The Effects of Regulation and Deregulation in the Recent Financial Crisis - Essay Example

The effects of regulation and deregulation in the recent financial crisis Introduction Regulation of the financial system actually entails setting up rules and regulations and also establishing an enforcement mechanism that is designed to control the operation of the systems constituent institutions and markets (Macey, 5). The main objectives of regulation are basically to raise state revenue, minimize the risk of financial crisis and to limit or channel financial power to an advantage. After the financial crisis of 2008/2009 in the U.S, consumer organizations, labor unions and political parties advocated the tightening of financial regulation. Deregulation is basically concerned with reducing and redistributing rents, leading economic players to adjust in turn following this distribution. Unemployment may increase for a certain period while real wages may decrease before recovering. Deregulation put banks and other financial institutions in a situation where they took great risks resulting in their near insolvency. On the other hand, a large number of weak mortgages failed to regulate mortgage brokers (Macey, 14). Despite the fact that deregulation proves to be beneficial to some extent, it also comes along with strong distribution and dynamic effects. Discussion From late 1930’s to the 1960’s, there were regulatory initiatives which constituted microeconomic stabilization (Macey, 3). This system controlled price and competition in all the industries in the country. The federal agencies had extra ordinary powers of shaping most aspects of the market structure in the industries. The main objectives of these federal regulations put were high quality, widely available service, secure contractual arrangements and stable pricing, and indeed they were able to accomplish them. This era was characterized by prosperity, strong economic growth, low inflation rates and low interest rates. The financial system appeared to work well under regulation and its assets quadrupled. Financial deregulation then followed which went on for several decades prior to the financial crisis. Pre crisis disclosures pertaining off- balance sheet accounting and subsidized home ownership were imperfect (Macey, 6). The relaxation of credit standards and unsound governmental housing policies actually paved way to the crisis. The financial crisis which resulted from deregulation was a culmination of massive U.S. housing bubble which could have been prevented if the right regulatory measures had been employed at the right time. Some of the regulatory failures which led to the crisis are; Failure to manage the U.S. trade deficit The housing bubble was fuelled by cheap credit which was coupled with very low interest rates. The reason for this cheap credit was an influx of capital into the U.S. from china. Failure to intervene to curb the housing bubble With the influx of capital, the Federal Reserve policy kept the interest rates very low for so long. Although they had good reasons for this, they were not helpless in a way that they could have done nothing to save the situation which was growing from bad to worse. Financial deregulation and unchecked financial innovation The major reason why mortgages were made available with little review of recipient’s qualifications was a shift in which the institutions held the mortgages (Macey, 12). In the past, banks would make mortgages and hold them but in the new era, banks and non bank mortgage lenders would make loans then sell them to others. Investment banks put lots of mortgage loans into Collateral Debt Obligations (CDOs) and then sold them on Wall Street. This was in a promise of a steady stream of revenue from interest payments. Private regulatory failure It was the job of rating agencies to assess the CDOs and give investors guidance on how risky they were. However, they failed terribly because they wanted to maintain good relations with investment banks issuing the CDOs. Lack of control over predatory lenders Financial deregulation and the housing bubble created aggressive lenders who were looking to abuse vulnerable borrowers (Macey, 12). Lenders put borrowers into conditions they could not satisfy which made the quest for foreclosure in subprime loans inevitable. Effective regulation of the lending practice could have prevented the abusive loans and at the same time save the situation. In the U.S, the financial crisis began in 2006 where the U.S house prices fell and there was a rise in subprime Alt- A mortgage loans. In February 2007, the Federal Home Mortgage Corporation, Freddy Mac announced its cessation to buy risky subprime mortgages and mortgage related securities. In April 2007, the New Century Financial Corporation, a leading subprime mortgage lender filed for bankruptcy (Hemerijck, Ben and Ellen, 15). At the end of July 2007, Bear Sterns, a leading investment bank liquidated two of its hedge funds which were heavily involved in mortgage- backed securities and by the end of August the same year, BNP Paribas, Frances’ largest bank halted the redemption of three investment funds. In February 2008, the two large semi public mortgage banks, Fennie Mac and Freddie Mac were placed under the government conservatorship. In September of the same year, the 158 year old investment bank, Lehman Brothers fell without the authorities realizing the consequence of it triggering a worldwide credit freeze. A severe crisis erupted in the fall of 2008 because nobody knew which financial institutions had brought about the dangerous subprime mortgages. During the same time, finance had become so globalised and when the housing and asset price bubble burst, there was a near collapse of the financial system which spread rapidly across the whole world economy (Hemerijck, Ben and Ellen, 14). AIG, the world’s largest insurer had been involved in Credit Deposit Swap (CDS) market and was caught in severe liquidity strain and in September of the same year, the U.S government came to its rescue, bailing it out with 85 billion dollars. In the midst of the crisis, a complete seizure of interbank money markets broke out which largely exposed the micro flaws of internationally deregulated financial system. The global economy was thrown into a massive credit crunch and into the worst financial crisis and recession since the Great Recession. Given the severity of the crisis, the world economy will probably take more time to recover (Hemerijck, Ben and Ellen, 15). A second deep recession would be triggered by the increasing budget deficits which would trigger inflation and aggressive rise in interest rates by central banks. In future, several aftershocks caused by economic contraction will have to be taken into account. They are; The looming unemployment crisis If unemployment sets in the advanced industrial world, labor market conditions are expected to worsen even as stock markets improve. In the U.S, current unemployment is below 10% while in European countries, unemployment has already reached double digits. Unemployment will later result in mortgage defaults and insolvencies thus adversely affecting the already weakened banking system (Hemerijck, Ben and Ellen, 14). Reduced lending of the banks would lead to another contraction in the financial sector which would again disrupt the financial sector. Pension crisis The fall in equity market have severely affected the value of pension fund assets thus jeopardizing the income that pensioners get especially in countries with large private pension provisions. In the U.S, public pensions have been retrenched over the past two decades and instead people are being given incentives to choose their own private pension arrangement. While many used real estate as an old age investment, their savings were brought down during the financial crisis (Hemerijck, Ben and Ellen, 14). Fiscal crisis of the state Due to the costly bank bail outs, immense tax cuts and other measures put during the financial crisis, the public purse reduced to a large extent. In Europe for example, the declining population levels will soon trigger a shrinking work force which will in turn reduce tax revenues. Political aftershocks When the recession subsides, elevated public debt to GDP ratios will make fiscal consolidation imperative. On top of this, axes will be raised in the final stage of fiscal consolidation so as to pay down on public debt (Hemerijck, Ben and Ellen, 14). This could have a negative effect on the prospects of growth thus leaving little room for addressing the newly emerging social needs. Due to these economic, social and political aftershocks in the labor market, banking system, pension system, public finance and social spheres, the crisis is likely to persist for more years. Conclusion The crisis left most observers with renewed respect for regulation of a more substantive nature. Such regulation would include deposit insurance, capital rules and keen supervision of financial institutions to address hazards created by deposit insurance, government guarantees and the ad hoc bail out from the government. It right also includes subsidization and supervision of clearing facilities such as the credit default swap market which brought down the world’s largest insurance company and also control of agency purchase rating agencies and mortgage brokers. Works Cited Hemerijck, A., Ben, K. and Ellen, D. 2009. Aftershocks: Economic Crisis and Institutional Choice. Amsterdam: Amsterdam University Press. Macey, J. 2006. Commercial Banking and Democracy: The Illusive Quest for Deregulation. Yale Law School. 23(1): 1-27. Read More