Banking and Monetary Policies in a Changing Financial Environment

A regulatory approach

Wassim Shahin, Elias El-Achkar

• Publisher: Routledge
• Year: 2016
• Print ISBN: 9781138325098
• eBook ISBN: 9781317429951
• Edition: 1
• Topic: Business
• Subtopic: Banks & Banking
• Index: Business

The 21st century witnessed major changes in the financial environment surrounding bank regulators and banks. Banking and Monetary Policies in a Changing Financial Environment delves into three of these developments and challenges.

The first change in the financial environment relates to the rise in the number and sophistication of financial and economic crimes which shaped the international regulatory architecture. New rules and regulations led to the creation of new strategies to combat these crimes, especially those concerning the spread of more advanced money laundering methods and techniques, terrorist financing after the 9/11 attacks, and the proliferation of weapons of mass destruction. The second development concerns the global financial crisis of 2008 which drastically affected the regulatory environment of various international and domestic financial authorities causing major changes in bank lending and corporate governance policies, and in the development of the Basel III accord on capital adequacy for bank supervision. The third development manifests itself in the creation of a major European monetary union without a fiscal union and a giant European central bank impacting the conduct of monetary policy. This book combines theory, policy, regulation and institutional approaches with empirical testing, analyzing applications and case studies of various international regulatory authorities and administrations, countries and jurisdictions, central banks and commercial banks.

This volume is suitable for those who study international finance, Banking and white collar crime.

1 Introduction

The rationale for the book

The twenty-first century witnessed major changes in the financial environment surrounding banks and bank regulators, including central banks. This book is motivated by three of these developments and challenges. The first relates to the rise in the number and sophistication of financial and economic crimes, which shaped the international regulatory architecture. New rules and regulations led to the creation of new strategies to combat these crimes, especially ones concerning the spread of more advanced money-laundering methods and techniques, terrorist financing after 9/11 and the proliferation of weapons of mass destruction experienced lately. The second development concerns the global financial crisis of 2008, which drastically affected the regulatory environment of various international and domestic financial authorities, causing both major changes in bank lending and corporate governance policies and the development of the Basel III accord on capital adequacy for bank supervision. The third development saw the creation of a major European monetary union without a fiscal union and a giant European central bank that impacts on the conduct of monetary policy. The financial crisis also caused monetary authorities to resort to unconventional monetary policies of quantitative easing rarely witnessed previously in terms of their length and operational amount in a recessionary and deflationary environment. Additionally, some central banks resorted to holding more foreign reserves to hedge against future crises.

This changing financial environment necessitated a change in the strategies, measures and regulatory policies governing it, which drastically affected bank and central bank policies. These policies were impacted at the level of compliance with new international and domestic rules and regulations, corporate governance, capital adequacy in quantity, quality and composition, risk management, and various micro-prudential and macro-prudential policies. At the same time, monetary authorities and banks have to survive in a monetary policy environment of monetary unions, quantitative easing, historically low interest rates, and possible deflation. These developments in the financial environment acted as motivators for us to develop this book to address the new policies and monetary policy changes of banks and central banks. The framework and analysis we will use combine theory, policy, and regulatory and institutional approaches, along with some empirical testing, applications, and case studies of a range of international regulatory authorities and administrations, countries, jurisdictions, central banks, and commercial banks.

The organization of the book

The book is divided into three parts, reflecting the three developments and changes in the financial environment addressed above. The first part (including Chapters 2 and 3) deals with banking regulation aimed at combating financial and economic crime. Chapter 2 builds on the fact that the regulatory environment has changed drastically in the twenty-first century, with an increase in the sophistication and number of methods and techniques of money laundering and financial and economic crimes after the 9/11 attacks in the US at the beginning of the century and the proliferation of weapons of mass destruction at the present time. The rise of terrorism necessitated adding eight recommendations in 200l and a ninth in 2004 to the forty recommendations of the Financial Action Task Force on the laundering of money; these nine recommendations were incorporated within the forty new recommendations drawn up in 2012. The purpose of the chapter is thus to highlight the new regulatory environment governing financial and economic crimes by developing a complete list of these crimes and of the various policies, measures and strategies undertaken by all international bodies and organizations in order to combat criminal activities. Such crimes include money laundering, terrorist financing, organized crime, bribery, corruption, fraud, cybercrime, financing proliferation, human trafficking, the smuggling of migrants, identity theft, tax evasion, whistleblowing, stolen assets, and politically exposed persons, among a wider set of criminal activities.

Chapter 2 is a necessary analytical introduction to the following chapter, on bank compliance with measures taken by worldwide financial intermediaries. These compliance policies and measures have changed the nature and structure of bank practices and policies from those of the previous century. Therefore. Chapter 3 is based on the premise that compliance has become, in recent years, a major regulatory and supervisory issue and an essential part of the bank's business activities and corporate culture. Compliance, as addressed in this chapter, refers to the compliance of banking institutions with established domestic and international laws, rules, and standards related to the banking profession. Compliance risk is defined by the Basel Committee on Banking Supervision of the Bank for International Settlements as: "the risk of legal or regulatory sanctions, material financial loss, or loss to reputation a bank may suffer as a result of its failure to comply with laws, regulations, rules, related self-regulatory organization standards, and codes of conduct applicable to its banking activities." Issues addressed by compliance cover anti-money laundering (AML), countering the financing of terrorism (CFT), economic and financial sanctions, and tax evasion regulations. Failure to comply in these areas tends to expose the bank to significant fines and reputational damage. Dealing effectively with compliance risk requires a dynamic, transparent, and centralized approach to compliance and a board of directors and senior management responsible for ensuring full compliance with regulations and enforcing the culture of compliance throughout the banking firm. In addition, a compliance function originating from a compliance policy must be in place; that function could be organized within other functions, when commonalities exist, or located as a separate function with clear lines of cooperation with other functions on the organizational chart. Large differences exist among banks not only regarding the organization of the compliance function but also when it comes to the responsibilities and activities of its staff. What matters, however, is whether banks' compliance functions and adopted policies and procedures adhere to international rules and regulations in the area of compliance and compliance-related issues, and are consistent with existing best industry practices. Though banks in theory and practice support measures aiming at reducing the compliance risk and avoiding reputational damage, they are also concerned with the uncertainty and burden presented by regulatory complexity, and the substantial direct and indirect costs of compliance with new or modified regulations.

This book's second part addresses the causes and origins of the crisis, bank lending policies in a number of countries after the crisis ensued, the changes in governance policies regulating financial institutions and the new Basel III accord on capital adequacy. The discussion in Chapter 4 is based on the premise that the global financial crisis of 2008, and those that subsequently hit many peripheral European countries, reignited interest in the topic of financial instability and financial crises among academics, researchers, and policy-makers. Awareness was similarly awakened following the East Asia financial crisis almost ten years earlier in 1997–8 and other episodes of financial turbulence throughout the current and previous centuries. Financial crises are recurring phenomena and have a long history dating from well before the great depression of 1929. Most crises are similar in many respects, often resulting in serious economic and social costs often associated with a sharp drop in employment and output. Adverse implications may extend as well to the fiscal situation, the effectiveness of monetary policy, and the external sector. In addition, in an interlinked world the damage may not be limited to the economy in which the crisis originated, and the fear of adverse contagion or spill-over effects, involving the rapid spread of the crisis across other economies, is a major policy issue. Therefore, understanding the origins of the crisis and the contributing roles of monetary and fiscal policies and identifying the real causes and linkages are of the utmost importance both to monetary and fiscal authorities and to financial system regulators and supervisors in terms of learning the right lessons, addressing existing weaknesses, strengthening the financial system, and limiting contagion effects.

Chapter 5 empirically examines the effects of the global financial crisis of 2008 on total bank lending in selected countries, as declining bank credit is both one of the major causes of economic slowdown or recession and, in many cases, one of its results. The goal of the chapter is therefore first to investigate whether the global credit crisis and ensuing world economic recession resulted in a decline in bank private sector credit in these countries. Second, given that a decline was found, the chapter addresses whether this decline was supply- or demand-driven by bank borrowers. The supply side effect could result if bank credit to the private sector was constrained by a decline in deposits or an increase in non-performing loans, and if issues of risk aversion by banks reflected in adverse selection and moral hazard mechanisms, whereas the demand side could result from an increase in unemployment, a decline in business opportunities, and risk aversion by borrowers regarding investment profitability. To test whether there has been a contraction of bank credit following the global credit crisis, and if so whether it came from a shift in the demand or a shift in the supply or both, we built on the methodologies commonly used in the literature, addressing both the determinants of bank lending and the means to disentangle shifts in loan supply from shifts in loan demand. Initially we developed a credit theoretical model in line with the existing models in the literature. Then, employing empirical methodology, we estimated with panel data the overall impact on banks' loan extension. The determination of the cause of credit slowdown or retreat has important policy implications: if the credit decline is related to weak demand for bank loans, whether due to pessimistic economic perspectives, deteriorations in borrowers' balance sheets, excessive leverage or other factors, then policies aiming at stimulating aggregate demand could be effective; if, on the other hand, the decline is due to banks' inability and reluctance to lend because of a decline in deposits, capital losses related to loan losses, or asset price collapse and increased riskiness, then other sets of measures, including easy monetary policy, are needed to revive bank lending and foster investment.

Chapter 6 centres on the fact that, since the early 1990s, corporate governance has been receiving increasing attention from international standard-setters, domestic law-makers and regulators, and all domestic and external stakeholders in general, with a rising awareness of its importance for and impact on the soundness and performance of financial and non-financial companies and on certain economic outcomes. The ongoing pressure to adhere to constantly updated international standards in this area as well as to related applicable domestic laws and regulations and a mounting conviction on the part of shareholders and investors of the positive efficiency, profitability and sustainability signals that adequate corporate governance can send to the markets have been the main drivers in influencing the board and senior management of banks and non-banks to incorporate the best corporate governance practices into their daily operations and decision making. There is no single definition of corporate governance, yet it is commonly known to be a set of structures, systems, policies and procedures by means of which corporations are managed and controlled. One of the best definitions is that of the Organization for Economic Co-operation and Development (OECD), which mentions that corporate governance "specifies the distribution of rights and responsibilities among the main participants in the corporation—including shareholders, directors and managers—and spells out the rules and procedures for making decisions on corporate affairs. By doing this, corporate governance provides the structure through which company objectives are set, implemented and monitored." The commitment to and adoption of good corporate governance practices in reference to well-known international standards differ from one company or industry or country to another, because such practices are decided only in part by companies and are dictated to a large extent by laws and regulations. In addition to the regulatory and legal considerations, there are other factors that play a role in the divergence in practices, including the size, complexity, and risk-taking culture of the firm, and the political, institutional, social, and cultural environment. Nevertheless, a company devoted to sound corporate governance has clearly described shareholders' roles and equal rights, an empowered board of directors with well-determined responsibilities to exercise management and oversight, strong internal controls and accountability, and high levels of transparency and disclosure. A corporate governance framework of guiding principles and practices is exceptionally momentous in the banking industry given the role played by banks in the economy and the functions performed, which are central to financial market development and economic growth. The importance of corporate governance in the banking sector is also related to the fact that weak corporate governance and poor management and oversight can lead to bank failures and heighten systemic risk, potentially destroying savings and necessitating costly bailouts by governments. Thus, well-established laws and regulations for proper corporate governance framework at banks and the strong commitment of bank shareholders and management to the implementation of the best practices are essential. This chapter also addresses the Basel III accord, a set of reform measures developed by the Basel Committee on Banking Supervision in the wake of the financial crisis to strengthen the regulation, supervision and risk management of the banking sector, and its ensuing challenges. The aim of the accord is to improve the banking sector's ability to absorb shocks. The reforms are partly bank-level—or micro-prudential—and partly system-level—or macro-prudential. These two approaches to supervision are complementary, as greater regulation and supervision at the bank level tend to reduce systemic risk. The discussion of the Basel III accord thus analyzes the many challenges that the new accord will present to banks. These relate largely to raising more capital, improving the quality of capital, and meeting the liquidity capital requirements of coverage ratio and liquidity requirement tools. At a time when many banks worldwide are still trying to meet the Basel II capital adequacy requirements, banks are asked to address the composition and quality of capital, as well as creating buffer capital zones to address pro-cyclicality. Specifically, it is very challenging for banks that are not operating as public ones to raise the share of common stock in their tier one capital and apply the stricter definition of this equity. In addition, it is difficult to create a capital conservation buffer of common equity to withstand future periods of stress. Such requirements are believed to influence the way banks do business in most countries, especially if Basel III has effects on financial markets and on monetary policy implementation.

The third part of this book addresses issues of monetary policy arrangements, looking at changes that are occurring in the practice of this policy in the current century. The environment and conduct of monetary policy have drastically changed in the last fifteen years, with the establishment of monetary unions without fiscal unions and the adoption of unconventional policies of quantitative easing aimed at combating the financial crisis. This book analyzes these two new developments in the financial environment and conduct of monetary policy and their impact on its administration and its strategy in two chapters. Chapter 7 addresses quantitative easing by the US and the UK in the immediate aftermath of the financial crisis with the aim of addressing the recessionary and deflationary impacts of the crisis in order to restore economic growth and price stability. This involves an analysis of the new unconventional monetary policy, including its background and description; its strategy of instruments–targets–goals; its channels of transmission mechanisms; the experiences of the US and the UK (the first two countries to adopt it after the crisis); the assessment of its success based on empirical support and evidence; and, finally, various exit strategies from quantitative easing on the road to policy normalization. The analysis also addresses the nature of monetary policy when short-term interest rates are zero-bound, using a money demand and velocity framework.

Chapter 8 deals first with the rise of European Monetary Union (EMU) and a European Central Bank (ECB), which shape the conduct of monetary policy for the nineteen countries currently forming the euro area with a common euro currency. This monetary union was not coupled with a fiscal union, making the ECB operate in an environment in which it faces many fiscal authorities rather than one, which was the traditional form of monetary policy until 2000. This monetary union operates in a euro area in which countries are sometimes divided between two tiers on the basis of widely divergent unemployment and growth rates. Inflation rates are calculated based on a harmonized index of consumer prices (HICP), aiming at an average for the nineteen countries below but close to 2 percent to achieve the price stability objective as per the Maastricht treaty. The differences in the macroeconomic indicators cause the common monetary arrangements to be loose for some countries and tight for others, making policy interest rates relatively too low for one group and too high for the other. Differences in economic fundamentals cause the euro sometimes to be overvalued for some countries and undervalued for others, impacting trade activities within the euro area and with the rest of the world. Additionally, the lack of a fiscal union or some type of disciplined fiscal integration has been perceived by many to leave member countries with fiscal imbalances prone to inflows of shocks and crisis, causing declines in aggregate demand with contagious systemic dangers across the euro-zone. These salient features require different monetary policy arrangements than the ones practiced by central banks facing one fiscal authority, given that the aim is to achieve the price stability objective and a macroeconomic environment characterized by high output and employment growth across various members. The twenty-first century also witnessed a major financial crisis that has shaped the international financial architecture. This crisis caused many central banks across the world to hold additional reserves for both precautionary reasons, reflected in their responses to various market shocks and attempts to prevent of disorderly market conditions, and non-precautionary reasons, to protect fixed pegged exchange rate arrangements and provide international liquid assets. However, when inappropriate amounts of reserves are accumulated there is believed to be a social cost, and a literature dealing with reserve adequacy, or the determination of the optimal amount of reserves to be held by central banks, is developing. This chapter thus aims at covering two main topics: first, it deals with monetary policy arrangements in monetary unions without fiscal unions by using the EMU as a case study; second, it examines the social cost of reserve accumulation using a set of countries from the Middle East and North Africa region (MENA).

Readership and competition

The readership we expect to reach includes academic scholars, central bankers and other regulators, bankers and other practitioners and professionals, upper-level undergraduates and graduate students. We strongly feel that no book to date has addressed these three facets of change in the regulatory financial environment of banks and central bank policies in the way that we have approached the subject matter. There exists a wide literature, of course, on the financial crisis and its impact on economic activity. There is another, as well, on combating economic and financial crimes using various regulatory measures. Monetary unions in the absence of fiscal unions as well as central bank policies of quantitative easing have also been covered extensively. However, using a regulatory approach to address and examine banks and central banks in a changing financial environment incorporating the three changes discussed earlier has not been attempted, and the choice of topics and the way we approach and analyze them using theory, policy, regulation, country-specific cases, empirical evidence from selected countries and central bank developments after the financial crisis have not been so far addressed in an integrated document.

Part 1
Banking regulation to combat the rise in financial and economic crimes

2 The changing regulatory environment governing financial and economic crimes

Introduction

Hegel's dialectic, consisting of a thesis, an antithesis, and a synthesis, best describes the dynamics among financial and economic criminals, on the one hand, and domestic and international regulators, organizations, and conventions on the other. While regulators are satisfied with enforcing and improving existing laws and regulations constituting the "thesis." financial and economic criminals develop new modes of crime for the purpose of—simply stated—profits and gains. These new criminal modes and techniques become the "antithesis." The new laws and regulat...

Table of contents

• Cover
• Title
• Copyright
• Dedication
• Contents
• List of illustrations
• Acknowledgments
• 1 Introduction
• PART 1 Banking regulation to combat the rise in financial and economic crimes
• PART 2 New policies in the wake of the latest financial crisis
• PART 3 Central banks in the new era of quantitative easing, monetary unions without fiscal unions, and the holding of foreign reserves
• Author index
• Subject index