Banking Regulation and Practice - Coursework Example

Banking Regulation and Practice Name Course Instructor College Date of Submission Measures of Competition Concentration Ratio: This is the approach used to compute the concentration of market divide controlled by some traders in a market. The ratio shows the comparative magnitude of particular firms in an industry. Low concentration ratio translates to a greater competition amongst the firms in that industry (Delis & Tsionas 2009, p.1855). Herfindahl Index: It is an additional measure of concentration in an industry. The Herfindahl index is basically the sum of the squares of the market shares held by each one firm in the industry. The measure is intended to gauge industry concentration, and by implication the extent of market control. The index varies from 0, indicative of perfect competition, to 10,000, indicative of total monopoly. However, as a general rule, 0.1 but 0.18 implies high concentration (Delis & Tsionas 2009, p.1857). Efficiencies Technical Efficiency: Technical efficiency narrates the quantity of output that is obtainable from a specified input level. It is the efficiency with which a specified combination of inputs is applied to create a product. A firm is regarded as technically efficient if it produces the optimum output from a minimum amount of inputs or is utilizing minimum inputs to manufacture a specified output level. Essentially, the phrase means producing goods at the least feasible opportunity cost (Delis & Tsionas 2009, p.1876; Berger & Humphrey 1997, p.212). Allocative Efficiency: Allocative efficiency denotes an optimal and efficient allocation of resources. This entails taking into account consumer preferences. Allocative efficiency refers to a production level where the Marginal Cost (MC) of producing equals the Price (P) since the price that consumers are prepared to pay is correspondent to the marginal utility they would acquire (Berger & Humphrey 1997, p.219).  Economic Efficiency: Economic efficiency is attained at the least achievable cost of producing a specified amount of output. It denotes the procedure by which resources are capitalized on to produce more productive value than they utilize; it is habitually based on value. Economic efficiency is the combination of technical efficiency and allocative efficiency (Berger & Humphrey 1997, p.221). Basic Structure-Conduct-Performance (S-C-P) Model The structure-conduct-performance (SCP) outlines indicate that the structure of an industry is established on the forces of demand and supply in that industry. According to Delis & Tsionas (2009, p.1874) the competition resulting from this industry structure affects the conduct of companies and in the end dictates the performance of the industry. The model has three elements; market structure, market conduct and market performance. Market structure institutes the general setting in which all firms manoeuvre. Fundamental market structure features comprise the number of live rivals, barriers to exit and entry, nature of product, and existence of any unevenness of information among buyers and sellers. Market structure usually varies from one industry to another due to variances in fundamental surroundings, together with the basic hi-tech base, the regulatory setting, demand, and economies of scale (Berger & Humphrey 1997, p.235). Market conduct is founded on the expectedness of definite pricing along with productivity choices cropping up from market power or its nonexistence. Whether a firm settles on its policies autonomously or in union with other firms in the market, the outcome is a crucial impact on the industry’s conduct. Finally, market performance dictates conduct and is replicated by the level of productive plus allocative efficiencies, fairness, and hi-tech advancement (Berger & Humphrey 1997, p.237). Financial Development and Economic Growth There is conflicting debate on the link between financial development and economic growth in literature. However, most research point out that financial development is vital for economic growth not the other way round. Levine & Zevros (1996, p.690) states that there is proof that financial development is a good predictor for future rates of economic development plus capital accumulation, and technological change – which are fundamental for economic growth to occur. In addition, financial markets and institutions rise to reduce the transaction costs thereby facilitating the allocation of resources in an uncertain environment leading to economic growth (Pagano 1993, p.617). ‘’AK’’ Growth Model To find out the probable effects of financial development on growth, consider the simplest endogenous growth model; ‘AK’ model, where aggregate output is a linear function of the aggregate capital stock: -------------------------------------------------Eqtn. 1 Consider a closed economy and assume that is a combination of capital and labour. Also simply assume that population is static, and the economy produces a single commodity that is either consumed or invested; if invested, it depreciates at the rate of per a given period. Gross investment then becomes; ------------------------------------Eqtn. 2 In a closed economy, where there is no government influence, capital market balancing necessitates that total saving. Assume that a percentage of 1 - of the flow of savings is disappears in the course of financial intermediation; -------------------------------------------------------Eqtn. 3 From eqtn 1, the growth rate at time t + 1 is - 1. Using eqtn 2 and dropping the time indices, using eqtn 3 and letting the steady state of economic growth can be written as; ----------------------------------Eqtn. 4 The above eqtn 4 indicates how financial development can affect steady state of economic growth by either raising or influencing s (Pagano 1993, p.619). McKinnon/Shaw Approach McKinnon and Shaw regard financial liberalization as the foundation of economic improvement in developing economies. According to Shaw (1973, p.121), "'the argument for liberalization in finance is that shortage prices for savings boost rates of saving, perk up savings share, bring on some switch of labour for capital equipment, and support income equalization" Both McKinnon and Shaw uphold that financial liberalization, relating to the establishment of higher interest rates that associate the demand for and the supply of savings, will guide to increased savings. This would bring progress in investment efficiency therefore low-yielding investment projects would be eradicated thereby encourage economic growth (Galindo et al 2001, p.213). Role of the Stock Market In theory, a strong stock market ought to augment saving and economically apportion resources to prolific investments, which results to an amplified rate of economic growth. Stock markets facilitate the mobilisation of household savings by attracting the set of financial instruments offered to savers to spread their investment selections thereby offering a vital source of investment capital at moderately low cost (Levine & Zevros 1996, p.634). Stock markets assist savers to manage liquidity risk by permitting individuals affected by a liquidity blow to trade their shares to safer investors. Therefore capital is not rashly taken from firms due to temporary liquidity requirements. Additionally, stock markets majorly engage in distributing funds to the commercial sector, which will have an actual upshot on the overall economy (Galindo et al 2001, p.219). Credit Risk Credit risk is the possible risk assumed by a debt holder by accommodating the risk that a debtor will default on a loan. This is an unexpected manifestation. There are three diverse types of credit risk, default risk, recovery risk and migration risk (Jolly 2003; p.63). Default risk occurs when a debtor cannot meet their obligations when it comes to repaying the debt. This may be due to bankruptcy, liquidation or general default. In these circumstances, a credit risk report is produced, on the basis of the debtor's credit past, assets, as well as savings. Recovery risk is a credit risk prevalent when the actual recovery rate reported after bankruptcy of a debtor is lower than the initially projected amount since the insolvency value would be than as projected or else the process of recovery was prolonged. Lastly, migration risk is the danger associated with the worsening of a debtor’s creditworthiness particularly when the debtor’s credit rating is downgraded. Basel II Committee Approaches Three methods offered by Basel II Framework for computing the capital requisite for operational risk, manifest by escalating difficulty and sensitivity are: ((Ritchie & Marshall 1993, p.125) The Basic Indicator Approach which makes use of a bank’s total gross income per year as a risk measure. The approach assumes that the higher the income, the larger the bank thus open to a greater operational risk. The bank’s necessary level of operational risk is then calculated at a proportion set at 15 percent by the Basel Committee. However, the actual application of this approach is restricted as it is not regarded as a proper indicator of risk and is not sensitive to the bank’s activities and systems along with procedures. The Standardised Approach splits the bank’s actions into eight business ranks and then applies a preset beta factor aligned with the average positive total proceeds per year over three years. The beta factor differs, depending on the dealing line. This approach tries to connect a bank’s operational risks more directly to its capital necessity. Although it is better than the Basic Indicator Approach, it does not incarcerate the bank’s definite operational risk since it does not take into account the bank’s comprehensive risk evaluation. The third approach is the Advanced Measurement Approach is a more complicated method. This approach permits the bank to apply created models within it to work out the operational risk capital necessity. This may prove to be expensive, however it is very advantageous due to the belief that if offers an extra exact evaluation of a bank’s operational risk, thus letting banks to steer off plain and too conformist weights in the other two techniques. Also, banks employing this approach gain from the watchful deliberation of its trade customs that have to crop up in weighing up and computing operational risk. However, in using this approach, the bank has to conform to thorough quality standards and propensity to incur losses due to the procedures involved in developing the models. The bank also has to oblige to an era of obligatory screening. Market Risk and the VAR Approach Market risk covers the danger of monetary loss owing to variations in market stock prices. The worth of investments can go down due to financial changes or other occurrences (Jolly 2003; p.53). The Value at Risk approach (VaR) is a means for risk measurement. VaR simply is the normal greatest loss over an intended prospect for a certain confidence interval. The method is preferred as it is straightforward plus it offers an approximation of the quantity of capital that is required to maintain a given risk level. Where: = Portfolio Market Value, = Sensitivity of Market Prices and = change in price movement over a given time (Ritchie & Marshall 1993, p.113). Interest Rate Risk, Reinvestment Risk and the Refinancing Risk Interest rate risk is the probability that a security's price will vary due to a change in interest rates. For example, a bond's price goes down as interest rates go up (Ritchie & Marshall 1993, p.98). Reinvestment risk is the likelihood that when a bond or note matures its interest charge, will be lesser than what the depositor is getting at present. Therefore, when the investor wishes to reinvest the income from the bond or note, he or she will have to accept a lower interest rate. On the other hand, refinancing risk is the extent of risk that the expected upshot of a certain financial deal will not succeed. It leads to a failure to realize the proceeds looked-for when the business deal was originally executed (Ritchie & Marshall 1993, p.102; Jolly 2003; p.59). Operational Risk Operational risk is the possibility of loss ensuing from deficiencies in information systems or internal controls. The risk is associated with human error, systems malfunction or exterior occurrences (Credit-Suisse 2012; Jolly 2003; p.56). Operational risk is covered in five broad categories; Organization risks is due to change and project management, corporate customs and communication, responsibilities, allocations or business continuity programs Policy and process dangers linked to weak processes including settlement and payment, non-compliance with internal policies or external regulation. Technology risks arising from faulty software or hardware, breakdown in other technology networks or violation of IT safety measures. Human risks due to failure of employees, employer, conflicts of interest. External operational risk arising from fraud or legal action by parties outside the firm or lack of physical security to the firm or its representatives. References List Berger, A.N and Humphrey, D.B 1997, ‘Efficiency of financial institutions: international survey and directions for future research’, European Journal of Operational Research 98 (2), 175-212 Credit-Suisse, 2012, Operational Risk, viewed 06 April 2013 Duffie, D and Pan, J 1997, An overview of value at risk, The Journal of Derivatives Spring, 7, 49 Delis and Tsionas 2009, “The joint estimation of bank-level market power and efficiency”, Journal of Banking and Finance, 33, 1842-1850 Galindo, A, Schiantarelli F and Weiss, A 2001, Does Financial Liberalization Improve the Allocation of Investment? Micro Evidence from Developing Countries, Mimeo International Development Bank Jolly, A 2003, Managing business risk, Kogan Page Publishers Levine, R and Zevros, S 1996, Stock Markets, Banks, and Economic Growth, World Bank Policy Research Working Paper, No. 1690 Pagano, M 1993, Financial Markets and Growth: An Overview, European Economic Review, 37(2-3), p. 613-622 Rirchie, B and Marshall, D 1993, Business Risk Management, 1 edn, Chapman & Hall Shaw, E.S 1973, Financial deepening in economic development. New York: Oxford University Press Read More