the GFC. For instance, in the US, the number of bank failures increased and the value of bank stocks declined significantly (Kwan 2010, p. 1). This was initiated by the bankruptcy of Lehman Brothers, an investment bank (Delia 2012, p. 1262). In response to the effects of the GFC and the dire conditions that the banking industry was facing, banks tightened their terms and requirements of lending to very high levels (Kwan 2010, p. 1). The exceptionally high lending requirements meant that many borrowers could not access bank loans, leading to a significant decline in bank lending (Moseley 2009). This in turn resulted into reduced profitability for banks since the banks could only earn interest on finances that they lent to the few borrowers who passed the stringent borrowing requirements. There were also many bank runs (a situation whereby many depositors withdraw cash from their deposit accounts due to the belief that the financial institution with which they have kept their money will collapse). This led to a banking panic because many banks were suffering runs at the same time, as people tried to change their deposits into cash or resorted to getting out of the banking system completely (Ciro 2016, p. 20). The situation led to massive banks collapses or left many institutions in the banking sector in various countries, especially those that were connected to international financial markets, requiring bailouts (Ciro 2016, pp. 20-21; Delia 2012, p. 1262). Such institutions include the UK’s Lloyds Banking Group, which required a bailout, as well as Allco Finance Group and Babcock & Brown – both being investment banks in Australia – which collapsed because of massive corporate debt (Ciro 2016, p. 21). These are just but a few of the banking institutions that were adversely affected by the GFC. Consequently, governments of many countries across the world started instituting measures to protect the banking industry. In particular, governments in Europe and the United States started a globally managed plan to restore confidence in the banking industry. Such measures included attempts to guarantee depositors that their deposits were safe so as avoid further runs on banks (Ciro 2016, p. 21). In Australia, the downturn in the share market resulted in a notable increase in both systemic and systematic risks for Australia’s large and internationally connected banks. As well, as the effects of the GFC spread, banks started holding onto cash instead of lending it (Bollen et al. 2014). As a result, the Reserve Bank of Australia (RBA) (Australia’s central bank) responded by increasing precautionary demand for cash by banking institutions and other financial organisations by raising the supply of cash in the country’s financial system (Debelle 2009). This reduced pressure on the cash rate and helped stabilise the banking system. As well, the RBA introduced a guarantee scheme for all Australian Banks, which helped stabilise the banking industry further (Bollen et al. 2014). In spite of the protection measures that were taken by the RBA in Australia, some impacts of the GFC were still felt in the country. In particular, various financial institutions failed as a result of the GFC. For instance, Opes Prime, a broking firm, collapsed, resulting in massive losses for its customers (Brown & Davis 2010, p. 539). The failure of Opes Prime also caused a notable reputational damage to the key banks that were providing funding to the organisation. Another collapse was that of Storm Financial, a large financial planning company, in December 2008. The collapse of Storm Financial was associated with losses to the organisation’s clients, who had invested in various portfolios in the company. With the collapse also came reputational damages for banks that had funding arrangements with Storm Financial (Brown & Davis 2010, p. 539). The GFC also led to changes such as consolidation of some institutions to strengthen the banking sector in Australia. For example, Commonwealth Bank acquired Bankwest while Westpac Bank acquired St. George Bank (Brown & Davis 2010, p. 539). This enabled such banks to raise additional equity capital and hence increase their market capitalisation (Brown & Davis 2010, p. 539). Q2. What is the importance of Basel III? Basel III is a detailed set of reform measures that were created to improve supervision, regulation as well as management of risk within the banking industry (Bank for International Settlements 2016). The importance of Basel III is based on the aims that the measures in the framework aim to achieve. The aims are as follows. First is to improve the ability of the banking sector to absorb shocks that arise from financial and economic distress, whatever the source of the stress is. The second aim of Basel III is to improve governance and risk management within the banking industry. The third point is that Basel III aims to strengthen the disclosures and transparency of banking institutions (Bank for International Settlements 2016). With these aims come several benefits, as explained below To start with, Basel III aims to improve the ability of banks to absorb shocks that occur due to financial and economic distress, given that it raises the minimum capital requirements for banks. The increased minimum capital requirement for banks as outlined in Pillar 1 of Basel III makes it possible for banks to withstand financial shocks. This is unlike the past situation whereby the minimum requirements for bank capital were too low, meaning that banks could easily collapse even with small shocks, such as mass withdrawals of customers’ deposits. The scenario in the banking sector is that the less capital a bank keeps and the more capital it lends, leads to an increase in the bank’s profitability but makes the institution more susceptible to losses and collapse (Eubanks 2010, p. 1). Therefore, the Basel III requirement for banks to hold a larger amount of minimum capital makes banks more stable, as regulators would not allow banking organisations to operate without the required level of capital (Eubanks 2010, p. 1; Byres 2012, p. 3). In particular, having the required minimum capital implies that banks will still be able to function when faced with different kinds of shocks. For instance, raising the minimum level of capital that banks should have makes such institutions better able to absorb losses (OECD 2011, p. 90). With regard to improving risk management and governance within the banking industry, it can be noted that Basel III introduces a non-risk-based leverage ratio in addition to the risk-based capital regime. This is aimed at limiting the build-up of excessive leverage within the banking industry so as to avert conditions that may cause instability in the wider financial system as well as the economy (Unicredit 2015, p. 1). In particular, the build-up of too much leverage (both on the balance sheet and outside of the balance sheet of banks) was identified as a key contributor to the emergence of the recent GFC (Unicredit 2015, p. 2). Thus, by increasing the scope of probable risks that need to be identified as having the potential to cause instability in the banking sector, Basel III makes banks better able to deal with a wider scope of risks. The significance of governance is also emphasised in Basel III. This highlights the importance of Basel III as regards governance and disclosures. In particular, Pillar 2 and Pillar 3 of Basel III raise the standards for the supervisory review process and public disclosures respectively (Adamson 2012, p. 1). Supplemental requirements in Pillar 2 of Basel III deal with firm-wide governance as well as risk management practices. This includes issues such as reflecting exposures that are related to off-balance sheet transactions and securitisation activities (Bank for International Settlements n.d.). Pillar 2 of Basel III also emphasises the need to manage risk concentrations, provision of incentives that can help banks to better deal with risks as well as returns over the long run and the need to have effective compensation practices. As well, Pillar 2 outlines measures that can ensure good health of banking institutions. These include valuation practices, accounting benchmarks for different financial instruments, stress testing and corporate governance (Bank for International Settlements n.d.). Additionally, Pillar 3 of Basel III provides guidelines that relate to securitisation and how to deal with off-balance sheet items. For instance, under Pillar 3, there is a requirement for enhanced disclosure on the particulars of the elements of regulatory capital and how they are treated in the reported accounts. There is also a requirement for banks to explain how they calculate their regulatory capital ratios (Bank for International Settlements n.d.). Basel III is therefore important because its requirements seek to increase the minimum capital that banks can have, which enhances their stability. As well, Basel III is important because it aims to raise the level of risk management and governance by raising risk management and disclosure standards. References Adamson, R 2012, The impact of Basel III on risk management and corporate governance, Hitachi Consulting On Financial Services – Q1 2012, viewed 4 May 2016, . Bank for International Settlements 2016, International regulatory framework for banks (Basel III), viewed 3 May 2016, . Bank for International Settlements n.d., Basel committee on banking supervision reforms - Basel III, viewed 4 May 2016, . Bollen, B, Skully, M, Tripe, D & Wei, X 2014, ‘The global financial crisis and its impact on Australian bank risk’, International Review of Finance, vol. 15, no. 1, pp. 89–111. Brown, C & Davis, K 2010, ‘Australia’s experience in the global financial crisis’, in RW Kolb (ed), Lessons from the financial crisis: causes, consequences, and our economic future, John Wiley & Sons, Hoboken, New Jersey, pp. 537-544. Byres, W 2012, Basel III: Necessary, but not sufficient, Bank for International Settlements, viewed 3 May 2016, . Ciro, T 2016, The global financial crisis: triggers, responses and aftermath, Routledge, New York. Debelle, G 2009, Some effects of the global financial crisis on Australian financial markets, Reserve Bank of Australia, viewed 3 May 2016, . Delia, D 2012, ‘The impact of the financial crisis on the European banks, ‘The Journal of the Faculty of Economics’, vol. 1, no. 1, pp. 1262-1268, viewed 3 May 2016, . Eken, MH, Selimler, H, Kale, S & Ulusoy, V 2012, ‘The effects of global financial crisis on the behaviour of European banks: a risk and profitability analysis approach’, in OM Lehner & H Losbichler (eds), Proceedings in Finance and Risk Perspectives ’12, ACRN Cambridge Publishing House, Enns, Australia, pp. 269-294. Eubanks, WW 2010, Status of the Basel III capital adequacy accord, CRS Report for Congress, 28 October, viewed 3 May 2016, . Kwan, SH 2010, ‘Financial crisis and bank lending’, Federal Reserve Bank of San Francisco Working Paper Series, Working Paper 2010-11, May, viewed 3 May 2016, . OECD 2011, Future global shocks: improving risk governance, OECD Publishing, Paris. Unicredit 2015, ECB on Basel III leverage ratio and risk-taking, viewed 3 May 2016, . Read More