The 2007-08 global financial crisis has revealed a severe effect of financial crisis on the economy at the global scale, which highlights the importance of the banking sector. As part of the responses, the Basel Committee proposed the new Basel III Capital Accord on 1 June 2011 to promote financial stability.
Requirement: In the context of the 2007-2008 global financial crisis and Basel capital regulation, the essay should build discussions along the following lines:
(1) briefly describe how the 2007-08 global financial crisis unfolded; (30 marks)
(2) explain the rationale of banking regulation; (30 marks)
(3) explain the limitations of Basel II and the main changes in the requirements in Basel III; (40marks)
Suggested reading: See reading lists in the lecture slides of relevant topics as a primary source of information and students are expected to expand their reading beyond the lists, such as academic journal articles.
2007-08 Financial Crisis
Although the 2007-08 financial crisis began in the United States, its impact was experienced globally. The global financial crisis (GFC) was a severe problem for all nations globally since it shook their economic stability. Until the ongoing COVID-19 pandemic, the global crisis was the worst financial crisis in recent history and since the Great Depression. The crisis has its genesis in the United States banking sector, but by the summer of 2007, it was clear that its impact would extend the country’s borders (Fernández Sánchez, Odriozola Zamanillo & Luna 2020). By then, many countries globally showed financial detriment caused by years-long binge on cheap credit. Thus, what was happening in the United States was a reflection of back financial decisions that were taking place globally. The banking sector played a key role in economies globally, which was why its impacts led to a global financial crisis. The crisis led to the increased need for banking regulation to curtail decisions that would lead to a similar financial crisis.
Description of the 2007-08 Global Financial Crisis
The financial crisis that hit the world originated from the United States before spreading to the rest of the world so fast that the global financial system was left on its knees. The sub-prime mortgage disaster resulted from a series of bad decisions with the US banking and real estate sectors. The events led to the serious contraction of liquidity within the international financial market with major ramifications for countries and their citizens (Dedi & Faith Yavas 2017). The collapse of the American housing market was the genesis of the crisis, which had shown clear warning signs for years. The financial crisis threatened to destroy global financial systems due to numerous leading commercial and investment banks, real estate companies, insurance companies, and mortgage lenders. The events led to one of the worst economic crises, and with far-reaching ramifications, since the Great Depression (1929–c. 1939) (Fernández Sánchez, Odriozola Zamanillo & Luna 2020). The economic interconnectedness left no country unaffected by the global financial crisis, whose negative ramifications lasted for years.
The actual causes of the financial crisis remain uncertain, and economists have speculated about what could have actually caused the problem. However, most experts agree about the factors that were responsible for the events that shoot the global economic system. The events started in 2001 when the Federal Reserve (Fed) cut the federal funds rate when it expected a minor recession (Fernández Sánchez, Odriozola Zamanillo & Luna 2020). The change made it possible for financial institutions to extend credits to their consumers at lower prime rates and motivated them to give credits even to high-risk clients, but at a higher rate of interest. The change in the lending behavior encouraged customers to borrow the finances to buy durable assets, such as homes. A “housing bubble” resulted around the late 1990s. At the same time, the 1980s changes in banking regulations made it possible for them to give mortgages to subprime customers with balloon payments or interest rates they could easily adjust (Lin & Yeh 2016). As a result, customers could negotiate changes in their loans any time the prices of homes changed. Subprime customers became a lucrative source of business for banks in the United States.
Another factor that contributed to the crisis was the Depression-era Glass-Steagall Act (1933). In 1999, the legislation was partially repealed, making it possible for financial institutions, securities companies, and insurance firms to operate in any of the three markets and even merge. The results were “too big to fail” financial institutions since their failure would affect the whole financial system (Fernández Sánchez, Odriozola Zamanillo & Luna 2020). Additionally, the Securities and Exchange Commission (SEC), in 2004, made the net-capital requirements weaker, which motivated financial institutions to invest larger amounts of money in MBSs, which augmented the housing bubble (Jefferis 2017). During the period leading to the crisis, the financial institutions have an illusion of financial stability and would not anticipate the looming crisis. At the same time, their working environment was largely unregulated, and the financial institutions largely policed themselves, creating a risky environment that contributed to the global crisis (Dedi & Faith Yavas 2017). Furthermore, the resulting environment caused stakeholders in the banking and other relevant sectors to ignore the warning signs long before the crisis.
Banks give loans to customers, including mortgages, which is a huge risk on their side since repayment is never guaranteed. The practice in the banking sector indicated a potential for a problem before 2007. In fact, Taques, De Souza and Alencar (2017) argue that the global financial crisis was years in the making and that the banking sector should have read the signs long before. Years-long binge on cheap credits was the main factor leading to the crisis, whose signs were evident long before then. The excessive risk-taking in the United States banking sector before 2007 and the bursting of the housing bubble in the US contributed to the financial crisis. The bursting of the bubble resulted in the plummeting of the mortgage-backed securities linked to the United States real estate’s values (Lin & Yeh 2016). The events led to a negative outcome for financial institutions internationally. The series of events in the banking sector also caused Lehman Brothers’ bankruptcy on September 15, 2008, and the resultant global banking disaster.
Besides the awarding of cheap credits, the banking sector has lax lending standards, which left room for uncontrolled financial decisions. The environment created the housing bubble, leaving financial institutions with almost worthless investments worth trillions of dollars in sub-prime mortgages. Regardless of warnings that a crisis was looming, few investors questioned the possibility of one of the worst global financial crises since the Great Depression that would bring Wall Street’s giants down and trigger severe effects internationally (Taques, De Souza and Alencar 2017). Their failure to recognize the danger led to the massive failures that left businesses down and millions of people without jobs, their savings, and homes (Taques, De Souza and Alencar 2017). Many of the Americans with mortgages were left with debts to financial institutions that were way higher than the value of their homes. Some could not service their mortgages, causing them to lose their homes. Even then, the banks could no longer resell the homes at a high enough value to recover their loans.
The Rationale of Banking Regulation
A lack of effective regulation in the banking sector was one of the factors behind the 2007-2008 global financial crisis. Thus, the rationale for banking regulation includes the need to prevent detrimental risk-taking that could cost countries and the global economic system (Brandao-Marques, Correa & Sapriza 2020). Microeconomic concerns indicate the demand for increased regulation in the sector to mitigate against the inability of bank creditors (depositors) to track risks emanating from the lending side. Furthermore, from the micro and macroeconomic side of the argument, regulation is necessary to ensure the banking system’s stability in the event of a bank crisis (Wagner 2018). Regulation is also necessary to protect the interests of numerous stakeholders, including the government, which pays a hefty cost in the bailout in cases of a financial crisis. Basically effective regulation in the banking sector would have prevented or mitigated the 2007-2008 global financial crisis.
The aftermath of the 2007-2008 global financial crisis revealed major shortcomings in how the banking sector in the US and beyond was being operated. Regulation in the banking sector is formal state control over the operations of banks or financial institutions. The government uses various requirements or conditions, guidelines, and limitations to develop market transparency and accountability (Harnay & Scialom 2016). The government recognizes the need for regulating the sector to prevent decisions and risks similar to those that led to the financial crisis. Policymakers consider strong regulation and supervision as an effective way of ensuring that the banks do not operate in an uncontrolled environment or make decisions without being accountable to the government and the public (Wagner 2018). Considering that banks play a critical role in economic development, their activities must be closely supervised. The sector’s stability and inclusiveness demand effective regulations to protect the economy and consumers.
The banking sector is one of the most important in any economy. Considering the close connection between the banking sector and the dependence that the local and international economies have on the financial institutions, a failure to regulate it can have detrimental consequences (Harnay & Scialom 2016). As a result, national and international regulatory agencies should create controls over standardized practices that banks use to serve their customers and contribute to the economy (Sum 2016). Another critical case of the interconnectedness is that financial sector regulations focus on several related industries, including the capital, and insurance markets, suggesting that failure in the financial sector can have detrimental implications on the related sectors and sub-sectors (Fève & Pierrard 2017). Any failure in the system can also affect economies, nationally and internationally, and people, especially in terms of losing jobs and the ability to access their basic needs. Therefore, regulation protects the entire financial system and people’s livelihoods.
Many economic experts and other stakeholders nationally and internationally support extensive regulation of the banking sector to protect the economy. According to Sum (2016), regulation is necessary considering the “too big to fail” notion. The banking sector operates in an environment in which it has created strong mergers, becoming global giants. Their place in any economy is so important that their failure is considered detrimental to the local and international financial systems (Brandao-Marques, Correa & Sapriza 2020). With time, the sector has grown to have excessive control over the economy, meaning that their failure can cause detrimental consequences. As a result, the government has been bailing out the institutions to prevent them from falling. The government always comes out when the institutions are on the brink of collapse to protect them and the economy (Fève & Pierrard 2017). Therefore, the government must prevent the failure by regulating and supervising their operations. Regulation would prevent the rippling effect throughout the economy and possible systemic failure in case they collapse.
The Limitations of BASEL II and the Changes in the Requirements in Basel III
The Basel Accords provided the necessary regulations to the banking sector to prevent the mistakes such as those which led to the financial crisis. They were a series of banking supervision regulations created to ensure the effective functioning of the banking sector. The rules were created by the Basel Committee on Banking Supervision (BCBS) but underwent several changes over their years to improve their regulatory efficiency (Pham & Daly 2020). The Basel Accords would provide a global regulatory environment to manage market risk and credit risk within the financial sector. They would ensure that financial institutions have adequate cash reserves to fulfill their responsibility to consumers and recover from financial shocks and risk management, strengthen corporate governance, and transparency within the industry. Basel II was the second set of rules that extended Basel I (Shakdwipee & Mehta 2017). Implemented in 2004, the Basel II had regulatory additions that would improve supervisory mechanisms, minimum capital requirements, and transparency and market discipline. However, the accord had limitations that led to the implementation of the third set.
Basel II developed an expected improved standard to measure operational risk in the banking sector and mitigate them in time to prevent a crisis. When looking at credit exposure, the accord focused on market values rather than working with book values. The accord also focused on improving supervisory means and market transparency by creating requirements for exposure to supervising regulations (ElBannan 2017). The accord also ensured that adequate information was available to the public as a way of ensuring transparency. However, the 2007-2008 financial crisis revealed limitations in Basel II regulations since they were not adequate enough to prevent the crisis. The international financial system had major limitations that the second set of accords could not prevent. Some of the limitations of the second set of accords included a complicated internal rating method of risk evaluation, high responsibilities of bank supervisors, and uncontrolled innovations in capital markets. The complexities and limitations affect Basel II’s effectiveness in preventing the financial crisis (ElBannan 2017). The reputation risk, systemic risk, and strategic risk were not accounted for in Basel II, creating the need for critical changes to have a more effective regulatory environment.
The creation of Basel III was necessary to address the limitations in Basal II regulations. The set of regulations emerged in November 2010 following the 2007-2008 financial crisis. The new set of accords established why a financial crisis would occur (Baud & Chiapello 2017). Notably, the set of accords emerged from a real-life experience of a financial crisis. Basel III regulations recognized the role of factors, such as inadequate corporate governance and liquidity management. The rules also included the role of over-levered capital structures because of poor regulatory limitations and skewed incentives in the past two regulations (Pham & Daly 2020). Basel III improved the regulatory environment, such as setting minimum capital requirements. The regulation also included numerous requirements related to capital, leverage, and liquidity ratios. Regulations in the new set of accords required banks to maintain the three financial ratios:
In addition, Basal III added capital reserve requirements that would regulate the capital market and prevent the relevant collapse of the sector. They included countercyclical measures aimed at increasing reserves in the credit expansion period to protect the institutions and consumers (Kuvalekar 2016). Basal III would also relax requirements if banks were experiencing decreased lending to protect their financial interests. The new guidelines required the categorization of banks into various groups on the basis of their size and general significance to the local and global economy (Baud & Chiapello 2017). Considering the importance of bigger banks and their contribution to the economy, the regulations subjected them to higher reserve requirements. Although the new accords have taken time to be implemented, they are highly significant for effective global financial markets management and supervision. Their implementation will strengthen the role of the banking sector to the economy and regulate them more effectively to prevent another crisis.
The United States was the genesis of the severest financial crisis since the Great Depression. The 2007-2008 global financial crisis resulted from poor regulation in the financial sector that caused the inability of the industry to regulate the market and save the economy and consumers from the detrimental consequences. The crisis reveals the need for effective regulation in the banking sector to prevent any such occurrence in the future. The crisis led to the creation of Basal III accords to regulate the sector more effectively to avoid another crisis. However, the real impact of Basal III requirements in preventing a future crisis is yet to be realized. The current COVID-19 pandemic poses a risk of another financial crisis, and the world watches how the banking sector will navigate through to prevent economic detriment.
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