Government and Market Effects on Financial Institutions

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will impose guidelines on liquidity which will require banks to hold a greater cushion of liquid assets, mainly in the form of government bonds. The suggestions have attracted plenty of criticism but they are suggestive of what is coming which is a more healthy approach to liquidity in general and will impose greater efforts by national regulators to safeguard the local operations of banks from the risk of getting into trouble.

Banks that may be doing a good job could still find themselves subject to higher charges if uni-versal risks are rising. Rules and regulations requiring banks to beef up capital in good times and run it down in bad times may well rely on the discretion of authorities. Standalone investment banks have failed and are too central to the style of global finance to disappear smoothly without causing friction. Pure retail banks have collapsed too. Any fundamental action would also require governments to mark out some very artificial boundaries. Take the distinction that some make between deposit taking institu-tions, which should be protected, and wholesale funded entities, which should not. With so much wholesale funding coming ultimately from individual investors in the form of pension and mutual funds, that distinction is blurrier than it .first looks. (QIAN & STRAHAN, 2007)

There are similar problems with defining the borders between acceptable and unacceptable un-dertakings. There are many institutions of the industry doing blameless but critical things like cash management and trade finance for companies that fall outside the meaning of narrow banking. The ex-tension of credit to a small business is one of the riskiest things a bank can do, but it wins taxpayers’ unmistakable support. (Rosengren, 2008) Credit default swaps are belittled, by contrast, but they serve a valuable function. Trademarked trading is harder to defend when it is sheltered by a government guarantee but any bank that acts as a market maker between buyers and sellers will end up taking some form of trademarked risk.

The amount of weight on risks associated with assets are rising as the special effects of the downturn feed through into banks’ risk models, forcing them to set aside more capital. Bondholders want a greater cushion beneath them in the capital structure to protect them against losses. Shareholders too are belatedly happy to trade higher returns on equity for a reduced chance of being wiped out. So banks with more equity capital are now valued more highly by the marketplace.

The amount of capital banks hold is not the only thing under inspection. They also need to have the right kind. Their capital is a mix of common equity (which is first in line when things slow down) and various other instruments (often crosses of equity and debt) A steady increase in the proportion of this sort of capital has enhanced rapidly in recent months, as common equity has been plagued by the losses in which governments have largely filled the gap with preferred shares. This in turn helps to avoid nationalization.

Quality of management is superior at the amplification of the consistency in performance be-tween banks. The right approach theoretically is a lively controlling government that looks skeptically at the boardrooms and strategies of .financial institutions and has the ability of overruling successfully when the need arises. In any case, universal changes to institutions will have a considerable impact on the types of businesses banks become. Faced with this disorderly set of choices, a sensible viewpoint would not make hard and fast judgments about what businesses belong together. (QIAN & STRAHAN, 2007) \

The changes to the environment in which banks operate including tougher regulation, higher capital requirements and scarcer funding will have a dramatic impact on the way that banks are man-aged. But banks are also reflecting hard on some fundamental core questions, such as how to manage risk, compensation and growth itself. Besides working out what they are good at, banks must decide how much risk they want to take. Helped along by the increasing capital charges in trading books and other planned governing changes, a sweeping shift in risk desire is already under way. (Rosengren, 2008) But in general, trademarked risk-taking is being scaled back radically. Risk capital will reside outside the banking system, in hedge funds and private equity .firms, much more than before. (QIAN & STRAHAN, 2007)

With government effects in place involving financial institutions, banks will have a deeper awareness of funding risk. Organizations that intensely abused the pricing differences between long term assets and short term liabilities have paid heavily when liquidity dried up and they were unable to refinance fast maturing debts or sell the assets that they held. It is possible to glance at the emerging setting of banking and think that not a lot is going to change. Aside from a few small changes to capital here, some tougher rules on liquidity and the elimination of a handful of badly run institutions, the same big names dominate the industry will survive. Banks will make less money than before but the industry will still return decent profits and still pay well. With so many assets trading at such distressed levels, many expect the general side of the industry to record massive gains when things finally turn around. Given what has gone before, that may seem like a not so bad thing but it will consist of costs. No one knows exactly what the right balance of debt and equity is in an economy, but the reduction of securitization by the government on financial institutions lending actions in particular makes it more likely that the process of deleveraging will pass.