Public Policy Issues - Need For Regulation in the UK Financial Institutions - Article Example

Public Policy Issues - Need For Regulation in the UK Financial Institutions Table of Contents 1. Introduction: 1 1.2. Public Policy Issues: 2 2. Need For Regulation in UK Financial Institutions: 3 2.1 Addressing Causes of De-regulation: 4 2.2 Regulation at Management Level 5 2.3. Regulation and Management of Risk 6 2.3.1 Role of Board: 6 2.3.2 Governance of Risk: 7 2.3.3. Shareholder Value: 7 3. Conclusion 9 4. Implication for the Policy Makers 11 4.1 Promotion of Robust Regulation and Supervision of Financial Companies: 12 4.2 Establishment of Comprehensive Regulation of Financial Markets: 12 4.3 Protection of Investors and Clients from financial Abuse: 13 4.4 Arming the Government with Financial Crisis Management tools: 13 References 15 1. Introduction: The report considers a public policy issue of regulation of private financial institutions in the United Kingdom. Since the subprime mortgage crisis, the issue has a lot been under debate by the policy makers. Often, it is debated to an extent that if private financial institutions were been regulated properly, the subprime mortgage crisis could have been avoided. In this report, the flaws in the regulation of the private financial institutions were studied first from the public policy point of view and the outcome in what possible ways was related to the subprime mortgage crisis. Based on the findings the conclusion was then made to the study and recommendations were drawn for the policymakers. The study gives an analysis of the public policy issue of regulation of the financial institutions in the private sector. The public policy in many forms and through various means can regulate or deregulate the financial institutions in the private sector that include several measures and techniques other than the monetary policy, central bank regulation and the Securities and Exchange Commission. 1.2. Public Policy Issues: The public or the governmental bodies in any of the countries, makes policies, distribute the resources of the country and enforces the laws. The method by which it does so is the public policies that it introduces. The public policy is a course of action, the rules and law for regulation, social contracts and prioritization related to a particular issue or topic disseminated by the respective government institutions. How the public policies are formed is yet another issue. The role of public policy makers, which is most of the time the government institutions or their representatives comes here. The powerful groups, individuals, and members of unions through debate, awareness, education, mobilization and advocacy try to influence the decision making of the policy makers (Evans, pp 5-10). One of the main purposes that the public policy should serve is the addressing of the deficits in the budget of the economy, regulation in the economy and availability of services to all the people in an economy. Based on these assumptions, one can say that financial condition of an economy must be catered to, by the public policy in a country. Since the world is now a global village the financial condition in one part of the world even can have a positive or negative impact on the financial markets in the other part of the world. For this reason each country should make its public policy and implement it in a way that it ensures financial stability not just on the macro level but also at the micro level (Singh, pp 3-8). 2. Need For Regulation in UK Financial Institutions: To influence the decision making of the policy makers it is important to have sufficient evidence, feasible alternatives and solutions to problems. Therefore here we are first going to make a background study of why the private intuitions regulations was necessary and the where the public policy lacked. In the subprime mortgage crisis Because of the reason that the public policy was not appropriate lead to the failure of governance in the financial sector and this was not the case of some developing country but higher for the most sophisticated financial markets of the world which are in the United Kingdom and United States (Cline, Pp 286-298). The public policy weakness is often reflected in the level of governance also. The policy makers not only should take measures to address the particular issues but also for the enactment of the related public policy. In the United Kingdom, a lot of deregulation was said to have taken place after the 1980’s. There were development of some large world famous financial intuitions an giants on the Wall Street. In order to complete with the global market and to stay ahead in the competition the control on bank loans and credit policies were removed in the UK in late 1980. The banks and various other financial institutions were then able to expand, grow their business, provide their services to every class and group of people in the economic and \all these measures allowed for great financial innovation during the century. The public policy itself enabled this innovation and thus deregulation in the financial institutions in the private sector of UK (Buckle and Thompson, pp 50-54). In the next section of the study the various causes that lead to de regulation and how the public policy related to the private sector catered to it has been explained. 2.1 Addressing Causes of De-regulation: In the twentieth century with the information technology industry on its boom, there were better communication, better information management, telecommunication and data processing, which facilitated innovation in many of the sectors of the economy. The financial sector was also one f them. The financial sector with the capital markets getting powerful was able to develop some complex securities and instruments. The nature of these securities and instruments did not allow for much intervention of the governmental institutions but they were allowed because they met the demand in the economy for the financial services. Examples of these instruments included the real estate mortgages, credit cards, the various mortgage plans. To promote the innovation and to make sure the financial market of the country is at par with the international financial markets less restrictive and decentralized financial regulations were needed and later introduced. This was the point of deregulation of the private financial institutions. As White (pp 5-28) mentioned in one of his articles that, “The financial innovations that have geographically widened financial markets have clearly placed pressures on financial regulation to be centralized at the federal level and away from the states. This trend has been most prominent for banking and securities. Though there can be potential gains from financial innovations and international harmonization of financial regulation, there are serious dangers as well.” When we say the private financial organizations, it includes a number of sectors in the finance, which includes bank, insurance companies, securities and financial instruments dealers, pension funds, mutual funds, Mortgage conduits, leasing companies etc. By public policy issue related to the regulations of financial institutions it just does not mean the regulation of products and services offered by these institutions but also several causes that can lead to failure of these institutions which in turn can lead to the failure of the whole financial institutions eventually in the form of financial crises. Some of these factors as highlighted by the World Bank were Engagement of stockholders, Independence of the board members, their selection, qualification and compositions, the risk management in the company and last but not the least the alignment of incentive, structure and remuneration for the management, board members and executives (Aras and Crowther, pp 138-142). One issue highlighted by the OECD for the regulation of private financial markets is the alignment of incentive and remuneration of the board members and the executives of these companies to ensure that there is not conflict with the long-term interests of the actual owners that are the shareholders of the companies. 2.2 Regulation at Management Level One of the problems with the implementation of the public policy in the subprime mortgage crisis was reflected in the form of weakness at the management level in many of the private financial institutions. Since in the private financial institutions the working of the management is not something intervened in by the governments there are still general governance policies in these organizations formed. For example, the government bodies address the issue that the generally accepted accounting standards are followed by the organizations as well various other important accounting and management reforms. In the subprime mortgage, crises the later studies revealed that there were accounting frauds, problems in the financial reporting, risk and return reporting of the organizations. 2.3. Regulation and Management of Risk The public policy did not sufficiently address the issue of risk management in the private financial institutions of the. It did not make sure enough transparency and the policy makers did not consider the aggregate risk of a firm (only risk related to returns was mainly addressed). The public policy in this issue would have been a certain level of risk, liquidity and return important for the private financial institutions to follow. According to the UK treasury, “In some cases risk measurement systems narrowly focused on readily identifiable or already recognized risks and did not conduct adequate surveillance for other, less obvious and higher-level risks” (The World bank, p.2) 2.3.1 Role of Board: As mentioned before, it is also one of the issues that independence, selection and qualification of the board and executives of an organizations since the board takes various decision related to the measurement of risk and associated returns to the company. What happened in the subprime mortgage crisis was not sufficient risk governance, which is brought about by the board of the company. They make sure that all kinds of risks associated to the functioning of the company are carefully identified, analyzed, reported and taken care of. The qualification and selection of the board members affects their understanding of the measures that are used to identify and manage risk (U K Stationery Office, pp 148-152). First, they are not able to gather complete information about the risk profile of a company whereas incomplete information can lead to a artificial sense of safety even when the company survival might be at stake. Second, their expertise effects their decision making related to the risk management. 2.3.2 Governance of Risk: Governance is important in every business decision and measure. Not governing the risk is referred to as the omission by the management and the board members of the risk in a company along with its associated internal design for evaluation, measurement, reporting and diagnosing and thus can lead to poor risk management. The poor risk governance can further be due to a number of reasons including understanding, access, inability to identify and timely reporting of risk etc. Sometimes when the companies have enough resources to accurately measure and identify risk they might still ignore it and that is when the role of the public policy in these organizations comes. The public policy here can provide a credit line beyond which the companies cannot ignore the risk. The financial innovation in the world, in the early to mid twenty century, was one of the main reasons for the companies do ignore these risks; and since the government bodies, which could have been the central bank regulation in this case did not take place the result was the fall of many private old financial giants like Merrill Lynch, Bear Stearns, and the Lehman Brothers (Fry, pp 120-128). The board and CEOs of these organizations were taking high pays as the balance sheets of these firms did not show risky values or adverse results and they were later charged for their irresponsibility in risk governance in the organization. 2.3.3. Shareholder Value: There is often said to be conflict between the interest of the shareholders and the management of a firm e.g. in the distribution of the profits and dividends. When the companies are properly regulated the rights of the shareholders are given to them which not just includes the right in the profits in the form of dividends but also their participation in the appointment of the executives and directors of the firm and to be considered in the key decisions that the company takes (Marks, pp 24-28). This aspect was also ignored in the financial organizations before the subprime mortgage crisis. The product of subprime mortgage itself was not in the best interest of the shareholders and when the organist ions an large investments banks came down the investments of the shareholders and various other investors was also lost. 2.3.4 Central bank Role: The public policy implementation and suitability to the changing needs of the financial markets can be insured or rather it s role of the central banks to ensure it. The central bank plays the role of the supervisor in the financial markets in an economy and for that it must be given enough independence. In the subprime mortgage crisis, this was the main reason that the central banks did not intervened when the plans like “Income, No Job and No Assets” were introduced. The public policy should have addressed the issues of the independence of the central bank as it is directly related to the control and check and balance in the financial markets (Mimoun, pp 6-8). The public policy In the United Kingdom besides addressing this issues needed to incorporate the standards set for the regulation and governance by the Basel Committee, Organization for Economic Co-operation and Development, World Bank and Financial Stability Board etc. In many of the countries where the central banks were independent, they did not allow for much of the financial innovation, which at times were extremely risky; thus the financial systems of these countries proved to be much more stable. That is why the emerging countries and the developing countries were said to perform well and way better than many of the developed countries. The central bank through various means catered for the risk which included the interest rates, the deposit requirement etc. furthermore, the security and exchange commission which is again a public organizations in many of the countries had to play its role to ensure the regulation of the private financial institutions through the public policy. The complex products if handled properly the crisis would have been avoided. 3. Conclusion From the analysis of public policy, we found that one of the main issues that should have been catered to by the public policy was of the regulation of the financial institutions in the private sector of UK. If there is something one needs to learn from the current crisis, it is the lesson consistent with the financial crisis of Asia: corporate governance matters. The central irony in this crisis of governance failures is something that took place in the world’s most sophisticated banks. However, various financial institutions of developed countries chose to fare in a different manner during the time of crisis, partially depending upon the power of the overall governance structure and culture of the country. While researches and reviews have registered various types of governance failures, a common conclusion of all is that the current governance structures are generally adequate and ought to remain intact. The problem lies in the implementation details. It was found that the public policy related to the financial institutions regulation of the private sector did not consider the role of the member of boards in a company and its executives. It is recommended that the capacity of boards should be increased in order to oversee strategic risk occurrence and to precisely judge the institutional performance. Board capacity’s improvement would need upgrading the experience, skills and leadership of non-administrative directors while re-balance the productive strain that will come up with the high performance of the board. Furthermore, the public policy did not cater sufficiently to ensure delivery of value to the Long-term institutional investors of a firm. Long-term institutional investors amongst other shareholders can play a part in such manner by being more responsible in interacting with the boards and focusing beyond the temporary achievements that may compromise the longer termed safety and contentment. The most apparent governance-oriented policies’ responses have convoyed government assistance to troubled financial organizations. Along with this, international standard setters and institutions are updating their guidelines and principles while aiming more at the impactful implementation of the current rules than on additional or radically different standards. Regulators and governments also pursue reforms via both, through the enhancements in business governance codes applicable to all the enlisted institutions and through the mandatory principles applicable only to financial companies. Changes for the better are expected in corporate remuneration, risk governance structures and in the composition and independence of the board. These issues aren’t only relevant to the developed economies, rather a number of obstacles present in the developed economies are less prominent elsewhere during financial crisis, such as the issues of executive pay etc. whereas other problems are more prominent in emerging economies comparatively, such as concentrated and opaque ownership etc. All countries, developed or developing, could learn from corporate governance failures and financial crisis. The laws and rules of good governance serve as an eminent part of the international financial standards and are considered necessary for the stabilization and integration of financial frameworks and systems. In the past decade, a lot of focus and energy was devoted to the improvement of the ability of the managers, boards and proprietors of a company to navigate cautiously the volatile and ever-changing market conditions. 4. Implication for the Policy Makers The current economic crisis, which was primarily orchestrated by wrong use of the trendy financial product, has pushed back the issue pertaining to financial regulation to a low priority, vis-à-vis the public policy. This is an unprecedented happening since the time of Great Depression; it has made the reforms impracticable. In fact, the intensity and magnitude of the problem, the failures of regulatory regime and the erstwhile and outdated regulatory structure of the US have convinced everyone to have in place a sound regulatory setup. This unanimity of view provides a unique opportunity for the US financial managers to rise to the occasion and assume the role of world leader in providing financial regulations. The responsibility, if discharged properly, will infuse tremendous confidence in the market and provide a lot of safety to both the consumer and the investor. This will also ensure improvement in the quality of regulation, expansion in the capital formation and enhancement in our capacity of systematic risk management, apart from helping proper coordination for global policy. The Capital Markets Committee for Regulations believes that there is a scope for bringing about improvement in the regulatory framework. Already, the US is making use of greater number of regulators for overseeing the financial management; it spends more than any other major country does on this count. The regulatory staff in the US exceeds 38,700 employees, as against 31,000 in the UK. Likewise, in terms of money spent on the system, the US bears a cost of US$ 497,984 per billion dollar of GDP versus US$ 276,655 spent by the UK. Regretfully, however, this large staff and more spending have not ensured a corresponding level of efficient financial management. The US Treasury Department acknowledges this lapse and has made in March 2008 a very courageous recommendation, entitled ‘Blueprint for Modernized Financial Regulatory Structure’. Inherently, the federal regulation on finance has four major functions to perform: providing lender; overseeing financial institutions for soundness of financial health and safety; regulating market framework and its conduct; and finally, protecting the consumer and investor (Melicher and Norton, pp 92-94). The efficacy of any regulatory regime would depend on effective performance of these roles. The Committee is also of the view that the President office must ensure implementation of these roles through the office of the Treasury Secretary. However, it is not easy to identify exactly as to which part or section of the regulatory structure was not performing its due role in time. This aspect poses a challenge to the financial market regulators. 4.1 Promotion of Robust Regulation and Supervision of Financial Companies: The finance companies, especially the ones’ critical to the market functioning, ought to be subjected to powerful oversight. Any financial firm posing a crucial risk to the financial system should not be weakly regulated, lest unregulated at all. Accountability in financial supervision and oversight should be very clear and specified. 4.2 Establishment of Comprehensive Regulation of Financial Markets: The strength to resist system-wide stresses and the fall of one or more big corporations should be a must-have in any financial market. The enhancement of securitization markets’ regulation consisting of new requirements for stronger supervision of credit rating agencies and market transparency and the need that originators and issuers should retain their interests in securitized investments should be considered. A comprehensive supervision is extremely crucial for derivatives all-over-the-counter. 4.3 Protection of Investors and Clients from financial Abuse: For the re-establishment of faith among the clients and also in the financial market, it is essential that effective and strong supervision of investment markets and customer financial services be established. This supervision and oversight should be based on the data that indicates how a customer makes his financial decisions rather than on abstract models and abstraction. For the promotion of simplicity, fair play, transparency and accountability, a Consumer Financial Protection Agency ought to be established. 4.4 Arming the Government with Financial Crisis Management tools: A government should be provided with tools effective for managing financially critical situations in advancement so that the customers and issuers feel protected and the crisis and bailouts are not left with untenable choices. With the increase in the interdependence of cross-borders financial markets upon one another, or in other words, with the inception of globalisation, the chance of easy and quick expansion of a financial stress is at peak. But still financial supervision is largely set in a national context. Without constant regulation and supervision, financial firms will move their activities to jurisdictions of lower standards, thus establishing a race to the intensifying systematic risk for the entire financial system of the world. For the prevention of this a call for strengthening the financial regulations across nations is mandatory. (Marquardt, pp 10-15). The role of public policy with regard to the regulation of the financial markets in the private sector was previously not given as much importance as it is now after subprime mortgage crisis. This was because of the reason as highlighted by the World Bank it was mainly the wrong credit system and rating method that was in use by the organizations that contributed greatly to the recent financial crisis. For this reason, the policy makers need to consider radical reforms and method to ensure carful inspection of previously used standard operating procedures and instruments and financial services not just in the developed countries that were hit by the crisis but also the emerging economics. Policy makers need to consider policy reform and choices that strengthen the reliability of various credit rating methods and encourage the development of alternative more reliable estimates of risk and institutional regulations to ensure that the private sector performs effectively and more smoothly under the supervision of the public sector. 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