Finance Term Paper Business & Marketing Essay Paper

Recurring themes in the development of financial markets and institutions in the 1980's, for the 1990's and the new millennium are financial deregulation, disintermediation, globalization, securitization, global financial stability and fragility, “Too-Big-to-Fail” and systemic risk. In many ways these individual themes are separate, but occurring at the same time. Some critics of financial deregulation point to the S&L debacle and the global financial meltdown in 2007-2009 as cases where deregulation went too far and allowed S&L and bank, commercial and investment bank, managers to take excessive risks. Other critics emphasize the dangers inherent in the development of derivative instruments and excessive globalization as causes of more volatile markets. They point to the stock market "crash" of October 1987 and the losses in the winter of 1994 to governments (Orange County, CA), major nonfinancial firms and banks trading in derivatives as instances. Additionally, the financial instability that occurred with the Asian Crisis in 1997, the insolvency of Long Term Capital Management (LTCM) in 1998 following the Russian default and ruble depreciation, and the housing boom and housing price bubble in 2001-2006 that led to the Great Recession and financial crisis of 2007-2009 are given as examples of financial system fragility and the need for global financial oversight of risk exposures taken by large, complex financial institutions to restore resilience. In contrast, many financial institutions, financial market participants, and some financial institution and market regulators favor accelerating deregulation and its expansion globally. Specifically, they point to the increased rate of securitization and issues of new debt instruments, such as asset-backed securities and the U.S. Treasury's recently issued inflation-indexed bond, as evidence that unfettered financial markets can more efficiently allocate capital than highly regulated and balkanized financial intermediaries and markets. Furthermore, these same critics point to available scale and scope economies and accelerated financial innovation that may result through deregulation that will accelerate the consolidation within the financial services industries to achieve these economies and more capital devoted to innovation.

Using the quotations and references presented below as guides and based on your understanding of the fundamentals of the need for efficient financial markets and institutions in a capitalist economy (Saunders and Cornett Chapters 1-7 and 26 to 27; FDIC History of the Eighties; class lectures; and any other material), prepare a case for how financial markets' and/or institutions' efficiency have been improved or how much greater instability and or fragility has resulted over the past 25 years due to any or all of the factors mentioned above. In addition, provide an analysis of the need for regulation (benefits, burdens and costs) in the example you have chosen. If you believe regulation is unnecessary, provide an analysis of either the lack of benefits and/or the burden imposed by regulation. CHOOSE ONE OR TWO OF THESE PROBLEMS TO ANALYZE.

In your presentation, clearly define the problem and financial market, industry, instrument, or financial institution that you have chosen to analyze. Use information and data that may be available in Fenwick Library, online or elsewhere (reference material, Flow of Funds Accounts published in the Federal Reserve Bulletin and at www.federalreserve.gov, FRED at frbstlouis.org, the Internet, and trade magazines) and from the textbook in your analysis to make your case. Of course, theoretical foundations for finance will help you develop your problem statement and will be useful to better put your choice into perspective.¹

A.

"In a 1989 study entitled Globalization and Canada's Financial Markets, the following was reported: 'An important feature of the increasing significance of some aspects of financial activity is the greater use of financial markets and instruments that intermediate funds directly -- a process called "market intermediation" which involves the issuance of, and trading in, securities such as bonds or stocks -- as opposed to "financial intermediation" in which the financial institution raises funds by issuing a claim on itself and provides funds in the form of loans.' "Commercial banks are such financial intermediaries. What are some of the implications of the shift from financial intermediation to market intermediation for commercial banks? What might be some of the obstacles to market intermediation?

B.

Alan Greenspan, the Chairman of the Federal Reserve Board, told the U.S. Senate on July 12, 1990: "As you know, the Board has long supported repeal of the Glass-Steagall Act that separated commercial and investment banking, We still strongly advocate such repeal because we believe that technology and globalization have continued to blur the distinctions among credit markets and have eroded the franchise value of the classic bank intermediation process. Outdated constraints will only endanger the profitability of banking organizations and their contribution to the American economy." What does Mr. Greenspan mean when he says that the value of the bank intermediation process has been eroded by technology and globalization? Are there risks, or only benefits, to repealing the Glass-Steagall Act? What might some risks be? How has the Gramm-Leach-Bliley Financial Modernization Act of 1999 changed the potential expansion of financial intermediaries into a wider array of financial services? Are the moral hazard costs of "too-big-to-fail" (TBTF) been made even more evident and severe after the Financial Modernization Act deregulation? How has TBTF been dealt with by this legislation, if at all? How has it been dealt with after the Great Recession in 2007-2009?

C.

"Chase Manhattan Bank is preparing its first asset-backed debt issue, becoming the last major consumer bank to plan to access the growing market. Asset-backed offerings enable banks to remove credit card or other loan receivables from their balance sheets, which helps them comply with capital requirements." Corporate Financing Week, October 29, 1990. What are the capital requirements referred to in this quotation?

D.

The trends shown below will have an impact on the investment banking industry. As a senior manager of "bulge-bracket" (premier, top-ten) investment bank, how would you consider responding to these trends?

• Major multinational corporations increasingly set up their own in-house investment banks. These companies have expertise on all major investment banking activities.



• Technological innovations such as CapitaLink that allow institutional investors to deal among each other, in the absence of intermediaries, becomes increasingly common.



• Deregulation of financial markets and institutions, that eliminates the distinctions imposed by the Glass-Steagall Act of 1933 between investment and commercial banking activities, accelerates after the passage of the Financial Modernization Act of 1999. J.P. Morgan, Bankers Trust, Citicorp and other major banking companies are permitted by the Federal Reserve to become major underwriters of corporate debt and equities through subsidiaries of their respective bank holding companies (so-called, Section 20 subsidiaries). How might financial service companies restructure to take advantage of this deregulation?



• Gramm-Leach-Bliley Act provided for financial holding companies and considerably greater powers for banks and other financial intermediaries, but it left unchanged the problem of too-big-to-fail.

E.

Alan Greenspan in recent testimony regarding the growing Asian financial crisis before the Joint Economic Committee on October 29, 1997 said:"...Nevertheless, rapidly developing, free-market economies periodically can be expected to run into difficulties because investment mistakes are inevitable in any dynamic economy. Private capital flows may temporarily turn adverse. In these circumstances, companies should be allowed to default, private investors should take their losses, and government policies should be directed toward laying the macroeconomic and structural foundations for renewed expansion; new growth opportunities must be allowed to emerge. Similarly, in providing any international financial assistance, we need to be mindful of the desirability of minimizing the impression that international authorities stand ready to guarantee the liabilities of failed domestic businesses. To do otherwise could lead could lead to distorted investments and could ultimately unbalance the world financial system.
"The recent experience in Asia underscores the importance of financially sound domestic banking and other associated financial institutions. While the current turmoil has significant interaction with the international financial system, the recent crisis would arguably have been better contained if long-maturity property loans had not accentuated the usual mismatch between maturities of assets and liabilities of domestic financial systems that were far from robust to begin with. Our lamented savings and loan crises come to mind." The question of future financial stability of the Asian markets is clouded by their ability to reform without the financial aid to these countries creating a more long-term threat of more instability due to the moral hazard of the international financial rescue packages.

F.

In a speech at a Federal Reserve Bank of New York conference on "Financial Services at the Crossroads: Capital Regulation in the Twenty-First Century" on February 26, 1998, Alan Greenspan outlined several "core principles" underlying any proposed changes in the current system of prudential regulation and supervision of financial services firms.
"First, a reasonable principle for setting regulatory soundness standards is to act much as the market would if there were no safety net and all market participants were fully informed. For example, requiring all of our regulated financial institutions to maintain insolvency probabilities that are equivalent to a triple-A rating standard would be demonstrably too stringent, because there are very few such entities among unregulated financial institutions not subject to the safety net....Ultimately, the setting of soundness standards should achieve a complex balance -- remembering that the goals of prudential regulation should be weighed against the need to permit banks to perform their essential risk-taking activities. Thus, capital standards should be structured to reflect the lines of business and degree of risk-taking in which the individual bank chooses to engage.
"A second principle should be to continue linking strong supervisory analysis and judgment with rational regulatory standards. In a banking environment characterized by continuing technological advances, this means placing an emphasis on constantly improving our supervisory techniques.
"Third, we have no choice but to continue to plan for a successor to the simple risk-weighting approach to capital requirements embodied within the current regulatory standard. While it is unclear at present exactly what that successor might be, it seems clear that adding more and more layers of arbitrary regulation would be counter-productive.
"Finally, we should always remind ourselves that supervision and regulation are neither infallible nor likely to prove sufficient to meet all our intended goals. Put another way, the Basle standard and the bank examination process, even if both are structured in optimal fashion, are a second line of support for bank soundness. Supervision and regulation can never be a substitute for a bank's own internal scrutiny of its counterparties, as well as the market's scrutiny of the bank."

G.

H.

I.

J.

Warren Buffet, legendary investor.

 2010: Dodd-Frank Wall Street Reform and Consumer Protection Act, July 2010.

This legislation included vast so-called reforms in banking regulation and established the Systemic Risk committee, composed of regulators and the Treasury, to monitor and recommend ways of closing failing large banks, the so-called “Last Will and Testament” approach. It essentially institutionalized the “too-big-to-fail” or too-big-to-resolve” policies of the past. Explain the problem that these policies had on bank performance and how Dodd-Frank did or did not address the problems of “too-big-to-fail” or too-big-to-resolve” regulatory policies.

Foundations of Risk-Based Capital Project

Capital Adequacy

                Risk-based is considered the method of developing capital adequacy standards for banks. These have been enhanced since the Great Recession of 2007-2009 and the collapse of a number of global banking companies in 2008 and afterwards. These revised standards are embodied in the Basle III Accord and in the stress tests performed by Central Banks of various nations and the European Union.  The foundations are based on an analysis similar to the Probability of Insolvency Model presented below:

                Consider that a bank with a portfolio of A which is on the efficient frontier is well capitalized at a capital-asset ratio of [K/A]₀. Bank with portfolio B, also lying on the efficient frontier for this bank, also has a capital-asset ratio of [K/A]₀. However its maximum probability of insolvency is given in accordance with Chebychev’s inequality as shown above:

Maximum probability of insolvency = σ²/[E(ROA)+K/A]².

Answer the following questions regarding the above diagram:

1. If bank with portfolio A is considered well-capitalized, is bank with portfolio B also considered well-capitalized? Why or why not?



2. Which portfolio is more risky at [K/A]₀– A or B?



3. Which bank portfolio demonstrates a greater maximum probability of insolvency at [K/A]₀ —A or B?



4. If the bank with portfolio B were to increase its capital-asset ratio to [K/A]₁, would the bank a. become better capitalized and b. decrease its likelihood of insolvency and c. have even a lesser or greater probability of insolvency than the bank with portfolio A and [K/A]₀? Explain your answer?



5. If σ as portfolio A is 0.03 and 0.045 at portfolio B what is the maximum probability of insolvency at each portfolio if E(ROA)_A = 0.01 and E(ROA)_B is .015 and [K/A]₀ is 0.1 and [K/A]₁ is 0.12? Which bank is the better capitalized bank from an insolvency perspective; from a portfolio risk perspective?



6. If a stress test were conducted for a bank with E[ROA] falling from 0.015 to 0.005, what would be the impact on the capital of the next period and the likelihood of insolvency if loan losses were the result of the decline in E[ROA] and charged to capital initially at 0.12 and σ of the portfolio went to 0.045?