Financial Markets and Risks
The rapidly changing structure of most business organizations is what has led to the occurrence of risks. Following their occurrences, there has been the need to manage the risks to ensure effective and efficient operations of the enterprise. The business of commercial banking is no exception and in fact, they are prone to different types of risks because of the type of operations they carry out. The volatility of risks in commercial banking is what makes the task of risk management be passed on to the private sector such as financial markets among others (Amadeo, 2009, p.1). This paper is an in-depth analysis of how financial markets may be used by commercial banks to manage some of their risks and how their use can cause systemic risks in the banking system. In addition, the stability of commercial banks through excluding them from investment business, proprietary trading while limiting their activities to traditional ‘narrow ‘banking will also be looked at.
How commercial banks can use financial markets to manage their interest rate risks and credit risks
Commercial banks incur many risks because of the high rate of leverage they use. The banks’ management therefore must effectively manage the risks lest the bank becomes insolvent (Amadeo, 2009, p.1). Some of the common risks experienced by commercial banks include credit risks, liquidity risks, interest rate risks, asset management, and liability management. Credit risk is incurred in circumstances where the creditor of the bank is not in a position to repay the loan either fully or partly (Hussain, 2010, p.130). If such a case occurs, the bank is obliged to write off the loan after 90 days. It is because of this reason that banks are required to keep a loan loss reserves account which is responsible for loan defaults. Interest risks on the other hand occur as a result of the difference in interest rates on long-term liabilities and the short-term deposits and borrowings (Lam, 2003, p.256). There are many ways in which a bank can manage the aforementioned risks and among them is the use of financial markets as a risk management tool. Financial markets such as capital markets essentially entail the buying and selling of market securities. The main aim of financial markets is to help businesses invest their money hence making them grow.
Through financial markets, the commercial banks can set aside funds that will cover the unexpected risks in the name of capital (Kannan, 2008, p.2). The advantage of managing risks through financial markets is that the stocks that have been placed in the capital markets keep on increasing if their market values increase (Fuentes, 2010, p.1). The other reason is that they are easily available whenever the banks require them. By the 1998 Basel Capital Accord banks were required to hold minimum levels of regulatory capital, however, the situation has changed in the recent past because of the increasing number of credit and interest rate risks. The Basel Capital Accord incorporation with the new changes advocates that the level of capital be maintained by the banks depends on the weight of the risk. Other factors to consider when setting the capital level are the assets of the banks as well as the off-balance-sheet exposures to ensure that the bank has adequate reserves to cater to circumstances of insolvency.
The other way through which commercial banks would use the financial market to manage their risks is by way of interest swaps. In Interest swaps, two companies such as banks exchange part of their interest payments for some time. In such a case, one bank pays part of the interests of the other bank and vice versa (Hussain, 2010, p.132). Interest wasps are a way of managing risks and especially the interest rate risk because the burden of fixed plus the floating interest rate are canceled out with the remainder of interest rate risk being offset by the interest rate swaps.
Last but not least, commercial banks may opt to take loans to counter the incurred credit and interest rate risks. The loans could be obtained from the central bank, other commercial banks, or other money lending agencies found in the stock market. However, for the bank to be issued with the loan, it must have passed the asset and market price tests as an indication that it has qualified. This is usually a fast way of solving the problem of having credit and interest rate risks.
From the above discussion, it can be deduced that risk management is an important prospect of ensuring that the commercial bank integrates with the global market as well as meets its regulations. The risk management procedure therefore ought to be carried out proactively to improve the credit quality hence resulting in a strong financial sector (Fuentes, 2010, p.1). In addition, because the financial markets are prone to risks and fraud, commercial banks could have the option of using alternative methods of dealing with the risks. This can be through the prevention of occurrences of the risks by first checking the financial position of the creditors to avoid loan defaulters.
How the use of financial markets by banks to manage some of their risks can create systemic risk for the banking system
The management of risks by commercial banks is a very technical issue that ought to be handled appropriately or else it may lead to problems of systemic risks in the banking system or insolvency if the problem persists. A systemic risk means that there is a total breakdown in the whole banking system. The bank is more prone to systemic risks if it opts to use the financial markets as a way of managing its risks. Since there are many ways of using financial markets to manage risks each comes with its different kinds of risks (Amadeo, 2009, p.1). For example, even after using the interest rate swaps to manage risks in the bank, the swaps could lead to more occurrences of the credit and interest rate risks. This happens because the actual interest rates at a certain time are not equivalent to the expected interest rates (Santomero, 1997, p.1).
The alternative of the commercial banks taking loans from other commercial banks, the central bank, or other money lending agencies to solve the issue of credit and interest rate risk is not a healthy one for the bank. This is because, the loans may be going for very high-interest rates thus making the bank have to pay more hence putting the financial status of the bank at risk (Kannan, 2008, p.3). The reason will be because once the risks have occurred; there are very high chances that they will remain unsolved until the bank intervenes. Hence the funds that the bank loans have to be paid back using other sectors of the bank therefore in the long run it could lead to systemic risk in the banking system.
On the other hand, the stock market has for a long time been known for its unpredictability. In the instant that the commercial bank decides to deposit a certain amount with the stock market, they should be ready for any outcome. In cases where the market value of the shares goes up, the bank is safe. However, in a situation where the market price of the shares that the commercial bank has invested in goes down, the value of the investment goes down simultaneously (Santomero, 1997, p.1). In such a case instead of the bank gaining from the deposits made, it incurs further losses in addition to the credit risk and interest rate risk thus not solving the problem. If the situation persists, it could lead to systemic risk in the banking system which in the long run may lead to complete insolvency of the commercial bank.
It is therefore important that commercial banks scrutinize the financial markets well enough before using them as ways of managing their risks lest they create more problems for themselves. It should also be considered that the systemic risks of one commercial bank may affect the financial status of other commercial banks as well and if persistent lead to their insolvency as well. For example, in the case of interest rate swaps, if the swapping bank is forced to pay higher interest rates than it would have paid on its own and yet it does not have reserves to resulting interest rate risk it will thus undergo financial distress as a result of another commercial bank. Several instances of such occurrences would affect a nation’s banking system unless with the intervention of the central bank of the nation (Amadeo, 2009, p.1). Similarly, in a situation where several commercial banks invest in the stock market and there happens to occur a natural disaster that affects the market prices of the shares, many commercial banks will be finically affected and especially those with numerous risks and with no fund reserves hence leading to systemic risk in the national banking system.
Based on the aforesaid causes and results of systemic risks it can be deduced that systemic risk is very dangerous to the economy (Fuentes, 2010, p.1). One alternative to avoiding systemic risks by commercial banks is by asking them to pay into an FDIC insurance pool. The other method is through government intervention whereby the government regulates the financial system (Kannan, 2008, p.2). The government does this through the initiation of certain market behavior making the affected companies or organizations hardcore to shocks in the financial sector. Lastly, commercial banks should take precautions before they enter the financial market as it is prone to vast risks.
An evaluation and analysis as to Why commercial banks should be prohibited from undertaking investment banking business, including proprietary trading, and limit their activities to traditional, ‘narrow’, banking to ensure stability in the banking system
The banking system is prone to many risks that lead to its stability and eventually lead to the economic crisis of the nation (Pilkova, 2010, p.1). Even though the central bank has a hand in ensuring the stability of the banking system, the major key players of this system are the commercial banks. This is because they act as the intermediaries between the central bank and the citizens of the nation. It is for this reason that commercial banks should be effectively managed as they primarily determine the stability of the banking system.
As much as investment banking business is undertaken by most commercial banks as a way of sourcing their capital, it is one cause of instability in the banking system. Investment banking services entail the acquisition of capital whereby the institution acts as an agent during the issuance of securities. In such a case the commercial bank may act as the agent or the client (Tapiero, 2004, p.342). The bank may be the agent if it guarantees other institutions or banks in acquiring capital. On the other hand, the bank may act as the client if it raises capital by using another bank or institution to guarantee it. On both occasions, there are risks of the undertaking which could affect the bank’s financial status and stability of the banking system (Amadeo, 2009, p.1). Investment banks are usually prone to bankruptcy because of failure of repayment by creditors. Since investment banks mostly deal with securities whose market prices are usually unpredictable, they are again prone to financial stresses. Because of these reasons, commercial banks should distance themselves from the investment banking business to stabilize the banking sector.
Other than investment banking business, commercial banks should be prohibited from indulging in proprietary trading. Proprietary trading occurs when the bank subjects part of its capital such as securities and bonds to trade to obtain direct gains or profit. Proprietary has commonly been used by many commercial banks and other institutions as it is highly profitable. However, the business of propriety trading is disadvantageous because it uses very huge funds and is also very risky (Tapiero, 2004, p.342). Therefore if commercial banks indulge in proprietary trading and by bad luck it fails, huge losses will be incurred. Thus commercial banks should be prohibited from indulging in the business of proprietary trading to protect the stability of the banking system.
In addition to the above, commercial banks are also required to limit their activities to traditional, ‘narrow’ banking which essentially involves a very narrow range of banking activities whereby the bank is funded by the deposits made by account holders to the bank (Kay, 2009, p.1). In such a case, the banks will be using the deposits as the source of lending money to individuals and the interest generated from the services used to cater to all its financial needs. In the Traditional or narrow banking concept the deposits are further secured on safe assets so that in the event of failure, the bank has a backup. If commercial banks limit their activities to the traditional narrow system of banking, they will not indulge in money lending businesses such as participating in the financial markets or even investment banking business. This way, the commercial bank will be minimizing the amount and number of risks. As a result, the bank’s financial operations will be smooth running hence making the banking sector stable as well.
The above discussion clearly shows that indulging in some of the aforementioned financial decisions by commercial banks will have adverse effects on the stability of the entire banking system (Marrison, 2002, p.105). Thus in a nation that cares about the stability of their banking sector, commercial banks should be prohibited from indulging in the investment banking business and proprietary trading among other investment decisions. Nevertheless, commercial banks should limit their activities to traditional or narrow banking which is less prone to risk, fraud, and bankruptcy. It can therefore be concluded that the banking sector should be effectively managed for the proper economic growth of any nation (Pilkova, 2010, p.1). The fact that instability of the banking sector is inseparable from the speculative markets it is of essence that the issue of financial markets is efficiently handled. This is because consumers in the financial industry expect that they will be provided with good quality and reliable services at affordable prices. For this to happen, the banking sector should be stable and free from any discrepancies. The stability of the banking sector also ensures that the nation is not suffering from an economic crisis. Just as mentioned above, commercial banks are the key determinants of the banking sector and should therefore be operating efficiently for the whole sector to be efficient and stable (Pilkova, 2010, p.1). Thus, their activities ought to be closely monitored to ensure the sustainability of the banking sector and economic stability.
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