Free Essay

Banking

In: Business and Management

Submitted By rahmed
Words 1214
Pages 5
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|FINANCIAL MARKETS AND RISK |
|17th October 2012 |
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|This report will look at monetary and financial stability and the consequences it may have |
|on capital adequacy should interest rates increase in the future. |
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|The Bank of England has two main functions and these are Monetary Stability and Financial |
|Stability. The Bank of England’s Monetary Policy Committee (MPC) meet on a regular basis to|
|discuss Monetary Stability each month. This entails setting the bank rate, this rate has |
|been 0.5% for the longest period in the Banks history and the reason for doing so is to |
|keep inflation low and to achieve the 2% target set by the Government. A stable economy is |
|intended to encourage growth in the economy. |
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|Financial stability on the other hand was overseen by the tripartite authorities who were |
|made up of Her Majesty’s Treasury (HMT), Financial Services Authority (FSA) and the Bank of|
|England (B of E). This system was one of the factors that contributed to the banking crisis|
|as they did not act quickly and decisively. All three authorities seemed reliant on the |
|other to take a course of action. |
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|The Financial Policy Committee (FPC) has since replaced the Tripartite Committee and is |
|based in the Bank of England. FPC’s sole responsibility is to ensure that macro prudential|
|regulation does not become a crisis again in the future. Alongside the FPC is a subsidiary |
|called the Prudential Regulation Authority (PRA). The PRA regulate at a micro prudential |
|level and ensure individual organisations are operating safely and in a risk averse way. |
|Both policies need to work parallel to each other in order to maintain economic and |
|financial stability. As the Central Bank, the Bank of England’s role is on the one hand to |
|keep inflation low and on the other to supervise and make sure financial stability is |
|stable and hence both of its objectives are closely linked. |
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|Capital Adequacy ratios are a measure of the amount of a bank’s capital indicated as a |
|percentage of the exposure of its risk weighted assets. Adhering to this measure is crucial|
|for financial stability, by not having sufficient reserves in place and relying heavily on |
|wholesale markets, banks found themselves to be in huge debt. Banks were heavily |
|undercapitalised and the government had to step in and bail out some banks to avoid further|
|systemic risk. This had an impact on both monetary and financial stability and will |
|continue to do so for some time. |
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|Over the years banks have become systemically important financial institutions (SIFI), for |
|example the mergers of banks like National Westminster and the Royal Bank of Scotland. The|
|risk of banks of this size failing and becoming solvent would have a big impact on |
|financial stability. If capital adequacy measures had been enforced the buffers in place |
|would have offered depositors some protection and avoided a run on banks for example the |
|Northern Rock. Since the financial crisis, reviews of systemic risk have been carried out |
|and Basel I was introduced for banks to hold minimum capital requirements. This was |
|followed by Basel II which was introduced to ensure the supervision process was in place. |
|These regulations were not supervised sufficiently and the Basel Committee on Banking |
|Supervision. This was supported and approved by members in the G20, resulting in enhanced |
|requirements in Basel III. |
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|Banks will have to hold a minimum of 4.5% of tier 1 capital from January 2015, going up to |
|8.5% by January 2019. This will be measured by the quality of risk weighted assets as well|
|as retained earnings, equity and other measures. There are also tier 2 and 3 requirements |
|which will include conservation buffers and countercyclical buffers. Basel III has also set|
|standards in place for liquidity measures. Banks will be required to meet a liquidity |
|coverage ratio (LCR) to ensure they can commit to a 30 day stress funding scenario. This |
|and the capital requirement measures are intended to prevent another financial crisis |
|happening again in the future, therefore safeguarding financial stability. |
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|These changes in Basel III will impact financial institutions. It is expected that as a |
|result of these changes banks will increase their lending costs between 15 to 50 basis |
|points (Bank of England website). |
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|2 Following on from the financial crisis in 2008, the MPC started to cut interest rates, by|
|March 2009 base rate was at an all-time low of 1/2% and still is the same rate today. The |
|Bank of England as well as other central banks loosened their monetary policies so that |
|they were able to meet inflation targets. This base rate affects other short term money |
|markets and filters down to asset prices and bonds. |
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|As well as the cut in interest rates the Bank of England also purchased assets which were |
|made up of government securities. By January 2010 £200 billion of assets were purchased |
|which was 14% of GDP. This is more commonly known as quantitative easing (QE). The Bank of |
|England created new money electronically and with it purchased government debt from pension|
|funds, banks, and insurance companies. This money from the QE process then flows back to |
|the sellers (insurance companies, pension funds etc.). They will have more money which |
|starts to flow into circulation resulting in banks being able to lend more. Research shows |
|that that the economy and GDP would have fallen and inflation may have been lower and |
|possibly a minus figure had these measures not been put in place. |
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|Banks have become far more cautious and even with Quantitative Easing in place and the bank|
|rate so low, other factors and risks need to be considered. |
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|3 Should the Bank of England decide to raise interest rates significantly, this will affect|
|other rates in the economy which will in turn impact on financial stability. An increase in|
|the banks base rate will initially filter through to the wholesale money markets. Bank use |
|these markets to lend money to each other. With very small margins in place the repo |
|markets adjust the cost of these funds and mark up the “repo” rates. Borrowers both |
|personal and corporate customers who have overdrafts or loans that are linked to a variable|
|rate will be notified and affected. |
|Prices of fixed-interest bonds are linked to interest rates and a rise in rates will reduce|
|the price of these bonds. Another important area of the economy to mention is imports and |
|exports. A rise in rates Imports in the UK are cheaper for the nation to buy, however |
|exports become less competitive and this makes it harder for businesses to sell overseas. |
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|3 Credit risk is also affected by market factors that impact on the value or cash flow of |
|assets |
|that are used as security for loans. For example, if a bank has made a loan to a person to |
|buy a house, and taken a mortgage on the house as security, movements in the property |
|market have an influence on the likelihood of the bank recovering all money owed to it. |
|Even for unsecured loans or contracts, market factors which affect the debtor's ability to |
|pay the bank can impact on credit risk. |
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|For Markers Use Only |
| |1st Mark |2nd Mark |
|A | | |
|B | | |
|C | | |
|D | | |
|TOTAL Awarded: | | |

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