Banking Sector Reforms and Risks

This assignment delves into the multifaceted realm of banking sector reforms, examining their influence on various aspects of the industry. It analyzes the effects of concentrated control, institutional frameworks, and accounting reforms on banking operations. The assignment also investigates the implications of interbank liquidity crunches and macroprudential policies. Furthermore, it highlights significant risks encountered by banks worldwide, encompassing both operational and systemic challenges.

Critically Review

TABLE OF CONTENTS
INTRODUCTION...........................................................................................................................3
Systematic risk.............................................................................................................................3
Risks which are facing by financial institution............................................................................4
Liquidity crisis and its impact on banking firms.........................................................................6
Financial regulation and an overview of the Basel accords........................................................7
Causes of the crisis 2007-08........................................................................................................8
Regulations in relation to controlling bank’s liquidity and solvency for the minimization of
risk after post crisis era..............................................................................................................9
Structural reforms in UK banking sector...................................................................................11
CONCLUSION..............................................................................................................................12
REFERENCES..............................................................................................................................13

INTRODUCTION
Risk implies for the potential in relation to gaining or losing some value in terms of
financial wealth etc. Hence, risk may be served as intentional interaction with the aspect of
uncertainty. From assessment, it has been identified that risk entails the possibility in relation to
losing money from the original investment. On the basis of cited case situation, the main motive
of banking firms is to maximize shareholders wealth through the means of profit maximization.
For the attainment of such objective banking firms lay high level of emphasis on taking risk.
Moreover, risk and return both the variables share positive relationship with each other. In this,
report will highlight the situation of financial crisis and causes associated with it. Besides this,
report will also shed light on the aspects of liquidity crisis, financial regulation, Basel accord and
global financial crisis. Further, it also entails and provide deeper insight about the reforms in
banking sector.
Systematic risk
In accordance with the views of Danielsson (2013), systematic risk is known as un-
diversifiable, volatile and market peril. Such risk has high level of negative impact on the
condition of overall market not only on particular stock or industry. Hence, in the real life, it is
not possible for the banking institution and other investors to predict systematic risk as well as
avoid the same to a great extent. Thus, it can be presented that systematic risk cannot be
mitigated through the means of diversification. However, on the other side, Fratzscher (2012)
stated that by employing or right asset allocation strategy investors or firm can mitigate
systematic risk. On the basis of such aspect, by putting some of the assets in bond and others in
stock the concerned risk can be reduced to the significant level. The main reasons behind this,
when interest rate shifts the bonds become less, whereas stock more valuable and vice versa. In
this way, assets allocation strategy limits the overall change in portfolio occurred due to
systematic risk.
Hence, interest rate changes, inflation, recession etc. reflect systematic risk which in turn
affects the entire market. Thus, it is one of the main reasons regulations are setting down by the
concerned authority for reducing the impact of systematic risk. Frankel and Saravelos (2012)
asserted that global crisis 2008 is one of the best examples of systematic risk. Moreover, such

risk does not affect individual firm as it places direct impact on the whole industry. Hence,
systematic risks are highly associated with cascading failures which means failure of big entity
place direct impact on others that are performing in the industry. At the time of global crisis there
were several banks which compelled to close their business operations due to having inadequate
income for meeting day to day expenses. Referring the same, it can be presented that systematic
risk has high level and adverse impact on the whole sector.
Risks which are facing by financial institution
By doing investigation, Frankel and Saravelos (2012) found that financial crisis indicates
the inability of banking firms in relation to identifying, understanding and controlling risk which
is facing by them. In the concerned study, it is mentioned that credit risk has significant impact
on the profitability and growth aspect of banking institution. Moreover, credit risk implies for the
one in which bank borrower and counter party fails to meet the obligations as per the agreed
terms and conditions. The main reasons behind the occurrence of credit risk are loan, acceptance,
interbank transaction, trade financing, foreign exchange transactions etc. For example: when
individual takes loan from the bank and fails to repay the same due to having inadequate income
then it is considered as credit risk. Hence, such risk is one of the main cause due to which
situation of monetary crisis occurred in 2007-08. Moreover, during such period several
borrowers were not in position to repay the amount of loan taken for home purpose due to less or
inadequate income. Thus, major risk which is facing by the financial institution highly associated
with the credit aspect.
However, on the critical note, Poole (2010) depicted that with the motive to generate
higher income or profit and sometimes due to the political pressure banking institutions prefer to
take credit risk. In this regard, banking firms can reduce or minimize the level of credit risk by
increasing the rate of interest. Along with this, by considering the factors such as unsteady
income, credit score, employment type, collateral assets banking firms can determine the extent
to which credit risk is associated with borrower. Hence, by taking into account such aspect
banking firm can decide the interest rate for borrowers and thereby would become able to exert
control on such risk. On the other side, Bengtsson (2013) mentioned in the study that condition
of loss is facing by bank when it performs interbank, foreign and other transactions. Moreover,
when transaction is unsuccessful at ones end then it may result into loss to other.

Iyer and et.al., (2013) claimed that macro factors have greater impact on the performance
and position of banking institution. Moreover, macro factors such as political, legal, social etc.
closely influences the economy, market as well as individuals. Hence, banks which issue or
offer credit products such as credit card etc. borne the risk of deliberate fraud. According to the
views of Carretta, Farina and Schwizer (2010) investment risks include interest rate, business,
credit, taxability, call, inflationary, liquidity, market, reinvestment etc. All such risks have major
impact on the profitability aspect associated with an investment. In this regard, interest rate risk
implies for the possibility in relation to declining aspect in the value of fixed rate debt
instrument. Such risk occurs when investors buy securities that provide them with fixed returns.
On the other side, Regan (2011) defined credit risk as possibility that specific bond issue
is not able to make payment of expected interest rates. In this, when credit risk is higher then
interest rate associated with bond is also higher. Further, Jones (2012) depicted that inflationary
risk has major impact on the returns that are associated with investment. Inflationary risk is
termed as purchasing power peril which in turn shows that value of an asset and income eroded
as per such trend. Germain (2012) identified from evaluation that market risk implies for the loss
that takes place in the trading book of bank due to the fluctuations take place in equity prices,
interest rates, credit spread, commodity prices etc. Thus, market risk also closely influences to
the smooth functioning of financial institutions and thereby overall performance. Haw and et.al.,
(2010) argued that now operational risk is also affecting the performance of financial institution
to a great extent. Such kind of risk is usually occurs due to having inadequate or failure of
internal processes, people and system.
Along with this, De Vogli (2014) stated that business risk also has greater influence on
the growth of financial institution. Business risk indicates the possibility of attaining higher
margin as compared to anticipated. From assessment, it has been identified that business risk is
the result of financial institutions failure in relation to the development and implementation of
long-term strategic framework. Then main examples of business risk can be supported with the
aspect of 2007-08 global crises. Moreover, due to the lack or absence of having sound back-up
plan large number of banks were collapsed, whereas several of them took decision in relation to
winding up the business operations and functions. Thus, absence of effectual and sound risk
management strategy is one of the main cause due to which several banking firms closed their

operations in 2007-08. On the critical note, Admati and Hellwig (2014) shared their views that it
is not an easy task to predict the functioning as well as future of entire banking sector. Due to
this, banking firms failed to prepare as well as execute appropriate strategy during financial
crisis.
Delis, Molyneux and Pasiouras (2011) investigated and thereby found that risk of moral
hazard has significant impact on the performance of banking institution. This risk occurs when
large financial institution intentionally takes burden that cannot be handled by others easily.
Hence, moral hazard implies for the situation when one institution or authority takes decision
about how much risk to undertake by knowing the extent to which someone else is capable to
bear the cost when other things wrong. Hence, moral hazard may be served as a root cause of
subprime mortgage crisis 2008-09. Thus, subprime mortgage crisis was a nationwide banking
emergency that occurred within 2007 to 2010. Such crisis contributed in US recession and
thereby impacted the whole economy. Report reveals that after the collapse of a hosing bubble
home prices started to decline. Moreover, around 2007-08 housing bubble was associated with
mortgage backed securities and collateralized debt obligation. Moreover, such securities and
debts were offering higher return to the investors as compared to the government. Thus, moral
hazard is the main cause due to which in September 2008, several major financial institutions
were collapsed (8 Risks in the Banking Industry Faced by Every Bank, 2017). In addition to this,
disruption in the flow of credit to businesses and consumers caused to global recession. Thus,
there is a requirement for financial institutions to develop and employ sound framework which in
turn reduces the impact of undesirable or unpredictable situation.
Liquidity crisis and its impact on banking firms
Hyndman and et.al., (2014) investigated that financial crisis occurred in US in the mid of
2007 resulted into default rates. Along with this, devaluation of real estate property in 2007 is the
reflection of financial crisis. In addition to this, US subprime mortgage also reduced in the period
of financial crisis. As per the views of Jones and et.al., (2013) over the short period situation of
financial crisis affected firms operated in the banking sector to a great extent. Moreover, during
this, bank loses money on mortgage default, inter-banking lending to freeze. The rationale
behind this, before the period of financial occurred in 2008, regulation which was passed in US
compelled banking firms to allow people in relation to buying homes. Further, Brewer and

Ratcliffe (2012) revealed that in the starting of 2004, Fannie Mae and Freddie Mac invested
more money in the mortgage assets which also contains highly risky Alt-A. Hence, both charged
high fees and received high profit from subprime mortgage. In addition to this, before the period
of financial crisis there were several foreign banks which bought collateralized US debt in the
form of subprime mortgage loan which in turns rebundled into collateralized obligations. Hence,
when large number of US customers started to default in relation their mortgage loans then it
resulted into bank lost money (The Basel Accords, 2017). Along with this, banks stopped lending
to each other when such situation occurred. Meanwhile, it becomes tougher for the customer as
well as businesses to get credit.
Christensen and Lægreid (2013) revealed in their study that after the period of liquidity
crisis Financial Stability Oversight Council was created by legislation. It includes Federal
Reserve Bank and other agencies whose main purpose is to co-ordinate the regulation of larger
as well as systemically important banks. Along with this, new orderly liquidation fund was
established to provide monetary assistance to the banking institutions for liquidation that fall into
trouble.
Financial regulation and an overview of the Basel accords
Reisberg (2010) stated that after the period of financial crisis 2008, government of all the
countries were empowered to take initiative for financial reforms. This in turn ensures greater
transparency of transactions and reduces the level of risk to a great extent. Along with this,
regulations will also assist in making the system high stable as well as regulated and thereby
contributes in the safe global market. The main motives behind the introduction of new rules and
regulations in the banking sector are to enhance transparency and reduce the risk prevailed in
derivative market. Reforms initiative includes European Market and Infrastructure Regulation
(EMIR) through EU etc. Hence, regulations which are established for derivatives with the motive
to improve transparency as well as reduce the risk majorly include EMIR, AIFMD, specific trade
reporting legislation etc. Along with this, Arnold (2012) entailed that structural reforms are being
addressed through the introduction of new regulations. Structural reforms such as Dodd-Frank
Act Volcker rule in US, reforms of banking in UK as well as European Union were designed and
introduced for offering protection to the customers and taxpayers.

Caune, Jacquot and Palier (2011) presented that for addressing the aspect of tax
avoidance exchange of information between the tax authorities as well as co-operation of
financial institution has requested. Hence, Foreign Tax Compliance Act (FATCA) may be served
as execution of G20 commitment. This Act or legislation has direct impact on the global players.
Along with this, UK and EU& are ion process of undertaking similar measures with the motive
to avoid the tax liability to a great extent. Further, Regan (2011) said that Basel iii accord has
been introduced with the motive to strengthen the capital requirements of banking institution and
enhance liquidity reserve to drive down systematic risk. Basel iii introduces requirement
pertaining to liquid asset holding and funding stability. On the basis of Basel III, from 2010,
banks need to fund themselves with 4.5% of common equity in relation to risk weighted assets.
As compared to Basel II requirement in relation to funding themselves increased by 2%. Thus, it
can be presented that from 2015, minimum common equity tier 1 ratio of 4.5% needs to be
maintained by the banks all time. ]
In addition to this, as per Basel III banking units are required to maintain leverage ratio in
excess of 3%. In 2013, US Federal Reserve announced that minimum Basel III leverage ratio
should be 6 to 8% respectively. Hence, as per the regulations and liquidity coverage ratio bank
needs to hold assets that can be used to cover net cash outflows over 30 days.
Causes of the crisis 2007-08
As per the views of Fratzscher (2012) international trade imbalance is one of the main
causes due to which situation of great recession occurs. Moreover, in August 2007, subprime
mortgage market crumbled. On the other side, Frankel and Saravelos (2012) depicted that in the
period of 2007, president of Federal Reserve Bank said that US economy is forecasted to grow
by 3%. Hence, before recession, in the two consecutive quarters negative GDP growth has been
found and recorded. Hence, inappropriate estimation in relation to GDP growth is one of the
main causes of recession. However, Poole (2010) contradicted and said that housing slump
which was spread in 2007 under financial industry is the main causes behind recessionary trend.
Moreover, during this period, hedge funds had invested high level of amount in the mortgage
backed securities. Further, Bengtsson (2013) asserted that financial crisis occurred because three
rating agencies standard & poor’s, Fitch and Moody has classified subprime securities as

investment grade. Thus, failure of rating agencies resulted into high default in the loans and
returns.
From assessment, Iyer and et.al., (2013) found and presented that the prime cause of
credit crunch in originated in USA such as subprime mortgage crisis. Over expansion of credit
and lending by bank is the main reason behind the greater recession. Subprime mortgage may be
served as a financial innovation that is designed provides riskier borrowers with home
ownership. Hence, in 2007, mortgages were lent to the borrowers who might be unable to repay
the amount in the case of rising interest rates. In addition to this, subprime mortgages were
bundled into CDO’s portfolio as per double and triple A rating. Hence, considering such rating
CDO’s were sold to the investors worldwide. Thus, due to inappropriate credit rating situation of
over expansion occurred. In UK, consequences of over expansion was severe and contraction
suffered by the economy accounts for 6.2%. Hence, by taking into account all such aspects it can
be said that due to the ignorance of banking institution towards the safe investment situation of
financial crisis occurred. Moreover, banks have placed high level of emphasis on wealth as well
as profit maximization.
Regulations in relation to controlling bank’s liquidity and solvency for the minimization of risk
after post crisis era
Delis, Molyneux and Pasiouras (2011) found that there are several initiatives which had
undertaken by the cioncerned authorities after financial crisis 2007-08. Dodd-Frank wall street
reform and Consumer Protect Act may be presented as a piece of financial reform legislation.
This was passed by Obama administration after the period of 2007-08. Hence, Financial Stability
Oversight Council and liquidation authorities are provided with the responsibility in relation to
monitoring the stability of firms whose failure places direct and negative impact on the
economical aspect. It assists for liquidation or restructuring through the means of orderly
liquidation fund. Along with this, such has also authority to break up the banks which are too
large and impose systemic risk. Further, concerned council and authority also force large banks
to enhance their reserve requirements. Admati and Hellwig (2014) critically evaluated that not
only monitoring is enough to strengthen the position of banking units. Hence, effectual guidance
needs to be provided to the banking institution for the development of sound back-up plans.

Moreover, in 2007, due to not having competent long term strategic plan banking unit failed to
survive.
Jones (2012) found that Consumer Financial Protection Bureau lays high level of
emphasis on preventing predatory mortgage lending. Moreover, in 2008, due to high subprime
mortgage banking firms failed to get payment from the borrowers. Along with this, such Bureau
focuses on preventing mortgage brokers from earning higher commissions. CFPB also governs
the type of consumer lending which in turn includes credit and debit card etc. Germain (2012)
identified and stated from evaluation that Dodd-Frank, Volcker Rule is highly effectual which in
restrict the ways on the basis of bank invests. Thus, it can be presented that Title VI of Act tends
to make focus on limiting speculative trading and eliminating proprietary trading. Hence,
Volcker’s rule limits the ability of an institution in relation to employing risk on trading
techniques as well as strategies (U.S. banks gear up to fight Dodd-Frank Act's Volcker rule,
2017). In addition to this, rules developed after the period of financial crisis do not allow banks
to involve with hedge funds or private equity firms. Moreover, both types of firms are considered
as too risky. Thus, concerned Act or rule focuses on minimizing the possible conflicts of interest.
In accordance with Haw and et.al., (2010), CFPB is highly significant that contains rules
and regulations pertaining to the regulation of derivatives such as credit default swap etc.
Moreover, in 2008, worst situation or recession occurred in 2007-08 due to the defaults in
relation to swap. Thus, by keeping all such aspects in mind Dodd-Frank set up centralized
exchanges for swap which in turn contributes in reducing the level of counterparty defaults.
Further, Dodd-Frank makes focus on the greater disclosure of swap with the motive to enhance
transparency in the market. However, it is be critically evaluated by De Vogli (2014), who said
that, both the variables such as risk and return are positively correlated. On the basis of such
aspect, investors earn higher return when risk level is greater. Thus, there is the need of
regulation which in turn helps in limiting the risk and offers chance in relation to earning higher
returns. By considering all such aspects, it can be presented that Dodd-Frank negatively impacts
the objectives of financial institution pertaining to wealth as well as profit maximization. Along
with this, higher reserve requirement under Dodd-Frank also negatively influences holding
negatively in relation to the marketable securities. Moreover, as per Dodd-Frank banking
institution is required to hold their higher percentage of assets in cash.

Structural reforms in UK banking sector
The UK government proposal aiming to impose higher standards of conduct on the UK's
banks in the Financial Services Banking reforms Act of 2013. After the global economic crisis of
2007-08 government of UK has laid down the new rules in place of the existing one to protect
the economy and the taxpayers. Hence, HSBC must separate its retail banking operations from
the wholesale and investment divisions, changing the way it is structured in UK and this forms a
new bank HSBC UK. All these said changes in HSBC should be before 1 January 2019 and to
achieve this need to complete required activities before the deadlines. These structural changes
mean a lot to the global banking and the market clients but the customer will still continue to
bank with HSBC. This will be beneficial to the international network and the ring fenced bank
i.e. HSBC UK. The government of UK’s reforms is based on almost 5 years of consultation on
the future of UK's financial sector (UK Banking Reform, 2017). UK's biggest banks will certainly
need to run their retail and wholesale and the investment operations as an independent one they
must separate from their overseas operations as well.
The customer who is remaining at the HSBC Bank plc the customer in UK will remain as
global banking and market customer within wholesale and investment banking division. All
relevant financial institutions including UK corporate banking will be categorised as Non Bank
Financial Institutions. The customers of non UK branches of HSBC bank plc including all global
banking markets and commercial customers, export and private bank channel Island customer.
The customer who will be transferring to HSBC UK is all personal and commercial banking
customers of HSBC. All the other UK retail brands Marks and Spencer bank and the UK private
bank clients are also included in this. HSBC UK customers will be getting a new Internation
bank account number or IBAN as HSBC UK will have new Bank Identifier Code or BIC.
Whereas basic service such as payments and bank account access should be able to continue
even if the parent group collapse.
The small number of GBM clients will be given new sort codes as sort code is a number
given to only one bank and few of existing one will need to be adopted by HSBC UK. By the
term ring fencing means that any entity which will continue to bank with HSBC bank plc is not a
relevant financial institution or RFI and it needs to go through a qualification process to confirm
that it is meeting the set criteria. For all kinds of corporate and partnerships which are not in their

first year of trading the following criteria is used to determine which clients will remain part of
HSBC bank plc.
CONCLUSION
From the overall critical analysis, it has been concluded that default swap and subprime
mortgages are the main reasons due to which recession occurred in 2007-08. Besides this, it has
been articulated that systematic risk level closely influences the overall sector rather than
specific firm. It can be seen in the report that due to over expansion and high lending banking
units started to collapse in 2007-08. Further, it can be stated that several reforms and rules have
been introduced by the concerned authorities to ensure the smooth functioning of banking sector.
In addition to this, it can be presented that Basel III accord has enhanced liquidity requirement of
the banking firms to a great extent.

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