Determinants of Bank Profitability in South Africa
Dissertation Title: Determinants of Bank Profitability in South Africa. The prime rationale for conducting the research is to find the factors that affect the bank’s profitability in the South African region so that appropriate measures can be taken to improve the financial performance. This research provides empirical evidence based on the analysis of the bank’s real financial data in support of the determinants of the bank’s profitability. Thus, this research is considered to be useful in enhancing the knowledge of the bank professionals, as well as the students pursuing higher studies in finance and banking.
The banking sector has been blamed the most for the financial crisis that happened in the recent past. Therefore, it has been perceived to be very important to research and find the factors that affect the bank’s profitability so that the situation could be controlled in the cases of the financial crisis. In this context, this research explores the relationship of the factors such as liquidity, management efficiency, capital adequacy, the scale of operations, productivity of assets, growth in gross domestic product, and inflation with the return on equity.
The primary aim of this dissertation is to explore the determinants of bank’s profitability in the South African region. For this purpose, the research is aimed to find the crucial factors that affect the bank’s profitability in the South African region. Further, in this regards, the degree of influence of the factors on the bank’s profitability has also been evaluated in this dissertation. With regards to the research aim, the following objectives have been developed, which are to be addressed in this research:
To review, research, and understand the regulatory framework prevailing in the South African region
To study the bank system in South Africa through developed models and evaluate the factors, which contribute to the bank’s profitability
To explore the determinants of bank’s profitability in the South African region
Background of the Research
Rationale for Doing the Research
Aim and Objectives
Significance of the Research
Organisation of the Research
Bank Specific Factors Affecting the Profitability
Size of the Bank
Credit Risk Management
Product and Service Portfolio
Efficient Management Team
Industry or Sector Specific Factors
Banking Regulation in South Africa
Gross Domestic Product
Prime Lending Rates
Taxation and Foreign Trade
Data Collection Method
Selection and Justification
Sample Size and Sampling Strategy
Data Analysis Process and Tools
Limitations of the Research
Analysis of the CAMEL Ratios
Net Interest Margin
Productive Asset Ratio
Advance and Loans to Deposit Ratio
Analysis of the Gross Domestic Product
Analysis of the Inflation
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Corporate Accounting – Significance, Application and Standards
Corporate Accounting is one of the major parts in financial management procedures of an organization. Accounting practices are necessary for a company in order to show how an organization has been successfully operating over the course of the year and making future plans for budgets and expenditures (Das, 2011). However, it is studied that accounting is a broadest term which have several branches and areas for different business and for different purposes. In which some of them are financial accounting, cost accounting and corporate accounting (Malwitz, 2008). However, this paper is merely focusing on defining the corporate accounting by incorporating corporate accounting theories, significance, concepts, legislation, applications and standards.
Corporate accounting is a special branch of accounting which can be defined as the quantity, recording and interpretation of financial information and data of a limited company which can be either a public limited company or a joint stock company (Fyler, 2013; Ijiri, 1980). Moreover, it is found that corporate accounting is an accounting which is particularly for larger companies since smaller-scale companies, sole traders or partnerships business cannot implement corporate accounting to maintain their financial record or information.
It is because smaller-scale companies, sole traders or partnerships businesses have not much requirements and demands in order to fulfil the accounting standards and to meet with accounting principles (Ijiri, 1980). On the other hand, large scale organizations or limited companies have sufficient financial information and data that they have to show to the general public and regulatory bodies therefore they have to maintain proper financial records with the help of corporate accounting (Fyler, 2013; Ijiri, 1980; Das, 2011).
Furthermore, it is studied that corporate accounting also deals helps the limited companies or large scale organizations in term of preparing final accounts, maintaining cash flow statements, analysing and interpreting financial results of the respective company particular for any specific events such as amalgamation, absorption, and helps company in preparation of consolidated balance sheets (Paton & Littleton, 1986).
By reviewing several studies, it is identified that the corporate accounting has some basic principles and foundations on which the overall accounting practices are based. The key foundations of corporate accounting include Accounting Cycle, Double Entry Accounting, and financial statements (Bennett, 2013). In which Accounting Cycle involves the regular recording and reporting of financial data or information. The accounting cycle completed within a specific period of time as per the policies of companies. Usually, it completed in a month or year.
Corporate Accounting Cycle
The accounting cycle begins by recording all financial transactions such as cash exchanges or debits and credits by using a general ledger approach. General Ledger is a precise and clear summary of all accounts including payable and receivable (Bennett, 2013; Ijiri, 1980). The next stage of accounting cycle is the adjustment of general ledger which can be done by taking items or entries which are not the direct transactions, such as bad debt, taxes and accrued interest. Thus, it is a key area therefore accountants must ensure that revenues and expenditures are match up as per each accounting period. In case, of accountant failed to do this properly, it can lead to confusion over financial irregularities and at the end of the period it can create confusion in overall revenue and total profit for the period (Bennett, 2013; Ijiri, 1980).
The second key element of the corporate accounting is double entry accounting, which can be defined as the standard accounting concept used by limited companies or large scale organizations. The basic of double entry accounting is based on the notion that for all actions there is an equal and opposite reaction (Bennett, 2013; Ijiri, 1980). It means that when a financial gain takes place in any part of financial statement, it should be escorted by a loss somewhere else on the balance sheet.
Suppose that of if a limited purchases a product to sell, so it will show the decrease in cash in financial statement and in the same way it will show the increase in inventory of certain organization (Bennett, 2013; Ijiri, 1980). Finally, the financial statement is another key aspect of corporate accounting, which is refers to the financial reports prepared at the end of the company’s financial year.
This financial report basically includes the cash flow statements, balance sheets and income statements for the previous 12 months. The financial reports of an organization show the summary and of all financial activity including overall profits or losses incurred by respective company (Bennett, 2013; Ijiri, 1980). Furthermore, it has been examined that the financial report helps accountant of a limited company in terms of preparing tax returns, while stockbrokers and investors use the same financial reports for the comparison between respective company and international business performance.
In addition to this, it is found that the financial reports also help the managers of certain company in terms of a assessing the performance of the company as well as in making proper plan and budget for company to successfully execute its operation in upcoming year. Following is the table that represents the different accounting terms used in UK and USA (Joos & Lang, 1994):
Table 1 – Accounting Terms as Per UK and USA Standards
United States of America
Balance sheet/Statement of financial position
Accounting for loss contingencies
Profit and loss Reserves
Paid in surplus
Shares premium account
Management’s premium of operations
Management’s discussion of financial resources and liquidity
Income statement/Statement of earning
Profit and loss account
Earnings per share
Net income per share
Balance sheet/Statement of financial position
Tangible fixed assets
Property, plant and equipments
In addition to the above, it is identified that in most of the limited companies particularly in UK (United Kingdom) and USA (United States of America), for the preparation of financial reports or execute corporate accounting practices specific accounting standards are used which are only set in common law (Joos & Lang, 1994). However, in different countries, it has been studied that the corporate accounting are different from each other therefore different countries uses different accounting regulations in order to maintain financial records and for the preparation of yearly financial reports.
Furthermore, it has been examined that throughout the world there are two types of accounting standards are used which includes the International Financial Reporting Standards (IFRS) and the Generally Accepted Accounting Principles (GAAP) (Young & Wiley, 2011; Everingham, et al., 2007).In which International Financial Reporting Standards (IFRS) provides rules for business affairs from the global perspective in which the accounts and financials of a company can be understood and compared across international boundaries (Young & Wiley, 2011; Everingham, et al., 2007). On the other hand, General Accepted Accounting Principles (GAAP) provides rules to collect and interpret financial data for multinational competitors with the help of financial statement (Young & Wiley, 2011; Everingham, et al., 2007).
International Financial Reporting Standards
It is further examined that the International Financial Reporting Standards (IFRS) are mostly adopted by the companies operating throughout the European Union. Beside it, the organization in several countries like Australia, South Africa and Russia are also now widely followed IFRS accounting standards for the recording of financial information and analysing and interpreting financial data. In contrast, specifically in the United States limited companies are bound to utilize the GAAP accounting standards for all kinds of accounting practices (Young & Wiley, 2011; Everingham, et al., 2007).
Thus, it has been concluded that, the corporate accounting system allow companies to successfully maintain financial data as per their company policies, regulated accounting standards and accounting principles or laws determined by common law.
Bennett, R. (2013) Corporate Accounting Basics. Free Press.
Das, B. (2011) Is Corporate Accounting a science or an art? Accounting, pp. 1-1.
Everingham, G. K., Everingham, G., Kleynhans, K., Posthumus, L., Kleynhans, J. E., & Posthumus, L. C. (2007) Principles of Generally Accepted Accounting Practice. Juta and Company Ltd.
Fyler, T. (2013) What Is A Definition Of Corporate Accounting
Ijiri, Y. (1980) An Introduction to Corporate Accounting Standards: A Review. The Accounting Review, 620-628.
Joos, P., & Lang, M. (1994) The Effects of Accounting Diversity: Evidence from the European Union. Journal of Accounting Research, 32, 141-168.
Malwitz, M. (2008) Financial Consolidation and Reporting Solutions: Adding Value to Enterprise Resource Planning Systems. Oracle Paper, pp. 1-21.
Paton, W. A., & Littleton, A. C. (1986) An Introduction to Corporate Accounting Standards. Amer Accounting Assn.
Young, E. &., & Wiley, J. (2011) International GAAP 2012 – Generally Accepted Accounting Practice Under International Financial Reporting Standards. John Wiley & Sons.
The financial crisis commenced in August 2007 after the preceding inflation. The crisis became more defined throughout 2007 and gained momentum in 2008. This took place even after the financial regulators and the central banks’ tireless attempts to tame the situation. It is alleged that the main factors that influenced its manifestation include corruption, fraud, speculation, greed, bankers and bankers’ bonuses. However, the academic discourse, politics or media has been unable to solve the mystery surrounding the main causes of the crisis. The mystery is academically relevant to the world of research just like the Great Depression, whose causes are still being discussed. Other sources believe that the crisis might have been as a cause of human failures especially following the refusal to bail out the Investment Bank Lehman Brothers. The housing bubble was the immediate trigger of the 2008 financial crisis. The following were the triggers under the housing bubble.
A subprime mortgage is the mortgage that is readily acceptable without imposing strict measures of standard on it. Before the 2008 financial crisis, there existed a fierce competition between mortgage lenders. The competition between the mortgage lenders ensued from the struggle for market share and revenue. It also took place in tandem with limited supply of creditworthy borrowers which put unconditional stress on the financial institutions. The relaxing mood by the mortgage was apparent and hence less creditworthy borrowers were granted mortgages. This was a financial err due to failure to adhere to high standards of lending and hence riskier mortgages were granted to the borrowers. This was also evident in early 2003 where the Government Sponsored Enterprises (GSE), due to their conservative nature, sustained relatively high underwriting standards. The Government Sponsored Enterprises also policed mortgage originators prior to 2003 while maintaining high underwriting standards at the same time. Consequently, the market power shifted originators straight from the securitizers and hence led to tight competition between Government Sponsored Enterprises and the private securitizers. This competition undermined the power of Government Sponsored Enterprises and therefore compromised the mortgage standards. The situation also led to proliferation of risky loans.
During the years preceding the 2008 financial crisis, there was a competitive pressure that ultimately accelerated the subprime lending by the investment banks in the United States and Government Sponsored Enterprises such as Fannie Mae. The Fannie Mae became the biggest lender while the GSE relaxed their quest for the purpose of catching up with the private banks in the United States. Summarizing the subprime lending, there were low bank interest rates, existence of abundant credit and hiking prices of houses. Due to these, there was relaxation of the lending standards and hence the increase in the number of loan borrowers. Through the scheme, the borrowers were able to borrow loans to buy very expensive houses that they could not afford initially. Later on, the house prices started to decline, the loans went sour and hence the cause of shock to the financial system and the global economy. This happened prior to 2008 and hence it can be declared as the major instigator of the 2008 financial crisis
Growth of the Housing Bubble
Identification of a bubble is complicated before it bursts. It is counter intuitive to state that early detection of the housing bubble and its immediate eradication is the best mitigation practice. However, mitigation of housing bubble is the worst thing to do because it can damage the economy. It is advisable to wait for the housing bubble to burst and then respond to its effects.
The housing bubble, as far as the 2008 financial crisis is concerned, led to 124 per cent increase in the price of typical American houses. The bubble took place between 1997 and 2006-approximately one decade. The bubble had drastic consequences on the economy and especially to the home owners in the United States of America prior to the 2008 crisis. The homeowners started to finance their mortgages at very low interest rates and hence denying the financial banks room for development. Other homeowners picked on securing secondary mortgage loans due to appreciation of prices.
The housing bubble started to collapse in early 2006. Several factors led to the bursting of the housing bubble. There was decline or stagnation of the hourly wages in the United States of America between 2002 and 2009 and hence house prices could not continue rising. This is because the houses had become completely unaffordable. The second cause of bubble bursting was as a result of increased supply of houses due to the high market demand. Consequently, the supply of houses superseded the demand in the market. This case reduced monopoly by the housing providers and later increased the desired healthy competition in the housing industry. As a result, the house prices began to decline due to the high supply and less demand. The above causes were also related to the subprime lending-another cause of the 2008 financial crisis.
Increased Debt Burden or Over-Leveraging
Before the 2008 financial crisis, there was an increased leveraging of financial institutions. The institutions were very optimistic and hence they did not mind engaging in risky investments. They also set up smart measures that would cushion them from the unexpected consequences. The leverage entailed the use of complicated financial tools such as derivatives and off balance sheet securitization. This was risky because it denied the financial monitors and crediting institutions the capability to curb the impending risks. It became harder to reduce the risk levels due to the vulnerability exposure by the financial institutions and their subsequent moderations. Consequently, the measures could not curb the stress on the financial institutions and hence exacerbating bankruptcy of several commercial banks and other lending institutions.
There was evidence of over-leveraging by the financial institutions in the United States during this prime period. The financial institutions became highly indebted just before the 2008 financial crisis set in. The institutions were hence vulnerable to the failure of the housing bubble. The economic tantrums became worse in precedence to the crisis. At this time, the U.S household debt hit 127 percent in 2007, up from 77 percent in 1990. Allegedly, the debt led to economic recession that in turn led to the fall in employment rates and increased credit losses by the involved financial institutions. Other effects were also felt prior to the crisis as far as the household and the financial institutions finances are concerned. After the spread of the balance sheet leveraging across the economy, consumers started to save on the purchase of durable goods, businesses started to lay off workers, planned investments were cancelled and the financial institutions started to freeze their assets to improve their financial stability while bolstering capital.
Following the collapse of housing bubble in early 2007, prices of essential commodities increased. The increase in commodity prices was one of the very many consequences of the housing bubble burst. The housing bubble, according to economists, was very stressful to the household economy and the banking institutions at large. Consumption of certain commodities was either regulated or cut off to increase on savings and carter for the other basic needs. To prove this, it is on record that the price of oil was approximately three times the initial price. The price tripled to US $147 from a mere US $50 between 2007 and 2008. There was speculation that money was flowing from the household finances into commodities. The financial institutions were also blamed for the increased commodity prices. There existed an acute shortage of raw materials and hence increasing the cost of production. This scenario subsequently raised the prices of essential commodities. The raw material crisis was somehow contributed by the Chinese dominance in Africa and the other potential states in the world.
The soaring prices of oil directly affect the arithmetic involved in consumer spending. Most often, production cost is transferred to the consumers who are required to spend more on gasoline and gas than on the other essential commodities. During the 2008 financial crisis, house bubble was part and parcel of all these occurrences and hence its exacerbation as a result. The pending issues were not solved in accordance with the economic situation due to the surging oil prices. The oil producing countries were the main beneficiaries of this scheme as they ended up accumulating most of the wealth. Apparently, the oil importing countries had to spend more in purchasing the oil and hence the cost of commodity production in the respective states increased. The consumers were the main sufferers because they had to redirect finances from other avenues to settle the commodity bills. Copper and Nickel prices also went high prior to the crisis. Without any doubt, it is evident that the effects of the price instabilities and price variations contributed to the financial crisis.
Role of Economic Forecasting
Economists are the principle advisors whenever economic issues such as depression, recession and stability are concerned. They are required to analyze the past financial crisis and should be responsible for forecasting any impending economic crisis. They are also required to advice the ordinary people, stakeholders and financial institutions on economic trends, future crises and the mitigation measures of mitigating them. An unfortunate occurrence took place prior to the eruption of the 2008 financial crisis. The crisis was not predicted by the mainstream economists in the United States. However, it is rife that several heterodox economics had a feeling of the occurrence of the crisis but there was an argument of misunderstanding between them. They had varying arguments on the estimating of the appropriate time of the crisis. Only 12 of the economists managed to predict the crisis. They included Eric Janszen of the US, Dean Baker of the US, Fred Harrison of the UK, Wynne Godley of the UK, Kurt Richebacher of the US, Peter Schiff of the US, Nouriesl Roubini of the US, Steven Keen of Australia and Denmark’s Jens Kjaer Sorensen.
Schools and other economic institutions also predicted the crisis. The schools based their predictions on observing the effects of artificial and laxity in the supply of money. It was also stated that the economists were unable to predict the crisis since the 1930’s global Great Depression. There were several articles including the New York Times and other university journals that had a revelation of the occurrence of the 2008 global financial crisis. However, from the economic school of thoughts’ perspective point of view, it is stated that predicting financial crises is a nearly impossible task.
Impacts on Financial Markets
The 2008 financial crisis impacted negatively on financial markets. Since the financial markets greatly affect the economy, various stakes were upheld and hence the stress on the economy. The impact was evident on the U.S stock market and the other financial institutions.
U.S Stock Market
In October 2007, the stock market in the United States peaked after exceeding the Dow Jones Industrial Average Index with 14, 000 points. In early 2008, the stock market started experiencing a steady decline until it reached approximately 6, 000 points by March 2009. The statistics started to flourish again between March 2009 and early 2011 when it exceeded 12, 000 points. The points were recorded above 13, 000 points by 2012. This was a positive improvement based on the comparison between the performances of the stock market during 2007, 2008, 2009, 2010, 2011 and 2012. The steady increase was quite beneficial to the economy of the United States at a time when it was experiencing the most drastic effects of an economic downtown.
Partially, the quantitative easing technique that was applied by the Federal Reserve’s economic policy of aggression was behind the success of recovery of the United States stock market. The recovery of the United States stock market back to its functional status was a welcome effect that was essential to curb the effects of the financial crisis and mitigate the future occurrences of the same caliber. The positive performance in the stock market was also attributed to various factors concerning the efforts steered by the financial community to save the economy from succumbing to the financial crisis. The poor performance by the United States’ stock market was also experienced during the Great Depression.
Financial institutions are a conglomerate of bankers and providers of banking services. Lending firms and institutions are also part and parcel of the financial institutions. There was an estimated amount of money by the International Monetary fund alleged to have been lost by the U.S banks and European banks. The estimated amount of the lost money was $ 1 trillion. The money was lost through poor techniques of loan allocations between the time period of 2007 and September 2009. Approximately 60 percent of American banks were affected while 40 percent of the banks in Europe were affected.
Northern Rock bank of Britain was one of the worst-hit banks in the European region. The bank engaged in over leveraging matters of business that later forced it to seek security and protection from the Bank of England. This led to bank-run and instilled panic among the investors in September 2007. The bank’s management was then put under the receivership of the public by the British government after failing to secure the interests of willing private investors to take control of the bank. The Northern Rock’s scenario was just an indication of the very many problems that the other financial institutions were facing. The mortgage lending firms were the most affected since most of them became bankrupt. They were unable to secure their loans and financial benefits from credit markets. Almost all financial institutions predicted danger in terms of downfall and bankruptcy. The consequences included complete failure of the institutions to survive, subjection to takeover by the government or fire-sale in terms of duress acquisition by the willing investors. Most of the U.S and European banks were completely eliminated from the financial map.
Effects on the Global Economy
Global economy is supposed to be sustained at all costs. It is responsible for diversification of the resources and economic empowerment of the countries that operate under one umbrella. When one country is hit by an economic crisis, the other countries that engage in economic activities with the affected country are likely to experience an economic shakeup. Financial crisis is just like any other crisis but its effects are the most tragic because they impair economic growth. Economic stability is beneficial to a country while its instability has negative impacts on both the country and the citizens within its borders. Matters of economic interest are given the first priority when it comes to security and protecting citizens from economic depressions and its aftermaths such as high production costs, high interests on the borrowed funds and the subsequent increase in commodity prices. Apparently, the 2008 financial crisis affected several states both directly and indirectly.
Analysis of the commentators’ suggestion is welcome for argumentation. The commentators, with too much experience in the world economic trends commented on the impending effects of liquidity on the global economy. However, if the liquidity crisis persists, recession is likely to continue manifesting. With no mitigation measures urgently put in place to curb the liquidity crisis, it is likely that even more drastic effects of the recession will be experienced. Continued persistence of the financial crisis is predicted to affect the global economy which in turn can cause a collapse of the economy if not mitigated as soon as possible. This is an argument from a group of certain forecasters. Contrary to this argument, there also exists another group of optimistic forecasters who believe that financial crisis is not likely to affect the global economy.
School of thoughts has it that the financial crisis is likely to cause a major shakeup in the banking industry due to the melt-down of loans and savings. In mid-October 2008, the Investments Banks in the United States and the United Kingdom declared that continued financial crisis was a clear-cut indication of an impending global recession. They even had the audacity to estimate the time it would take for the global recession to start manifesting itself. They estimated the minimum period before the global recession could start shaking the economy as two years or less. Later on, the economists predicted that the crisis would end soon and that it was now the beginning of its end. This was evidenced by the efforts made by financial stakeholders in the world. This action was supposed to mitigate the financial situation immediately. Subsequently, the government injected reasonable capital into the economy that facilitated the cut-down of interest rates. This was one of the initial steps meant to enhance the well-being of the interested borrowers or the borrowers who were still repaying their loans. This meant that mortgages were now more affordable or better off. Their repayment was made cheaper as compared to the previous times when they were very high.
The United Kingdom was clever enough to mitigate the effects of the financial crisis by injecting the mentioned capital into its economy. The central banks across the globe were forced to cut-down the bank interests imposed on borrowers. This sufficiently helped to revive the deteriorating economy by attracting large numbers of borrowers. The United States was also required to systematically inject capital into its economy. This was not meant to completely mitigate the crisis because the worst was expected. It was only meant to deal with the financial crisis at that time but not the main solution to the crisis and the presumably impending economic crisis such as the global economic recession.
The UBS had already estimated the presumed duration of the expected recession in various economic power houses in the world. Recession in the Euro zone was to last for an approximated period of six months, the United States was to experience it for three quarters while the United Kingdom was to face a recession that would last for four quarters. Iceland is an example of some of the commonest countries on earth to be directly affected by the financial crisis. There was a major banking collapse in Iceland. It is still rated as the world’s major banking collapse in the history of economy.
The other countries in the world were also affected by the crisis because the Unites States was by then, the biggest shareholder in the world economy. Its spending habits were very beneficial to the world and hence it is intuitive to state that the rest of the world depended greatly on its success. The negative effects on the global economy were first observed in 2009 when Japan experienced a 15% decline in its GDP, 14% in Germany, 21% in Mexico, and 7% in the UK. The other developing countries also suffered significant slowdowns in their economic trends. However, the Arab World was least affected by the financial crisis because there were different sources of finances.
The government of the United States was supposed to establish the most appropriate mitigation measures and thereafter implement them for the purpose of streamlining the economy and its subsequent cushioning from any future crisis. There were various measures that were lined up by the government to gain both temporary and permanent stability of the economy. The two main responses included the short-term and emergency responses and long-term responses and regulatory proposals.
The Short-Term and Emergency Responses
The central banks across the world and the US government under the jurisdiction of the Federal Reserve have put the most appropriate measures in place to facilitate money supply and prevent occurrence of deflationary spiral. Deflationary spiral is the situation where high employment rates and lower wages cause low global consumption trends. The governments are also spending and borrowing funds from outside sources to increase demand by the private sector. The Federal Reserve in the United States dealt with the emergency by expanding liquidity facilities to enable the central bank to carry on with its duty of lending money. In mid-2008, the Central Banks and the Federal Reserves responded promptly to the crisis by settling government debts and buying private assets from the hard-hit banks. The European governments and the United States raised their national banking systems’ capital by approximately U.S$ 1.5 trillion. They purchased stocks from the major banks to set-off the liquidity saga. To curb further liquidity, the U.S government decided to create currency valued at approximately 600 Billion dollars and injected them into its banks. Brave enough, the banks invested the money in foreign investments and currencies.
Long-Term Responses and Regulatory Proposals
There was a series of regulatory proposals introduced in 2009 by President Barack Obama of the U.S. The contents of the proposal included consumer protection, cushioning of bank finances, and regulation of the systems involved with shadow banking. Another proposal was to limit involvement of banks in proprietary banking. In Europe, the regulators drafted regulations for their banks. The proposals required the banks to amend their liquidity requirements, increase capital ratios and limit leverage. The regulations have since increased lending to the government by the banks and hence increasing the risk of a possible financial crisis. More lending to the government has been encouraged.
Without the long-term, short term responses and regulatory proposals, the crisis could have worsened and even led to a global economic recession. The government of the United States through its Federal Reserves, the government of the United Kingdom and the economic regulators in both countries were pivotal in mitigating the crisis and preventing a repeat of the same in the future. The short term measures were meant to deal with the situation immediately before the most appropriate long-term measures could be approved and implemented. The proposals were also implemented by various central banks across the affected nations in the world. The United States led the other nations such as the United Kingdom in the fight against the financial crisis through the most appropriate short-term and long-term responses. A positive improvement was observed as the economy started to be more stable and sustainable. The proposals were also very significant because they managed to streamline the banking systems which are still effective at the moment. There is optimism that the measures and proposals will continue to be effective for the purpose of decreasing the probability of occurrence of another financial crisis in the future. These measures and proposals are still in place up to now though with subjectivity to legislated amendments.
Response by the Congress of the United States
The United States-being the worst affected by the financial crisis-sort assistance from the law makers and the Congress. Under the leadership of President Barack Obama, the congress and the senate were required to pass the most important financial Bills into law. The Bills were meant to cushion the U.S economy from any impending financial crisis. Stability of the economy was achieved after the implementation of the Bills. At the end of 2009, the House approved a Bill titled Wall Street Reform and Consumer Protection Act 2009. The Act was enacted to protect the consumers against exorbitant prices of consumer goods and services. The interest rates were also shelved for the benefit of borrowers. Another response involved the enactment of Restoring American Financial Stability Act 2010 in mid 2010 by the U.S Senate. Several other Acts were enacted in response to the financial crisis. Meanwhile, in April 2012, a court in Iceland prosecuted a former Prime Minister for instigating the Icelandic Financial Crisis between 2008 and 2012.
Economic stability was the main remedy for the persisting financial crisis which impacted greatly on the global economy. Stabilization was to be achieved through the well-researched mitigation measures. The affected economies were supposed to get back on their feet after nullifying the threat from interfering with their finances. The United States and the United Kingdom were the front runners in ensuring economic stability.
The U.S recession lasted between December 2007 and June 2009. Similarly, the financial recession also ended at the same time. By the beginning of 2010, President Barack Obama declared that the markets were stable and that he had managed to retrieve the money spent on the banks during the crisis. The stability can also be evidenced by the observed growth of most stock markets. However, fundamental changes are yet to be made on financial markets and banking.
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Liquidity Risk: Gap Analysis is a process that helps in determining what all steps are required to be taken by the businesses so that they can make best possible use of all the current resources. In other words, it means comparison between the actual performance and expected performance. When a company is not utilizing its resources economically that means the company is performing below its potential. It is also called need gap analysis or need assessment.
Liquidity simply means the availability of liquid assets to a market or to a company. It determines up to what extent a person or company has the ability to meet its short term commitments. Now liquidity fund means a mutual fund that invests into a large number of securities, bonds and options that have high credit rating but for a short duration. Funding simply means money provided by any bank, financial institutions, Government etc. for particular purpose.
In finance liquidity risk is defined as a risk in which a particular security cannot be traded rapidly in the market to prevent loss. A liquidity gap can be positive or negative depending on the number of assets and liabilities that the company have. Liquidity risk maintains the postures of business ‘AS USUAL’ and thus causing more adverse position. The latest events relating to financial crisis have made a good enough impact on the mind of regulators and have concluded that this matter can’t be taken lightly.
A contingency funding plan frames the firm’s strategies and determines liquidity shortfalls in crucial situations. There are two types of risk:-
Funding Liquidity Risk
It is the risk where the firm is able to fulfill both present as well as future cash flow needs and collateral needs only after changing daily operations and financial position of the firm.
Market Liquidity Risk
It is the risk where because of poor market depth or disruption firm cannot equipoise a position at market price.
Points To Be Considered To Manage Liquidity
In order to manage liquidity gap following points should be considered:
1Allocate cash flows over various time horizons.
2 To control the mismatches set target gap and also warning gap for deficit positions.
3 Design a structure to attain disparities within target gap limits.
Challenges Faced By Company against Liquidity Risk
A company has to face various challenges against liquidity risk and these are:
Positive or active approach to liquidity management.
Incorporate a liquidity culture in the company.
More investment in technology and research their results.
To sustain stability, evenness and symmetry between business and risk.
To measure effect of negative result.
Applying rules and various assumptions while creating models
High pressures in achieving models designed.
Evaluating and analyzing funding sources and framing strategies in order to fulfil urgent liquidity needs.
Solutions to the weaknesses
Cost Impact Ratios
Volatile liabilities to Total deposits: It explains the share of volatile liabilities to total deposits. As per the given records it is 77%
Purchased funds to total assets: It explains the quantum of high cost funds to create assets.
Volatile liabilities to total assets: Through this we get to know about the assets funded through volatile liabilities. It is 55% in the given records. This ratio can be considered adequate.
Cash Flow Impact Ratios
Customer deposits/Total Assets: It gives knowledge about how the asset can be funded.
Liquid Assets / Short term liabilities: It determines the availability of assets to meet short term liabilities or immediate liabilities.
Large Deposits/Total Deposits: It shows the weight of large liabilities.
Large Advances/ Total Advances: Similarly this measures the advances.
Commitment Ratios/ Total Assets : It includes record of off balance sheet items to on balance sheet items
According to the data, the company has a cash ratio of 39% which is good. But on the other hand it has deposit ratio of 77% which is quite high and the asset ratio of 55% is adequate enough. Thus overall Liquidity risk of the company is not that worse.
Global Association of Risk Professionals, 2013, Risk Education
Liquidity & Funding Risk, 2013, Examine Balance Sheet Structures under New regulations
Currency risk is basically a risk that arises when a price of some country’s currency changes against the currency of some other country (Alastair, 2013). Whenever the companies or investors have their business operations or assets across their national borders, they are exposed to currency risk if they do have their positions hedged (Stephens, 2003). In these modern times of heightening currency volatility and increasing globalization, changes on the currency rates or the exchange rates causes to have a substantial influence over the profitability and operations of companies and even the government in those countries (Graham, 2014). The volatility of the exchange rates or currency rates not only affects the large corporations or multinationals, but also the medium and small sized businesses that operate only in their homeland (Horcer, 2011).
Types of currency risks or exposure
What follows is a brief account of different types of currency risks or exposure that are faced by companies and governments due to the volatility of the currency or exchange rates.
It is among the lesser discussed risks by researchers and scholars, but still is an evident one and has a substantial presence. Such a risk is basically caused by effects of unanticipated or unexpected fluctuations in currency on the future market value and cash flows of a company (Coyle, 2001). The impact of such a risk is long term is nature. It can have a substantial impact on the competitive position of a company even if the company is not making overseas sales or operating overseas. The source behind the economic risk is the change in competitive strengths of exports and imports (Plaza, 2011). This can be understood with an example.
For instance, if a company exports from UK to a country in the Eurozone and the price of the Euro weakens against the pound sterling i.e. it comes from 1.1 euros to 1.3 euros per pound sterling. This is a weak position because one would have to give 0.2 Euros more for one pound sterling. This means that a product from UK priced 100 pounds would cost 130 Euros instead of 110 Euros. This means that the goods from UK would become less competitive in the European market. On the other hand, the goods that are imported from Europe to UK would cost lesser than previously and would make them competitive in the UK market (MOguillansky, 2003).
Methods of risk mitigation for economic risk could be difficult, and especially the smaller companies which have limited international dealings (Hakala & Wystup, 2002). Some of the following approaches in general could be of importance.
Try exporting and importing from multiple currency zones and hope that those zones do not all move together, or move together to the same extent. For example, for the six months from January 2010 to June 2010 €/US$ rate of exchange moved from €/US$0.6867 to €/US$ 0.8164. This caused to strengthen the US dollar against the Euro by 19 percent. This resulted in making it less competitive for the USA manufacturers to make exports to a country in Eurozone. However if during the same period, the value of Pound relative to the US dollar moves from 0.6263 to 0.6783, this would have strengthened the US dollar relative the pound by 8 percent. In such a case, he trade from US to United Kingdom would not have been affected so badly(Poghosyan, 2010).
Another method here is to make the goods in the countries to which they are sold. This is something which is followed by multinationals. Though in such a case, the raw materials might need to be imported and affected by change in currency rates, but the other expenses such as electricity bills and wages in the local currency would not be subject to the currency risks(Clark & Ghosh, 2004).
The impact of currency rate fluctuations on the company’s fiscal statements results in translational risks. It is especially the case when the company features foreign subsidiaries (Matsukawa & Habeck, 2007). This risk is normally short to medium term. If the subsidiary of a company is in some country where the currency weakens, the value of assets of such subsidiary in the company’s consolidated accounts will weaken (Homaifar, 2004). The effect is not severe as it does not impact on the day to day cash flows. However, scholars and practitioners have reserved the translation risk usually for the consolidation effects (Stephen, 2003).
The exposure can be partially mitigated through funding of the foreign subsidiary through a foreign loan. For instance, take a USA subsidiary of a company which has been set up by the parent company using equity finance. The financial position statement of the company would appear something like this:
Current assets – 0.5 million US dollars
Non-current assets – 1.5 million US dollar
Equity – 2.0 Million US dollars
Now if the US dollars, the total assets of the company would have a lesser value as a result.
However, in case if the subsidiary for example was formed through using 50 % US borrowings and through 50 % equity, the financial position would be:
Current assets – 0.5 million US dollars
Non-current assets – 1.5 Million US dollars
The breakup of this position or the assets is that $ 1 million loan is used to finance the assets and the rest 1 million is equity borrowings. So the investment of the holding company is only $ 1 million US dollars and the net assets are only worth US dollars 1 million. Now if the US dollars weakens in such a case, only the net assets value of US dollars 1 million decreases (John Y, 2010).
Transaction risks are the most evident and talked about currency risks due to fluctuations in currency (Sebetian & Solnik, 2008). The exposure exists when the companies exporting and importing. This type of risk is of a short to medium term. If the rate of exchange during the time the company enters into contract and the time of actual receipt or payment of money changes, the amount of the home currency to be received or paid will alter and would make the future cash flows uncertain (Bartram & Bodnar, 2007).
Methods of currency risk mitigation and their shortcomings
Some of the most renowned and widely used risk mitigation strategies are those are used by companies to overcome transaction risks. Though in case of foreign currency transactions, there are chances of obtaining profit due to the increase in the rate of foreign currency (Ugur, 2012).
There are two obvious risk mitigation techniques for minimizing the transaction exposure.
Under this technique, the exposure or risk of the transaction is transferred to the other company. For instance, an exporter of US selling products in Germany could quote the sale price in US dollars. In such case the transaction exposure or risk for any uncertainty in exchange rate would be faced by the German importer (Ephraim & Judge, 2008).
The currency risk of transaction is minimized here by netting out. This method is of vital importance for the larger companies that are frequently involved in large amounts of currency transactions (Cavusgil, et al., 2012). Receivable of Deutsche marks of 100 million owed to some US company in 45 days is safe if the USA Company is to pay out some German suppliers Deutsche marks 75 million in about 30 days. The risk increases further if the business only has receipts on continuing basis in Deutsche marks. The risk is decreased when the receipts and payments are in various different currencies. An example has been given earlier in the exposition. Though the transaction of currency cannot be netted off fully, it may become so small that the company accepts the exposure or risks rather than incurring costs associated with hedging that are given below (Judge, 2009).
Hedging techniques for currency risk mitigation (hedging techniques or instruments)
Mitigating short term foreign exchange risks
For eliminating short term transaction exposures of currency, there are various hedging instruments available with different costs.
The most direct means to eliminate the transaction risk is by hedging the risk with forward exchange contract. For instance, suppose some USA exporter sells 50 wine cases to some Venezuelan company under sales contract, which specifies an amount of 15 million bolivars to be paid in 60 days. The exporter could eliminate the transaction exposure through the 15 million bolivars to his bank at a 60days forward exchange rate of 750 bolivars / dollar. Now it does not matter what happens to the currency rate during the next month, the company will have assurance that it will be able to convert 15 million bolivars into 20,000 US dollars (Bartram, 2008).
Now the risk or limitation with this method is that exposure could only be eliminated if Venezuelan buyer pays the obligation of 15 million bolivars. The default from the buyer would not relieve the US producer from the obligation towards the bank. Another limitation is that the forward contracts are not usually accessible for the small businesses. Banks normally quote rate that are unfavorable for the smaller businesses because the risk will be borne by the bank in case the company does not fulfill the forward contract. Creditworthy companies are also refused by banks. The non-eligible companies for forward exchange rate contracts can use the option to hedge transaction exposure through future contracts (Bartram, 2008).
The forward market hedge and future market hedge have many similarities. For instance, a US company has payable of $50,000 to be paid by the third Wednesday of September. This organization is able to purchase a Canadian dollar future contract for September. Now if value of Canadian dollar increases, the value of the payable of US Company will increase. However, value of the future contract will also increase by the same amount which would make the net value unchanged. Vice versa would be the case if the Canadian dollar value falls (Qing, et al., 2007).
The future contracts are marked by the market. The losses are to be met in cash and the offsetting currency transactions would be delayed till the transaction takes place. It might also bear the risk for insolvency for the company (Hull, 2008).
Hedging through the money market
Where future market hedge is expensive, not available, or bears large risk of insolvency, a company can use the money market hedge. Suppose a US exporter is to receive 4 million Brazilian reals in in one month time. The exposure or risk of currency fluctuation could be eliminated here through borrowing Brazilian reals at a 10 percent interest rate per month. The business can them convert them into US dollars at spot rate. When Brazilian customer after one month pays of the 4 million reals, they are utilize the settle the principle and interest on the loan.
Companies should pay out more for borrowing the funds than they could receive when they lend the funds. The interest rates charged by banks rises with risk and the requirement of collateral securities or pledge are also in place. In the situation in which the business borrows future payable, it could pledge reals deposit as the collateral security. The company’s and borrowing rate would be almost risk free when the bank has low risk. In such a case, money market hedge will be normally the least expensive option even if forwards and future contracts are available (Maurer & Valiani, 2007).
Cross hedging is another hedging method which is of importance for countries where options such as future contracts, forward rates, options or credits in the foreign currency are not available (Madura, 2012). It is a hedge that is established in currency which is related to value of currency in which the payable or receivable is denominated. In some of the cases, finding currencies that are correlated is easy because many small countries try pegging their currencies with major currencies like Euro, Dollar, or franc. However, there might not be perfect correlation among these currencies as efforts for pegging the values fail frequently (Lane & Shambaugh, 2010).
Now for instance, if there is a company that has receivables or payables denominated in the currency of some small nation that has no developed credit market or currency. In such case, it will explore possibility that the currency might be pegged to some major currency value. If not, then the company would observe the previous changes in value of that currency to determine whether such currency in correlated with the changes in value of some major currency. The company then undertakes a futures market, forward market, options or money market hedge in that major currency (Chue & Cook, 2008). A limitation with this method is that its success depends change in major currency value corresponds with the currency of the smaller country (Calamos, 2011).
For now, there is an only limited market for the currency futures options that features maturities greater than 1 year. Only a few banks render foreign exchange contracts of long term with maturities such as seven years. Only the credit worthy and the large corporations qualify for those contracts (Hull, 2008).
Back to back loans
Back to back loan arrangements are a method to reduce currency risks in long term transactions. For instance, where a company enters into a project with some company in another country, it can use parallel or back to back loan arrangements for reducing risk. Here the company will lend loan in its homeland currency to the other company if the other intends to invest in that country. Similarly the other company with whom the lending company is making investment will arrange loan in its own homeland currency for the investing company. Thus they will pay each other from the earnings they derive from their respective investments in the form of currencies of their respective countries. In such case both companies will be under bilateral arrangement which will be outside the scope of foreign exchange markets. Ultimately neither of them would be affected by fluctuations in exchange rate.
However the risk of default from either company always remains and they are not freed from their loan liabilities (Patnaik & Shah, 2010).
There are various other methods that are used for mitigating currency risks, but they vary from country to country and have their own limitations in general and in the context of specific countries.
Conclusion and recommendations
Effective legal drafting could be used to minimize substantial international transaction risk. The risk of currency fluctuation exposure could be eliminated or mitigated using the instruments or methods that have been described in this exposition. Though many of the instruments do not hedge the transaction exposure entirely, but they are more accessible for the medium and small size firms and the individuals. Though the instruments and methods increase transaction cost, but still businesses intend to minimize risks as a priority.
Individuals and companies should have an understanding of the transactions they do in terms of the risks associated with them. Similarly they should have an understanding of their financial and money market so that they can determine the risk mitigation instruments and techniques in those markets. In case the risk is higher, then the cost of mitigation techniques should never be avoided. They should have an eye on both the present and future currency risk of a transaction.
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