Financial stability: Shadow banking and securitization - Part 2

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Chapter 1. Literature Review

Banks and financial institutions offer loans that are called the function of lending and take deposits. However as banks and financial institutions evolved in their managerial practices and efficiencies, the lending capability permitted them to lend at higher rates and in many progressive market segments to generate revenues for themselves. Thus the additional liquidity in the market together with decreased interest rates allows financial organizations to focus on the untapped markets where the potential for return is very high. Personal Lending is one such area where the lending rates are higher as compared to other conservative users of banking consequently finance corporations tend to bet more on them and in the course often deviate from their own lending criterion.

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1.1 Effect of Credit Policy

The effect of credit policy on banks and financial institutions is so phenomenal that the implications of this activity are critical and must for the survival and success of the banks and financial institutions, but also for the economic stability of a country. At the macro level, the collective operations of the Banks and financial institutions affect the debt capital available to the industry while at the same time; the spreads resulting from the credit operations of the bank will have a bearing on its long-term sustenance.

When there is a shortage in the number of individuals that are eligible to obtain loans or if the conditions for obtaining loans are tightened then it can be termed as Credit crunch. When people lose their confidence in securitized mortgages then it would lead to a liquidity crisis. Facts about liquidity of a bank:

  • The more liquid a bank is, the less is its profitability
  • Liquid assets yield lesser benefits when compared to illiquid assets.
  • The shorter the maturity, the lesser is the yield.
  • The maximum yielding loans are the ones which have the highest default risk or interest rate risk and are thus less liquid in nature.

Asset liquidity is predisposed by the alignment and maturity of funds i.e. the ease with which a bank is able to convert assets into cash while losing negligibly in the bargain. Large holdings of cash assets evidently decrease profits because of the opportunity loss of interest income. In terms of investment portfolio, short-term securities yield lower returns compared to long-term securities. As investors value price stability and therefore long-term securities pay a yield premium over short term securities, to induce the investors to extend their holding period.

1.2 Role of Regulatory Framework

In his article titled The Framework for Financial Supervision: Macro and Micro Issues, written by Jeffrey Carmichael speaks about the key ingredients that make up an effective regulatory framework and monitoring. They are as under:

  • “a coherent regulatory philosophy;
  • the government’s commitment to the regulator;
  • the commitment and competence of the regulator’s staff; and
  • education of the public as to the role and limitations of regulation”

According to previous studies, the primary rationale behind regulation is nothing but market failure. Western economies are constructed on the primary principle that free markets yield resourceful results. It is extensively accepted, though, that even the best of markets might fail to yield efficient results in certain situations and that the failure can be due to numerous reasons.

Private initiatives best work only when there is a regulation which would help correct the market failure. Anti-competitive behaviour, asymmetry of information, instability of the system, and anti-competitive behaviour of the market, among others may be a few reasons for markets to fail. All markets are susceptible for probable problems which are linked with the conduct of the market participants.

Anti-competitive behaviour by way of exercising monopolistic power in the market has long been identified as a source of ineffectiveness in free market results. Regulation of competition would yield in laws that prevent these kinds of anti-competitive behaviour from resulting in overpricing of products and also under delivery of services that are crucial for economic growth and well-being.

The global financial system has been evolving rapidly in recent years and become issues of international concern. New technology has radically decreased the borrowing rates and lending across domestic borders, thus enabling the growth of new instruments and appealing to new players. The proven impotency of policy responses and multiple views of number of economists and analysts over causes of financial crisis have raised the root causes of global financial crisis. Although scholars and academicians cite number of sources of financial crisis but it was the presence of shadow banking and securitization with excessive reliance on credit rating agencies that led to global downturn in financial arena. This paper mainly focuses on the issue of shadow banking with process of securitisation and leaves aside the other sides of recent financial crisis.

Regulation are the rules and laws design to control the behaviour of those to whom it applies and if they not followed such rules that are made by government, they can be fined. These rules are followed in any case because they become necessary and have to be followed. A regulated market provides a lot of benefits such as:

  • A regulated market purely looks out for the safety and benefits of all the customers.
  • Such market takes care of the general public as well.
  • Non-regulated market looks after the stability of the economy

Following the advantages that are discussed above there are many other things that go against the implementation and operation of such markets that follow the regulations made by the government or the concerning bodies. This is argued in such a way that it creates huge government bureaucracy, create monopolies in the market because of the absence of competition in market. In these circumstances the customer has to pay more as compare to the non-regulated free market. Such regulated markets ignore the innovations by over regulating.

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Different people have different ideas about the regulated and non-regulated free market. Some give arguments it’s the favour and some goes against it. Some people support the non-regulated free market or the less regulated market and they argue that if the regulations of the government are removed, then the non-regulated free market will force business to protect the customers, provide good and superior products and services and create the affordable price for everyone as competition lies in these markets. By arguing against the government regulation market, they believe that the government regulation market is insufficient for the needs of the customers and that they create nothing but a big bureaucracy that increases the overall cost of the business for everyone in the market.

When we turn around towards those which are in favour of government regulated market and against the non-regulated free market, they argue that government regulations are very important and necessary to protect the customers in the market and the environment on a whole. The main point that is argued is that the general public claims that without the government regulations public interest is ignored or not taken much importance as it should be and that is precisely for this reason that regulations are much important and required.

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