Effects of Regulation/Deregulation in the Recent Financial Crisis - Assignment Example

Effects of Regulation/Deregulation in the Recent Financial Crisis In the of their operations, financial institutions are subject to some governing rules and regulations by an established body. The regulation of the financial system involves setting rules and establishing an enforcement mechanism that has been designed to control the operations of the financial system’s constituent institutions, markets, and instruments. Among the various forms of regulations that are instituted include antitrust enforcement, conflict rules, capital standards, asset restrictions, disclosure rules, interest rate ceilings, geographic and product line entries, investing and reporting requirements. O’Hara notes that the regulation of the financial system may be through direct government regulation1 or through self-regulation2 or even through corporate governance3. OHara argues that the primary and the long lasting reason for regulation is to raise the state revenue. Other objectives include the need to minimize the risk of financial crises, and to limit or channel financial power to some advantage. However, the reasons for regulating the financial system would be influenced by the status of the economy in terms of growth and development. In the developing economies, the state depends heavily on the seignorage for revenue. Governments can require that banks obtain charter as a means of limiting competition among money suppliers, and enable them to maintain control over seignorage. In addition to securing a revenue base, regulation of the financial system is also aimed at preserving the liquidity of financial systems and forestalling financial panic. Central banks have been used as the lenders of last resort so as to promote the soundness and stability of the modern financial system. Government provision of deposit insurance can also be used to prevent bank runs. OHara continues to say that the existence of a market failure that needs correction such as a potential financial crisis, or clear public advantage and the need to control abuses of power justify the need for financial regulation. The forces of change have impacted the financial system and include technological advances and declines in domestic capital controls. These forces have led to the growth of new institutions, markets and instruments, and most of which fall outside the existing regulations purview. These factors led to the call for the removal of various restrictions that had been imposed on some assets. Among the eliminated restrictions were the Glass-Steagall Act that required a separation between investment and commercial banking and the interest rate ceiling. Several views and arguments (Schneiderman) have been put across by analysts, scholars and politicians about exactly what caused the 2008 financial crisis. Some blame it majorly on deregulation while others argue that regulations were still there. In their articles, Wallison and Allison refer to the blame of deregulation on the 2008 financial crisis as a myth. Non-regulation or deregulation of the financial institutions for the past two decades permitted banks and other financial institutions to assume risks that made them almost insolvent. The large number of weak mortgages in the financial system was blamed for the failure to regulate mortgage brokers. According to Chan, the Commission formed to investigate into the causes of the financial crisis blamed the Federal Reserve and the regulators who permitted calamitous concoction: excessive loan packaging and sale to investors, shoddy mortgage lending and risky bets on securities that were backed by loans. The junk loans given in the US mortgage systems began defaulting at unprecedented rates and the resulting losses led to the collapse of the asset-backed financial markets. The asset-backed securitization markets failure caused a substantial reduction in financing for consumers and businesses, precipitating the current recession. Wallison posits that, even though the production of these deficient loans were primarily blamed on unregulated mortgage brokers, especially the predatory lenders, they could not create and sell them if there were no willing buyers. The author argues that it defeats o see that the governments agents were the primary buyers and banks and companies that purchased them were required by the government policies to purchase these junk loans. To this far, this paper borrows the views of Allison that the financial crisis was primarily a result of governments policy. This combines the mistakes committed by the government housing policy and the Federal Reserves mistakes. Referring to the book of John Taylor, Getting off Track, Wallison notes that there was empirical evidence that the default of these junk loans caused the financial crisis. The spread between the Overnight Index Swap rates and the London Interbank Offer Rate rose abruptly, indicating that counterparty risk had suddenly started among the major internationally active banks. Prior to 9th August 2007, the London Interbank Offer Rate was around ten basis points above the Overnight Index Swaps but on 9th the spread suddenly rose to about sixty basis points. This change can be deduced to mean that information defaulting US mortgages led to this sudden expression of counterparty risk. According to Gilani, deregulation fueled the financial crisis. In this context, the author notes that no one was responsible for the credit crisis, the insolvency of commercial banks, the failure of investment banks, explosion of the global stock markets, or cause for another great depression. After the 1930s great depression that caused devastating financial collapses, there was the formation of fundamental and pragmatic banking regulations that strengthened the US capital markets and banks. However, greed by bankers advocated for their removal beginning 1980s until 2004 when the Securities and Exchange Commission ruled that some of them be revoked. Such laws that were repealed are the Glass-Steagall Act that offered four main regulations4 on banks. This Act was intended to separate the investment banks, which are risk takers and are not backed by the government, from commercial banks. The Gramm-Leach-Bliley Act (GLBA) allowed banks to be affiliated with securities firms by repealing Glass-Steagall Act’s section 20 and 32. However, sections 16 and 21 were left intact. This makes Wallison fail to agree with arguments that the repeal of section 20 and 32 caused the financial crisis because the banks were not being regulated. Instead, he argues that banks remained prohibited from underwriting and securities trading. The necessary regulations were instituted to deter banks from engaging in risky activities using their insured deposits. Indeed, the US banking laws have been designed so as to separate banks from risks or speculations that their holding companies and affiliates create. Therefore, the holding companies and affiliates are allowed to fail without endangering the related bank’s healthiness. In addition, these banking laws and regulations have been designed to limit activities in which they should engage themselves in order to reduce the range of risks. From these provisions, Wallison argues that the financial crisis cannot be blamed on deregulations. Allison argues that indeed banks were never deregulated. In fact, he states that there was a massive increase in regulation during President Bush’s administration, including the Sarbanes- Oxley, the Patriot Act and the Privacy Act. The Glass-Steagall Act allowed banks to carry on with the business of making investments, but prohibited them from dealing and underwriting mortgage-backed securities As such, banks would acquire and dispose securities initially meant for investment. In this sense, a bank could purchase a security and then sell it at a later date when it needs cash or believes that such investment is no longer worth. This contrasts with a situation where a bank would have bought such securities for the purposes of selling them5. Securitization was also allowed and banks could purchase and sell securities based on assets like mortgages. These restrictions and provisions remained in force after the Gramm-Leach-Bliley Act. The problems faced by the largest banks and the financial weakness was due to the banks failure to act prudently in their lending and investment activities despite the presence of substantial regulation. In simpler terms, they failed in their capacity as banks and not because they were affiliated with investment banks or engaged in securities trading. According to Allison, the banking industry was misregulated and not deregulated. The introduction of these new rules fundamentally, misdirected banking risk management. A majority of them bought and held mortgage-backed securities rated AAA, yet performed very poorly. Others committed themselves to make mortgage loans in order to be granted the approval for expansions and mergers, a requirement by the Community Reinvestment Act (CRA)6. The banks regulators required that loan borrowers to be given a loan of 80 % or below of the median income, a case that these borrowers did not meet especially when the housing prices ceased rising in late 2006 and 2007. Another blame for the financial crisis was easy money by the Federal Reserve where the currency debauching and the resulting boom or cycle of inflationary credit expansion was followed by financial panic (Schneiderman). When, Federal Reserve printed money, there was excessive consumption since people thought they were wealthier. This consumption considerably shifted toward the residential real estate market, which is not an investment (Gramm). The government-driven housing boom made the housing experience a capital surplus when commercial innovators were experiencing capital deficits. Schneiderman further claims that altruism is a philosophical cause of the financial crisis and not greed. In conclusion, several arguments have been put across in trying to explain what exactly caused the financial crisis. There are those who view that the financial system was deregulated or non-regulated while other maintain that the system remained regulated, and even new laws were introduced. The repeal of some sections in Glass-Steagall Act by the Gramm-Leach-Bliley Act did not eliminate the regulations and restrictions that banks could not engage in underwriting and dealing in securities. Others have placed the blame on the unregulated mortgage brokers. However, this still does not hold since they created assets because there was a demand for them. The poor policies by the government have also been blamed for the crisis such the government-driven housing boom. The banks also failed by themselves when they failed to act prudently in their lending and investment activities. The regulators especially the Security Exchange Commission is also blamed for failing to institute prudent regulations over investment banks by leaving them to determine their net capital primarily. The Federal Reserve is also seen as a cause when it increased the money supply unreasonably. Therefore, the causes of 2008 financial crisis remain a mystery. Works Cited Allison, John A. The Financial Crisis and the Bank Deregulation Myth. 10 December 2012. 4 April 2015 . Chan, Sewell. "Financial Crisis Was Avoidable, Inquiry Finds." The New York times Retrieved on 25 January 2011 from http://www.nytimes.com/2011/01/26/business/economy/26inquiry.html?_r=0. Gilani, Shah. How Deregulation Fueled the Financial Crisis . 13 January 2009. 4 April 2015 . Gramm, Phil. "Deregulation and the Financial Panic." The Wall Street Journal (2009): http://www.wsj.com/articles/SB123509667125829243. O’Hara, P. A. "Regulation and Deregulation: Financial." Encyclopedia of Political Economy (1999): 971-974. Schneiderman, R.M. "Did Deregulation Cause the Credit Crisis?" The New York Times 8 October 2008: http://economix.blogs.nytimes.com/2008/10/08/did-deregulation-cause-the-credit-crisis/?_r=0. Wallison, Peter J. Deregulation and the Financial Crisis. 31 October 2009. 4 April 2015 . Read More