Banks – the regulations that govern them – and what happens when they are not governed.

In addition to my Facebook posting previously on the issues that have been faced in the aluminum markets, banks are generally now increasingly involved in a number of markets from energy to aluminum.

I was reading an excellent article in Bloomberg which very neatly explained the connections. Banks are now subsidized by the government. The Federal Deposit Insurance Corporation and the Federal Reserve (both backed by the taxpayers) provide a subsidy to banks – allowing them to draw on reserves during times of market instability.

 

This means that the banks which are too big to fail (and can cause catastrophic consequences should they go under) are effectively allowed to borrow at low or cheap rates.

 

What this means is that banks who can borrow at a lower rate than most other corporations, start investing in markets such as energy or the metal markets such as the aluminum markets, create stockpiles and cut supply which in turn creates a higher price from which they benefit from when they then sell the commodities in the open market.

In the event they bet wrongly, and the prices of the commodities they are stockpiling drop and lead to financial distress at the banks, then the government (and taxpayers) are obliged to provide emerging funding reserves to tide them through.

This creates similar risk-incentive situations which caused the 2008 financial crisis in the first place.

It will be also useful to learn about some of the existing regulations which are in place or which have been lifted but which may need to be considered to prevent the type of problems we had/have now.

The Dodd-Frank Wall Street Reform and Consumer Protection Act (Link: in full here) –

This is an act that has polarised America with one faction arguing that the Act does little to prevent another financial crisis or stop risky behaviour that will lead to another bailout whilst another faction argued that it was too restrictive and draconian.

The volcker Rule – Within this Act, under the section of “Improvement to Regulation” is the Volcker Rule – which essentially restricts US banks from making a number of speculative investments that do not benefit their customers and only seeks to boost the banks and bonus payouts of senior management at the banks.

With the aim of reducing the amount of speculative investments on large firms’ balance sheets, it limits banking entities to owning no more in a hedge fund or private equity fund than 3% of the total ownership interest.The total of all of the banking entity’s interests in hedge funds or private equity funds cannot exceed 3% of the Tier 1 capital of the banking entity. Furthermore no bank that has a direct or indirect relationship with a hedge fund or private equity fund, “may enter into a transaction with the fund, or with any other hedge fund or private equity fund that is controlled by such fund” without disclosing the full extent of the relationship to the regulating entity, and assuring that there are no conflict of interest

 

Glass-Steagall Act (Link to Act here)

This was an Act that was around from the time of the Great Depression in the 1930s until the Clinton Administration repealed it at the turn of the century.

Established as a part of President Franklin D. Roosevelt’s New Deal following the Great Depression, the Glass-Steagall Act actually refers to a handful of provisions sponsored by Sen. Carter Glass and Rep. Henry B. Steagall, which were a part of the larger Banking Act of 1933.

These provisions accomplished a number of things, but most notably prohibited commercial banks from participating in investment banking; this includes activities such as underwriting securities (except for certain treasuries), providing services by brokers or dealers in transactions in the secondary market, as well as facilitating mergers, acquisitions and other forms of restructuring. Investment banks were likewise prohibited from accepting deposits.

The ending of Glass-Steagall removed the distinction between investment banks and commercial banks, leading to a scenario where banks started making risky investments with government-guaranteed deposits.

However, in the last few months, a bipartisan group of senators put forward a proposal for new Glass-Steagall legislation that would restore a strict separation between commercial banks and speculative trading. It is argued that this will inhibit the excessively risky behaviours demonstrated by a number of banks and help prevent the next financial catastrophe.

 

Nepal – overcoming structural challenges

Following on from my previous article on the opportunities in Nepal, it is also important to address some of the wider structural challenges that may severely impede Nepal’s development and economic progress.

Some of the issues to consider will be:

  • Political reforms and stability – the ongoing political stalemate does not help either the local populace or international business sentiment. Long-range planning and investment decisions become virtually impossible. A quick resolution of the deadlock is required. 
  • Greater clarity on the rule of the law and resolution of regular labour/union strikes – A better balance needs to be found to addressing valid and legitimate labour concerns and the crippling strikes (or hartal) that take place which paralyse all business activities and operations. Widespread strikes do not provide any stability to businesses or visitors to the country. However, it is also important that a heavy handed approach is not taken to resolving the issue of strikes. A calibrated approach needs to be taken to ensure workers’ rights are taken into serious consideration but also allow for optimal business operations.
  • Enhanced governance and anti-corruption – Both of the above can only be addressed through taking on a robust governance approach – from government down to businesses to individuals. This is a wider problem across emerging economies (particularly in a South Asian subcontext) but if serious approaches can be taken to tackle them, some headway will be made. This will be critical for sustained growth and development prospects for the country.
  • Continued support to rural and agricultural development – Nepal still remains a largely agricultural nation. It is vital that farmers and rural areas are given complete assistance from the Nepal government and other international donors. Often, nations in their hasty eagerness towards development focus a disproportionate amount of resources towards the development of a commercial and industrial centre and tend to ignore the rural development. The protection of a nation’s food sources and breadbasket is a vital aspect of nation building which cannot be overlooked or underestimated.
  • A more open and liberal banking system – Currently, the Nepali banking system is not widely integrated into international banking systems. The use of credit cards are low and electronic payment facilities are also limited. To further support the export sector development, Nepal needs a greater liberalisation of the banking sector and financial markets to further support growth. Greater investor education is also required for a more efficient functioning of the existing capital markets too. Banks should also further support micro-financing initiatives and SME initiatives to further spur easier access to finance which will support greater innovation. SME focused growth always provides for a broad-based economic development and creates a more resilient and innovative economy.
  • Continued focus on education – Nepal should increase the level of GDP spend on education. This will include increasing the quality of schools (from primary level up to college (SSLC) levels). Increased investment is also required for the leading universities in the country (including Tribhuvan University, Kathmandu University and Pokhara University) and to support enhanced teaching and research faculties. There should also be a support for vocational and professional training to ensure better alignments of educational outcomes to the country’s developmental needs.
  • Improved redistribution of resources and income – Nepal has the worst levels of income inequality in South Asia (and amongst the highest in all of Asia – Hong Kong has the highest followed by Singapore). Nepal’s gini coefficient has increased from 31 to 47 over the last decade. The gini coefficient is a measure of income inequality across the country’s entire population. A value of zero suggests absolute equality and a score of 100 suggests absolute inequality. What this also means is that in Nepal, over 40 percent of income/consumption is held by the highest 10 percent of the population whilst the lowest 10 percent of the population only share 2.6 percent of income. This means that the growing economy of Nepal is not benefitting all of the country and much of the wealth is being concentrated at the very top. This is a problem faced by most emerging nations and one that needs to be tackled at policy and operational level. Over a long period, this will also lead to political and economic instability and the potential for class warfare becomes much more distinct. It is vital that the Nepali government, policy makers and international donors address this very critical issue. It is also something which the larger businesses should address – ensuring better equality will lead to greater stability of the business environment – it’s simply good business to have greater equality.
  • Infrastructure improvement – It is excellent to see that the roads are being widened, expressways being built and greater investment in information and communications technology. Nepal also needs to address the chronic electrical brownouts or outages and ensure better redistribution of hydro power being generated (Nepal has the potential to be the world’s largest producer of hydro power) to wider segments of the country. Ongoing commitment to infrastructure commitment will be crucial to support future growth.
  • Renewed focus on environmental and social protection – It is vital that amidst all of the industrial and commercial developments that Nepal does not take an eye off the impacts on the environment. With the large investments in hydroelectric power stations, there will always be a temptation to close an eye to the environmental degradation and pollution, but the impacts will be significant, if not immediately then over a longer time frame. Progress today is worthless if future generations do not have clean water, fresh air and a healthy environment.
  • Prevent a housing bubble – With rapid developments, most emerging economies go through a period of a sharp upward creep of property and housing prices. It is critical that the Nepal government and relevant authorities ensure that this is tackled swiftly. Housing booms lead to bubbles and as most children can attest – all bubbles burst! There are some instructive experiences from Vietnam, Iceland and other emerging economies and if nothing else, it is important we learn through the painful experiences of others. Housing and property booms do not contribute to the economic growth of a nation. They are depreciating asset classes which do not produce or contribute to a nation’s growth contrary to popular beliefs and expectations. Affordable housing has to remain at the core of nation building and the moment it becomes too expensive for the locals to afford a home in their own lands, it leads to painful corrections.

The above are some of my own personal thoughts on the various structural challenges facing Nepal based on my own limited experiences in the country. Nepal has reaffirmed her commitment to the Millennium Development Goals and this is highly laudable. The commitment must not only be in the form of agreement at international meetings and forums but also in the form of concrete developments and actions on the ground.