Vous consultezFinancial innovations, crises and regulation: some assessments

AuteursFrancisco Pinto du même auteur

Rogério Sobreira du même auteur

The new banking system

8 The widely used advantages of electronic payments reduce the attractiveness of holding bank deposits for longer times as was required when using checks. In other words electronic payments increased speed and system efficiency, whilst reducing the need to hold deposits for longer terms. This example alone, as recalled by Chami et al. (2003), raises pressures for dramatic changes in loan agents. The policy shift of fund managers to operate administration at shorter intervals requires more transparency in gains and losses, exploiting the more agile players, either through better management of funds in a scenario of fast movement of resources, new tariffs, fees and payment services, or in the opposite direction by punishing those who have more difficulty in adapting to this environment.

9 From a strictly financial point of view it can be said that the speed in operations in turn leads to a reduction in service costs and a decrease in expenses that has an important effect on the financial liabilities of institutions, especially banks. In the past most payments were made using checks, which offered more possibilities for a natural source of financing for commercial banks since they retained these funds for longer periods in current accounts. This suggests that the reliability generated by these funds may have been critical to the special role of banks in financing companies, thereby confirming benefits to borrowers who established long term banking relationships since longer maturities were to meet higher insurance guarantees provided by banks. In other words, if the period funds remain in current accounts changes intensely, it is undeniable that product profiles and bank guarantees will also alter.

10 In recent years the settlement of expenditures through electronic payments has increased dramatically. Initiated primarily with ATM terminals, electronic transaction technology is still developing and expanding rapidly. The number of ATMs has consistently risen and as a result of this growth banking transactions have expanded. Furthermore, the use of credit cards and debit cards to perform retail payments has also increased rapidly. More recently, the advent of internet and telephone banking, or even a combination of these two, has ensured a final consolidation, expanding and extending other means. Thus, the increment of the existence and efficiency of electronic payments reduces the need to retain bank deposits. A wide range of payments through credit cards, even small ones, can be made and a single payment processed once a month, possibly through another electronic payment. The set of average balances in current accounts can be much smaller than in the past when consolidating payments in this way. In reality, these values are migrating to diverse funds offering better rates.

11 On the one hand, improvements in information technology and the impacts of this on information asymmetry and transaction costs enable investors and banks to obtain better information, to be better prepared to perceive differences between good credits and bad debts, to otherwise better assess the risk of a potential customer, and to monitor more effectively the market, thereby reducing the problems of adverse selection and moral hazard resulting in the lowering of barriers to the issuing of credit and other bank products, thus encouraging the use of these products. On the other hand, immense possibilities are also opened for new types of risks that were not previously present in the banking market.

12 The key issue related to the impact of information technology on credit and derivative markets dramatically varies depending on the extent conditions for risk taking were altered. Increased incorporation of information technology resources and the monitoring of risk levels have lowered the barriers for the expansion of these markets. In other words, the advent of computational models with greater range and higher performances has greatly assisted assessment in risk decision making, an area previously treated with more caution.

13 It is in this context that the development of financial products associated with higher risk technology found a special base to expand markets among lower socio-economic groups and micro-businesses, who generally did not have sufficient assets and guarantees to be offered credit in securities lending operations. With the expansion of the volume of information offered by new technologies, however, these social sectors came to rely on their own payment history, which is their ‘guarantee’ in the form of reputation for various credit markets. With these instruments the risks of default seemed to end. In essence, they were virtually ignored, offering the perfect basis for proper business expansion and a lowering of the cost of credit. In other words, the extension of credit markets favoured by better technological tools established ‘subprime’ layers of new consumers, but without better guarantee instruments for the risks involved, which clearly explains the consequences of the mortgage credit crisis which arose in the roots of the subprime entry segment. This system created strong competition among banks, encouraging banks and finance companies to seek new markets[1] [1] The most promising market was the mortgage market in the...
suite that promise additional earnings. However, it was known that the risks associated with these markets had not essentially changed.[2] [2] Some works, such as those of Edwards and Mishkin (1995),...
suite Furthermore, in addition to subtle ways to dilute and distribute risks, technology also contributed much in this regard.

14 The accelerated pace of technological progress has produced a financial system in which the tools for better decision making, and as a result the level of information, have stimulated the opening up of credit markets, such as securities, to a level of retail and income never before imagined. All this movement has led to a decline in the traditional brokerage acquisition of funds. Financial intermediaries are now working in order to break down risks, allowing assets to be financed by larger number of less informed investors, thereby enhancing a wider range of liquidity.

15 Derivative markets, in turn, essentially arose out of the advent of new technology. Until the 1980s banks made loans and used these to manage their portfolios. However, the new technological scenario required speed, diversification and expansion of markets, bringing the need for risk mitigation. Securitization, in part provided and facilitated by information technology tools, is the process by which financial agents forward the transfer of credit risks by granting it and retaining it in more sophisticated debt distribution portfolio products. With the help of managing and monitoring tools, loans were shared and aggregated in order to be transformed into specific financial products and in turn were traded in secondary markets.

16 The origin of derivatives markets is linked to reasons of both supply and demand. The macroeconomic turbulence of the 1970s, associated with instability in interest and exchange, probably raised the demand of companies for a better management of systemic risks. On the supply side, a better framework of financial theory allowed institutions to perform at lower costs in these markets. Options markets, in turn, took off after Black, Scholes and Merton[3] [3] Merton was the first to publish a paper expanding the mathematical...
suite showed how to create synthetic options, taking long and short positions in underlying securities. This fundamental perspective led to a new field of finance - financial engineering - where the mathematics associated with computing-intensive algorithms provides pricing and managing risks associated with any derived evidence that depends only on the movement of exchange rates, underlying interest rate etc. The derivatives market has expanded with technological support, increasingly sharply in recent years.

Banking fragility, systemic risk and banking regulation

17 Some structural weaknesses result from the nature of banking activities, since banks operate under a constant inherent financial fragility with the continuing existence of contrasts on both sides of their balance sheets. On one hand, there is the rigidity of the liquidity value of the liabilities, and on the other the slow liquidity and flexibility of assets (Lima, 2005). Banks offers the public obligations which effectively have no such need to be honoured. Bank debt constitutes in fact in a large part of demand deposits, which in reality are promises of delivery to depositors, specific values at the legal currencies. When capturing assets, banks create deposits in the short term. However, they keep in reserve only a fraction of bonds issued in the form of deposits (fractional reserve) and, following this logic, can only fulfil a portion of deposits at any given moment. Therefore, the bank can only act if the trust of investors is strong enough so that withdrawals are kept at levels that can be effectively covered by reserves held by the institution[4] [4] If all depositors decide to withdraw their values at the...
suite. In theory, if not all depositors recognize that the bank cannot honour their applications at the desired time, a problem of reputation can be created with unpredictable consequences. Under normal conditions, however, it is much more convenient to operate a business transaction with the bank instead of the required legal currency itself. In reality, there is no incentive to serve the lawful currency while there is confidence that the bank is able to do so if required.

18 If, however, reputation problems continue and depositors are concerned that a bank is unable to honour its commitments (either with their own resources, either using the interbank market)[5] [5] The interbank market works as an insurance mechanism between...
suite, they shall immediately draw on their reserves. Nevertheless, when this failure causes the public to doubt the capacity not only of one bank, but of others, i.e., when banks’ reputations are no longer enough to protect them from a widespread movement, the phenomenon of widespread attempted withdrawals is reported. Since it is known that the initial withdrawal demands of depositors are met in full, while later ones are likely to get nothing, a race to withdraw, or a so called bank run, is started. In this case, the single most rational attitude is not only to get money out of the bank, but do so as quickly as possible, before any other more agile depositors can do it[6] [6] A classical reference to this systemic risk can be found...
suite.

19 Apart from the above mentioned weaknesses, there is also a complex network of high-value positions among banks through the interbank market and payments, and consequently through security settlement systems. Indeed, banks tend to play a crucial role in settlement systems and retail payment. Exposure to adverse risks in banking generates real probabilities of banking default for payment commitments that generate risks of immediate impacts on the ability to fulfil obligations to other banks. Even more intense is a crisis that can generate a number of technical difficulties in performing the various steps of the payment and settlement process, resulting in domino effects for other banks.

20 Looking at the above statement it can be noted that with the increase in information evaluation and estimation (valuation), loans and bank assets that were previously retained in the balance sheets of financial intermediaries have become marketable and liquid (Chami et al., 2003) and, therefore, negotiable. As previously mentioned, the use of automated decision-making and credit classification for residential mortgage loans, credit cards, and loans for small businesses not only reduced the fixed costs of such loans in this environment, but also offered financial institutions an understanding of the sorting, packing and packaging risks, allowing them to create information from securities with very little transparency, where most of the credit risk associated with the title remains with the bank, while the majority of funds comes from other markets.

21 An environment of perceptive low risks, coupled with the complex understanding of the functioning of derivative transactions and securitization, might have been enough to generate the broth for the formation of a credit crisis by itself alone (Sobreira, 2008). The crisis, though commonly associated with the bad performance of subprime mortgages, was undoubtedly boosted by the behaviour of the derivatives and securitization markets. It is the logic of operations of these markets that explains the intensity of the decline observed lately. This logic, unless redesigned by new forms of regulation, will remain in force in the market, maintaining the high level of risk of the operations involved, making it more difficult to define the extent of losses. This leads to the necessity to change the philosophy of the current banking regulation.

22 The banking and financial sector system has always been strictly controlled by governments and public authorities, especially after the 1930 crisis which caused serious damages to global economy at that time. After the 1980s, however, the banking framework started to change, as a strong movement of deregulation took shape, increasing spaces of banking autonomy and drastically transforming its nature. The development of technologies for processing and transmitting information and data, as well as the financial techniques cited in the preceding paragraphs, provided new means for the preparation and distribution of financial products and services (European Parliament, 2000). The growth of international flows of trade and capital required new products and services and, as a result, companies that could provide them. The new business environment needs greater performance and capacity on the part of the new banking company, a scenario that ended up pressing local and regional governments to allow more deregulation in their banking markets. The main feature of this process was the gradual elimination of market segmentation and the expansion of the degree of financial openness among regions and countries. Market deregulation in turn, in addition to changing banking profiles, has brought increased competition not only among banks, but also among other financial institutions as claimed by Sobreira and Pinto (2008).

23 The set of events mentioned in the previous session, together with financial deregulation, led to the creation of more complex financial institutions, operating in multiple segments of the financial market, with freedom of choice in contexts of greater uncertainty when compared with preceding periods. Market opportunities, and consequently the associated risk, increased in this new scenario. What is not surprising, however, is the fact that occurrences of instability took place in far greater number than at any other recorded time in the financial history of the last century. In fact, as the elements that allow more advanced operations are created, in parallel they arise greater difficulties in tracking and monitoring these complex operations. The specific and special capacity of banking operators cannot be accompanied in real time by the specialization and training of regulators and supervisors. Even the management of the bank itself cannot have full control of all its operations. In other words, the tools and expertise required to monitor and control risk does not necessarily arise alongside the development of tools for decision-making and mapping. This whole scenario turns out to encourage a change in the philosophy of the prudential regulation.

24 A better understanding of how to answer this question first involves a dissection of the current circumstances where precepts based heavily on the recommendations of the Basel agreements, consisting of capital ratios in relation to assets, have apparently proved imperfect or ineffective in curbing the risks assumed by financial agents, i.e., current regulation, subordinated to the dictates of Basel, operated and supervised by independent central banks, seems not to have had enough strength in the case of U.S. subprime mortgages to prevent the insolvency of large institutions. This assertion intuitively points to the necessity to expand or alter requirements, while a deepening of this understanding leads to reforms that may suggest that the modification of current regulation requires new procedures to limit the financial transactions at the root of the spread of this sort of crisis. Additionally, it can be assumed that the monitoring of institutions by themselves using self-management models, alongside presumed market discipline and supervision at a distance by central banks, has not had the desired effect. Since Basel II accepted and encouraged the filling of risks taken by private institutions by external agencies or the banks themselves, it indirectly offered the possibility of the mindset inclusion of market actors in the regulatory framework, understanding that financial institutions would be more apt to manage the volume of capital to be maintained on their risks in this self-supervision model rather than in any other instance. The logic, therefore, that pervaded and still pervades these arrangements, in particular Basel II, is that the management of risk held by each institution would tend to lead to systemic stability – a fact that apparently was not true, given the evidence showing that such a framework of self-management was not able to avoid problems of this nature and magnitude due to the extensive presence of the effects of distrust of self-supervision of risks shown in the subprime mortgage crisis.

25 It is also important to mention that financial innovations such as securitization, which eventually withdrew the risks from the institutions’ accounting balance sheets, to be assumed, as shown by Farhi et al. (2008), by agents of the “shadow banking system”[7] [7] The term ‘shadow banking system’ includes the range...
suite, making the impacts of the financial instruments more complex and difficult to visualize (Mendonça, 2008) were not subject to the norms of the Basel Accords. As a consequence, the central pillars created by the dictates of the Basel agreements do not necessarily respond to crises such as the one mentioned above. It is, therefore, evident that a complete change of the whole framework regulation set of the international financial order is required, which may impose limits on existing statutes, such as the self-regulation of agents and financial markets, derivatives, securitizations, high levels of leverage and the permissiveness of organizations like financial supermarkets to financial innovations.

26 However; the emphasis on the introduction of extensive prudential regulation and supervision in real time may still not necessarily offer all necessary guarantees, whilst possibly inhibiting financial ventures or stimulating innovation that may be relevant. Regardless of its innate difficulties facing a market that is more agile, regulation that can possibly produce benefits can arise out of a focus on the following points:

27 • Revision of the legal framework for funds recorded outside the balance sheets of banks, which are virtually unregulated and whose artifice is invariably confirmed to reduce the minimum regulatory capital required. In this sense, capital requirements should include liquidity obligations assumed with ‘off-balance-sheet’ vehicles, which will involve the valuation of illiquid and complex financial instruments where regulators can restrict or confine the complexity of instruments that can be issued by regulated entities.

28 • Similarly, one must not underestimate counterparty risk.[8] [8] Investment banks and the financial community in general...
suite Economies with higher organizational levels can mitigate the occurrence of this by the use of clearing houses, which interpose guarantees between the parties for the proper performance of operations (Farhi and Cintra, 2009). Assuming for example that all derivative credit contracts based on operations are made, recorded and secured in a clearing house, would help shift the delivery risk to the clearing house, which would not hesitate to take the necessary precautionary measures such as margin calls and collaterals, preventing obligations from being honoured where a default by one party may lead to a systemic crisis.

29 • Implementing the requirement of countercyclical reserves, (Danielson et al., 2001). In this sense, as well argued by Carvalho (2005), the risk assessment is strongly (and inevitably) influenced by subjective evaluations, which at any given time may be shared by other market participants. Therefore, a similar feeling in the global market which could lead banks to underestimating risks in a cyclic period of prosperity would be likely to be shared by other market players, even though all involved are fully aware that prosperity may be temporary. Thus, the opportunity of generating profits during this cycle is stronger than the inclination to careful conduct. In other words, market discipline can be a force to enhance the action of regulators, but can hardly replace their behaviour.

30 • Overseeing the philosophy and the categories imposed by rating agencies. The prevailing belief is that rating agencies are effective in monitoring the financial health and the risks involved in each market agent. However, the risk analysis of complex instruments such as derivatives requires expertise, agility and technological upgrading, which invariably is not readily available to rating agencies in general.

31 • Review the existing requirements of hedge funds and private equity with regard to financial stability, excessive debt and financial leverage.

32 • Although it is more controversial, the pursuit of more conservative monetary policies by central banks should not be dismissed as precautionary measures. Generally, the heightened valuation of certain assets is correlated with expansionary monetary policies practiced by central banks (Calomiris, 2008). An accommodating monetary policy, as also highlighted by Bordo and Wheelock (2007), has always been the key factor in all price cycles and credit assets of any kind. The excess of a phenomenon of credit expansion is always at the centre of an asset bubble and is certainly the starting point for understanding a crisis.[9] [9] The U. S. mortgage crisis resulting from the excessive valuation...
suite Asset prices should be part of the toolset for developing monetary policy as central banks cannot control how the money in circulation is allocated, but can try to control its supply.

33 Although duly agreed and implemented, the extensive and additional regulatory provisions, however, have not completely immunized the financial market from the occurrence of new crises, which are inherently present in the capitalist financial system. It is necessary to recognize the limited capacity of financial regulation and supervision to monitor the quality of claims held by the banking system in the face of the various types of risks, Farhi et al. (2008), and the inherently instability of this activity. The very dynamics of the banking market system promotes the underestimation of risks and the pursuit of new products and tools to circumvent the limits imposed by state regulation. Recognizing these limits does not imply that the state should relinquish its essential function of regulating banking and finance, even though it is essentially difficult to stay ahead of problems. The figure below illustrates our main arguments.

Additional outbreaks of regulatory action for market equilibrium

Additional outbreaks of regulatory action for market equilibrium

34 In relation to the revision, expansion, or adaptation of banking regulation to new times, it is worth remembering that the principles of regulation should always be justified by their benefits. Since regulations of any kind always impose costs on the business regulated, circumstantial evidence of its benefits can no longer be enough. Its object should, therefore, be strictly necessary to protect the public service and consumer services involved, in addition to systemic risks. In the case of banking, due to the aspects already mentioned, financial regulation should attempt to not impose too many restrictions which might hinder open market operations, preventing or restricting the challenge of new entrants, innovations etc. or, in other words, not constraining the actions of competition.

35 In economies with a large number of small banks like the U.S., the economic consequence of the decline of small institutions is limited to the regions or sectors in which they operate. However, in a market situation which impacts on large banks, even a banking system with several agents; the effects are far more serious. These banks have economic strengths and financial relations with other banks with reciprocal credit in the interbank market and a high volume of compensation payments.

Concluding remarks

36 Disassociated from classical economic rationality, the banking industry is prone to runs in the event of adverse economic instability. However, in a scenario where large international banks operate sophisticated channels of credit transactions and risk assessment, it is necessary to improve the financial regulation. There is certainly a case for disclosure, greater transparency and rapid dissemination of critical information by banks in order to increase the effectiveness of banking supervision.

37 In this sense, since it is always difficult to anticipate the direction that markets will take, financial regulation should be as dynamic as possible. Its full operation will help to minimize the obvious weaknesses of the markets. The essence of its role is not exactly to prevent operations from being performed, but to guarantee to the market and to the economy itself that those who perform them are well equipped with assets to cover their bets and losses. The main idea is to reduce systemic crises and to always give more businesses visibility and transparency, allowing the market more flexibility and resilience to absorb shocks and alleviate crisis.

38 What must finally be recognized is the limited capacity of financial regulation and supervision to control the range of risks held by the banking system in the face of the inherently unstable financial activity. The very dynamics of competitive banking tends to promote an underestimation of control and strongly encourage the search for new tools and products that bypass the regulatory limits. Recognizing these limits does not imply that the state ignores its regulatory function in banking and finance, but that function should be continually evolving in order to create an adequate buffer against misbehaviour of the market in its continuous search for high profits.

Bibliographie

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Notes

[ 1] The most promising market was the mortgage market in the United States whose stock of mortgages was valued at 10 trillion dollars (Carvalho, 2008).

[ 2] Some works, such as those of Edwards and Mishkin (1995), raised the possibility that banks themselves often fail to effectively control the risks incurred by their employees as a result of these new financial technologies, featuring a typical problem of the relationship between agent and principal.

[ 3] Merton was the first to publish a paper expanding the mathematical understanding of the standard pricing of options and coined the term ‘Black-Scholes options pricing model’, praising the work written by Fischer Black and Myron Scholes, first published in 1973. The vision of Black-Scholes was that the price of the option is implied if the shares have been sold. Merton and Scholes received the 1997 Nobel Prize in Economics for this work and other research.

[ 4] If all depositors decide to withdraw their values at the same time, the insolvency of the bank will result in asset devaluation as banks, in order to honor their commitments, consume their liquidity reserves, and once these reserves are consumed banks need to commercialize their assets in secondary markets, although this is difficult to do as well. It is important to note that banks use the interbank market and ultimately the lender of last resort, in general central banks; in order to manage their needs for liquid reserves.

[ 5] The interbank market works as an insurance mechanism between banks, to the extent that each funds the liquidity needs of others, in order to dilute the liquidity risk of each institution. Thus, if a bank has temporary liquidity problems, it can look for help in the interbank market to fund its needs (Cortez, 2002).

[ 6] A classical reference to this systemic risk can be found at De Bondt and Hartman (2005).

[ 7] The term ‘shadow banking system’ includes the range of institutions involved in leveraged loans that had no access to deposit insurance and/or to the rediscounting operations of central banks. It covers big independent investment banks, hedge funds, pension funds and insurers. In the U.S., regional banks specializing in mortgages and government-sponsored agencies are still covered (Farhi et al., 2008). This term was first coined by Paul McCulley, chief executive of one of the largest asset management company in the world, Pimco.

[ 8] Investment banks and the financial community in general are at huge risk of being a counterparty to each other. The insolvency of the U.S. banks Bear Stearns and Lehman Brothers in the recent mortgage crisis was derived above all from their debts to their counterparts on account of derivative mortgage papers.

[ 9] The U.S. mortgage crisis resulting from the excessive valuation of real estate assets showed a strong correlation between the accelerated growth of the U.S. monetary base from the second half of 1990, under Alan Greenspan, in contrast to the contractive era under Paul Volcker 1979 to 1987, with price and assets stabilization and the consequent normalization of the banking market, but with the unpopular policy of raising the basic interest rate. The subject, however, is controversial because the same contractionary monetary policy, according to Gontijo (2008) led many banks (Savings & Loans), to experience significant losses of revenue, as depositors transferred their money to market funds to increase profitability, a loss that occurred at a time of strong growth in the mortgage market, where such institutions used long-term mortgages with fixed rates of interest, so that with rising market interest rates the present value of housing loans fell below the face value of bonds, eroding the stock of S&L’s putting down roots for future crisis (Morris, 2009).

Résumé

PLAN DE L'ARTICLE

• The new banking system
• Banking fragility, systemic risk and banking regulation
• Concluding remarks

Francisco Pinto et Rogério Sobreira « Financial innovations, crises and regulation: some assessments », Journal of Innovation Economics 2/2010 (n° 6), p. 9-23.
URL : www.cairn.info/revue-journal-of-innovation-economics-2010-2-page-9.htm.
DOI : 10.3917/jie.006.0009.