An Evaluation of the Economic Issues Identified in the ICB Report on Banking

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Table of Contents

Introduction
The Independent Commission on Banking report
The Role of Money and Liquidity in the Economy
Understanding Liquidity provision
The approach to regulation of the Financial Services Authority
Examination of the various financial markets involved
Conclusion
References

Introduction

In 2007, the United States of America woke up to a financial crisis that resulted from a continuum of malpractices among the financial institutions in the country.

The crisis spread to the other countries in the world and this caused a major panic among many world economies; both developing and developed.

The worst was yet to come as at the latter stages of the financial crisis various international financial institutions would collapse due to failure in their stress test.

This problem meant that millions of people and institutions lost wealth through the various companies’ collapsing stock. Virtually all the economies of the world experienced a negative growth.

The effects of the financial global financial crisis continue to be felt to this date and as such various measures have been taken to cushion individuals, institutions and governments from further adverse effects from the crisis or any future economic crunch. Governments have enacted rules and regulations that aim at controlling the financial sector.

These measures taken to create a cushion against such effects in the future need to address the problem both regionally and internationally.

This is because of the link that exists among the modern day financial institutions of the world. International borrowing is a common phenomenon in the modern day business world and as such, the problem of the international financial crisis needs to be addressed on international fronts.

In effect, governments instituted committees and engaged various research firms to come up with reports on the causes of the global financial crisis and the measures that ought to be taken to curb the effects.

One such report is the one given by the Independent Commission on banking (ICB). This essay evaluates the economic issues identified in the ICB report on banking that highlighted a number of issues in the way banks and the banking sector, operated in the run up to the economic crunch of 2007.

The Independent Commission on Banking report

This commission was established by the UK government in June 2010. The main responsibility of the commission was to establish structural and non-structural reforms in the banking sector that would ensure financial stability and competition.

The commission came up with an interim and a final report which majorly focused on the reduction of the probability of systemic financial crises in the future, to ensure a constant flow of credit in the real economy and to enable households to manage their financial risks.

The commission came up with recommendations that were aimed at providing financial stability to the economy through various measures most of which revolved around government regulations.

The main recommendations were to have financial institutions enhance their loss absorbing abilities; make it less costly to help banks that get into financial trouble. These recommendations together with others aimed at improving the competition will be discussed in the ensuing text.

The Role of Money and Liquidity in the Economy

One of the attributes of money is that it is used as a medium of exchange. This means that all financial transactions take place with money being the measure of value.

Money is considered the most liquid asset that an organization can hold at any given time. The term liquidity refers to the ability to buy real goods immediately. Money is therefore the most liquid asset although other assets such as treasury bills are also very liquid.

Assets can be classified as liquid, semi-liquid or illiquid. A company that has liquid assets such as cash is able to meet its current obligations as they fall due.

However, if a company has semi liquid assets and illiquid assets, it may experience problem when trying to convert the semi-liquid assets to liquid assets so as to meet the current obligations as they fall due.

Illiquid assets are those that cannot be easily converted to liquid assets on demand. A company is therefore required to maintain a certain amount of its assets in the liquid form so as to help it meet its liquidity needs whenever they fall due.

The importance of liquidity can therefore not be over emphasized. In the run up to the global financial crisis the main problem arose when financial institutions experienced liquidity problems in the mortgage markets.

Other financial banks that had cash became reluctant to lend to these financial institutions and since a lot of assets were held up in illiquid assets the financial sector came tumbling down.

The importance of money is seen herein therefore since money is able to help a company meet its current financial obligations as they fall due.

Liquidity is therefore as vital aspect of any financial institution since financial obligations are usually net by liquid assets. There is always a relationship between liquidity and crises.

When the financial industry increases in capital and liquidity decreases, a crisis is likely to occur and a look at the recent financial crises reveals that the fall of liquidity has a high correlation with financial crises.

Understanding Liquidity provision

It is clear that liquidity played a critical role in the 2007 financial crisis. It is therefore paramount to understand the importance of liquidity provision in the financial institutions and markets context.

To understand this, the concept of financial intermediation will need to be introduced. Financial intermediation occurs due to financial surplus and deficits.

It is defined as the act by the financial institutions mostly banks to acquire cash from money lender through deposits and savings and avail this cash to the various money borrowers. Therefore a bank acts as a financial intermediary between the borrowers and the lenders.

In carrying this role, banks usually receive liquid cash and avail the same to the borrowers. The banks are required to however, reserve a portion of the deposits as a reserve ratio.

This enables them to cushion themselves from defaulting loans as thus reducing the effects of possible default risk. In this regard the ICB had a recommendation to the government to enact regulations that will help the banks absorb the losses that come from defaulting and this is meant to increase liquidity.

The need for financial intermediation therefore comes in where at any given time there are individuals or corporate who have the surplus cash at their disposal while at the same time there are others that have deficit.

The need to borrow raises the need for financial intermediation. The problem arises however when the financial institutions lend much money to the borrowers leading to a liquidity problem.

Since financial institutions also borrow from one another, the only solution to this liquidity problem from the money lenders is to borrow from other financial institutions. A failure in the inter-bank borrowing usually depicts signs a financial crisis.

The approach to regulation of the Financial Services Authority

The whole report aimed at proposing regulation and enacting requirements that seek to provide financial stability among the financial institutions.

The several methods that were put forward to achieve this were to increase the loss-absorbency by banks, structural reforms, as well introducing the ring fencing concept in retail banking.

These proposals were all aimed at ensuring that the financial institutions and hence the economy is cushioned from the adverse effects of the financial crisis.

Loss absorbency meant that banks are required to have a primary loss absorbing capacity of at least 17%- 20%. This would ensure that retail banking sector would have equity as part of that loss-absorbing capacity.

The other methods such as financial stability and structural reforms were all aimed at ensuring that the market risk is cushioned against. These measures are however not to be used in seclusion. They are meant to complement each other and not to act as mutually exclusive courses of actions.

The importance of regulation therefore comes in that the financial need to practice rational and have measures that are referred to as prudent.

This is important more so when operating in a financial environment that is highly volatile. The various principles behind the financial regulation are increasing the ratio of capital to “risk weighted” assets and providing a thick layer of equity capital.

The structural reforms were aimed at having a structural separation that would make it easier to help out banks that get into problems.

This was proposed because of the observation made there were various structural malpractices such as a combination of retail and investment banking and so on.

Examination of the various financial markets involved

Financial market is the system that incorporates the financial institutions, financial intermediation, the money and the capital markets in one system and seeks to provide a common playground where all the financial players can operate.

If the financial markets are perfect, the liquidity in the financial system is efficient and as such the banks are able to hedge on the possible liquidity shocks.

A successful management of the liquidity in the market means that the firms are able to operate at equilibrium with the financial securities.

If the financial markets are incomplete, the firms experience the problem of liquidity since they are unable to hedge on the liquidity risks.

This is a primary source of financial crisis among many financial institutions and as they continue on their financial intermediation role it becomes exceedingly strenuous for them to operate under such liquidity problems.

This can further lead to cash-in-the-market pricing. This leads to a subsequent fall in the prices of safe assets and as such, a situation of financial fragility can result.

Since liquidity holders have the opportunity cost of lending their cash to banks, they can in turn choose to invest their cash in other assets.

This means that the financial system will experience a shortfall in the amount of liquid assets in terms of deposits. Therefore the complete and the incomplete financial markets have a role to play in ensuring that the money lenders prefer savings to direct investing. As such, financial markets ought to be less volatile so that the money lenders can deposit their cash and consequently boost the liquidity.

The other problem that may be experienced by incomplete financial markets is the contagion. This happens when there is a high inter-linkage between the banks.

The problem with high inter-linkage is that a problem in one bank easily spreads to other banks and as such a liquidity problem experienced by one bank can result in a subsequent problem on another one.

This is because a bank that experiences a financial shock will cause another bank that has claim on its stock which falls in value. If the system in the financial markets is highly inter-related, the effects may spill over to many other banks resulting in a crisis that affects the whole economy.

The recommendations proposed by the ICB therefore sought to deal with this problem of contagion through proposing structural reforms that encouraged smaller control spans among the financial institutions.

Conclusion

The final report by the Independent Commission on Banking (ICB) aimed at creating a more stable and a competitive financial sector in the United Kingdom.

The run up to the global financial crises was characterized by a lot of financial institutions’ malpractices. As such according to the ICB final report, the financial institutions ought to put in place measures that ensure that the various critical requirements such as liquidity provision, financial stability and loss absorption are well catered for.

The financial markets also ought to be complete as this will ensure that the inter-relationship between banks do not pose a huge financial risk to the financial institutions and the financial markets as well.

The financial institutions’ structures ought to be simplified such that the firm can easily be sorted in case of a financial crisis. The aspect of ring-fencing should also be incorporated in the retail banking so as to ensure that the banks operate within allowable limits of lending and reserve ratios.

All these solutions ought to be used to complement each other rather that as mutually exclusive courses of action. This will ensure a diversified approach that will allow the financial institutions to operate in clearly spelt out financial markets and reduce the various financial risks that pose a threat to the sustainability of complete financial markets.

These factors once incorporated in the modern day financial institutions management will ensure that the firms do make decisions that will avoid future financial crises.

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