CU-MBA-SEM-IV-International Banking and Forex Second draft

10.12 KEYWORDS  Net Exchange Position – An imbalance between all the assets and purchases of a currency, and all the liabilities and sales of that currency.  Net Position – A bank has a position in a foreign currency when its assets, including future contracts to sell, in that currency are not equal. An excess of assets over liabilities is called a net long position and liabilities in excess of assets result in a net short position. A long net position in a currency that is depreciating results in a loss because, with each day, that position (asset) is convertible into fewer units of local currency. A short position in a currency that is appreciating represents a loss because, with each day, satisfaction of that position (liability) costs more units of local currency.  Netting Arrangement – Arrangement by two counterparties to examine all contracts settling in the same currency on the same day and to agree to exchange only the net currency amounts. Also applies to the net market values of several contracts.  Open Market Operations – Purchases or sales of securities or other assets by a central bank on the open market.  Open Position Limit – A limit placed on the size of the open position in each currency to manage off-balance sheet items. 10.13 LEARNING ACTIVITY 1. Create a survey on Euro Deposits. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on Floating Rate Instruments. ___________________________________________________________________________ ___________________________________________________________________________ 10.14 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write the full form of Repos? 2. Write the full form of GDRs? 3. Write the full form of ADRs? 201 CU IDOL SELF LEARNING MATERIAL (SLM)

4. What are Floating Rate Instruments? 5. What are Euro Deposits? Long Questions 1. Explain the concept of GDRs. 2. Explain the concept of ADRs. 3. Examine the concept of IDRs. 4. Illustrate the concept of Euro Bonds. 5. Illustrate the concept of Derivatives. B. Multiple Choice Questions 1. What is the price of a futures contract at the expiration date of the contract? a. Equals the price of the underlying asset b. Equals the price of the counterparty c. Equals the hedge position d. Equals the value of the hedged asset 2. What is the elimination of riskless profit opportunities in the futures market? a. Hedging b. Arbitrage c. Speculation d. Underwriting 3. What is your profit if you purchase a $100,000 interest-rate futures contract for 110, and the price of the Treasury securities on the expiration date is 106? a. Your profit is $4000. b. Your loss is $4000. c. Your profit is $6000 d. Your loss is $6000. 4. What is the outcome if you purchase a $100,000 interest-rate futures contract for 105, and the price of the Treasury securities on the expiration date is 108? a. Your profit is $3000 b. Your loss is $3000. c. Your profit is $8000 d. Your loss is $8000. 202 CU IDOL SELF LEARNING MATERIAL (SLM)

5. What happens ff you sold a short future contract you will hope that interest rates? a. Rise b. Fall c. Are stable. d. Fluctuate Answers 1-a, 2-b, 3-b, 4-a, 5-a 10.15 REFERENCES References book  Agarwal, R. N. (2000). Financial Integration and Capital Markets in Developing Countries:  A study of Growth, Volatility and Efficiency in the Indian Capital Market. Discussion paper no:21, Institute of Economic Growth, New Delhi.  Allen, F. & Gale, D. (1999). Diversity of Opinion and Financing of New Technologies. Journal of Financial Intermediation, BONY (2000). DR Market Statistics. Textbook references  Foerster S.R. & Karolyi G.A. (1993). International Listings of Stocks: The Case of Canada and the U.S. Journal of International Business Studies.  Gande, A. (1999). Raising International Capital Through ADRs: Evidence from Emerging Markets, Owen Graduate School of Management, Nashville, TN.  IFC (2000). Emerging Stock Markets Factbook 2000, New York: Standard & Poors. Website  https://www.europarl.europa.eu/document/activities/cont/201103/20110317ATT1573 4/20110317ATT15734EN.pdf  https://www.investopedia.com/terms/e/eurodeposit.asp  https://www.investopedia.com/terms/f/floating-rate-fund.asp 203 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 11 – INTERNATIONAL BANKING LAW AND REGULATION STRUCTURE 11.0 Learning Objectives 11.1 Introduction 11.2 Principles of International Banking Regulation 11.2.1 International Business Law 11.2.2 Banking and Finance Law 11.3 Prudent Regulation of Banks 11.4 Summary 11.5 Keywords 11.6 Learning Activity 11.7 Unit End Questions 11.8 References 11.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Illustrate the concept of Principles of International Banking Regulation.  Explain the International Business Law.  Illustrate the concept of Banking and Finance Law. 11.1 INTRODUCTION Bank regulation is a form of government regulation which subjects banks to certain requirements, restrictions and guidelines, designed to create market transparency between banking institutions and the individuals and corporations with whom they conduct business, among other things. As regulation focusing on key factors in the financial markets, it forms one of the three components of financial law, the other two being case law and self-regulating market practices. Given the interconnectedness of the banking industry and the reliance that the national economy holds on banks, it is important for regulatory agencies to maintain control over the standardized practices of these institutions. Another relevant example for the interconnectedness is that the law of financial industries or financial law focuses on the 204 CU IDOL SELF LEARNING MATERIAL (SLM)

financial (banking), capital, and insurance markets. Supporters of such regulation often base their arguments on the \"too big to fail\" notion. This holds that many financial institutions hold too much control over the economy to fail without enormous consequences. This is the premise for government bailouts, in which government financial assistance is provided to banks or other financial institutions who appear to be on the brink of collapse. The belief is that without this aid, the crippled banks would not only become bankrupt, but would create rippling effects throughout the economy leading to systemic failure. Compliance with bank regulations is verified by personnel known as bank examiners. The first component, licensing, sets certain requirements for starting a new bank. Licensing provides the license holders the right to own and to operate a bank. The licensing process is specific to the regulatory environment of the country and/or the state where the bank is located. Licensing involves an evaluation of the entity's intent and the ability to meet the regulatory guidelines governing the bank's operations, financial soundness, and managerial actions. The regulator supervises licensed banks for compliance with the requirements and responds to breaches of the requirements by obtaining undertakings, giving directions, imposing penalties or (ultimately) revoking the bank's license. The second component, supervision, is an extension of the license-granting process and consists of supervision of the bank's activities by a government regulatory body (usually the central bank or another independent governmental agency). Supervision ensures that the functioning of the bank complies with the regulatory guidelines and monitors for possible deviations from regulatory standards. Supervisory activities involve on-site inspection of the bank's records, operations and processes or evaluation of the reports submitted by the bank. Examples of bank supervisory bodies include the Federal Reserve System and the Federal Deposit Insurance Corporation in the United States, the Financial Conduct Authority and Prudential Regulation Authority in the United Kingdom, the Federal Financial Markets Service in the Russian Federation. Among the most important regulations that are placed on banking institutions is the requirement for disclosure of the bank's finances. Particularly for banks that trade on the public market, in the US for example the Securities and Exchange Commission (SEC) requires management to prepare annual financial statements according to a financial reporting standard, have them audited, and to register or publish them. Often, these banks are even required to prepare more frequent financial disclosures, such as Quarterly Disclosure Statements. The Sarbanes–Oxley Act of 2002 outlines in detail the exact structure of the reports that the SEC requires. In addition to preparing these statements, the SEC also stipulates that director of the bank must attest to the accuracy of such financial disclosures. Thus, included in their annual reports must be a report of management on the company's internal control over financial reporting. The internal control report must include: a statement of management's responsibility for establishing and maintaining adequate internal control over financial 205 CU IDOL SELF LEARNING MATERIAL (SLM)

reporting for the company; management's assessment of the effectiveness of the company's internal control over financial reporting as of the end of the company's most recent fiscal year; a statement identifying the framework used by management to evaluate the effectiveness of the company's internal control over financial reporting; and a statement that the registered public accounting firm that audited the company's financial statements included in the annual report has issued an attestation report on management's assessment of the company's internal control over financial reporting. Under the new rules, a company is required to file the registered public accounting firm's attestation report as part of the annual report. Furthermore, the SEC added a requirement that management evaluate any change in the company's internal control over financial reporting that occurred during a fiscal quarter that has materially affected, or is reasonably likely to materially affect, the company's internal control over financial reporting. Banks may be required to obtain and maintain a current credit rating from an approved credit rating agency, and to disclose it to investors and prospective investors. Also, banks may be required to maintain a minimum credit rating. These ratings are designed to provide colour for prospective clients or investors regarding the relative risk that one assumes when engaging in business with the bank. The ratings reflect the tendencies of the bank to take on high risk endeavours, in addition to the likelihood of succeeding in such deals or initiatives. The rating agencies that banks are most strictly governed by, referred to as the \"Big Three\" are the Fitch Group, Standard and Poor's and Moody's. These agencies hold the most influence over how banks are viewed by those engaged in the public market. In recent years, following the Great Recession, many economists have argued that these agencies face a serious conflict of interest in their core business model. Clients pay these agencies to rate their company based on their relative riskiness in the market. The question then is, to whom is the agency providing its service: the company or the market? European financial economics experts – notably the World Pensions Council (WPC) have argued that European powers such as France and Germany pushed dogmatically and naively for the adoption of the \"Basel II recommendations\", adopted in 2005, transposed in European Union law through the Capital Requirements Directive (CRD). In essence, they forced European banks, and, more importantly, the European Central Bank itself, to rely more than ever on the standardized assessments of \"credit risk\" marketed aggressively by two US credit rating agencies – Moody's and S&P, thus using public policy and ultimately taxpayers' money to strengthen anti-competitive duopolistic practices akin to exclusive dealing. Ironically, European governments have abdicated most of their regulatory authority in favour of a non-European, highly deregulated, private cartel. In the US in response to the Great depression of the 1930s, President Franklin D. Roosevelt's under the New Deal enacted the Securities Act of 1933 and the Glass–Steagall Act (GSA), setting up a pervasive regulatory scheme for the public offering of securities and generally prohibiting commercial banks from underwriting and dealing in those securities. GSA 206 CU IDOL SELF LEARNING MATERIAL (SLM)

prohibited affiliations between banks (which means bank-chartered depository institutions, that is, financial institutions that hold federally insured consumer deposits) and securities firms (which are commonly referred to as “investment banks” even though they are not technically banks and do not hold federally insured consumer deposits); further restrictions on bank affiliations with non-banking firms were enacted in Bank Holding Company Act of 1956 (BHCA) and its subsequent amendments, eliminating the possibility that companies owning banks would be permitted to take ownership or controlling interest in insurance companies, manufacturing companies, real estate companies, securities firms, or any other non-banking company. As a result, distinct regulatory systems developed in the United States for regulating banks, on the one hand, and securities firms on the other. 11.2 PRINCIPLES OF INTERNATIONAL BANKING REGULATION The module will provide students with in-depth knowledge and critical analysis of the legal and regulatory principles and the soft law standards applicable to international banking activities. It also investigates banking supervisory architecture in the UK, the EU, and at international level. The regulatory framework analysed covers the entire life cycle of a bank from its inception to failure. It also discusses banks' types and activities. By the end of the module, you will be equipped with adequate knowledge and critical understanding of both the special nature of banking activities and of the applicable regulatory and supervisory framework. 11.2.1 International Business Law As businesses increasingly cross borders, the practice of law must equally develop and change. If you intend to pursue and develop a career in business law, it is vital to understand the complexities of transnational business interactions. The International Business Law LLM will prepare you for a career in global business.  Gain knowledge of regulation affecting business in different jurisdictions  Choose from a wide range of modules to tailor your LLM to your planned career path  Your fellow students will come from the UK and more than 80 other countries, each able to draw on prior academic and professional experience from different jurisdictions  Take part in a wide range of academic, networking and social events 11.2.2 Banking and Finance Law The Banking and Finance Law LLM provides a thorough grounding in the fundamental principles of international finance and financial services law, covering local and international developments from both practical and policy perspectives. From financial regulation, 207 CU IDOL SELF LEARNING MATERIAL (SLM)

corporate finance, and mergers and acquisitions, to online banking and fintech, you can choose from a wide selection of modules.  Cover a wide range of regulatory and transactional areas, including monetary law, banking law, financial regulation, central banking and securities law  Study with academics who are engaged in current banking and finance policy making and legal regulatory reforms  Undertake modules developed in the light of recent new regulations, such as ‘Ethics in Business and in Finance’  Attend our seminar series, featuring prominent figures from both industry and academia  Your fellow students will come from the UK and more than 80 other countries, each able to draw on prior academic and professional experience from different jurisdictions 11.3 PRUDENT REGULATION OF BANKS In the aftermath of the financial crisis of 2007-2009, a number of “narratives” about the causes of the crisis have developed. One specific narrative will be the topic of this chapter: That causes of the crisis have developed. One specific narrative will be the topic of this chapter: That a major (if not the major) cause of the crisis was poor corporate governance of the largest banks and other large financial institutions of the United States. This poor governance encouraged the senior managements of these institutions to undertake excessively risky strategies that may have benefitted these managements but that were not in the long-run interests of the shareholder owners of these institutions. The strategies caused these institutions to “blow up”, and the financial crisis followed. An immediate implication of this narrative is that better corporate governance – a better alignment of the interests of senior management with the interests of their shareholders – would have prevented the crisis, and that better governance is necessary for the prevention of future such crises. One manifestation of this belief is the inclusion of measures that are intended to improve corporate governance – especially for financial institutions – in the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010. This chapter will argue that this corporate governance narrative is largely misguided and reflects an inadequate understanding of modern finance and financial theory.1 This lacuna applies to the understanding of the role of debt and therefore leverage in a corporation’s capital structure in potentially encouraging the owners of the corporation to undertake more risky strategies than they would in the absence of the debt. If senior managements of more risky strategies than they would in the absence of the debt. If senior managements of corporations are properly representing and responding to the interests of their shareholders, then they ought – unless restrained by the debt holders or by prudential regulators – to be undertaking activities that might otherwise appear to be excessively risky. 208 CU IDOL SELF LEARNING MATERIAL (SLM)

Accordingly, even if corporate governance is improved in the future, this improvement is unlikely to play a major role in restraining risk-taking and thus avoiding future financial crises. Instead, future avoidance must rely on a different narrative: That excessive risk-taking combined with excessive leverage (i.e., inadequate capital) by large, complex, and interconnected financial institutions that were inadequately restrained by prudential regulation was the cause of the crisis. In turn, this calls for forestalling future financial crises the “old-fashioned” way: through heightened, expanded, and improved prudential regulation of these financial institutions, with a special emphasis on higher and better-measured capital requirements.2 This chapter will proceed as follows: Because the concept of leverage is central to this chapter – for understanding the motives of corporate owners for excessive risk- taking and thus why poor corporate governance isn’t needed to explain the risky behaviour and also why prudential regulation is appropriate for these large financial institutions – Section II will review the concept and its implications, as well illustrating the closely related concept of “capital” for financial institutions. Section III will bring diversified owners, and then managers and corporate governance, into the discussion. Section IV will provide a brief overview of prudential Although this chapter is primarily about financial institutions and their regulation, we will start somewhere else:3 a stylized balance sheet for a roughly typical manufacturing will start somewhere else:3 a stylized balance sheet for a roughly typical manufacturing corporation of the middle of the decade of the 2000s,4 as portrayed. That firm has assets of $100, consisting of plant, equipment, inventories, accounts receivable, cash on hand, etc. Its direct obligations to creditors are $60, consisting of loans owed to banks, any bonds owed to bond investors, accounts payable, etc. By simple subtraction, its net worth or owners’ equity – the value of its assets minus the value of its direct obligations – is $40. This firm has a leverage ratio – its ratio of assets to net worth – of 2½ to 1. The sense of the leverage ratio: If the firm’s assets increase by $10 say, because it makes and retains operating profits of $10, or its assets simply appreciate by $10 – without an increase in its direct obligations, then its net worth also increases by $10 (to $50). Thus a 10% increase in the value of its assets results in a 25% increase in its net worth; this is a notion of “leverage” that is comparable to the high school physics example of a plank and a fulcrum.5 Leverage also works in reverse, as in A 10% decrease in the value of the firm's assets results in a 25% decrease in the value of its net worth. These simple examples portray an important point: Leverage and the amount of net worth are inversely related to each other. Further, the relative amount of net worth is important for the lenders/creditors to the corporation because of the strictures of the legal system of “limited liability” for the shareholder-owners: If the company’s assets were to fall below $60 and thus be company’s assets were to fall below $60 and thus be inadequate to cover the claims of the company’s creditors, those creditors normally have no claim against the owners. The creditors will simply have to divide the assets among themselves to satisfy their claims, usually in a bankruptcy proceeding. 209 CU IDOL SELF LEARNING MATERIAL (SLM)

There is an important corollary, from the perspective of the owners of the borrowing corporation: Limited liability means that they may not bear the full losses from the “downside” of their corporation’s risk-taking, if the losses are so large as to more than wipe out the corporation’s net worth. In turn, this limited downside alters the owners’ incentives for taking risks: The more that the owners do not bear the downside losses, the greater are their incentives for taking risks, since they get the full gains from the upside but are limited in the losses that they bear.7 Since net worth is also owners’ equity, the extent of net worth is also a measure of the disincentive for the owners to take large risks, since a larger net worth means that the owners have more to lose and are farther away from the limit on their losses that limited liability provides. Accordingly, from the creditors’ perspective, the level of a company’s net worth represents the extent of the buffer that protects them against a decrease in the value of the company’s assets that would expose them to a loss, as well as an indicator of the owners’ disincentive for risk taking. The thicker the buffer, the more assured the creditors should feel. Creditors to non-financial corporations long ago figured this out: Typically, when a bank makes a loan to a company, there are restrictions in the lending agreement that are intended to prevent the company from taking excessively risky actions, the downside of which would erode the company’s net worth and thus place the lending bank at risk; and, as the company’s net worth buffer becomes thinner, the bank’s restrictions get tighter. The same basic ideas apply to a commercial bank or thrift institution: Figure 2a provides the stylized balance sheet of a well-capitalized bank or thrift. Its $100 of assets are primarily the stylized balance sheet of a well-capitalized bank or thrift. Its $100 of assets are primarily the loans that it makes and the bonds that it owns. Its direct obligations of $92 are primarily its deposits.9 And, again, by simple subtraction, it has $8 of net worth or owners’ equity. For financial institutions, this net worth is also called “capital”. Note that “capital” is not “money”, or “cash”, or “liquidity”. It is net worth.10 Although a bank can increase its “capital” by getting a “cash injection” from investors, the increase in capital occurs because the additional cash adds to the assets of the bank and therefore to its net worth. If the bank lends or invests the cash, its capital is still augmented by the investors’ infusion. By contrast, a loan of an equivalent amount of cash to the bank would not increase its capital. Note that this bank has a substantially thinner net worth buffer than does the manufacturing firm.11 Equivalently, it is much more leveraged: 12½ to 1. This is illustrated in Figure 2b: A 10% increase in the value of the bank's assets yields a 125% increase in the bank’s capital. Again, leverage also works in reverse, as in Figure 2c: A 10% decrease in the value of the bank’s assets more than wipes out its capital and renders it insolvent. The protections of limited liability apply to the shareholder-owners of banks and other depository institutions as well. 210 CU IDOL SELF LEARNING MATERIAL (SLM)

11.4 SUMMARY  Accordingly, the greater leverage of financial institutions provides enhanced incentives for their owners to take risks at the potential expense of their depositor creditors. enhanced incentives for their owners to take risks at the potential expense of their depositor creditors. Unlike the lender-creditors to non-financial corporations, however, the depositor creditors to depositories generally do not directly place restrictions on the risk-taking of the banks to which they have entrusted their deposits. Instead, government regulators are the entities that impose these restrictions.  In an important sense, prudential regulation of depository institutions by government can be considered to be the public-sector counterpart to the restrictions and covenants that private-sector lender-creditors impose when lending to non-financial corporations. The balance sheets – and leverage – of two other categories of financial institution are worth considering. the balance sheet of the two “government sponsored enterprises” (GSEs): Fannie Mae and Freddie Mac. As can be seen, their on-balance sheet ratio of capital to assets was only 4%; equivalently, their leverage was 25-to-1.  This unbalance- sheet portrayal, however, neglects an important additional facet of the GSEs’ operations: their issuance of the equivalent of an additional $200 of residential mortgage-backed securities (RMBS). These securities carried the GSEs’ guarantees to the RMBS investors that, in the event that the underlying mortgage borrowers defaulted on their obligations, the GSEs would keep the investors whole. If those contingent obligations are included, their leverage was effectively 75-to-1. Finally, it portrays a highly leveraged investment bank. Its $100 in assets are its investments in bonds, loans, shares of stock, real estate, and just about any other asset -- real  One impediment to greater risk taking might be risk aversion on the part of the owners. Suppose that, in the example at the end of Section II of the +$5/-$5 Suppose that, in the example at the end of Section II of the +$5/-$5 opportunity that was posed for the owners of the investment bank of Figure 4, all of the owners’ net worth’s were solely invested in the equity of that institution. In that case, even though limited liability creates a positive expected value of the opportunity for the owners, they might nevertheless be reluctant to embrace it, since it would carry a 50% probability of wiping out their net worth’s. 11.5 KEYWORDS  Override Limit – The total amount of money measured in terms of a bank’s domestic currency that the bank is willing to commit to all foreign exchange net positions. 211 CU IDOL SELF LEARNING MATERIAL (SLM)

 Parallel Banking Organizations – A PBO exists when a U.S. depository institution and a foreign bank are controlled, either directly or indirectly, by an individual, family, or group of persons with close business dealings, or that are otherwise acting in concert.  Parity – A term derived from par, meaning the equivalent price for a certain currency or security relative to another currency or security, or relative to another market for the currency or security after making adjustments for exchange rates, loss of interest, and other factors.  Parity Grid – The system of fixed bilateral par values in the European Monetary System. The central banks of the countries whose currencies are involved in an exchange rate are supposed to intervene in the foreign exchange market to maintain market rates within a set range defined by an upper and lower band around the par value.  Par Value – The official parity value of a currency relative to the dollar, gold, special drawing rights, or another currency. 11.6 LEARNING ACTIVITY 1. Create a survey on Banking and Finance Law. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on International Business Law. ___________________________________________________________________________ ___________________________________________________________________________ 11.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What is Law? 2. What is Regulation? 3. Define Finance Law? 4. Define Business Law? 5. Write the main aim of bank? Long Questions 212 CU IDOL SELF LEARNING MATERIAL (SLM)

1. Explain the concept of Principles of International Banking Regulation. 2. Explain the concept of International Banking Law and Regulation. 3. Examine the concept of International Business Law. 4. Illustrate the concept of Banking and Finance Law. 5. Illustrate the concept of Prudent Regulation of Banks. B. Multiple Choice Questions 1. Identify the right option from the following statement - Today 1 euro can be purchased for $1.10? a. Spot exchange rate. b. Forward exchange rate c. Fixed exchange rate. d. Money exchange rate. 2. What is the price in an agreement to exchange dollars for euros in three months at a price of $0.90 per euro? a. Spot exchange rate. b. Money exchange rate. c. Forward exchange rate. d. Monthly exchange rate 3. What occurs when the value of the British pound changes from $1.25 to $1.50? a. The pound has appreciated and the dollar has appreciated b. The pound has depreciated and the dollar has appreciated c. The pound has appreciated and the dollar has depreciated d. The pound has depreciated and the dollar has depreciated. 4. When the value of the British pound changes from $1.50 to $1.25, then________. a. The pound has appreciated and the dollar has appreciated. b. The pound has depreciated and the dollar has appreciated. c. The pound has appreciated and the dollar has depreciated. d. The pound has depreciated and the dollar has depreciated. 5. What occurs when the value of the dollar changes from 0.5 pounds to 0.75 pounds? a. The pound has appreciated and the dollar has appreciated. 213 CU IDOL SELF LEARNING MATERIAL (SLM)

b. The pound has depreciated and the dollar has appreciated. c. The pound has appreciated and the dollar has depreciated d. The pound has depreciated and the dollar has depreciated Answers 1-a, 2-c, 3-c, 4-b, 5-b 11.8 REFERENCES References book  IMF (1996). International Monetary Fund, Balance of Payments Statistics Yearbook, IMF, Washington, DC.  Kulikov, D. G. (2000). American Depository Receipts as a Way for Russian Companies to Enter the U.S. Capital Market. Available on internet (12.12.2000): http://www.lawfirm.ru/text/art/1-6.shtml. Retrieved from URL  Lucas, D. J. & McDonald, R. (1990). Equity Issues and Stock Price Dynamics. Journal of Finance. Textbook references  Mullin, J. (1993). Emerging Equity Markets in the Global Economy. Quarterly Review (from Federal Reserve Bank of New York), June.  Pagano, M., Roell, A. A., & Zechner, J. (2002). The Geography of Equity Listing: Why Do Companies List Abroad? Journal of Finance, Forthcoming December 2002.  Patil, R. H. (1994). Capital Market Developments. The Journal of the Indian Institute of Bankers, July-September. Website  https://en.wikipedia.org/wiki/Bank_regulation  https://r.search.yahoo.com/_ylt=Awr469zlYw5h4jYA0VFXNyoA;_ylu=Y29sbwNnc TEEcG9zAzMEdnRpZANEMTA0NV8xBHNlYwNzcg  https://en.wikipedia.org/wiki/Market- based_environmental_policy_instruments#References 214 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 12 – INTERNATIONAL BANKING LAW AND REGULATION STRUCTURE 12.0 Learning Objectives 12.1 Introduction 12.2 2007-2009 Financial Crisis 12.2.1 What Happened and When 12.2.2 Cause and Effect: The Causes of the Crisis and Its Real Effects 12.2.3 Was This a Liquidity Crisis or an Insolvency/Counterparty Risk Crisis? 12.2.4 The Real Effects of the Crisis 12.2.5 The Policy Responses to the Crisis 12.3 Next Generation of International Standards of Financial Institution Regulation (Basel Accords) 12.4 Summary 12.5 Keywords 12.6 Learning Activity 12.7 Unit End Questions 12.8 References 12.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Examine the concept of Financial Crisis  Illustrate the concept of Next Generation of International Standards of Financial Institution Regulation  Explain the concept of The Real Effects of the Crisis 12.1 INTRODUCTION The period between 1980 and 1994 saw more legislative and regulatory change affecting the financial services industry than any other since the 1930s. This is hardly surprising, for the legislative and regulatory landscape was inextricably bound up with the profound transformation that took place within the industry. The structure of banking legislation and 215 CU IDOL SELF LEARNING MATERIAL (SLM)

regulation might be compared to a stratified but active geologic formation: clearly identifiable separate levels are present, but these come into contact at various points, and sometimes collide. At the legislative level, Congress passed five major laws between 1980 and 1991, and significant bills were considered, if not passed, in nearly every session.1 Regulatory change during the period was equally extensive, much of it stemming from these new laws. But because the federal banking agencies have authority to protect the safety and soundness of the banking system, 2 they often proposed and implemented new regulations under authority granted by earlier statutes. In addition, the existence of the dual banking system gave state legislatures and state banking authorities a significant role in the regulation of state-chartered institutions and they played this role frequently. The constant interaction among all of these legislative and regulatory bodies was made even more complex by their occasional differences in viewpoint and by the often-fragmented voice of a banking industry in which competing needs shaped conflicting responses to regulatory proposals. With such a multiplicity of actors, it would be overly simplistic to identify the period 198094 with a single trend in policy. The early 1980s, after at least a decade of debate about restructuring the financial services industry, was dominated by movement toward deregulation: both DIDMCA and Garn St. Germain readily fall under that heading. Moreover, proponents of continued deregulation did not see 1982 as the end of that process, and continued to press for congressional action; their main objectives were to repeal Glass Steagall and expand the powers of banks. Nevertheless, in Congress the momentum of deregulation slowed markedly, and certainly by 198991 the environment had become far more favourable to stringent bank regulation. By 1994, however, with the thrift and banking crises in the past, the climate in Congress and the industry was again conducive to at least some deregulation. After 1982, none of the bills introduced in the 1980s to extend deregulation became law, and the main objectives of CEBA, passed in 1987, were to clean up various problems in the banking and thrift industries. As originally written, CEBA would have granted banks additional powers in securities, insurance, and real estate, but in its final form it created a comprehensive albeit temporary moratorium on federal regulators’ ability to grant those powers. The attempt to legislate expanded bank powers continued, but FIRREA, passed in 1989 and described as supervisory reregulation, concentrated on reforming the thrift industry and providing regulators with greater enforcement powers.3 In 1991 FDICIA, like CEBA four years before, began as an ambitious attempt to repeal Glass-Steagall, expand bank powers, and restructure the banking industry but, again, ended much more narrowly, recapitalizing the Bank Insurance Fund and providing for banks what FIRREA had provided for thrifts: more supervisory regulation and oversight. So, in Congress, although deregulation remained an undercurrent, the laws actually passed during the latter part of the period were aimed at recapitalizing the depleted deposit insurance funds and equipping regulators with a stronger and, indeed, less flexible hand in supervising depository institutions. National legislative developments, however, form only part of the story. A great deal of regulatory activity took place within the federal banking agencies, although often congressional and 216 CU IDOL SELF LEARNING MATERIAL (SLM)

agency strands would meet. For example, frequently the agencies asked Congress for legislative action, particularly with regard to supervision, enforcement, and dealing with failed and failing institutions. At the same time, the agencies were responsible for drafting regulations to implement statutory changes, and the agencies ‘interpretations of congressional intent were significant. The agencies also had the authority under previous laws to make new regulations that required no additional action from legislators. An important example of such authority, and one that had implications for the banking crises of the 1980s, was the Office of the Comptroller of the Currency’s (OCC) procompetitive policy for chartering new banks, inaugurated in 1980 partly at congressional urging. As was the case in Congress, deregulation and the reaction against it were crucial components of the regulators’ policies. In general, all of the federal banking agencies endorsed deregulation, although they often differed as to its extent and the manner of accomplishing it. Of the three federal agencies, the OCC was generally the first to push for deregulation and did so most actively; both the Federal Reserve Board (FRB) and the FDIC were less sanguine about some proposals. Still, by the mid-1980s, regulators at all three agencies were increasingly allowing banks to enter new product areas. 4 At the same time, however, deregulation hardly meant an end to new regulation. Instead, it became one of the most important forces behind stricter regulatory developments in the 1980s and early 1990s. One of the most significant and comprehensive of these was the imposition of more stringent capital requirements for banks: the regulators imposed mandatory capital to assets ratios in 198081, refined and made them more uniform in 198485, and then moved to a combination of risk-based and leverage capital ratios by 198892.5 After the implementation of prompt corrective action (PCA) under FDICIA, capital ratios became key regulatory measures of bank soundness. The definition and redefinition of capital standards was one of the most pervasive regulatory stories of the 1980s and early 1990s. The federal banking agencies also were active in responding to downturns in specific sections of the financial services industry. For example, when thrifts, including savings banks, were struggling with the interest-rate conditions of the early 1980s, the agencies adopted forbearance policies that would allow institutions to continue to operate even when failing to meet regulatory standards. The first formal use of forbearance in banking during the period was the Net worth Certificate Program implemented under Garn St Germain. The second was several years later, in 1986, when all three agencies responded to sectoral problems in agriculture and then energy by inaugurating capital forbearance programs for banks in the affected sectors.6 By the end of the 1980s the broad use of regulatory for bear and had been roundly condemned for contributing to the S&L crisis; its role in banking, however, had been much more limited. Nevertheless, by 1991 and the passage of FDICIA, law maker shaving previously urged such programs were now unwilling to allow the agencies to exercise discretion in keeping banks afloat. Another regulatory issue involved the use of brokered deposits. Again, even as deregulation was the watchword in the industry and in Congress, some of the regulators in the wake first of Penn Square’s failure and then of the failures of other banks and thrifts moved in 198385 to restrict the perceived risk that such deposits 217 CU IDOL SELF LEARNING MATERIAL (SLM)

created for the deposit insurance funds.7 Although the initial regulatory attempts were invalidated by the courts, this so-called hot money became one of the bêtes noises of those seeking causes for the thrift crisis. Eventually, both FIRREA and FDICIA placed limits on the use of brokered deposits by troubled institutions. Although after 1982 Congress failed to grant banks new powers, from the early 1980s state legislatures and state banking authorities were increasingly allowing their state-chartered banks to enter securities, insurance, and real estate activities not permitted by federal statutes.8 As has already been noted, regulatory decisions were also allowing banks into new areas. But although many of the new powers granted by the states were not thought to add significant dangers to the banking system, others notably in real estate investment and development were perceived as risky by the FDIC and the FRB, both of which proposed regulations in the middle to late 1980s to control them. The result was conflict not only among the agencies but also between the agencies, the states, and the industry. Neither of the proposed regulations was adopted, but this episode illustrates how the question of banking regulation could be played out beyond Congress. FDICIA and its requirements mark the legislative boundary to the banking crisis, although in 1993 Congress did pass legislation that at least partly was a residual reaction to the crisis: a national depositor preference law. This law established a uniform order for distributing the assets of failed insured depository institutions. Although designed as part of a deficit reduction plan, the law was also intended to reduce the FDIC’s losses from bank failures. By 1994 the banking crisis was clearly over, and Congress sought to pull back from what it now perceived as the imposition of overly onerous regulatory requirements on banks. The beginning of this trend was embodied in the Riegle Community Development and Regulatory Improvement Act of 1994. Also in 1994, Congress returned to the more structural industry issues that had become less critical during the immediate crisis. The Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994 addressed the longstanding question of geographic expansion within the banking industry, but other structural issues, such as the separation between banking and commerce, have not been resolved even yet (though at this writing, a financial modernization bill is again under consideration). If FDICIA can be viewed as the end of the immediate legislative response to the banking crisis, a law passed five years later, the Deposit Insurance Funds Act of 1996, provided for the capitalization of the Savings Association Insurance Fund (SAIF) and thereby effectively closed the chapter on the troubled period of the 1980s and early 1990s. 12.2 2007-2009 FINANCIAL CRISIS This review of the literature on the 2007–2009 crisis discusses the precrisis conditions, the crisis triggers, the crisis events, the real effects, and the policy responses to the crisis. The precrisis conditions contributed to the housing price bubble and the subsequent price decline that led to a counterparty-risk crisis in which liquidity shrank due to insolvency concerns. The policy responses were influenced both by the initial belief that it was a market-wide 218 CU IDOL SELF LEARNING MATERIAL (SLM)

liquidity crunch and the subsequent learning that insolvency risk was a major driver. I suggest directions for future research and possible regulatory changes. In its analysis of the crisis, my testimony before the Financial Crisis Inquiry Commission drew the distinction between triggers and vulnerabilities. The triggers of the crisis were the particular events or factors that touched off the events of 2007–2009—the proximate causes, if you will. Developments in the market for subprime mortgages were a prominent example of a trigger of the crisis. In contrast, the vulnerabilities were the structural, and more fundamental, weaknesses in the financial system and in regulation and supervision that served to propagate and amplify the initial shocks. Financial crises are a centuries-old phenomena, and there is a substantial literature on the subject. Despite this familiarity, the financial crisis of 2007–2009 came as a major shock that is widely regarded as the worst financial crisis since the Great Depression of the 1930s, and rightly so. The crisis threatened the global financial system with total collapse, led to the bailouts of many large uninsured financial institutions by their national governments, caused sharp declines in stock prices, followed by smaller and more expensive loans for corporate borrowers as banks pulled back on their long-term and short-term credit facilities, and caused a decline in consumer lending and lower investments in the real sector.2 For a detailed account of these events, see the excellent review by Brunner Meier. Atkinson, Luttrell, and Rosenblum estimate that the financial crisis cost the United States an estimated 40% to 90% of one year’s output, an estimated $6 to $14 trillion, the equivalent of $50,000 to $120,000 for every U.S. household. Even these staggering estimates may be conservative. The loss of total U.S. wealth from the crisis including human capital and the present value of future wage income is estimated in this paper to be as high as $15 to $30 trillion, or 100%–190% of 2007 U.S. output. The wide ranges in these estimates reflect uncertainty about how long it will take the output of the economy to return to noninflationary capacity levels of production. As lo points out, we do not have consensus on the causes of the crisis. This survey discusses the various contributing factors. I believe that a combination of global macroeconomic factors and U.S. monetary policy helped to create an environment in which financial institutions enjoyed a long period of sustained profitability and growth, which elevated perceptions of their skills in risk management, possibly increased bullishness in a non- Bayesian manner, and encouraged financial innovation. The financial innovation was driven by advances in information technology that helped make all sorts of securities marketable, spurred the growth of the subprime mortgage market, and made banking more intertwined with markets. These innovative securities led to higher risks in the industry and eventually these risks led to higher-than-expected defaults, causing the securities to fall out of favour with investors, precipitating a crisis. The early signs of the crisis came in the form of withdrawals by 219 CU IDOL SELF LEARNING MATERIAL (SLM)

investors/depositors and sharp increases in risk premia and collateral requirements against secured borrowing. These developments were interpreted by U.S. regulators and the government as indications of a market-wide liquidity crisis, so most of the initial regulatory and government initiatives to stanch the crisis took the form of expanded liquidity facilities for a variety of institutions and ex post extension of insurance for investors. As the crisis continued despite these measures, there was growing recognition that the root cause of the liquidity stresses seemed to be counterparty risk and institution-specific insolvency concerns linked to the downward revisions in the assessments of the credit qualities of subprime mortgages and many asset-backed securities. This then led to additional regulatory initiatives targeted at coping with counterparty risk. It is argued that some of the government initiatives despite their temporary nature and their effectiveness have created the expectation of future ad hoc expansions of the safety net to uninsured sectors of the economy, possibly creating various sorts of moral hazard going forward. This crisis is thus a story of prior regulatory beliefs about underlying causes of the crisis being heavily influenced by historical experience, followed by learning that altered these beliefs, and the resulting innovations in regulatory responses whose wisdom is likely to be the subject of ongoing debate and research. All of these policy interventions were ex post measures to deal with a series of unexpected events. But what about the ex-ante regulatory initiatives that could have made this crisis less likely? The discussion of the causal events in Section 2 sheds light on what could have occurred before 2006, but a more extensive discussion of how regulation can enhance banking stability appears in Thakore. In a nutshell, it appears that what we witnessed was a massive failure of societal risk management, and it occurred because a sustained period of profitable growth in banking created a false sense of security among all; the fact that banks survived the bursting of the dotcom bubble further reinforced this belief in the ability of banks to withstand shocks and survive profitably. This led politicians to enact legislation to further the dream of universal home ownership that may have encouraged risky bank lending to excessively leveraged consumers. Moreover, it caused banks to operate with less capital than was prudent and to extend loans to excessively leveraged consumers, caused rating agencies to underestimate the true risks, and led investors to demand unrealistically low risk premia. Two simple regulatory initiatives may have created a less crisis-prone financial system significantly raising capital requirements in the commercial and shadow banking systems during the halcyon pre crisis years and putting in place regulatory mechanisms either outright proscriptions or price-based inducements to ensure that banks focused on originating and securitizing only those mortgages that involved creditworthy borrowers with sufficient equity. This is perhaps twenty-twenty hindsight, but some might even dispute that these are the right conclusions to draw from this crisis. If so, what did we really learn? There is a sense that this crisis simply reinforced old lessons learned from previous crises and a sense that it revealed new warts in the financial system. Reinhart and Rogoff’s historical 220 CU IDOL SELF LEARNING MATERIAL (SLM)

study of financial crises reveals a recurring pattern in most financial crises are preceded by high leverage on the balance sheets of financial intermediaries and asset price booms. Claessen and Kodres identify two additional “common causes” that seem to play a role in crises: financial innovation that creates new instruments whose returns rely on continued favourable economic conditions, and financial liberalization and deregulation. Given that these causes go back centuries, one must wonder whether, as a society, we simply do not learn or whether the perceived benefits of the precrisis economic boom are deemed to be large enough to make the occasional occurrence of crises one worth bearing. Numerous valuable new lessons have emerged as well insolvency and counterparty risk concerns were primary drivers of this crisis, the shadow banking sector was highly interconnected with the banking system and thus a major influence on the systemic risk of the financial system, high leverage contributes to an endogenous increase in systemic risk, and piecemeal regulation of depository institutions in a highly fragmented regulatory structure that leaves the shadow banking system less regulated makes it easy for financial institutions to circumvent micro prudential regulation and engage in financial innovation, some of which increases systemic risk. Moreover, state and federal regulators implement similar regulations in different ways, adding to complexity in the implementation of regulation and elevating uncertainty about the responses of regulated institutions to these regulations. And, finally, compensation practices and other aspects of corporate culture in financial institutions may have encouraged fraud, adding another wrinkle to the conditions that existed prior to the crisis. However, it is also clear that our learning is far from complete. The pursuit of easy-money monetary policies in many countries seems to reflect the view that liquidity is still a major impediment and that these policies are needed to facilitate continued growth-stimulus objectives, but it is unlikely that such policies will help allay concerns about insolvency and counterparty risks, at least as a first-order effect. The persistence of low-interest rate policies encourages banks to chase higher yields by taking higher risks, thereby increasing the vulnerability of the financial system to future crises. And the complexity of regulations like Dodd-Frank makes the reactions of banks that seek novel ways to lighten their regulatory burden to these regulations more uncertain. All this means that some of the actions of regulators and central banks may inadvertently make the financial system more fragile rather than less. This retrospective looks at the 2007–2009 crisis also offers some ideas for looking ahead. Three specific ideas are discussed in Section 5 and previewed here: First, the research seems to indicate that higher levels of capital in banking would significantly enhance financial stability, with little, if any, adverse impact on bank value. However, much of our research on this issue is qualitative and does not lend itself readily to calibration exercises that can inform regulators how high to set capital requirements. The section discusses some recent research that has begun to calculate the level of optimal capital requirements. We need more of this 221 CU IDOL SELF LEARNING MATERIAL (SLM)

kind of research. Second, there needs to be more normative research on the optimal design of the regulatory infrastructure. Most research attention has been focused on the optimal design of regulations, but we need more research on the kinds of regulatory institutions needed to implement simple and effective regulations consistently, without the tensions created by multiple regulators with overlapping jurisdictions. Third, beyond executive compensation practices, we have virtually no research on culture in banking. Yet, managerial misconduct whether it is excessive risk taking or information misrepresentation to clients is a reflection of not only compensation incentives but also the corporate culture in banking. This area is sorely in need of research. 12.2.1 What Happened and When The financial crisis of 2007–2009 was the culmination of a credit crunch that began in the summer of 2006 and continued into 2007.8 Most agree that the crisis had its roots in the U.S. housing market, although I will later also discuss some of the factors that contributed to the housing price bubble that burst during the crisis. The first prominent signs of problems arrived in early 2007, when Freddie Mac announced that it would no longer purchase high- risk mortgages, and New Century Financial Corporation, a leading mortgage lender to risky borrowers, filed for bankruptcy. Another sign was that during this time the ABX indexes which track the prices of credit default insurance on securities backed by residential mortgages began to reflect higher expectations of default risk. While the initial warning signs came earlier, most people agree that the crisis began in August 2007, with large-scale withdrawals of short-term funds from various markets previously considered safe, as reflected in sharp increases in the “haircuts” on repos and difficulties experienced by asset-backed commercial paper (ABCP) issuers who had trouble rolling over their outstanding paper. Causing this stress in the short-term funding markets in the shadow banking system during 2007 was a pervasive decline in U.S. house prices, leading to concerns about subprime mortgages. As indicated earlier, the ABX index reflects these concerns at the beginning of 2007. The credit rating agencies (CRAs) downgraded asset-backed financial instruments in mid-2007.13 The magnitude of the rating actions in terms of the number of securities affected and the average downgrade in mid-2007 appeared to surprise investors. Benmelech and Dlugosz show that a large number of structured finance securities were downgraded in 2007– 2008 and the average downgrade was 5-6 notches. This is substantially higher than the historical average. For example, during the 2000–2001 recession, when one-third of corporate bonds were downgraded, the average downgrade was 2–3 notches. Consequently, credit markets continued to tighten. The Federal Reserve opened up short-term lending facilities and deployed other interventions to increase the availability of liquidity to financial institutions. But this failed to prevent the haemorrhaging, as asset prices continued to decline. 222 CU IDOL SELF LEARNING MATERIAL (SLM)

In early 2008, institutional failures reflected the deep stresses that were being experienced in the financial market. Mortgage lender Countrywide Financial was bought by Bank of America in January 2008. And then in March 2008, Bear Stearns, the sixth largest U.S. investment bank, was unable to roll over its short-term funding due to losses caused by price declines in mortgage-backed securities (MBS). Its stock price had a precrisis fifty-two-week high of $133.20 per share, but plunged precipitously as revelations of losses in its hedge funds and other businesses emerged. JP Morgan Chase made an initial offer of $2 per share for all the outstanding shares of Bear Stearns, and the deal was consummated at $10 per share when the Federal Reserve stepped in with a financial assistance package. The problems continued as IndyMac, the largest mortgage lender in the United States, collapsed and was taken over by the federal government. Things worsened as Fannie Mae and Freddie Mac became sufficiently financially distressed and were taken over by the government in September 2008. The next shock was when Lehman Brothers filed for Chapter 11 bankruptcy on September 15, 2008, failing to raise the capital it needed to underwrite its downgraded securities. On the same day, AIG, a leading insurer of credit defaults, received $85 billion in government assistance, as it faced a severe liquidity crisis. The next day, the Reserve Primary Fund, a money market fund, “broke the buck,” causing a run on these funds. Interbank lending rates spiked. On September 25, 2008, savings and loan giant, Washington Mutual, was taken over by the FDIC, and most of its assets were transferred to JP Morgan Chase.15 By October, the cumulative weight of these events had caused the crisis to spread to Europe. In October, global cooperation among central banks led them to announce coordinated interest rate cuts and a commitment to provide unlimited liquidity to institutions. However, there were also signs that this was being recognized as an insolvency crisis. So, the liquidity provision initiatives were augmented by equity infusions into banks. By mid-October, the U.S. Treasury had invested $250 billion in nine major banks. The crisis continued into 2009. By October, the unemployment rate in the United States rose to 10%. 12.2.2 Cause and Effect: The Causes of the Crisis and Its Real Effects Although there is some agreement on the causes of the crisis, there are disagreements among experts on many of the links in the causal chain of events. We begin by providing in Figure 1 a pictorial depiction of the chain of events that led to the crisis and then discuss each link in the chain. In the many books and s written on the financial crisis, various authors have put forth a variety of precrisis factors that created a powder keg just waiting to be lit. Lo provides an excellent summary and critique of twenty-one books on the crisis. He observes that there is no consensus on which of these factors were the most significant, but we will discuss each in turn. 223 CU IDOL SELF LEARNING MATERIAL (SLM)

Rajan reasons that economic inequities had widened in the United States due to structural deficiencies in the educational system that created unequal access for various segments of society. Politicians from both parties viewed the broadening of home ownership as a way to deal with this growing wealth inequality a political proclivity that goes back at least to the 19th century Homestead Act and therefore undertook legislative initiatives and other inducements to make banks extend mortgage loans to a broader borrower base by relaxing underwriting standards, and this led to riskier mortgage lending.16 The elevated demand for houses pushed up house prices and led to the housing price bubble. In this view, politically motivated regulation was a contributing factor in the crisis. This point has been made even more forcefully by Kane who argues that, for political reasons, most countries establish a regulatory culture that involves three elements: politically directed subsidies to selected bank borrowers, subsidized provision of implicit and explicit repayment guarantees to the creditors of banks, and defective government monitoring and control of the problems created by the first two elements. These elements, Kane argues, undermine the quality of bank supervision and produce financial crises. Perhaps these political factors can explain the very complicated regulatory structure for U.S. banking. Agarwal et al. present evidence that regulators tend to implement identical rules inconsistently because they have different institutional designs and potentially conflicting incentives. For U.S. bank regulators, they show that federal regulators are systematically tougher and tend to downgrade supervisory ratings almost twice as frequently as state supervisors for the same bank. These differences in regulatory “toughness” increase the effective complexity of regulations and impede the implementation of simple regulatory rules, making the response of regulated institutions to regulations less predictable than in theoretical models and generating another potential source of financial fragility. A strikingly different view of political influence lays the blame on deregulation motivated by political ideology. Deregulation during the 1980s created large and powerful financial institutions with significant political clout to block future regulation, goes the argument presented by Johnson and Kwak. This “regulatory capture” created a crisis-prone financial system with inadequate regulatory oversight and a cosy relationship between government and big banks. It has been suggested that the desire of the U.S. government to broaden ownership was also accompanied by monetary policy that facilitated softer lending standards by banks. In particular, an empirical study of Euro-area and U.S. Bank lending standards by Maddaloni and Paydro finds that low short-term interest rates lead to softer standards for household and business loans. Moreover, this softening is amplified by the originate-to-distribute (OTD) model of securitization, weak supervision over bank capital, and a lax monetary policy.18 These conditions thus made it attractive for commercial banks to expand mortgage lending in the period leading to the crisis and for investment banks to engage in warehouse lending using nonbank mortgage lenders. Empirical evidence also has been provided that the OTD 224 CU IDOL SELF LEARNING MATERIAL (SLM)

model encouraged banks to originate risky loans in ever increasing volumes. Purnanandam documents that a one-standard-deviation increase in a bank’s propensity to sell off its loans increases the default rate by about 0.45 percentage points, representing an overall increase of 32%. The effect of these developments in terms of the credit that flowed into the housing market to enable consumers to buy homes was staggering.19 Total loan originations rose from $500 billion in 1990 to $2.4 trillion in 2007, before declining to $900 billion in the first half of 2008. Total amount of mortgage loans outstanding increased from $2.6 to $11.3 trillion over the same period. Barth et al. show that the subprime share of home mortgages grew from 8.7% in 1995 to a peak of 13.5% in 2005. 12.2.3 Was This a Liquidity Crisis or an Insolvency/Counterparty Risk Crisis? Determining the nature of this crisis is important for how we interpret the evidence and what we learn from it. The two dominant views of what caused this crisis are illiquidity and insolvency. It is often claimed that the financial crisis that caused the Great Depression was a liquidity crisis, and the Federal Reserve’s refusal to act as a Lender of Last Resort in March 1933 caused the sequence of calamitous events that followed. Thus, determining what caused this crisis and improving our diagnostic ability to assess the underlying nature of future crises based on this learning would be very valuable. The loss of short-term borrowing capacity and the large-scale withdrawals from money- market funds discussed in the previous section have been viewed by some as a systemic liquidity crisis, but there is some disagreement about whether this was a market-wide liquidity crunch or an institution-specific increase in concerns about solvency risk that caused liquidity to shrink for some banks, but not for others. That is, one viewpoint is that when people realized that MBS were a lot riskier than they thought, liquidity dried up across the board because it was hard for an investor to determine which MBS was of high quality and which was not. The reason for this difficulty is ascribed to the high level of asymmetric information and opaqueness in MBS arising from the opacity of the underlying collateral and the multiple steps in the creation of MBS from the originations of multiple mortgages to their pooling and then to the specifics of the trenching of this pool. So, when bad news arrived about mortgage defaults, there was a market-wide effect. A theoretical argument supporting the idea that this was a liquidity crisis is provided by Diamond and Rajan (2011). In their model, banks face the prospect of a random exogenous liquidity shock at a future date before loans mature, at which time they may have to sell their assets in a market with a limited number of “experts” who can value the assets correctly. The assets may thus have to be sold at fire-sale prices, and the bank may face insolvency as a result. This may cause depositors to run the bank, causing more assets to be dumped and a further price decline. They argue that those with access to cash can therefore purchase assets at very low prices and enjoy high returns, causing holders of cash to demand high returns 225 CU IDOL SELF LEARNING MATERIAL (SLM)

today and inducing banks to hold on to illiquid assets; this exacerbates the future price decline and illiquidity. Moreover, illiquidity means lower lending initially. While the liquidity view focuses on the liability side of the bank’s balance sheet the inability of banks to roll over short-term funding when hit with a liquidity shock the insolvency view focuses on shocks to the asset side. It says that when the quality of a bank’s assets was perceived to be low, lenders began to reduce the credit they were willing to extend to the bank. According to this view, the crisis was a collection of bank-specific events, and not a market-wide liquidity crunch. Banks with the biggest declines in asset quality perceptions were the ones experiencing the biggest funding shortages. While one can argue that the underlying causes discussed in the previous section can be consistent with either viewpoint of the crisis and the end result is the same regardless of which viewpoint is correct banks face dramatically reduced access to liquidity the triggering events, the testable predictions, and the appropriate policy interventions are all different. In this section I will discuss the differences with respect to the triggering events and testable predictions. I will discuss what the existing empirical evidence has to say and also suggest new empirical tests that can focus more sharply on distinguishing between these viewpoints. Note that empirically distinguishing between these two viewpoints is quite challenging because of the endogeneity created by the relationship between solvency and liquidity risks. A market-wide liquidity crunch can lead to fire sales that can depress asset prices, diminish financing capacity, and lead to insolvency. And liquidity crunches are rarely sunspot phenomena they are typically triggered by solvency concerns. If a liquidity shortage caused this crisis, then what could be identified as triggering events? The Diamond and Rajan modelsuggest that a sharp increase in the demand for liquidity by either the bank’s depositors or borrowers could provide the liquidity shock that could trigger a crisis. In the data one should observe this in the form of a substantial increase in deposit withdrawals at banks as well as a significant increase in loan commitment takedowns by borrowers prior to the crisis. If this was an insolvency crisis, then the trigger for the crisis should be unexpectedly large defaults on loans or asset-backed securities that cause the risk perceptions of investors to change substantially. This is implied by the theories developed in the papers of Gennaioli, Shleifer, and Vishny and Thakor. I will use these different triggering events when I discuss how empirical tests might be designed in future research. On prediction, the evidence seems to point to this being an insolvency crisis. Boyson, Helwege, and Jindra examine funding sources and asset sales at commercial banks, investment banks, and hedge funds. The paper hypothesizes that if liquidity dries up in the financial market, institutions that rely on short-term debt will be forced to sell assets at fire- sale prices. The empirical findings are, however, that the majority of commercial and investment banks did not experience funding declines during the crisis and did not engage in 226 CU IDOL SELF LEARNING MATERIAL (SLM)

the fire sales predicted to accompany liquidity shortages. The paper does find evidence of pockets of weakness that are linked to insolvency concerns. Problems at financial institutions that experienced liquidity shortages during the crisis originated on the asset side of their balance sheets in the form of shocks to asset value. Commercial banks’ equity and asset values are documented to have been strongly affected by the levels of net charge-offs, whereas investment banks’ asset changes seemed to reflect changes in market valuation.52 Another piece of evidence comes from MMFs. The notion that MMFs were almost as safe as money was debunked by Kaspersky and Schnabel, who examined the risk-taking behaviour of MMFs during 2007–2010. They document four noteworthy results. First, MMFs faced an increase in their opportunity to take risk starting in August 2007. By regulation, MMFs are required to invest in highly rated, short-term debt securities. Before August 2007, the debt securities MMFs could invest in were relatively low in risk, yielding no more than 25 basis points above U.S. Treasuries. However, the repricing of risk following the run on ABCP conduits in August 2007 caused this yield spread to increase to 125 basis points. The MMFs now had a significant risk choice: either invest in a safe instrument like U.S. Treasuries or in a much riskier instrument like a bank obligation. Of course, this by itself does not settle the issue of whether these events were due to a liquidity shock that prompted investors to withdraw money from MMFs, turn inducing higher risk taking by fund managers, or whether the withdrawals were due to elevated risk perceptions. However, Kaspersky and Schnabel point out that the increase in yield spreads in August 2007 had to do with the fact that outstanding ABCP fell sharply in August 2007 following news of the failure of Bear Stearns’ hedge funds that had invested in subprime mortgages and BNP Paribas’ suspension of withdrawals from its investment funds due to the inability to assess the values of mortgages held by the funds. Moreover, the massive withdrawals from MMFs from September 16–19, 2008, were triggered by the Reserve Primary Fund announcing that it had suffered significant losses on its holdings of Lehman Brothers Commercial paper. Thus, it appears that the runs suffered by MMFs were mainly due to asset risk and solvency concerns, rather than a liquidity crisis per se, even though what may have been most salient during the early stages of the crisis had the appearance of a liquidity crunch. As for the second prediction, I am not aware of any evidence that large deposit withdrawals or commitment takedowns preceded this crisis, particularly before asset quality concerns became paramount. There is evidence, however, that loan quality was deteriorating prior to the crisis. The Demyanenko and Van Hemet evidence, as well as the evidence provided by Purnanandam, points to this. It also indicates that lenders seemed to be aware of this, which may explain the elevated counterparty risk concerns when the crisis broke. Now consider the third prediction. There seems to be substantial evidence that banks with higher capital ratios were less adversely affected by the crisis. Banks with higher precrisis 227 CU IDOL SELF LEARNING MATERIAL (SLM)

capital were more likely to survive the crisis and gained market share during the crisis, took less risk prior to the crisis, and exhibited smaller contractions in lending during the crisis. Turning to the fourth prediction, the empirical evidence provided by Taylor and Williams is illuminating. Taylor and Williams examine the LIBOR-OIS Spread. This spread is equal to the three-month LIBOR minus the three-month Overnight Index Swap (OIS). The OIS is a measure of what the market expects the federal funds rate to be over the three-month period comparable to the three-month LIBOR. Subtracting OIS from LIBOR controls for interest rate expectations there by isolating risk and liquidity effects. 12.2.4 The Real Effects of the Crisis This financial crisis had significant real effects. These included lower household credit demand and lower credit supply, as well as reduced corporate investment and higher unemployment. I now discuss each of the real effects in this section. The argument for why the crisis adversely affected household demand for credit has been presented by Mian, Rao, and Sufi, and it goes as follows: First, due to a variety of reasons discussed earlier, household debt went up significantly. Then the bursting of the house price bubble shocked household balance sheets, depleting household net worth. In response, the highly levered households reduced consumption. However, the relatively unlevered households did not increase consumption to offset this decline because of various frictions in the economy related to nominal price rigidities and a lower bound of zero on nominal interest rates. Mian, Rao, and Sufi show that this interaction between precrisis household leverage and decline in consumption made a major contribution to the events witnessed during the crisis. In particular, their evidence indicates that the large accumulation of household debt54 prior to the recession, in combination with the decline in house prices, explains the onset, severity, and length of the subsequent consumption collapse. The decline in consumption was much stronger in high-leverage counties with larger house price declines and in areas with greater reliance on housing as a source of wealth. Thus, as house prices plunged, so did consumption and the demand for credit. There is persuasive empirical evidence that the crisis caused a significant decline in the supply of credit by banks. One piece of evidence is that syndicated loans declined during the crisis, which is important since syndicated lending is a major source for credit for the corporate sector. The syndicated loan market includes not only banks but also investment banks, institutional investors, hedge funds, mutual funds, insurance companies, and pension funds. The evidence is that syndicated lending began to fall in mid-2007, and, starting in September 2008, this decline accelerated. Syndicated lending volume in the last quarter of 2008 was 47% lower than in the prior quarter and 79% lower than in the second quarter of 2007, which was the height of the credit boom. Lending declined across all types of corporate loans. 228 CU IDOL SELF LEARNING MATERIAL (SLM)

Accompanying the fall in lending volume was an increase in the price of credit. Santos documents that firms paid higher loan spreads during the crisis, and the increase was higher for firms that borrowed from banks that incurred larger losses. This result holds even when firm-specific, bank-specific, and loan-specific factors are controlled for, and the endogeneity of bank losses is taken into account. As usual, separating supply and demand effects is difficult. Puri, Rocholl, and Steffen examine whether there are discernible reductions in credit supply, even when overall demand for credit is declining. They examine German savings banks, which operate in specific geographies and are required by law to serve only local customers. In each geography there is a bank, owned by the savings bank in that area. These Landesbanken had varying degrees of exposure to U.S. subprime mortgages. Losses on these exposures therefore varied across these Landesbanken, requiring different amounts of equity injections from their respective savings banks. In other words, different savings banks were impacted differently, depending on the losses suffered by their Landesbanken. What the paper uncovers is that the savings banks that were hit harder cut back on credit more. The average rate at which loan applicants were rejected was significantly higher than the rate at which rejections occurred at unaffected banks. Campello, Graham, and Harvey survey 1,050 chief financial officers (CFOs) in thirty-nine countries in North America, Europe, and Asia and provide evidence of reduced credit supply during the crisis. About 20% of the surveyed firms in the United States indicated that they were very affected in the sense that they faced reduced availability of credit. Consequently, they cut back on capital expenditures, dividends, and employment. With both household consumption going down and credit availability becoming scarcer and more expensive, it is not surprising that corporate investment fell and unemployment spiked. The United States entered a deep recession, with almost nine million jobs lost during 2008 and 2009, which represented about 6% of the workforce. It also discouraged many from trying to re-enter the workforce after the crisis abated, leading the labour participation rate to plunge. This meant that subsequent measurements of the unemployment rate tended to understate the true unemployment rate. Even measured unemployment rose every month from 6.2% in September 2008 to 7.6% in January 2009. U.S. housing prices declined about 30% on average, and the U.S. stock market fell approximately 50% by mid-2009. The U.S. automobile industry was also hit hard. Car sales fell 31.9% in October 2008 compared with September 2008.55 A causal link between the reduction in credit supply during the crisis and an increase in unemployment is provided by Haltenhof, Lee, and Stebunovs. They provide evidence that household access to bank loans seemed to matter more than firm access to bank loans in determining the drop in employment in the manufacturing sector, but reduced access to commercial and industrial loans and to consumer instalment loans played a significant role. 229 CU IDOL SELF LEARNING MATERIAL (SLM)

12.2.5 The Policy Responses to the Crisis Beginning in August 2007, the governments of all developed countries undertook a variety of policy interventions to mitigate the financial crisis. The IMF identifies as many as 153 separate policy actions taken by thirteen countries, including forty-nine in the United States alone. That represents too large a set of policy interventions to discuss here. So, I will briefly describe the major categories of interventions here56 and then provide a brief assessment The policy responses fell in four major groups: provision of short-term liquidity to financial institutions, provision of liquidity directly to borrowers and investors, expansion of open market operations, and initiatives designed to address counterparty risk. This set of interventions included the discount window, Term Auction Faculty (TAF), Primary Dealer Credit Facility (PDCF), and Term Securities Lending Facility (TSLF). The Federal Reserve also approved bilateral currency swap agreements with fourteen foreign central banks to assist these central banks in the provision of dollar liquidity to banks in their jurisdictions. The discount window has long been a primary liquidity-provision tool used by the Fed. In December 2007, the TAF was introduced to supplement the discount window. The TAF provided credit to depository institutions through an auction mechanism. Like discount window loans, TAF loans had to be fully collateralized. The final TAF auction was held on March 8, 2010. The PDCF was established in March 2008 in response to strains in the triparty repo market and the resulting liquidity pressures faced by primary securities dealers. Primary dealers are broker-dealers that serve as the trading counterparties for the Federal Reserve’s open-market operations and thus play a pivotal role in providing liquidity in the market for U.S. treasuries. The PDCF served as an overnight loan facility for primary dealers, similar to the discount window for depository institutions. Credit extension required full collateralization. This facility was closed on February 1, 2010. The TSLF was a weekly loan facility designed to promote liquidity in Treasury and other collateral markets. The program offered Treasury securities for loan for one month against other program-eligible collateral. The borrowers were primary dealers who participated in single-price auctions to obtain these loans. The TSLF was closed on February 1, 2010. The CPFF was established in October 2008 to provide liquidity to U.S. issuers of commercial paper. Under the program, the Federal Reserve Bank of New York provided three-month loans to a specially created limited liability company that then used the money to purchase commercial paper directly from issuers. The CPFF was dissolved on August 30, 2010. The AMLF was a lending facility that provided funds to U.S. depository institutions and bank holding companies to finance their purchases of high-quality ABCF from MMFs under prespecified conditions. The goal of the program was to bolster liquidity in the ABCP market. The AMLF opened on September 22, 2008 and was closed on February 1, 2010. 230 CU IDOL SELF LEARNING MATERIAL (SLM)

The MMIFF was designed to provide liquidity to U.S. money market investors. Under this facility, the Federal Reserve Bank of New York could provide senior secured loans to a series of special purpose vehicles to finance the purchase of eligible assets. This essentially “insured” money market investors who might have otherwise suffered losses due to the decline in the values of their holdings. The MMIFF was announced on October 21, 2008 and dissolved on October 30, 2009. TALF was created to help market participants meet the credit needs of households and small businesses by supporting the issuance of asset-backed securities collateralized by consumer and small-business loans. The goal was to revive the consumer-credit securitization market. The facility was launched in March 2009 and dissolved by June 2010. These initiatives included various programs. One was the Troubled Asset Repurchase Program (TARP), which was initially authorized in October 2008 and ended on October 3, 2010. The original idea was for the government to buy troubled, illiquid assets from financial institutions in order to diminish concerns about their solvency and to stabilize markets.57 In practice, it took the form of the government buying equity and taking ownership in various financial and nonfinancial firms and providing help to consumers to avoid home foreclosures. The willingness of the U.S. government to take equity positions in banks was also accompanied by regulatory demands that banks recapitalize themselves through other means as well. The implied threat that the alternative to recapitalization via shareholder-provided equity was the infusion of equity by the government was an effective one. No bank wanted to be nationalized. The result was that U.S. banks were recapitalized fairly quickly. In retrospect, this may have been one of the most effective policy responses to the crisis, as the contrast with the struggling banking systems in the Euro zone—where regulators did not force banks to recapitalize reveals. Another program involved the Federal Reserve purchasing direct obligations of housing- related Government-Sponsored Enterprises (GSEs). The goal of these purchases, combined with the purchases of mortgage-backed securities by Fannie Mae, Freddie Mac, and Gennie Mae, was to make it cheaper and easier for people to buy homes. The idea was that this goal would be served if the spread between GSE debt and U.S. Treasury debt narrowed, and it was believed that these purchases would do that. In addition to these programs, the Federal Reserve also introduced stress tests of large banks, in order to determine their ability to withstand systemic shocks of various magnitudes. These simulations were designed to shed light on how much capital and access to liquidity banks would need if confronted with the kinds of shocks that pummelled banks during the crisis of 2007–2009 and hence to provide early-warning signals to both banks and regulators. Many believe that the liquidity support provided by central banks was effective in calming markets in the initial phases of the crisis. However, there is no consensus on whether these were the right measures for the long run or whether the problem was even correctly 231 CU IDOL SELF LEARNING MATERIAL (SLM)

diagnosed. At the very least, markets exhibited considerable volatility after the collapse of Lehman Brothers, indicating that central banks were learning as they went along—building the bridge as they walked on it, so to speak—and not all the initiatives had the intended effects. A key issue for central banks was to determine whether the unfolding events were due to liquidity or counterparty risk arising from asymmetric information about the quality of assets on bank balance sheets and the opaqueness of those balance sheets. The Federal Reserve and the European Central Bank (ECB) clearly believed it was a liquidity problem, at least until the failure of Lehman Brothers, and this is reflected in many of the measures discussed earlier. But if the issue was counterparty risk, then the proper approach would have been to require banks to make their balance sheets more transparent, deal directly with the rising mortgage defaults, and undertake measures to infuse more capital into financial institutions, possibly with government assistance to supplement private-sector infusions. Some of the programs that were developed in the later stages of the crisis were directed at dealing with the counterparty risk issue. These include TARP’s Capital Purchase Program, the purchases of GSE debt, and large-bank stress tests, all of which were discussed in the previous section. Perhaps it should come as no surprise that the initial assessment of central banks was that this was a market-wide liquidity crunch, since beliefs about the underlying causes of the crisis were conditioned on historical experience, especially that associated with the Great Depression.58 There are many who believe that what began as a recession turned into a big depression back then because the “gold standard” pegged currencies to gold stocks, so when the drop in global demand caused balance-of-payments crises in various countries due to gold outflows, governments and central banks responded by tightening monetary policy and exercising greater fiscal restraint. This led to the view that interest rate reductions and monetary-stimulus initiatives like quantitative easing were the appropriate policy responses to crises. Of course, every crisis is different, and the circumstances that existed around the time the subprime crisis hit the economy were quite different from those that preceded the Great Depression. Nonetheless, the rapid escalation of unanticipated problems made quick policy responses an imperative, and the time for deep explorations of the root causes of observable events was simply not there. As discussed earlier, the existing evidence suggests that this was an insolvency crisis. The Taylor and Williams paper discussed earlier also examines the effect of some of the policy interventions to shed further light on this issue. Taylor and Williams show that the TAF had little effect on the LIBOR-OIS spread. Moreover, the sharp reduction in the federal funds rate during the crisis—the Fed funds target rate went from 5.25% in August 2007 to 2% in April 2008—also did not succeed in reducing the LIBOR-OIS spread. However, it caused a depreciation of the dollar and caused oil prices to jump, causing a sharp decline in world economic growth. 232 CU IDOL SELF LEARNING MATERIAL (SLM)

Taylor and Williams go on to show that in October 2008, the crisis worsened as the LIBOR- OIS spread spiked even further. That is, more than a year after it started, the crisis worsened. Some point to the failure of Lehman Brothers in September 2008 as a proximate cause. Taylor and Williams suggest, however, that that may have been more a symptom than a cause and that the real culprit may have been the elevated perception of risk in the fundamentals, fuelled by sinking house prices and rising oil prices. The main point brought out by the Taylor and Williams analysis is that counterparty risk concerns generated by rising insolvency risk perceptions were an important driver of short- term funding strains for banks during August 2007–2008. This suggests that interventions designed to address counterparty risk should have been implemented earlier than they were. Their analysis does not necessarily imply that liquidity facilities for banks were not helpful in the early stages of the crisis or that liquidity was not a concern of any magnitude during the crisis. One problem with making a determination of whether liquidity interventions by the Federal Reserve served any useful purpose is that we do not observe the counterfactual, that is, we do not know how market participants would have reacted in the absence of the liquidity intervention. While it is true that borrowing at the discount window was somewhat limited until 2008, it is difficult to know what would have happened had the discount window assurance provided by the role of the Federal Reserve as a Lender of Last Resort (LOLR) been absent. Would the absence of the initial liquidity interventions have exacerbated the later counterparty risk concerns? Even apart from the issue of whether the real problem was liquidity or counterparty risk, the massive ex post expansion of the government safety net to mutual fund investors and non- depository institutions to deal with the crisis raises the possibility that the expectations of market participants about the nature of implicit government guarantees have been significantly altered insofar as future crisis events are concerned. This has potentially significant moral hazard implications that may distort not only the behaviour of investors and institutions but also possibly regulators who may feel compelled to adopt more intensive regulation to cope with the greater moral hazard. 12.3 NEXT GENERATION OF INTERNATIONAL STANDARDS OF FINANCIAL INSTITUTION REGULATION (BASEL ACCORDS) In an environment in which a long sequence of good outcomes induces a “false sense of security,” as discussed above, it would be useful to consider higher capital requirements in both the depository financial institutions sector and in shadow banking.60Purnanandam’s empirical evidence indicates that banks with higher capital control credit risk more effectively when it comes to mortgages. Moreover, as Thakore discusses, increasing capital requirements will reduce correlated risk taking by banks, and hence lead to lower systemic risk.61 In addition, if only mortgages with sufficient borrower equity can be securitized, then consumer leverage can also be limited. While these initiatives are unlikely to suffice by 233 CU IDOL SELF LEARNING MATERIAL (SLM)

themselves to reduce the probability of future crises to socially acceptable levels, they may go a long way in enhancing financial stability. Moreover, by achieving some reduction in the probability of future crises, they will also reduce the probability of ad hoc ex post expansions of the government safety net that carry with them the baggage of increased moral hazard. Increasing capital in banking also has other advantages. Sufficiently well capitalized institutions have little need to engage in fire sales of assets and therefore are unlikely to run into funding constraints. This leads to high liquidity in the market, indicating that liquidity risk can be diminished without having institutions keep lots of low-return liquid assets on their balance sheets. Thakore discusses how higher bank capital reduces insolvency risk by attenuating asset-substitution moral hazard and strengthening the bank's monitoring and screening incentives. So, higher levels of bank capital can reduce both liquidity risk and insolvency risk. There have been two major impediments to the adoption of higher capital requirements in banking. One is that regulators have used backward-looking models of risk assessments, which makes it difficult to overcome the temptation to keep capital requirements low during economic booms and periods of low defaults. The use of stress tests, and calculations of capital surcharges based on those tests, can help to partially overcome this problem. The second impediment is that our models of bank capital structure are largely qualitative,62 so, while they can identify the factors that will tend to tilt the bank’s optimal capital structure in one direction or the other, they are not amenable to calibration exercises that provide the magnitudes of bank capital requirements. This makes it difficult to answer questions like “what should regulators set minimum capital requirements at?” And if we cannot answer such questions, the guidance we can provide to regulators is limited. With differences of opinion, even among researchers, about the desirability of asking banks to keep more capital, this limitation creates the risk that debates on this may devolve into mere assertions based largely on assumptions made in qualitative models that cannot be tested. 12.4 SUMMARY  This Framework will be applied on a consolidated basis to internationally active banks. This is the best means to preserve the integrity of capital in banks with subsidiaries by banks. This is the best means to preserve the integrity of capital in banks with subsidiaries by eliminating double gearing.  The scope of application of the Framework will include, on a fully consolidated basis, any holding company that is the parent entity within a banking group to ensure that it captures the risk of the whole banking group.4 Banking groups are groups that engage predominantly in banking activities and, in some countries, a banking group may be registered as a bank. 234 CU IDOL SELF LEARNING MATERIAL (SLM)

 The Framework will also apply to all internationally active banks at every tier within a banking group, also on a fully consolidated basis. A three-year transitional period for applying full sub-consolidation will be provided for those countries where this is not currently a requirement.  Further, as one of the principal objectives of supervision is the protection of depositors, it is essential to ensure that capital recognised in capital adequacy measures is readily available for those depositors. Accordingly, supervisors should test that individual bank are adequately capitalised on a stand-alone basis  Fortunately, recent research has begun to address this issue by calculating how increases in bank capital requirements may affect the cost of capital and profitability of banks. For example, Hanson, Kashyap, and Stein argue that a ten percentage-point increase in capital requirements will increase the weighted average cost of capital for banks by a mere 25 basis points, which the authors describe as “a small effect.” Kisin and Manela use a clever empirical approach to estimate the shadow cost of bank capital requirements.  They document that a ten-percentage point increase in capital requirements would impose an average cost per bank of only 4% of annual profits, leading to an increase in lending rates of only 3 basis points. Roger and Vitek develop a macro econometric model to determine how global GDP would respond to an increase in bank capital requirements, and conclude that monetary policy responses would largely offset any adverse impact of capital requirements. 12.5 KEYWORDS  Price Quotation System – A method of giving exchange rates in which a certain specified amount of a foreign currency is stated as the corresponding amount in local currency.  Privatization – The selling of a government owned business (power, gas, communications) to the public. Governments privatize businesses to raise money for fiscal operations or to improve the efficiency of a firm.  Quota – A government-imposed restriction on the quantity of a specific imported good.  Rate Risk – In the exchange market, the chance that the spot rate may rise when the trader has a net oversold position (a short position), or that the spot rate may go down when the operator has a net overbought position (a long position).  Reciprocal Rate – The price of one currency in terms of a second currency, when the price of the second currency is given in terms of the first. 235 CU IDOL SELF LEARNING MATERIAL (SLM)

12.6 LEARNING ACTIVITY 1. Create a survey on The Real Effects of the Crisis. ___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on Next Generation of International Standards of Financial Institution Regulation. ___________________________________________________________________________ ___________________________________________________________________________ 12.7 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. Write the main cause of crises? 2. What do you mean by political factor? 3. What is financial innovation? 4. Define Monetary policy? 5. Define the term crises? Long Questions 1. Explain the Cause and Effect: The Causes of the Crisis and Its Real Effects. 2. Examine the Liquidity Crisis or an Insolvency/Counterparty Risk Crisis. 3. Examine the Real Effects of the Crisis. 4. Illustrate the Policy Responses to the Crisis. 5. Illustrate the Next Generation of International Standards of Financial Institution Regulation. B. Multiple Choice Questions 1. What differs futures from forwards? a. Used to hedge portfolios. b. A standardized contract. c. Used to hedge individual securities. d. Used in both financial and foreign exchange markets 236 CU IDOL SELF LEARNING MATERIAL (SLM)

2. Which of the following term is best defined by the statement: “There will be a change of organizational management with different priorities.”? a. Staff turnover b. Technology change c. Management change d. Product competition 3. What is the advantage of futures contracts relative to forward contracts is that futures contracts? a. Are standardized, making it easier to match parties, thereby increasing liquidity b. Specify that more than one bond is eligible for delivery, making it harder for someone to corner the market and squeeze traders. c. Cannot be traded prior to the delivery date, thereby increasing market liquidity d. Both (a) and (b) of the above. 4. What if a firm is due to be paid in deutsche marks in two months, to hedge against exchange rate risk? a. Sell foreign exchange futures short. b. Buy foreign exchange futures long. c. Stay out of the exchange futures market. d. None of these. 5. What happens if a firm must pay for goods it has ordered with foreign currency, it can hedge its foreign exchange rate risk? a. Selling foreign exchange futures short. b. Buying foreign exchange futures long c. Staying out of the exchange futures market. d. None of these. Answers 237 1-b 2-c, 3-d, 4-a, 5-b 12.8 REFERENCES References book CU IDOL SELF LEARNING MATERIAL (SLM)

 Lim, Ewe-Ghee (June 2006). San Jose, Armida (ed.). The Euro’s Challenge to the Dollar (PDF). Statistics Department. IMF Working Paper (Technical report). International Monetary Fund.  Promina, Lyubov (10 July 2009). \"Medvedev Shows Off Sample Coin of New 'World Currency' at G-8\". Bloomberg. Archived from the original on 13 June 2010.  Charvez (2009) UN panel touts new global currency reserve system. Archived27 June 2013 at the Way back Machine AFP, 26 March 2009. Textbook references  Jordan, A., Wurzel, R., Zito, R., and Bruckner, L. (2003). Policy innovation or 'muddling through'? 'New' environmental policy instruments in the United Kingdom. Environmental Politics.  •Alan P. Loeb, (1995) \"Addressing the Public's Goals for Environmental Regulation When Communicating Acid Rain Allowance Trades,\" The Electricity Journal, May.  R D Van Buskirk; C L S Kantner; B F Gerke; S Chu (2014-11-14). \"A retrospective investigation of energy efficiency standards: policies may have accelerated long term declines in appliance costs\". Website  https://www.fdic.gov/bank/historical/history/87_136.pdf  https://r.search.yahoo.com/_ylt=Awr9Duj8fA5htZIAhxNXNyoA;_ylu=Y29sbwNncT EEcG9zAzIEdnRpZANEMTA0NV8xBHNlYwNzcg--  https://r.search.yahoo.com/_ylt=Awr9Duj8fA5htZIAlRNXNyoA;_ylu=Y29sbwNncT EEcG9zAzgEdnRpZANEMTA0NV8xBHNlYwNzcg-- 238 CU IDOL SELF LEARNING MATERIAL (SLM)

UNIT 13 – FOREX MARKETS IN INDIA STRUCTURE 13.0 Learning Objectives 13.1 Introduction 13.2 Types of Foreign Exchange Market 13.2.1 Spot Markets 13.2.2 Forward Markets 13.2.3 Future Markets 13.2.4 Option Markets 13.2.5 Swaps Markets 13.3 Objectives of Foreign Exchange Control 13.4 Problems in Foreign Exchange Market in India 13.5 Mechanism to Settle Problems 13.6 Role of RBI in Settlements 13.7 Summary 13.8 Keywords 13.9 Learning Activity 13.10 Unit End Questions 13.11 References 13.0 LEARNING OBJECTIVES After studying this unit, you will be able to:  Illustrate the concept of Types of Foreign Exchange Market.  Explain the Forward Markets.  Illustrate the concept of Swaps Markets. 13.1 INTRODUCTION Foreign Exchange, Forex (FX) as it is called is trading of a single currency for another at a certain price and bank deposits on the over-the-counter (OTC) market place. It simply means buying one currency and selling the other. The values appreciate and depreciate as a result of 239 CU IDOL SELF LEARNING MATERIAL (SLM)

various economic and geopolitical factors. The objective of FX trader is to make profits from these fluctuation in prices, speculating on which way the foreign exchange rates are likely to move in the future. Currency trading markets are available 24-hrs a day, five days a week, Sunday being a holiday. Forex transactions are generally quoted in pairs because when one currency is bought, the other is sold. The first currency is called the ‘base currency’ and the second currency called the ‘quote currency’ Currency prices are determined by a host of economic and political conditions, most importantly, interest rates, international trade, inflation, and political stability. Occasionally, the government participates in the foreign exchange market to influence the value of the country’s currency by either flooding the market with their domestic currency to lower the price or buy in order to raise the price. This is known as central bank intervention. When the currency of our country appreciates corresponding to the prices of another country, the price of goods of our country goes up abroad and foreign goods prices in our country come down. Since the onset of liberalization, Foreign Exchange markets in India has experienced tremendous growth. In February 1992, started to make the Rupee convertible, and in March 1993, a single floating exchange rate in the market of Forex in India was started. The Indian Foreign Exchange Market comprise of the buyers, sellers, market mediators and the Monetary Authority of India. The main centre of Foreign Exchange in India is Mumbai with other centres in all the major cities such as Kolkata, New Delhi, Chennai, Bengaluru, Pondicherry and Cochin. Foreign Exchange Dealers Association is a voluntary association that also acts as a regulator. All resident individuals/HUFs and eligible corporate meeting the FEMA criteria are eligible to trade in Forex. Central bank such as RBI play a very important role in the foreign exchange markets. They participate in the foreign exchange market to regulate currencies as per their economic requirement. Central banks control the money supply, inflation and/or interest rates. Commercial companies trade in small quantities as compared to banks or speculators. Their trades have a relatively short-term impact on the market rate. Like commodity market, foreign exchange market also operates as: -Spot Market, which handles only spot/current transaction. The rate of exchange is one that prevails at the time the transaction takes place. - Forward Markets for Forex is the market which handles foreign exchange meant for future delivery. Currency derivatives is a binding contract to buy/sell a currency exchange rate at an agreed price in the future. Like any other derivative trading, currency derivatives also are efficient risk management instrument and the benefits of hedging, speculation, arbitrage and leverage can be derived from it. The foreign exchange market is the largest highly and liquid financial market in the world with worldwide average daily turnover around $5.3 trillion, which makes foreign exchange highly global trading asset. Foreign exchange forms the basis of dealings for trade and other monetary transactions between economies of the world. Foreign exchange market operates 240 CU IDOL SELF LEARNING MATERIAL (SLM)

with heterogeneous participants comprises of central banks, commercial banks, companies, brokers, fund managers, speculators and individuals. Central banks regulate the market for smooth and orderly operations with a broader objective of economic and financial development. On the other hand, other participants try to minimize the potential risk with the best possible way and try to maximize the profit. Presences of high volatility make the exposure management challenge since the global capital is highly volatile and purely depends on the performances in the economic fundamentals. Moreover, country-specific and market- specific investors sentiments also influence the same. This volatile pattern in the foreign exchange market is extremely crucial for a country like India which has unfavourable trade balance and facing stiff competition in the global market. 13.2 TYPES OF FOREIGN EXCHANGE MARKET The foreign exchange market is a global online network where traders and investors buy and sell currencies. It has no physical location and operates 24 hours a day for 5-1/2 days a week. Foreign exchange markets are one of the most important financial markets in the world. Their role is of utmost importance in the system of international payments. In order to play their role efficiently, it is necessary that their operations/dealings be trustworthy. Trustworthy is concerned with contractual obligations being honoured. For example, if two parties have entered into forward contract of a currency pair, both of them should be willing to honour their side of contract as the case may be. 13.2.1 Spot Markets These are the quickest transactions involving currency in the foreign exchange market. This market provides immediate payment to the buyers and sellers as per the current exchange rate. The spot market account for almost one-third of all currency exchange, and trades usually take one or two days to settle transactions. This allows the traders open to the volatility of the currency market, which can raise or lower the price, between the agreement and the trade. There is an increase in volume of spot transactions in the foreign exchange market. These transactions are primarily in forms of buying and selling of currency notes, cash-in of traveller’s cheque and transfers through banking systems. The last category accounts for almost 90 percent of all spot transactions are carried out exclusively for banks. As per the Bank of International Settlements (BIS) estimate, the daily volume of spot transaction is about 50 percent of all transactions in foreign exchange markets. London is the hub of foreign exchange market. It generates the highest volume and is diverse with the currencies traded. 241 CU IDOL SELF LEARNING MATERIAL (SLM)

13.2.2 Forward Markets In forward contract, two parties agree to do a trade at some future date, at a stated price and quantity. No security deposit is required as no money changes hands when the deal is signed. Forward contracting is very valuable in hedging and speculation. The classic scenario of hedging application through forward contract is that of a wheat farmer forward; selling his harvest at a known fixed price in order to eliminate price risk. Similarly, a bread factory wants to buy bread forward in order to assist production planning without the risk of price fluctuations. There are speculators, who based on their knowledge or information forecast an increase in price. They then go long on the forward market instead of the cash market. Now this speculator would go long on the forward market, wait for the price to rise and then sell it at higher prices; thereby, making a profit. 13.2.3 Future Markets The future markets help with solutions to a number of problems encountered in forward markets. Future markets work on similar lines as the forward markets in terms of basic philosophy. However, contracts are standardized and trading is centralized. There is no counterparty risk involved as exchanges have clearing corporation, which becomes counterparty to both sides of each transaction and guarantees the trade. Future market is highly liquid as compared to forward markets as unlimited persons can enter into the same trade 13.2.4 Option Markets An option is a contract, which gives the buyer of the options the right but not the obligation to buy or sell the underlying at a future fixed date and at a fixed price. A call option gives the right to buy and a put option gives the right to sell. As currencies are traded in pair, one currency is bought and another sold. For example, an option to buy US Dollar ($) for Indian Rupees (INR, base currency) is a USD call and an INR put. The symbol for this will be USDINR or USD/INR. Conversely, an option to sell USD for INR is a USD put and an INR call. The symbol for this trade will be like INRUSD or INR/USD. 13.2.5 Swaps Markets Unlike most standardized options and futures contracts, swaps are not exchange-traded instruments. Instead, swaps are customized contracts that are traded in the over-the-counter (OTC) market between private parties. Firms and financial institutions dominate the swaps market, with few individuals ever participating. Because swaps occur on the OTC market, there is always the risk of a counterparty defaulting on the swap. The most common and simplest swap is a plain vanilla interest rate swap. In this swap, Party A agrees to pay Party B a predetermined, fixed rate of interest on a notional principal on specific dates for a specified period of time. Concurrently, Party B agrees to make payments 242 CU IDOL SELF LEARNING MATERIAL (SLM)

based on a floating interest rate to Party A on that same notional principal on the same specified dates for the same specified time period. In a plain vanilla swap, the two cash flows are paid in the same currency. The specified payment dates are called settlement dates, and the times between are called settlement periods. Because swaps are customized contracts, interest payments may be made annually, quarterly, monthly, or at any other interval determined by the parties. 13.3 OBJECTIVES OF FOREIGN EXCHANGE CONTROL Restore the balance of payments equilibrium The main objective of introducing exchange control regulations is to correct the balance of payments equilibrium. The BOP needs realignment when it is sliding to the deficit side due to greater imports than exports. Hence, controls are put in place to manage the dwindling foreign exchange reserves by limiting imports to essentials items and encouraging exports through currency devaluation. Protect the value of the national currency Governments may defend their currency’s value at a certain desired level through participating in the foreign exchange market. The control of foreign exchange trading is the government’s way to manage the exchange rate at the desired level, which can be at an overvalued or undervalued rate. The government can create a fund to defend currency volatility to stay in the desired range or get it fixed at a certain rate to meet its objectives. An example is an import- dependent country that may choose to maintain an overvalued exchange rate to make imports cheaper and ensure price stability. Prevent capital flight The government may observe increased trends of capital flight as residents and non- residents start making amplified foreign currency transfers out of the country. It can be due to changes in economic and political policies in the country, such as high taxes, low interest rates, increased political risk, pandemics, and so on. The government may resort to an exchange control regime where restrictions on outside payments are introduced to mitigate capital flight. Protect local industry The government may resort to exchange control to protect the domestic industry from competition by foreign players that may be more efficient in terms of cost and production. It is usually done by encouraging exports from the local industry, import substitution, and restricting imports from foreign companies through import quotas and tariff duties. 243 CU IDOL SELF LEARNING MATERIAL (SLM)

Build foreign exchange reserves The government may intend to increase foreign exchange reserves to meet several objectives, such as stabilize local currency whenever needed, paying off foreign liabilities, and providing import cover. 13.4 PROBLEMS IN FOREIGN EXCHANGE MARKET IN INDIA To what extent can policy challenges and economic circumstances change over four years? Well, sometimes, they can turn upside down. Around this time in 2013, the Reserve Bank of India (RBI) was struggling to save the rupee from a free fall and was forced to raise emergency foreign currency deposits from non-resident Indians. The concerns today are an appreciating currency, and the problems the central bank is facing in managing the strong rupee. India’s foreign exchange reserves are fast approaching the $400 billion mark. Backed by strong foreign inflows, reserves have risen by over $23 billion so far in the current financial year. The problem now is of plenty. Curiously, a recent report by Edelweiss Securities Ltd noted that sustained intervention by the RBI has brought India close to getting included in the currency manipulation watch list of the US. Even though India has a trade surplus with the US, and has been intervening in the currency market, it still runs a current account deficit at the aggregate level and cannot be accused of currency manipulation. In fact, the Indian central bank is forced to do what it’s doing in part because of policies of the US Federal Reserve and other systemically important central banks. Thanks to excessively accommodative monetary policy in the developed world, the global financial system is flush with cheap money and investors are in a desperate search for yield. Here is an example. Earlier this month, $1 billion worth of bonds issued by the government of Iraq were oversubscribed and sold at a lower-than-expected yield. So, it shouldn’t surprise anyone if India given its macroeconomic fundamentals and prospects is witnessing foreign inflows that are more than what it requires to fund its current account deficit. But despite intervention by the RBI, the rupee has appreciated by around 6% since the beginning of the year, though the weakening dollar has also played a role. While strong foreign flows and rising reserves would be comforting for policymakers on the one hand, they pose significant policy challenges on the other. Non-intervention or insufficient intervention would result in further appreciation of the rupee and affect India’s competitiveness. The 36-currency export and trade-based real effective exchange rate index in July was at 117.89 showing significant overvaluation. It is sometimes argued that India should not worry about currency, especially with an inflation-targeting regime in place, and export competitiveness is not solely dependent on the exchange rate. It is correct that external competitiveness is not exclusively dependent on the exchange rate, but it is also true that markets sometimes tend to overshoot in the short to medium term. Therefore, there is no harm in quelling volatility if possible, and giving 244 CU IDOL SELF LEARNING MATERIAL (SLM)

businesses a more stable economic environment. There have been at least two instances in recent history that support the idea of intervention when necessary. First, on the back of strong inflows, the RBI accumulated reserves at an accelerated pace between 2006 and early 2008, which helped India deal with the consequences of the 2008 global financial crisis. Second, inadequate intervention in the years preceding the 2013 taper tantrum episode resulted in a higher current account deficit and India got pushed dangerously close to a crisis. To be sure, intervention in the currency market has costs and central banks do not have unlimited power to influence outcomes. Further, the present liquidity situation is making things more difficult for the RBI. The banking system has excess liquidity of around Rs3 trillion and currency market intervention will increase this. Even though there is no imminent threat of high inflation, persistent surplus liquidity can affect monetary policy operations. Mopping up liquidity through a sale of government securities will affect the central bank’s earnings and will have fiscal implications. For example, liquidity management costs after demonetization could be one of the reasons why the RBI gave a lower-than-expected dividend to the government. Also, yields on foreign assets are much lower than government of India bonds and sterilized intervention is in effect a switch in central bank holdings from rupee to dollar securities. So how can the central bank deal with this problem of plenty? One option is to work with the government and use an instrument like market stabilization scheme bonds and continue to build reserves. But, in this case, the cost would keep rising as higher reserves would attract more flows. Rising reserves will reduce the currency risk for foreign investors. The other option is that now that India has adequate reserves and stable macros, it reassesses the kind of foreign funds it wants. For instance, flows in the form of equity capital are more stable and less risky compared with debt. India’s external debt is at about 20% of gross domestic product, and about 37% of this is commercial borrowings. Policy rationalization on this front can ease the pressure on both the RBI and the rupee. 13.5 MECHANISM TO SETTLE PROBLEMS In response to the Herstatt episode, the G-10 central banks began by working together on supervisory issues, including FX market risk and the need for an international early warning system. supervisory issues, including FX market risk and the need for an international early warning system. In the early 1980s, they began to study the payments systems used for the settlement of domestic and cross-border transactions, with a view to ensuring that the structures and designs of those systems did not create unacceptable interbank credit exposures and did not generate liquidity risks for the financial markets or for the national or international banking systems. It was in particular apparent that large value cross-border payments, including those made in settlement of FX transactions, account for a large, and sometimes very large, proportion of flows through domestic payments systems, and this was seen to require detailed analysis. The work of the G-10 central banks on international 245 CU IDOL SELF LEARNING MATERIAL (SLM)

payment arrangements has produced several studies, including the February 1989 Report on Netting Schemes, the November 1990 Report of the Committee on Interbank Netting Schemes and the September 1993 report on Central Bank Payment and Settlement Services with respect to Cross- Border and Multi-Currency Transactions. Through these studies the central banks identified issues that may be raised by cross-border and multi-currency netting arrangements, recommended minimum standards and an oversight regime for cross-border netting schemes, and examined possible central bank service options that might decrease risk in the settlement of FX trades. In June 1994 the CPSS formed the Steering Group on Settlement Risk in Foreign Exchange Transactions to build upon this past work and to develop a strategy for reducing FX settlement risk. In preparing its report, the Steering Group developed a definition and methodology for measuring FX settlement exposure. Using this analytical framework, the Steering Group surveyed approximately 80 banks in the G-10 countries to document current market practices for, and barriers to, managing settlement risks in a prudent manner. 13.6 ROLE OF RBI IN SETTLEMENTS The central bank of any country is usually the driving force in the development of national payment systems. The Reserve Bank of India as the central bank of India has been playing this developmental role and has taken several initiatives for Safe, Secure, Sound, Efficient, Accessible and Authorised payment systems in the country. The Board for Regulation and Supervision of Payment and Settlement Systems (BPSS), a sub-committee of the Central Board of the Reserve Bank of India is the highest policy making body on payment systems in the country. The BPSS is empowered for authorising, prescribing policies and setting standards for regulating and supervising all the payment and settlement systems in the country. The Department of Payment and Settlement Systems of the Reserve Bank of India serves as the Secretariat to the Board and executes its directions. In India, the payment and settlement systems are regulated by the Payment and Settlement Systems Act, 2007 (PSS Act) which was legislated in December 2007. The PSS Act as well as the Payment and Settlement System Regulations, 2008 framed thereunder came into effect from August 12, 2008. In terms of Section 4 of the PSS Act, no person other than the Reserve Bank of India (RBI) can commence or operate a payment system in India unless authorised by RBI. Reserve Bank has since authorised payment system operators of pre-paid payment instruments, card schemes, cross-border in-bound money transfers, Automated Teller Machine (ATM) networks and centralized clearing arrangements. National Payments Corporation of India The Reserve Bank encouraged the setting up of National Payments Corporation of India (NPCI) to act as an umbrella organization for operating various retail payment systems (RPS) in India. NPCI became functional in early 2009. NPCI has taken over National Financial 246 CU IDOL SELF LEARNING MATERIAL (SLM)

Switch (NFS) from Institute for Development and Research in Banking Technology (IDRBT). NPCI is expected to bring greater efficiency by way of uniformity and standardization in retail payments and expanding and extending the reach of both existing and innovative payment products for greater customer convenience. Oversight of Payment and Settlement Systems Oversight of the payment and settlement systems is a central bank function whereby the objectives of safety and efficiency are promoted by monitoring existing and planned systems, assessing them against these objectives and, where necessary, inducing change. By overseeing payment and settlement systems, central banks help to maintain systemic stability and reduce systemic risk, and to maintain public confidence in payment and settlement systems. The Payment and Settlement Systems Act, 2007 and the Payment and Settlement Systems Regulations, 2008 framed thereunder, provide the necessary statutory backing to the Reserve Bank of India for undertaking the Oversight function over the payment and settlement systems in the country. 13.7 SUMMARY  Presently, there are over 61,000 ATMs in India. Savings Bank customers can withdraw cash from any bank terminal up to 5 times in a month without being charged for the same. To address the customer service issues arising out of failed ATM transactions where the customer's account gets debited without actual disbursal of cash, the Reserve Bank has mandated re-crediting of such failed transactions within 12 working day and mandated compensation for delays beyond the stipulated period. Furthermore, a standardised template has been prescribed for displaying at all ATM locations to facilitate lodging of complaints by customers.  There are over five lakh POS terminals in the country, which enable customers to make payments for purchases of goods and services by means of credit/debit cards. To facilitate customer convenience the Bank has also permitted cash withdrawal using debit cards issued by the banks at PoS terminals.  The PoS for accepting card payments also include online payment gateways. This facility is used for enabling online payments for goods and services. The online payment is enabled through own payment gateways or third-party service providers called intermediaries. In payment transactions involving intermediaries, these intermediaries act as the initial recipient of payments and distribute the payment to merchants. In such transactions, the customers are exposed to the uncertainty of payment as most merchants treat the payments as final on receipt from the intermediaries. In this regard safeguard the interests of customers and to ensure that the payments made by them using Electronic/Online Payment modes are duly 247 CU IDOL SELF LEARNING MATERIAL (SLM)

accounted for by intermediaries receiving such payments, directions were issued in November 2009. Directions require that the funds received from customers for such transactions need to be maintained in an internal account of a bank and the intermediary should not have access to the same.  Mobile phones as a medium for providing banking services have been attaining increased importance. Reserve Bank brought out a set of operating guidelines on mobile banking for banks in October 2008, according to which only banks which are licensed and supervised in India and have a physical presence in India are permitted to offer mobile banking after obtaining necessary permission from Reserve Bank. The guidelines focus on systems for security and inter-bank transfer arrangements through Reserve Bank's authorized systems. On the technology front the objective is to enable the development of inter-operable standards so as to facilitate funds transfer from one account to any other account in the same or any other bank on a real time basis irrespective of the mobile network a customer has subscribed to.  LIBOR, or London Interbank Offered Rate, is the interest rate offered by London banks on deposits made by other banks in the Eurodollar markets. The market for interest rate swaps frequently used LIBOR as the base for the floating rate until 2020. The transition from LIBOR to other benchmarks, such as the secured overnight financing rate (SOFR), began in 2020.4 For simplicity, let's assume the two parties exchange payments annually on December 31, beginning in 2007 and concluding in 2011. 13.8 KEYWORDS  Sight Draft – A draft payable upon presentation to the drawee or within a brief period thereafter known as days of grace.  Society for Worldwide Interbank Financial Telecommunications (SWIFT) – A telecommunications network established by major financial institutions to facilitate messages among SWIFT participants. These messages typically result in a monetary transaction between institutions. The network is based in Brussels.  Soft Currency – A currency that is not freely convertible into other currencies.  Soft Loans – Loans with exceptionally lenient repayment terms, such as low interest, extended amortization, or the right to repay in the currency of the borrower.  Sole of Exchange – A phrase appearing on a draft to indicate that no duplicate is being presented. 13.9 LEARNING ACTIVITY 1. Create a survey on Foreign Exchange Market. 248 CU IDOL SELF LEARNING MATERIAL (SLM)

___________________________________________________________________________ ___________________________________________________________________________ 2. Create a session on Objectives of Foreign Exchange Control. ___________________________________________________________________________ ___________________________________________________________________________ 13.10 UNIT END QUESTIONS A. Descriptive Questions Short Questions 1. What are Spot Markets? 2. What are Forward Markets? 3. Define Foreign Exchange? 4. Write the main problem in Foreign Exchange? 5. What is Role of RBI in Settlements? Long Questions 1. Explain the Types of Foreign Exchange Market. 2. Examine the Objectives of Foreign Exchange Control. 3. Explain the Problems in Foreign Exchange Market in India. 4. Illustrate the Mechanism to Settle Problems. 5. Illustrate the Role of RBI in Settlements. B. Multiple Choice Questions 1. What does seller of an option have? a. Right to buy or sell the underlying asset b. The obligation to buy or sell the underlying asset. c. Ability to reduce transaction risk d. Right to exchange one payment stream for another 2. What does the seller of an option have to buy or sell the underlying asset while the purchaser of an option has to buy or sell the asset? a. Obligated; right b. Right; obligation c. Obligated; obligation 249 CU IDOL SELF LEARNING MATERIAL (SLM)

d. Right; right 3. What is the amount paid for an option is? a. Strike price. b. Premium c. Discount d. Commission 4. When an option can be exercised at any time up to maturity is known as? a. Swap b. Stock option c. European option d. American option 5. Which of the following is an option that can only be exercised at maturity is called? a. Swap b. Stock option c. European option. d. American option. Answers 1-b, 2-a, 3-b, 4-d, 5-c 13.11 REFERENCES References book  Acharya, Viral V. and Matthew Richardson, eds., (2009) Restoring Financial Stability: How to Repair a Failed System. Hoboken, N.J.: Wiley,  Acharya, Viral V., Thomas F. Cooley, Matthew P (2011) Richardson, and Ingo Walter, eds., Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance. Hoboken, N.J.: Wiley,  Barth, James R., Gerard Caprio, (2006) Jr., and Ross Levine, Rethinking Bank Regulation: Till Angels Govern. New York: Cambridge University Press. Textbook references 250 CU IDOL SELF LEARNING MATERIAL (SLM)