© Arusha Cooray
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By channelling funds from savers to borrowers, a financial system plays a vital role in an economy's growth process. Due to this reason, the greater the risks taken by a financial system, the greater the global repercussions as demonstrated by the global financial crisis (GFC). The lack of adequate supervision and regulation was one of the main reasons for the GFC. With proposals underway for Basel III, we are likely to see greater emphasis on the quality of capital held by banks, increased capital adequacy requirements, increased liquidity standards, a coordinated leverage ratio controlling for risk, greater counter-cyclical capital controls and greater international co-ordination.
Will these regulations help to solve the obvious risk management problems in banks like JP Morgan, UBS?
Regulations alone will not help solving risk management problems unless accompanied by tighter enforcement, increased transparency and accountability. The likelihood of systemic risk is greater in the event of failure of companies such as JP Morgan and UBS due to their global nature. Accordingly, large financial institutions should be required to report on a regular basis to the monetary authorities or a regulatory authority to ensure that they are complying with regulations. This would permit early identification of problems leading to implementation of appropriate measures to minimize costs to society as a whole.
From your perspective what regulations should be introduced to stabilize the financial system and improve risk management of major investment banks?
- Explicit coverage in deposit insurance by monetary authorities. Banks have been concerned that providing deposit insurance could increase moral hazard problems by inducing financial institutions to take greater risks. If however, banks were required to pay a risk adjusted premium for deposit insurance this could perhaps reduce moral hazard problems.
- Emphasis could also be placed on greater diversification in lending by banks. If loans are given primarily to a particular sector, a group of borrowers or a region, risks inherent to that sector, group of borrowers or region would affect those banks. Diversification could reduce the likelihood of these risks.
- Tighter monitoring of large financial institutions which are most likely to pose a systemic risk should they fail.
- Ensure greater co-ordination between fiscal and monetary policy within nations.
- Ensure greater international co-ordination between nations given the global nature of financial institutions.