The Effect of Basel II Requirement on Kenyan Commercial Banks’ Lending

The report is about a detailed analysis of JP Morgan Chase. It comprises of a critical discussion of the key roles this banks plays in contributing to the nation’s financial system. In addition, it presents some of the problems associated with relying on debt financing provided by financial institution that is financially surplus compared to the one that is financially deficit. The report also presents explanations of the main changes to the capital adequacy, liquidity and leverage requirements as stipulated by Basel III as well as some of the likely impact of these changes on JP Morgan Chase’s financial conditions. Besides, it presents explanation of asset securitization process and the reason the bank would wish to securitize. Finally, it present a detailed discussion of the main implications of the 2008 financial crisis on JP Morgan Chase’s financial performance shortly after the crisis as well as some of the measures implemented by the US government to calm its financial markets during that time.   

1. Background of JP Morgan Chase and its two key rolesin terms of its contributionsto the US financial system       

JP Morgan Chase is one of the American multinational financial and banking services firm based in the New York (JP Morgan, 2016). It is usually amongst the largest financial or banking institutions across US and sixth largest across the globes by assets with a total assets of around $2.5 trillion. It is also the second most valuable firm across the world by market capitalization after commercial and Industrial banks of China (JP Morgan, 2016). In other words, JP Morgan Chase is one of the main providers of the financial and banking service (JP Morgan, 2016).

It provides numerous financial and banking services to governmental, institutional and corporate customers within the US and internationally. Further, it provides non-interest bearing deposits, savings accounts, interest-bearing time deposits as well as market deposits (JP Morgan, 2016). In addition, it offers clients loans such as home equity loans, lines of credits, residential mortgages, business banking loans, auto loans, as well as other loans. In other words it offers prime mortgage loans, credit card loans, payment option loans as well as wholesale loans to numerous clients (JP Morgan, 2016).

To be more specific, JP Morgan Chase is the world leader in banking and financial services, providing solutions to the global most significant governments, institutions and corporations in over 100 nations (JP Morgan, 2016). In other words, JP Morgan Chase is the largest bank and chief provider of financial and banking services across US by profit, market value, sales and assets. It serves over 1 million clients, small enterprises, and many prominent institutional, governmental and corporate customers (JP Morgan, 2016). It gives around $200 million every year to the non-profit firms across the globe. It also leads volunteer services events for the personnel in the local communities by using numerous resources including the one that stem from the access to capital, global reach, economies of scale and expertise. JP Morgan Chase invests in its partners and communities with the local firms to offer creative solutions which are said to respond to the neighbourhood development needs. Its leading expertise and scale assist in reducing environmental risks while producing new opportunities in order to make more sustainable worldwide economy (JP Morgan, 2016).

1. Critically explained the Problemsof Debt Finance Provided by JP Morgan Chase with those parties who are a Financial Surplus Unit in Comparison to Financial Deficit Unit

Financial Markets and the Global Debt Crisis: Toward a New Architecture for a More Reliable Financial Sector

Provision of debt finance by JP Morgan Chase to the surplus units as well as deficit units poses some problems to the bank (Bohn, 1998). For instance, the act of providing debt finance to financial surplus unit posed numerous issues on maturity mismatch where by it is forced to provide a loan with minimal or short maturity period. This was hectic to the bank since given the fact that financial surplus units was having some leverage issues due to the 2008 financial crisis, these units would struggle to meet their short maturity debts obligations provided by JP Morgan Chase. Such would not occur if the JP Morgan Chase decides to provide debt to the financial deficit unit that offers long maturity debts (Demetriades & Andrianova, 2004). In addition, JP Morgan Chase provision of debt finance to financial surplus unit would be challenging due to size mismatch whereby there are only small funds available being offered to these banks. For instance, JP Morgan Chase action in providing a loan to one of the banks in US posed a major problem since it was hectic to get the actual amount it required to finance its operations as compared to the amount it provided to financial deficit unit that are large (Demetriades & Andrianova, 2004). In addition, JP Morgan Chase providing debt finance to units with those parties who are a financial surplus unit would be hectic since it demands the bank to have as high return as possible (Bohn, 1998). Further, providing debt finance to parties that are financial surplus would be challenging since it would necessitate the bank to charge relatively high interest rates which would make the deficit units unable to repay the loans (Bohn, 1998). This would force JP Morgan Chase to get some collaterals in order to safeguard its loans. Nonetheless, where such risks are of greater concern, there are other risks involved such as risk of bankruptcy. This means that if the loans are on fixed rates, the US Fed act of imposing high interest rates would benefit the depositors but JP Morgan Chase would be forced to strike the balance in between the returns and risks to remain competitive (Petersen & Wiegelmann, 2014).

1. Main Changesto the Capital Adequacy, Liquidity and Leverage Requirements as Stipulated by Basel III and Impact of such Changes on JP Morgan’s Financial Conditions  

Basel III is usually a sequence of measures designed in repairing and augmenting Basel II accord (Ojo, 2013). This adjunct addresses the issues of the economic pro-cyclicality and gives suggestions on the means of mitigating such issues through increase in capital charges when country’s economies overheat as well as when capital charge reduces in the economic contractions (Kasekende, Bagyenda & Brownbridge, 2011). Basically, the Basel III is far much stricter and complete than the Basel II. Some of the reforms recommended in the Basel III include the five facets for enhancing capital, raising quality, transparency and consistency of capital base, enhancing risk-based capital needs with leverage ratio, enhancing risk coverage, promoting country-cyclical buffers and reducing pro-cyclicality as well as addressing interconnectedness and systematic risks (Ojo, 2013). The Basel III comprised of some measures that are mainly targeted at improving the value and capacity of capital within the economy, aimed at refining loss-absorption ability in both the liquidation and going concerns setups. By retaining a minimum capital competence of 8%, Tier 1 was increased to 6% with equity postulated at 4.5% (Jayadev, 2013). These new concepts are for countercyclical capital bumper and capital conversion bumper which ensured that financial institutions are capable of absorbing the losses without any breach to the minimum capital requirements and were capable of carrying their operations even during economic crisis without deleveraging (Bhowmik, 2014).

What We Know and What We Need to Know

The Basel III strengthened the leverage requirement through the use of a stressed input parameter in determining capital requirements for the counterparty credit default risks. The Basel III further strengthened liquidity requirements through development of two minimum standards; the NSFR and LCR (Kcharem, 2014). The LCR was aimed at making the banks to have sufficient stock of the imaginative high value liquid assets that comprised of assets or cash which could be in turn be transformed into cash at no or little loss of the worth in the private markets in meeting its liquidity desires. On the other hand, the NSFR was aimed at encouraging and incentivising the banks to utilize stable sources in financing their operations. It usually assist in reducing dependence on the short-term wholesale financing during the times of the floating market liquidity as well as encouraging better evaluation of the liquidity risks across all off- and on-balance sheet items (Petersen & Mukkudem-Petersen, 2014).

The Basel III also introduced the leverage acts as the non-risk sensitive backstop measurement in reducing risks of the build-up of extreme leverage in the banks and within the financial system (Kcharem, 2014). This prerequisite would establish an all-inclusive floor to a minimum capital requirement that would in turn minimizes the probable erosive impact of the gaming as well as model risk on the capital alongside the true risks. In essence, the Basel III necessitated financial and banking institutions to gradually increase their capital ratios and reaching a high capital ratio (Ojo, 2013). Furthermore, Basel III mainly focused on funding and capital. It specified the new capital ratios. It also set some new standards for the short-term financing and sketches out needs for the long-term financing. In strengthening minimum capital needs, Basel III necessitates financial institutions to make adequate high-quality capital by increasing it common equity tier, introducing qualifying criteria as well as enlarging the scope of reduction for the goodwill, treasury stock as well as deferred assets (Kcharem, 2014). Moreover, it mandates enhanced disclosure which in turn affects reporting on the securitization exposures, components of the regulatory capital ratio and off-balance sheet vehicles. The Basel III was mainly established to reduce probability of any recurrence of the global financial crisis (Kcharem, 2014). In essence, it main objectives was to improve s absorbing capacity of every individual banks. It has some measures in ensuring that financial institutions system do not crumble and some of its spill-over effect on the economy is reduced (Raman, 2012).

Why Do Banks Securitize Assets?

Furthermore, the change in capital requirements under Basel III, are more likely to enable the company raise capital set against certain exposures, provide extra incentive to move the OTC derivatives, contracts to the central counterparties as well as minimize pro-cyclicality; hence, assisting it reduce the systemic risks across its operations (Petersen & Mukkudem-Petersen, 2014). The change is also more likely to provide some incentives to JP Morgan Chase in strengthening its risk management of the counterparty credit exposures (Ojo, 2016). To be more specific, the change in capital requirements under the Basel III would expose the bank books to attract some enhanced capital charges. Therefore, JP Morgan Chase would have common equity capital under the Basel III which would stand it in good stead (Raman, 2012).

Basel III also introduced new liquidity policies aimed at improving resilience of the financial and banking institutions to liquidity shocks (Ojo, 2013). This necessitated financial institutions to maintain buffer of extremely liquid securities commonly measured by liquidity coverage ratio. The buffer is usually aimed at promoting resilience to probable liquidity disruptions over the month (Petersen & Mukkudem-Petersen, 2014). These standards are likely to affect JP Morgan Chase financial conditions by ensuring that this bank has adequate unencumbered, as well as high-liquid assets in offsetting its net cash outflows encountered under its acute short-term operations. In addition, the new liquidity standards is more likely to cause a significant downgrade in JP Morgan Chase’s public credit rating, a loss of the unsecured wholesale financing, increase in derivative substantial and collateral calls on the non-contractual as well as contractual off-balance sheet revelations, partial loss of deposits as well as increase in the secured funding haircuts (Raman, 2012).

Another liquidity measure under the Basel III is the net stable financing ratio (Ojo, 2016). This standard necessitates minimum value of the stable bases of financing at the institutions in relation to liquidity profile of assets and potential for the provisional liquidity requirements emerging from the off-balance sheet pledges, over the period. This standard would assist JP Morgan Chase to border its over-dependence on temporary financing throughout times of the floating arcade liquidity and would also hearten it to better evaluate its liquidity risk diagonally through all the off- and on-balance sheet objects (Kcharem, 2014). Such measures would promote resilience of the bank over the long-term by creating extra incentives for JP Morgan Chase to funds its operations with more steady sources of finance on a continuing basis (Saleuddin, 2015).

 The changes in leverage requirements on the other hand would enable the bank to protect itself against system-wide build-up of the leverage which would in turn cause some destabilization unwinding process in times of financial stress (Waithaka, 2013). In addition, the change would protect JP Morgan Chase against the perverse incentive in piling on the low-risk assets, which might not remain stable under extreme conditions producing some systemic risks (Petersen & Mukkudem-Petersen, 2014). Furthermore, with introduction of a more transparent, simple and non-risk-based leverage as the supplementary backstop measure to capital requirements, JP Morgan Chase would be able to contain excessive risk. Further, the change in leverage requirements under Basel III would have substantial impact on JP Morgan Chase’s profitability. In essence, the change would reduce the bank’s return on equity by around 3% (Kcharem, 2014). Its numerous core operations would also be profoundly affected, especially securitization and trading businesses (Raman, 2012).

1. Asset Securitizationand the Reasons Why Different Financial or Banking Institutions Might Wish to Securitize

Asset securitization is usually the process of taking illiquid assets and through financial engineering, transforming these assets into securities (Thakor, 2015).. In other words, asset securitization is the financial prearrangement that comprises of issues the securities funded by several assets, in most scenarios debt. In this scenario, the basic assets are usually converted into securities, therefore the securitization (Giddy, 2001). In essence, securitization is a complicated procedure that entails several actors as shown in Figure 1 below. Under the diagram, the firm originally holding the assets usually starts the progression by selling its assets to lawful entities. The Special Purpose Vehicle helps in limiting the risk of final investors’ vis-à-vis and issuers of the assets (Saleuddin, 2015). On the other hand, based on the circumstance, the SPV disburses securities unswervingly or resells a number of the assets to the trust. The trust sequentially issues securities since it is utilized for numerous securitization dealings and thus supervises numerous SPVs. The SPV is considered as more of a lawful structure compared to component that plays active role in a contract (Giddy, 2001). The most significant responsibility is usually played by the principal, basically the banks or financial institution, who is said to set up transactions and assesses the pool of total assets, the manner in which it would be fed, features of securities issued as well as probable structuring of funds (Thakor, 2015). Further, instead of paying final investors revenues generated by their assets, amortization regulations are defined in advance. Finally, the arranger assists in distributing securities to final investors (Saleuddin, 2015).

JP Morgan Chase might wish to securitize since securitizing its assets would enable it to refinance its debts (Thakor, 2015). Therefore, securitization comprises assets which are typically illiquid. Another reason why JP Morgan Chase would wish to securitize its assets is to produce marketable assets by combining numerous assets which are not readily sold or bought in order to generate a significant market for such assets and help it in making up more valuable pools. Further, JP Morgan Chase would wish to securitize its assets in lessening the total amount assigned to debt from its balance sheet, which in turn results in corresponding decrease in its regulatory capital requirements and enables its bring in extra liquidity which could be utilized in making new loans (Giddy, 2001).

In addition, JP Morgan Chase might securitize for risk management, greater leverage of the capital, balance sheet issues as well as profiting from the origination fees. In essence, by securitize their assets, JP Morgan Chases might benefit from moving default risks linked with securitized debts from their balance sheets allowing for more leverage (Wæver, 2011). As such, this results in reduced debt risk and loads, whereby JP Morgan Chase could utilize its capital more effectively. Also, JP Morgan Chase might securitize to reduce asset-liability mismatch since based on the structure selected, securitization could provide perfect matched financing by removing the funding exposure in both pricing and duration basis. In essence, JP Morgan Chase might securitize in order to be in a position to cater for the credit boom since they securitize their loans and utilize the money to give more credits. JP Morgan Chase might also securitize with the aim of increasing its profits (Martín-Oliver & Saurina, 2007). This is based on the notion that securitization provides the bank numerous options for financing its major activities and managing the risk profile which would in turn result in greater expected profits. Banks might also securitize for funding motives. In essence, by securitizing its loans, JP Morgan Chase is said to broaden its source of finances as the past sceptical investors could no longer have to venture in a bank they do not like, but just portfolio of the securities the bank originated which investors might consider worth investing. In other words, securitization permits for segment funding, produced by pooling of the assets so as the bank could borrow cash from numerous sources at numerous rates, which in turn result in decrease in marginal costs of the funding (Fabozzi & Kothari, 2008).

In conclusion, securitization has the capacity to affect JP Morgan Chase’s insolvency risks, profitability and leverage. Therefore, JP Morgan Chase might securitize in order to transform its risk profit of assets in the balance sheet. By focusing on assets and holding the liability fixed, the bank could be able to lower its insolvency risk as it serve as the insurance against its insolvency in adverse condition of the country’s economy. Furthermore, securitization would permit JP Morgan Chase to ideally select its disclosures in numerous facets of credit risks of the basic pool of the loans. Thus, relying on payments for numerous types of the risk exposures, as well as strict structure of transactions, securitization could assist JP Morgan Chase to decrease or increase its insolvency risk (Fabozzi & Kothari, 2008).

1. Implicationsof the 2008 financial crisis on JP Morgan’s financial performancesshortly after the crisis   

The 2008 financial crisis is considered as one of the worst crisis since the 1930s Great Depression (Lo, 2012). This began in the year 2007 with catastrophe in the subprime mortgage market across US and it then advanced into a complete international banking and financial crisis with collapse of huge investment banks such as the Lehman Brothers in 15^th September 2008. The current global financial crisis was more global and is said to have wider effects as compared to any other economic downturn in the last seventy years (Willett, 2012). In essence, the global financial crisis roots can be traced in US with sub-prime mortgage crisis where households experienced major challenges in making greater payments on their mortgages. This was then followed by fast announcement of the trouble amongst numerous big bans in US by 2008 and widespread credit contractions when banks across the country tightened their credit policies (Tallberg, Sommerer, Squatrito & Lundgren, 2015). After the fourth quarter, there was an increased delinquency rate which was found to affect not just the sub-prime mortgages but also the spill-over into the client and other credits. Its impacts are more encompassing as a result of the nature of financial integration and globalization in the markets within the twenty first century (Thakor, 2015).

Though there was other financial crisis such as the great depression experienced in 1930s, the 2008 financial crisis is anticipated to have far reaching and more impacts as compared to the great depression. This crisis manifested itself in severe credit, finance and currency crisis that spread to numerous developed countries in the year 2008 but that lagged in their range in the least developed and emerging nations (Willett, 2010).  Though this financial crisis started due to events that occurred in the US housing market, it spread across different regions with serious consequences for the global financial sector (Thakor, 2015). Therefore, the global financial crisis had significant implication for the financial and banking institutions, and particularly to the JP Morgan Chase.

To start with, after the 2008 financial crisis, JP Morgan Chase financial performance was largely hit evidenced by low cash flow in the 2009, which incurred deadweight loses in the firm without being insolvent. Furthermore, due to the 2007/2008 financial crisis, JP Morgan Chase was unable to meet its financial obligations to its depositors and creditors as a result of its incapacity to make sufficient cash, either through its operations (Claessens & Van Horen, 2015). Financial institutions provide benefits to domestic economies, therefore, with the 2008 financial crisis, JP Moran suffered a financial distress due to non-performing loans (Thakor, 2015).

The government employed massive bail-outs and other palliative fiscal and monetary policies to prevent probable downfall of global financial system (Petersen & Wiegelmann, 2014).  Furthermore, the financial crisis forced JP Morgan Chase to raise capital by disbursing new shares in order to preserve its capital ratios. Additionally, despite the sharp reduction in interest rates globally immediately after the global financial crisis, JP Morgan lending rates was relatively high, which in turn resulted in severe decline in both corporate and personal credit (Bolton, 2009). Basically, the 2008 global financial crisis caused a balance sheet crisis in JP Morgan Chase. Its balance sheets got out of the control immediately after the crisis. For instance, the ratio of assets to the annual value added for the bank exploded. In addition, its leverage measured by the assets to total shareholders’ equity also blasted. Information about liabilities and assets which was held in JP Morgan Chase balance sheets as well as other forms of the off-balance sheet was increasingly inadequate and incomplete (Claessens & Van Horen, 2015).

In spite of these impacts, the US government was extremely active in ensuring that financial systems across the country continued to work properly the financial crisis (Bolton, 2009). In fact, the government lowered most of its federal funds rates with the aim of providing extra liquidity to financial systems, prolonged broad range of the security it was ready to take for the loans, as well as delivered direct lines of the credit to the wider range of the financial institutions (Petersen & Wiegelmann, 2014). For instance, when some of the institutions were on a verge of liquidity, the government guaranteed a significant portion of the institutions liabilities to facilitate their takeover by other banks such as the JP Morgan Chase. This action assisted in maintaining confidence amongst the financial system customers and liquidity in financial systems as an effort to reduce the impacts of its financial crisis. The government also introduced a program that included increase in the FDIC bank deposit insurance to permit financial institutions to issue the short-term bonds which would carry the government guarantee and FDIC insurance for numerous deposits in the money market (Thakor, 2015). The government also introduced additional regulations restricting the capacity of financial institutions to engage in the property trading. The US government enacted some large fiscal stimulus, by spending and borrowing in order to counterbalance the decline in financial institutions demand contributed by the crisis. The expanded and new liquidity abilities were mostly aimed at enhancing the central bank fulfil its lender-of-last-resort function within the financial crisis while moderating the humiliation, widening the set of the financial institutions with contact to the liquidity as well as snowballing litheness with which the banks could tap these liquidity (Bolton, 2009). Furthermore, the government guaranteed debt issued by the financial or banking institutions and raised capital of national financial system purchasing around $1.5 trillion newly preferred stock in major banks (Willett, 2010). It also implemented another monetary policy by creating extra currency as a technique of combating liquidity trap in it financial system. By creating and inserting more currencies into the banks, the government aimed at spurring the financial institutions to refinance more mortgages and finance more of the domestic loans (Claessens & Van Horen, 2015). The US government also bailed out numerous banks by incurring relatively large financial obligations. The FED also expanded its open market operations in order to offer support to the operations of the credit market, put downward the burden on the long-term rates as well as assist in making wider financial situations more accommodative by purchasing the long-term securities for federal reserve’s portfolio (Petersen & Wiegelmann, 2014).

Therefore, after the 2008 financial crisis, the US government took a wide range of actions in fulfilling its statutory goals in calming the financial systems from the impacts of the crisis. Many of the actions entailed significant purchases of the long-term securities to put plunging force on the long-term interest rates as well as simplifying the entire financial situations (Claessens & Van Horen, 2015).

Conclusion

In conclusion, this paper has given me a wider understanding of the US financial systems particular in regard to JP Morgan Chase and the 2008 financial crisis. From the analysis, it is evident that JP Morgan Chase plays a crucial role in the US economy. In essence, it is evident that JP Morgan Chase provides numerous financial and banking services to governmental, institutional and corporate customers within the US and internationally. It provides non-interest bearing deposits, savings accounts, interest-bearing time deposits as well as market deposits. In addition, it can be concluded that the changes stipulated by the Basel III assisted JP Morgan Chase strengthen its risk management of the counterparty credit exposures. These measures are also found to promote resilience of the bank over the long-term by creating extra incentives for JP Morgan Chase to funds its operations with more steady sources of finance on a continuing basis.

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