Analyzing Banking Regulations: Risks, Returns, and Securitization

Verified

Added on  2020/02/05

|16
|4565
|257
Report
AI Summary
This report provides a comprehensive overview of banking regulations, focusing on the key risks associated with financial services and the measures to prevent them. It delves into operational risks, including conduct risk, regulatory fines, IT failures, and data protection risks. The report explores how banks can improve their return on equity through leverage and explains the process of securitization, highlighting its usefulness. Additionally, it defines the key features of Basel II, including its three-pillar framework for assessing regulatory, market, and operational risks. The report also analyzes various types of risks, such as systemic, business, reputational, liquidity, market, and credit risks, offering strategic moves for banking institutions to overcome these challenges. It emphasizes the importance of standardized risk management, continuous evaluation, and customer feedback to enhance brand image and minimize potential losses. Overall, the report offers valuable insights into the complexities of banking regulations and risk management in the financial sector.
Document Page
Banking Regulation
tabler-icon-diamond-filled.svg

Paraphrase This Document

Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
Document Page
Contents
INTRODUCTION...........................................................................................................................3
1. Describing the key risks that are associated with financial services along with prevention
measures......................................................................................................................................3
2. Stating the manner in which bank’s return in equity can be improved through leverage.......7
3. Explaining the process of securitization and presenting its usefulness...................................8
4. Defining the key features of Base II including three pillars framework...............................11
CONCLUSION..............................................................................................................................13
REFERENCES..............................................................................................................................14
Document Page
INTRODUCTION
Banking regulations implies for Act which in turn presents new laws for licensing and
regulation of institutions. With the motive to ensure smooth functioning of business operations
and functions of financial institution government authority frames some rules. Thus, monetary
institutions are required to follow rules and regulations pertaining to merchant banking, discount
house as well as money broking business. In addition to this, to avoid undesirable situations
government authority has framed some rules pertaining to financial matters or aspects. Hence,
banking rules and regulations are highly significant that provides high level of assistance in carry
out activities more effectively and efficiently. In this, the present report will describe the risk that
is related to monetary services and aspects. Besides this, it will also shed light on the process
needs to be followed at the time of scrutinizing. It will also provide deeper insight about the key
aspects related to base II which in turn helps in assessing regulatory, market and operational risk
more effectually.
1. Describing the key risks that are associated with financial services along with prevention
measures
In the strategic business arena, for attaining success and maximizing productivity it is
highly required for banking institutions to undertake suitable measures for preventing risk. There
are several types of risk such as financial, operational, legal etc. that have greater impact on the
performance aspect of firm. Thus, to carry out activities in the best possible manner it is highly
required for financial institution to assess the type of risk that closely influences their success
and growth level. By doing this, firm would become able to take suitable prevention measure
which in turn helps in getting the desired level of outcome or success. From assessment it has
been identified that banking institutions are majorly facing operational risks that directly impacts
the aspect of financial services. Operational risk implies for the loss that occurred due to having
inadequate system, procedures and policies. In the context of banking institution, operational
risks that are associated with financial services are enumerated below:
 Conduct risk: It implies for risk that arises according to the manner in which business
and its employees perform in relation to their clients and competitors. Hence, poor
conduct is one of the main issues that have direct impact on sales and profit aspect. Thus,
Document Page
for the attainment of success in the competitive business arena it is needed for banking
institutions to undertake effectual measure for the purpose of improvement.
 Regulation: In the past years, due to the aspect of mis-selling related to subprime
mortgage and manipulation of global foreign exchange market aspect in relation regulator
fine imposes high risk (Lujja and et.al., 2016). Hence, after the period of 2008 regulators
fine become a major issue for institutions operating in banking sector.
 Organizational change: By doing assessment, it has been found that in the case of
financial services change is constant to a great extent. During the period of 2008, when
monetary crisis occurs, there were several firms which undergoes from the process of
merger and restructuring. Besides this, at the time of 2008, many banking institutions
were compelled to close down their institutions.
 IT failure: In the business unit, IT failure and breakdown closely affects the performance
aspect of operational level employees. Moreover, in the recent times, all the activities and
functions of banking institutions are highly based on IT aspects. Thus, in the absence of
having sound IT mechanism it is not possible for the personnel of banking institutions to
interact with customers (PY Lai and Samers, 2017). For instance: Many trading firms are
highly relying on electronic trading platform which in turn facilitates transactions in a
fraction of seconds. In this, any breakdown which takes place in IT aspect closely
influences customer satisfaction and productivity as well as profitability.
Data protection risk: In the present era, undesirable or illegal practices such as hacking
increased more frequently. Now, hackers steal account details of individual from both banking
institution and concerned customer. Hence, sound data protection policy needs to be framed
which for reducing the level of risk.
Regulatory fatigue: Growth and performance aspect of company is going to be affected
due to the failure of government in making structural changes. Besides this, government
authority also fails to assess and develop additional rules for ensuring systematic financial
services. Further, it has been found that there are several firms whose IT change capacity is being
used to a great extent in line with the changing regulatory requirement. On the other side, there
were some firms who left with limited capacity or aspects (Abdul Wahab and et.al., 2017). This
in turn places direct impact on the strategic and performance aspects of concerned institute or
tabler-icon-diamond-filled.svg

Paraphrase This Document

Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
Document Page
firm. Moreover, in the lack of having enough capacity it is not possible for firm to upgrade and
renew IT system. Thus, skilled and sound risk management aspect is highly required to
maximize the firm’s capabilities.
Systemic risk: Global crisis occurred in 2008 is one of the main examples of systemic
risk. Moreover, due to economic slowdown loss was suffered by all the financial institutions to a
great extent. Hence, such kind of risk implies for the one that affects whole industry rather than
any specific banking firm. On the basis of such aspect, if one large sized business unit fails to
meet objectives then other players or participants of such industry also affected to a great extent.
Business risk: It implies for the possibility that company failed to attain higher margin
as compared to the one which is anticipated. Suck risk arises when banking institution fails to
prepare highly effectual long-term strategy and implements the same in appropriate manner
(Olayemi and et.al., 2016). The biggest example of business risk can be seen at the time of
global crisis or issue when large number of banks collapsed due to the lack of having sound risk
management strategy.
Reputational risk: Rumours about bank and its services impose high level of
reputational risk in front of concerned financial institution regarding reputational aspect.
Moreover, manipulated information such bad customer experience, service etc closely influences
the brand image and thereby productivity as well as profitability of firm.
Liquidity risk: It occurs due to the lack of marketability of an investment aspect. Thus, it
implies for an investment that cannot be purchased and sold quickly for the prevention of loss.
At the time of global financial crisis many banks were taken over by government because banks
got difficulty in meeting day to day cash transactions.
Market risk: Such risk is highly associated with the loss which occurs due to the changes
take place in equity prices, interest rates, credit spreads, foreign exchange rates and commodity
prices. According to Bank for International Settlements (BIS) presents market risk in the form of
loss which occurs due to the undesirable movements take place in market prices (Lujja and et.al.,
2016). Business risk is majorly faced by the investors which are involved in investment related
activities such as JP Morgan, Morgan Stanley etc. Thus, market risk majorly includes interest
rate, equity, currency and commodity risk.
Document Page
Credit risk: In the field of banking, credit risk occurs due to loans, interbank financial
and FOREX transaction, trade financing, future, swaps, bonds, option etc. Thus, it mainly occurs
when borrower is not is position to repay the amount of loan due to not having enough income
then it may result into high credit risk (8 Risks in the Banking Industry Faced by Every Bank,
2017).
Thus, for the attainment of goals banking institutions are required to undertake strategic
moves which in turn help in overcome all such risks:
 Adoption of standardized risk management: For providing high level of securities to
both customers and investors employment of standardize risk management principles
are highly required. In BASEL II aspects in relation to effectual management of risk are
include which all the monetary institution require to follow.
 Banking institutions can avoid systemic risk by preparing highly sound risk
management plan. Through the means of continuous evaluation of market situation and
keeping in mind the consequences of global crisis banking institution can develop
suitable framework for the upcoming time period. Thus, by undertaking such strategic
action firm would become to attain success in the near future.
 Credit risk can effectually be minimized by banking institution through charging high
interest rate from borrowers who fall under the category of defaulters. Through this,
level of loss can be controlled by firm more effectually.
 In the present times, it is highly difficult for investors to make assessment of market
movement in the right direction (Nordhaug, 2014). However, by making continuous
evaluation of securities trend or pattern banking institutions can deal with market risk in
the best possible manner.
 By taking feedbacks from customers on a regular and periodical basis regarding
services banking institution would become able to undertake suitable measure for
improvement. Through this, financial institution can build prominent relationship with
customers and thereby would become able to enhance brand image.
Document Page
2. Stating the manner in which bank’s return in equity can be improved through leverage
Return on equity (ROE) may be served as a measure which in turn helps in making
assessment of return that is generated by firm through the means of shareholders equity. By
dividing net income from shareholders equity ROE can be assessed or determined by firm. Such
measure places high level of impact on the decision making aspect of investors. Moreover,
usually investors undertake such ratio with the motive to measure and evaluate organizational
performance. Thus, banking institution has requirement to employ suitable measure which in
turn result into high return on equity (Lewis, Ariff and Mohamad, 2014). There are several ways
through which return on equity can be increased by banking firms include high leverage, profit
margin, improvement in assets turnover, effectual distribution of idle cash and lower taxes. Out
of all such ways banking institution should focus on enhancing return on equity through the
means of leverage.
In the organization, debt and equity are the main two sources that are undertaken by
business entity for meeting monetary needs and requirements. Thus, by raising the debt level
finance personnel can make improvement in ROE to the significant level. Moreover, debts are
included by firm then it may result into high assets level. Moreover, at the time of equity
valuation debt is subtracted from assets. Thus, it offers opportunity to the firm to decrease the
level of equity by adding or taking resort of more debt (How to Improve Return on Equity, 2017).
By considering such aspect, it can be said company’s ROE increases with the rise in debt level or
aspect. Nevertheless, increasing debt level also has adverse impact on the business operations.
The reasons behind this, debt level imposes fixed obligations in front of firm in the form of
interest amount and repayment obligation.
For instance: Financial institution of Malaysia has following income statement and balance
sheet then ROE will be:
Income statement
Particulars Amount ( in MYR million)
Revenue 11900
COGS 7000
Sales, general and administration expenses 2000
tabler-icon-diamond-filled.svg

Paraphrase This Document

Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
Document Page
Interest expenses 800
Pre-tax profit 2100
Profit after tax 1400
Balance sheet
Particulars Amount ( in MYR million)
Assets 25000
Liabilities 15000
Shareholder’s equity 10000
Return on equity (ROE) = 1400 / 10000
= 14%
The above mentioned calculation shows that if debt is taken by banking institution then
value of return on equity will be 14%. On the other side, in the case of no debt interest amount
will be zero and profit accounts for MYR 2255 million. Besides this, shareholder’s equity will
also account for MYR 25000 million. Hence, in such case value of ROE will be 9.02% which is
lower than other case. Thus, it can be said that value of ROE is higher when banking institution
include debt rather than other situation. Overall calculation and evaluation clearly shows that
return on equity can be maximized by financial institution to a great extent through the means of
leverage.
3. Explaining the process of securitization and presenting its usefulness
Securitization implies for the conversion of loan and recoveries into securities through
the means of SPV. It lays high level of pooling assets and thereby reduces the risk of portfolio to
the significant level via diversification. In addition to this, aspect of securitization lays focus on
isolation and efficient allocation of risk. Main parties who are involved in securitization aspects
are as follows:
Document Page
 Asset originators or sellers: They imply for the one who provide loans to borrowers.
Besides this, it also includes the authorities whose payment is due from customers or
having receivable.
 Issuer (SPV): refer to the entity that is involved in the activities regarding buying assets
from originator and converts them into security for further sale.
 Liquidity provider: Such body is involved in conducting documentary work or aspect.
 Swap counterparty: Under the process of securitization, counterparty plays a vital role in
hedging risk which is related to currency aspect (Bello and Mohd Yasin, 2015).
 Servicer: Such category involves personnel who manage asset pool and make focus on
the collection and remittance of cash flow to service debt.
 Trustees: In securitization, trustees are the one who have accountability to hold securities
of assets and represent the same to note-holders.
 Rating agencies: It includes independent agencies that make assessment of credit
enhancement level by taking into consideration the legal and structural aspects.
Mechanism of securitization process can be presented in the following way:
 In the first step, assets are selected by originator.
 Once, asset selection has done thereafter involved authorities focuses on packaging of
the pool of loans and advances.
 At the third step, assets are underwriting by underwriters to a great extent.
 In the fourth step, assets are assigned and selling to SPV in against to cash.
 Thereafter, emphasis is placed on the conversion of assets into divisible securities.
 Further, after the conversion of asset SPV sells such securities to investors through the
means of private stock market in against of cash (Mei and Zhou, 2015). Hence, in
against to making payment investors receive income and return of capital from assets
through the life-span. Besides this, risk that is associated with securities is faced by
Document Page
investors to a great extent. However, such risk level can be reduced by investors through
the means of collateralization of asset.
 Once sales of asset have been made then servicing fees is paid to originator and SPV.
Hence, by making comparison of rate of borrowers and the return which is promised to
investor’s service fee can be assessed.
Thus, by following all the above mentioned steps securitization process can be performed in
an effectual and structured way. However, parties who involved in the process of securitization
needs to keep in mind that only homogenous securities or assets having similar maturity and cash
flow period can be securitized.
From investigation, it has been assessed that subprime mortgage crisis occurred during the
period of 2008. Scholarly articles present that during the period of 2008, financial institution
persuaded homeowners to accept adjustable rate mortgages. In this, mortgage payment changed
interest rates to the significant level. At initial level, homeowners made low mortgage payment
but payment in relation to such aspect increased significantly because interest rate rests to higher
level. For instance: in the case of $100000 mortgage no any principal amount is paid by
individual. In this, interest rate climbs to 10% then homeowner’s monthly interest rate climbs to
10%. Under such situation, homeowner’s monthly payment increases to $878 per month. This in
turn shows that interest level or aspect increasing by $213 respectively. Outcome of assessment
shows that borrowers pay a total interest amounted to $215925 to the investors fund. In the year
of 2008, investment banks have made contribution in housing bubble because they earned high
level of profit from such aspect.
During such period, investment banks converted or packaged bonds from asset backed
securitized into Collateralized Debt obligations (CDO). One of the main deficiencies which took
place in the prior securitization process is that rating agency rated all CDO with AAA. In
contrast to this, some CDO included subprime mortgage which in turn shows that such agencies
were highly incompetent. In addition to this, large number of investors laid high level of
emphasis on investing money in highly rated investments. Further, it has been assessed from
evaluation that investment bankers are not in position to sell CDO’s. Besides this, CDO’s were
not highly transparent during the period of 2008 and created difficulty in front of investors. Thus,
due to having deficiencies in relation to credit rating created difficulty for investors. By taking
tabler-icon-diamond-filled.svg

Paraphrase This Document

Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
Document Page
into account such aspect it can be stated that current process of securitization is highly significant
which in turn offers high relief to the parties involved in investment purpose.
4. Defining the key features of Base II including three pillars framework
Basel II may be served as a set of international banking regulations that was introduced
by Basel Committee on Bank Supervision. Rules regarding the minimum capital requirements
were depicted in Basel II. Hence, specific guidelines are included in Basel II which in turn
provides framework for reviewing the regulatory aspects. In addition to this, disclosure
requirements have also setting down with motive to assess capital adequacy of banks. From
assessment, it has been identified that there is significant difference takes place in the aspects of
Basel II and Basel I. Moreover, Basel II entails that credit risk of asset is held by monetary
institution which in turn helps in determining regulatory capital ratios.
Hence, Basel II may be served as second International banking accord which is mainly
based on three pillars. Such framework or pillars include the aspect of minimum capital
requirement, regulatory supervision and market risk. In Basel II, minimum capital requirement
plays a vital role in ensuring smooth functioning of banking institutions. Such pillar of Basel II
obligates monetary firms or institutions to maintain minimum capital ratios of regulatory in
against to weighted risk assets level (Erol and et.al., 2014). Further, banking regulations are
highly varied from one country to another until Basel was not introduced. Hence, by keeping
such aspect in mind it can be stated that Basel II provides high level of assistance to the countries
in alleviating anxiety regarding the competitiveness regulatory aspect to the significant level.
Minimum capital requirements: According to Basel II banking institutions required to
maintain minimum 8% co-efficient in the form of regulatory capital. Hence, over risk weighted
assets it is highly required to maintain such criterion. Further, Basel II presents regulatory capital
in 3 tiers such as:
 Tier 1: includes shareholder’s equity, disclosed reserves, retained earnings and innovative
capital instruments
 Tier 2: contains tier 1 instruments plus bank reserves, hybrid instruments, medium as
well as long term subordinated loans.
 Tier 3: presents tier2 + short term subordinated loans
Document Page
Assessment of risk weighted assets: It is determined through multiplying the sum of assets
with weight for each asset type. On the basis of such aspect, assets with higher weight considered
as riskier. Thus, Basel II is highly effectual which in turn helps in evaluating the credit rating of
assets in the best possible way (BASEL II APPROACHES FOR THE CALCULATION OF THE
REGULATORY CAPITAL FOR OPERATIONAL RISK, 2017). Hence, by undertaking such
system risk weights can be determined in the best possible way.
Regulatory supervision and market discipline: It offers framework that assists national
regulatory bodies in dealing with several risks such as systemic, legal and liquidity. Further,
such Basel also helps users of final accounts because it furnishes information about disclosure
requirements for banks risk exposure, assessment and capital adequacy.
There are several methods or approaches that can be used by banking institution for
calculating the capital requirements pertaining to operational risk aspect.
The basic indicator approach: On the basis of such aspect, financial institutions must hold
capital in line mean gross income percentage of 3 years. In this, by using following formula
capital requirements can be assessed.
CRBIA = [∑(GIBi α)] / n
 CRBIA = Capital requirement for operational risk
 GIBi = annual gross income level of monetary institution
 Α = 15%
 N = Three years when GP or GI is favourable
The standardized approach: Such approach is highly effectual which in turn considers
operational activities separately. In this, activities are distinguished according to business lines or
areas:
Document Page
CONCLUSION
From the above report, it has been concluded that banking institutions should lay
emphasis on making assessment of risk on a periodical basis. By doing this, firms operated in
banking sector can develop competent plan for gaining competitive position over others. Further,
it can be revealed from the report that process of securitization is highly significant that offers
advantages to both banks and investors. It can be seen in the report that due to having ineffectual
credit rating system during the period of 2008 misuse of securitization process had taken place.
Besides this, it can be presented that leverage aspect enables banking institutions to make
improvement in their liquidity aspect to a great extent. Along with this, it has been articulated
that three pillars that are included in Base II are highly effectual which in turn makes
contribution in the attainment of organizational goals.
tabler-icon-diamond-filled.svg

Paraphrase This Document

Need a fresh take? Get an instant paraphrase of this document with our AI Paraphraser
Document Page
REFERENCES
Books and Journals
Abdul Wahab, H. and et.al., 2017. Risk-Taking Behavior and Capital Adequacy in a Mixed
Banking System: New Evidence from Malaysia Using Dynamic OLS and Two-Step
Dynamic System GMM Estimators. Emerging Markets Finance and Trade. 53(1). pp.180-
198.
Bello, S. I. A. A. and Mohd Yasin, N., 2015. Jurisdiction of courts over Islamic banking in
Nigeria and Malaysia. Journal of Islam, Law and Judiciary. 1(3). pp.54-76.
Erol, C., F. and et.al., 2014. Performance comparison of Islamic (participation) banks and
commercial banks in Turkish banking sector. EuroMed Journal of Business. 9(2). pp.114-
128.
Lewis, M.K., Ariff, M. and Mohamad, S. eds., 2014. Risk and Regulation of Islamic Banking.
Edward Elgar Publishing.
Lujja, S. and et.al., 2016. The feasibility of adopting Islamic Banking system under the existing
laws in Uganda. International Journal of Islamic and Middle Eastern Finance and
Management. 9(3). pp.417-434.
Lujja, S. and et.al., 2016. The feasibility of adopting Islamic Banking system under the existing
laws in Uganda. International Journal of Islamic and Middle Eastern Finance and
Management. 9(3). pp.417-434.
Mei, D. and Zhou, L., 2015. Anti-Money Laundering Game between Banking Institutions and
Employees in the Progressing CNY Internationalization. Modern Economy. 6(04). p.490.
Nordhaug, K., 2014. Global finance and financial regulation in Malaysia and
Taiwan. Occasional Paper. (25). pp.343-362.
Document Page
Olayemi, A. A. M. and et.al., 2016. The Quest for Effective Regulation of Islamic Money
Market: An Appraisal of the Applicable Laws in Malaysia. Journal of Islamic Legal Studies|
ISSN-2519-1535. 2(01). pp.55-72.
Olayemi, A. A. M. and et.al., 2016. The Quest for Effective Regulation of Islamic Money
Market: An Appraisal of the Applicable Laws in Malaysia. Journal of Islamic Legal
Studies, 2(1), pp.55-72.
PY Lai, K. and Samers, M., 2017. Conceptualizing Islamic banking and finance: a comparison of
its development and governance in Malaysia and Singapore. The Pacific Review. 30(3).
pp.405-424.
Online
8 Risks in the Banking Industry Faced by Every Bank. 2017. [Online]. Available Through:
<https://letstalkpayments.com/8-risks-in-the-banking-industry-faced-by-every-bank/>.
[Accesses on 15th June 2017].
BASEL II APPROACHES FOR THE CALCULATION OF THE REGULATORY CAPITAL FOR
OPERATIONAL RISK. 2017. [Online]. Available Through:
<https://is.muni.cz/do/econ/soubory/aktivity/fai/21952347/FAI_issue2011_01_valova.pdf >.
[Accesses on 15th June 2017].
How to Improve Return on Equity. 2017. [Online]. Available Through:
<http://smallbusiness.chron.com/improve-return-equity-59183.html>. [Accesses on 15th
June 2017].
https://medium.com/@ninan99/sequence-of-events-before-microsoft-acquired-linkedin-
6d9838434657
Document Page
http://smallbusiness.chron.com/improve-return-equity-59183.html
http://pubs.sciepub.com/jbe/2/5/3/
https://www.fool.com/investing/general/2015/01/21/5-ways-to-improve-return-on-equity.aspx
chevron_up_icon
1 out of 16
circle_padding
hide_on_mobile
zoom_out_icon
[object Object]