Regulatory Failures in the 2007-2008 Financial Crisis - Essay Example

?Regulatory failures in the 2007-8 financial crisis Executive summary This is a study on the regulatory failure that caused the global financial crisis of 2007-08. This mainly originated in the U.S. where the over-enthusiastic banks in the economic boom issued housing mortgage loans to the poorly rated borrowers who later defaulted . The mortgage loans were backed by exotic securities on which unsuspecting investors had invested their money. The investors included investment banks who had only invested public money held by them on fiduciary capacity. Fiduciary relationship should be highly regulated. In the absence of limitations on investments, US banks went on an investment spree. But for government intervention, the crisis would have been still persisting though it has not died down. Regulatory failure does not mean regulator caused the loss. The U.S. regulators have woken up to the crisis and offered practicable solutions to avert future crisis due to regulatory failure. The U.K. as major international financial centre has also been affected by the U.S. contagion and has been responsible enough to offer solutions to the regulatory failure by bringing in three more regulators. Introduction The origin of the 2007-08 financial crisis goes to the U.S. where housing mortgage loans were paid to unqualified (sub-prime) borrowers. The loans had been backed by exotic financial products with few tiers highly rated by credit rating agencies. These products were purchased by institutional and banking investors who did so for high yields at low risk. The crisis started when the de-facto borrowers started defaulting all over the U.S. leading to unexpected losses on the front end or back end? products. Chain of bankruptcies, balance sheet write-offs followed. The sub-prime crisis is only a part of the broader picture of debt expansion. In the U.S. for which detailed data is available, total debt as a proportion of GDP increased from 150 % of the GDP in the early 1970s to 330 % in 2005. Household debt also expanded in similar fashion marked by dot.com crash to over 100 % of the GDP by 2008. Financial services which held 10 % of the total increased their share to 30 % between 1975 and 2005. The structural shift towards financial services resulted in huge increase in its profitability from 10 % in early 1980s to 40 % by 2006 (Lewis, 2010, p. 2 & 8). World is not new to financial crises. The U.K. was not immune to the present one since world’s leading institutional and banking investors are spread across the world. It has witnessed a few major crises before for different reasons. The present crisis is due to regulatory failure. This paper examines the causes of regulatory failure and solutions to avert such failures in the future. Regulatory failure Regulatory failure does not mean that financial crisis was caused by regulators or regulations. Rather it was due to short-sightedness of financial institutions and recklessness of the borrowers although there were regulatory strategies that could have averted or mitigated the factors that caused the crisis. For example, five causes are attributed to the crisis of the U.S : 1) Failure of underwriting standards for subprime mortgages and loans to inadequately qualified buyers; 2) parties to the mortgage securitisation process not maintaining market discipline; 3) poor assessment of sub-prime mortgages by credit rating agencies; 4) poor risk management by large financial services institutions; 5) non-response from financial institutions for better risk management as pointed by the U.S. President’s Working Group on Financial Markets. Each of these causes had its own regulatory attribution. Thus, there was no regulatory mechanism for business conduct and consumer protection to control sale of mortgages to homebuyers with poor credit background. Regulators could have by tougher supervisory oversight assisted large financial services institutions for better risk management. There was no control on holding companies of investment banks, private equity funds, hedge funds that resulted in under-regulation in that no single agency was entirely responsible for monitoring these institutions. On the other hand, multi-function financial supermarkets were controlled by multiple agencies that resulted in overlapping of oversights without coordination among them. Failure by the credit rating agencies in not giving timely and accurate reports. The spread of the crisis from the U.S. to Europe and rest of the world reflected weaknesses on the part of the national regulators in timely sharing of information. The crisis also demonstrated the regulators’ trust in the principle of international financial firms being supervised by home country. See Table 1 below (Pan, 2010, pp. 743-744). (Pan, 2010, p. 744). In order to prevent recurrence of such crisis more effective regulatory mechanisms, U.K., U.S., and the European Union have made concurrent proposals. The proposals in the form of reforms emphasize reorganization of regulatory agencies. In spite of their common objectives, the proposals differed due to unique political and economic situations. It is argued that there should be no differences as such proposals will not prevent future crises. A durable regulatory reform has to meet four challenges. 1) Suitable structuring of regulatory systems in that each jurisdiction should allocate responsibilities among regulatory agencies with a consideration whether consolidation of such responsibilities into smaller number of agencies as alternative. In case of differences between agencies, there must be mechanism to ensure coordination among them and set regulatory priorities. 2) Whether there should be regulation for prudential supervision and consumer protection? “twin peaks” model posits that there is an inherent conflict between the two. Although in the U.K. and U.S.A. the twin peaks model is recognised, it is not so in other parts of the E.U. 3) Systemic risk control involve regular monitoring of market events and developments with potential to create instability and prevent such developments in time. As such it should be considered whether such a task should rest with a specialised agency or combined with the existing one. If former is the case, how multiple agencies should share powers and responsibilities for systemic regulation? 4) Monitoring of and regulation of cross-border financial services and transactions need to be regulated and the manner in which it should be carried out should be decided as home jurisdictions remain vulnerable to future crises if cross border regulation and supervision are not adequate (Pan, 2010, p. 745). Proposal by the United Kingdom The “Turner Review” as it is popularly called, reported that Financial Services Authority (FSA) which is the regulatory agency emphasized on broadening of its objectives and powers to have control over systemic risk threats. Turner Review pointed out FSA‘s failure to prevent many activities responsible for the crisis as it believed that monitoring huge institutions such as U.K.‘s large depository institutions or extending of its supervisory arm to unregulated financial institutions was not necessary. With this in view, the Turner Review emphasized on devoting more supervisory resources on systemically important institutions that are generally considered as “too big to fail” by employing personnel with more skills and better training in regulations and also focussing on credit and liquidity risk. Other proposals included enhanced capital adequacy ratio, and deposit insurance, development and enforcement of U.K. and International Codes for executive compensation, creating an agency for credit default swaps, and enactment stricter “conflict of interest rules” for credit rating agencies. For regulation of cross-border financial institutions, the Turner Review wanted the FSA to regulate more stringently the UK subsidiaries of non-UK financial institutions though it might affect cross-border financial services as a result overlapping national regulation. The Review did not recommend any changes in the tripartite arrangement among the FSA, Bank of England and HM Treasury in respect of financial market regulation but insisted that FSA and Bank of England should have should have defined responsibilities to ensure market stability and that FSA should be made an equal partner with Bank of England in responding to threats to the financial system (Pan, 2010, pp. 747-748). However, the newly formed Government announced in May 2010 wanted the tripartite arrangement to end and put the entire responsibility of prudential supervision on Bank of England and make FSA into a new Consumer Protection and Markets authority (Pan, 2010, pp. 748-749). Willem Buiter (2007) posits that financial crises could not be avoided in capitalism. It is illusory to expect that financial crises can be routed out by Governments through regulations. In fact, perverse regulations with too much liquidity at the same time contributed to the current crisis. It does not mean government regulation of financial markets and institutions are not necessary. In fact, many governmental initiatives did not solve the crisis but only prolonged it. Buiter argues that in times of economic boom, regulatory capture and corruption co-exist. Table below shows the relationship between regulation and financial crisis in various countries. While financial crises in Germany, Japan, New Zealand, Spain, Switzerland, Turkey and United Kingdom are not as a result of the regulation, in other countries such as the U.S.A. The relationship between regulation and the financial crisis depended upon Government and credit market. For example, financial systems in Norway and Sweden which had lesser number of large banks dominating the market were liberalized. Prior to liberalisation, there were interest-rate regulations, lending restrictions quantitatively, capital controls without entry for subsidiaries of foreign banks. This resulted in low-price competition among banks which had wide branch networks and stable profits. The financial deregulation and liberalization of capital flows led to increase in private consumption and investment (Shahchera, 2010, pp. 142-143). (Shahchera, 2010, p. 145) The above said study concludes that US mortgage market triggered the financial crisis all over the world through excessive lending practices through complex financial products. Defaults in repayments have eroded the capital base of banking systems in the U.K., U.S.A., Switzerland and the Euro zone. While financial markets have the potential to improve the lot of the people and country’s economy to which they belong, regulations can make them more effective while at the same add to the cost. The Enger granger causality test shows that there is reciprocal positive relationship between regulation and financial crisis. Exchange rate and interest rate have negative relationship. Increased bank equity resulted in lessened financial crisis. Overall result is that increasing regulation, increased financial crisis (Shahchera, 2010, pp. 147-148). Stigler (1974) posits that any enforcement of law is to ensure compliance but complete enforcement should be foregone as it is costly. Enforcement effectiveness depends upon availability of resources. Increasing punishment would save enforcement costs since enhanced punishment would deter offenders. The author states that an enforcement agency must be given more than a mandate to enforce an enactment with vigour and wisdom and incentives to enforce law more vigorously. Why regulate Baldwin, Cave and Lodge (2012), state that the need to regulate in above cases arises due to market failure. It is justified because market place that is not under control will not yield the expected result or behaviour consistent with public interest. There can also be other rationales to regulate such as human rights, social solidarity apart from market failure considerations. (p15). A good regulation needs to have the following criteria: It should be backed by a legislative mandate, it should have accountability, and there should be due process, availability of expertise and efficiency (p27). To be good regulation, assessment of its quality along with “performance of regulatory improvement tools, institutions and policies” (p34). This is however challenging for various reasons. Foremost among these is measurement of “regulatory quality (and tool or policy or institutional performance” (p35). International Compliance Association (ICA) defines “regulation” as a set of binding rules issued by a private or public body (Mwenda, 2006, p. 5) . These rules are those applied by financial services regulators in as part of their legal duties of enforcement. The rules are prudential rules concerned with influencing conditions of access to the market so as to prevent entry or emergence of parties with questionable reputation or with no financial backing for the operations they want to engage in. The prudential rules also aim at controlling risks concerned with “financial activities, corporate governance, internal control systems, conduct of business rules and methods of supervision” (ICA, 2003, pp. 46-48). General Statutory Powers of Regulatory Body Regardless of jurisdiction, a regulatory authority should be vested with sufficient powers, resources with clear responsibilities, objectives, transparency and accountability. The responsibilities and objectives of the regulator is dependent upon the model adopted and role the regulator is expected to fulfil (ICA, 2003, p. 49). For example, it has been argued that a regulator must have certain legal powers to authorize a business to carry on its intended regulated activities, supervise the said business, inspect, investigate and enforce compliance by imposing licence conditions or withdrawal of authorization and share information with other regulators. The regulator at the same time must be given protection against liability that may arise during the course of discharge of their duties unless they do it in bad faith. This is crucial because it is an incentive for diligent performance in a competent and independent manner without fear of prosecution by an affected party. Another common feature is that regulators across the world suffer from lack of resources to implement enforcement. Such a feature can compromise independence of a regulator having to rely on the State for funding its operations. Just as lack of trained human resources as discussed elsewhere, lack of infrastructure and technology is also equally important as otherwise they cannot process information in time with accuracy. General view is that regulator should be independent in their operations but accountable for exercise of their powers (Mwenda, 2006, p. 14). Authorization to conduct business Regulator should be vested with the power of licensing an individual or business entity to carry out financial services. Operating without licence from the regulator is a criminal offence in many countries. Before granting licence, the regulatory will assess the “honesty, integrity, reputation, competence, ability, and organisation and financial position” (p14) of the applicant, scope of the business, compliance procedures the applicant has put in place, management expertise, resources available in terms finance capital, human capital, information technology etc. In case of an applicant being a foreign entity, it would be prudent to concur with the regulator of applicant’s home country (Mwenda, 2006, pp. 15-17). Enforcement of regulations Many countries consider that enforcement of regulations should rest with the regulator themselves. Thus, the regulator is incentivised to conduct inspections, investigations and penalties. They have the power to request information, order sanctions, move courts or tribunals for orders, arrange criminal prosecution and suspend and/or cancel licence to operate business or trading. In fact, international standard setting bodies insist on empowering the domestic regulators adequately (Mwenda, 2006, pp. 15-17). UK Model In the U.K. unified financial services supervision is in forced after the power banking supervision was transferred from the Bank of England to Financial Services Authority in 1998 Bank of England Act. This day, supervision of banks, listed money market institutions and related clearing houses is vested with the Financial Services Authority (p82). Although some may argue for powers of regulation to be vested with Bank of England as A central bank and lender of last resort, the U.K. is an exceptional case an international monetary centre and its financial services industry is comparatively larger and more diverse. Besides FSA of the U.K controls prudential aspects and business conduct. Furthermore, creation of FSA resulted in consolidation of nine regulatory bodies (Mwenda, 2006, p. 81). Solutions for the U.S. scenario The economists, regulators and legislators have together suggested development detailed rules for regulation of mortgage lending, formulation of national licensure scheme for mortgage lenders, setting up a mortgage write-off system that would encourage homeowners to avoid foreclosure by making amending terms and conditions of their loans by the lending bank or institution as the case may be or by the courts or other governmental bodies. There will be broad systemic overhaul as happened in the case of bankruptcy system in 2005. The foregoing is in response to mass lending of high risk and sub-prime mortgages that resulted in mass defaults. This and predatory lending practices employed by many issuers of the subprime mortgages that aggravated the financial crisis of 2007-08. It is also in response to the regulatory failures or oversights in respect of mortgage origination which affected both private sector lenders and government lending institutions. The laxity on the part of the regulators or absence of any regulation on the private sector lending practices encouraged them to grant loans to people without looking into their income, net worth or employment and also by falsifying documents for eligibility. Besides the bad conduct of the private money lenders, Government Sponsored Enterprises (GSEs) such as Fannie Mac, Freddie Mac, and the Federal Home Loans Banks also behaved in a high-risk manner leading the crisis in question (Nothwehr & Manning, 2009, p. 1) . Regulatory failure in respect of SEC regulation of investment banks. Independent investment banks through shadow banking invested large amounts in high-risk mortgage backed securities (MBSs). These investments of high risk with no regulatory control on the issuing banks were deeply affected by the collapse of housing market. Prior to the crisis enactment such as Graham-Leach Bliley Act relating to securities did not envisage any mechanism within the SEC for regulation independent investment banks. SEC responded to this major regulatory gap by establishing a voluntary system for banks such as Goldman Sachs, Morgan Stanley, Merrill Lynch, Lehman Bros and Bear Steams to voluntarily subscribe to matters such as minimum capital requirements and leverage limitations. The Scheme was known as Consolidated Supervised Entities (CSE) program. This initiative was mainly due to EU requirement that such banks setting up subsidiaries should have a U.S. regulator that these banks opted for CSE supervision. But, for want of statutory authority and the investment banks’ freedom to opt out of CES scheme, CSE became entirely ineffective. In response to the above, solutions for the regulation of investment banks by the SEC are as follows: Such of those investment banks that opted for CSE regulation voluntarily and eventually collapsed have been acquired or converted into bank holding companies. By September 2008, SEC withdrew the CSE scheme but continues to make commitments for better regulation of the entities and enterprises having jurisdiction on. There is no alternative scheme to CSE program but there are suggestions to enact legislation giving SEC the required statutory authority or requiring the Federal Reserve monitor the investment banking activities. Until such time a permanent arrangement is made, SEC and Federal Reserve have signed an MOU for working together to formulate a an effective scheme of regulation of investment banks now known “bank-holding companies “ in short (Nothwehr & Manning, 2009, p. 1). Regulatory failures relating to the “shadow banking” System. Collapse of the shadow banking system has been due to expansion of the crisis from the U.S. housing market to the global financial system. With the use of shadow banking means such as structured investment vehicles (SIVs), collateralized debt obligations (CDOs) and credit default swaps (CDS), the investment banks purchase, financed and insured MBSs as high risk transaction off their balance sheets that kept off these banks free from most of the regulations. By indulging in these practices, the investment banks avoided minimum reserve requirements otherwise applicable to commercial banks and other institutions (Nothwehr & Manning, 2009, p. 1). See figure below: (Nothwehr & Manning, 2009, p. 1) In response to the above failure of shadow banking system, financial community at both national and international levels have pledged to make minimum reserve requirements for purchase of MBSs, the production of commercial paper etc. It has been agreed by the regulators and economists that there shall be stringent monitoring of shadow banking activities by more aggressive oversight and regulation of the risk management activities of all institutions and entities both on and off balance sheet. Withdrawal of over-the-counter trading of CDS and establishment of monitored international clearing house instead. And mandating all financial institutions to make increased disclosures (Nothwehr & Manning, 2009, p. 1). Regulatory failure attributed to accounting practices. Mark to market accounting especially in respect of its use to inactive or illiquid markets which are now the current markets for housing or mortgage backed securities has caused the current financial crisis. Prior to passing of Emergency Economic Stabilisation Act of 2008 FASB’s Fair Accounting Statement 157 (FAS 157) regulated the above said accounting practice. FAS 157 defines the fair value as the price it would fetch in the market at the time. Similar rule 7 in the IFRS which almost rest of the world follows, requiring banks and financial institutions value assets at current market rate, even if it is case of temporarily depressed market forces the institutions to post massive false losses. The aggregation of these paper losses caused the current financial crisis. In response to this regulatory failure, both FASB and SEC have disagreed to change the rule although they have authority to change the rule under EESA. On the other hand, American Bankers’ Association have argued strongly for changing the rule or suspend it. The deadlock continues (Nothwehr & Manning, 2009, p. 1). The remaining two categories of regulatory failure relate to credit rating agencies and Basel accords. Credit Rating Agencies which largely contributed to the development of the crisis have been advised to avoid conflict of interest and avoidance of consulting position where is to make rating also (Nothwehr & Manning, 2009, p. 1). Basel accord 1 of 1976 requires bank to hold 8 % of minimum of risk weighted assets in order to be considered as adequately capitalised. The accord 1 requires banks to hold assets under four buckets having different percentage of capital. It invited criticisms from the banking quarters as unrealistic not reflecting the real world risk. At the same time banks took advantage of keeping lower charges for off-balance sheet activities. By securitizing loans, bank could hold lower capital charges. Then Basel II accord came requiring banks to rely on Credit Rating Agencies or their own internal assessments. This encouraged banks to lower capital requirements for residential mortgages and no capital requirement for off-balance sheet activities. In response to the global crisis, the Financial Stability Forum (FSF) required Basel II to require higher capital requirements and asked Basel II to provide better guidance on risk management practices that include off-balance sheet exposures and resultant reputational risk. However experts think that it is the liquidity and not the capital ratio that caused 2007-08 crisis. The Basel Committee’s paper issued in September 2008 listed 17 principles which bank should follow for management of liquidity risk short of offering any formulas (Nothwehr & Manning, 2009, p. 1) Solutions for UK In response to the global financial crisis caused by regulatory failure, the UK is getting three more regulatory authorities by April 2013. While FSA and Bank of England are already in operation as a shadow structure similar to the new emerging regime. Thus, there are Financial Conduct Authority (FCA) , Prudential Regulation Authority (PRA) and Financial Policy Committee (FPC). By Spring 2013, a secondary legislation related to the Financial Services Act 2012 will be enacted. As per the new regime, FSA will be relieved of the responsibility of financial stability which will be taken over by the Bank of England. And the FPS will have a seat within the Bank and remain responsible for monitoring of systemic risks. The PRA will be responsible for solvency and resolution of systemically important institutions. The FCA will look after consumer protection and market regulation. The FCA will be expected to regulate about 27,500 firms out of 24,496 for prudential and conduct issues as they are deemed to have insignificant systemic importance. They include personal investment firms, investment management firms etc including Lloyd’s member’s agents and Lloyd’s brokers. 2, 143 firms mainly for conduct of business issues. They are systemically important and already prudentially regulated by the PRA and conduct by the FCA. The remaining 959 firms governed by other regulations are electronic money institutions and payment institutions. FCA will assume FSA ‘s existing responsibility of Financial Ombudsman Service and also look after Money Advice Service and managing the Financial Services Compensation Scheme. FCA will have newly created powers to prevent occurrence of any untoward. FCA can take action against financial promotion making false representations. It can also inform the public action taken against a firm if it does not respond to alert to the FCA’s proposed course of action (Wheatly, 2013, pp. 1-8). Please see figure below. Prudential Regulation Authority It has been entrusted with the responsibility prudential regulation systemically important firms. They are the firms that will pose risk to the financial system if they fail. According to the Act, PRA has to “promote the safety and soundness of PRA regulated persons” (Bailley, 2013, pp. 9-12). Financial Policy Committee (FPC) FPC will be responsible for “macro prudential supervision”. It will spot systemic risks due to structural features of the financial markets or spread of the risk within the financial sector. It will have 12 members consisting of six executives of the Bank of England, five outside members and the newly created post of Deputy Governor for prudential regulation (N.A., 2013, pp. 13-16) . Conclusion This paper went in to the aspects of regulatory failure which primarily caused the financial crisis of 2007-08. It was seen that capitalism was not immune to financial crisis. Regulation is necessary evil as otherwise it will meet the fate of what unregulated investment banks of the U.S. met with. While the US has multiple responses to the various regulatory causes that led to the crisis, UK has learnt from the US failure and accordingly brought out three more regimes to strengthen its overall financial services regulation. It has been proven that regulation and a punitive regime alone will put things in order as posited by Stigler in his treatise. World Bank’s country report of 2003 has already vouched for the UK’s robust financial system and the financial crisis of 2007-08 contagion is not of its own making. The UK’s three new regimes as solutions to the crisis are praiseworthy. References Bailley, A. (2013). Prudential Regulation Authority. The Chartered Insuarnce Institute. ICA. (2003). International Diploma in Compliance-Manual 1. Lewis, P. (2010). The Global Financial Crisis, 2007-08: Origins, Nature amd Consequences. Global Security and International Political Economy , 1, 1-12. Mwenda, K. K. (2006). Legal Aspects of Financial Services Regulation and the Concept of a Unified Regulator. Washington D.C.: The World Bank. N.A. (2013). Financial Policy Committee . Chartered Insurance Institute. Nothwehr, E., & Manning, T. (2009). Regulatory Failures and Insufficiencies that Contributed to the Financial Crisis and Proposed Solutions. The University of Iowa. Pan, E. J. (2010). Four challenges to financial regulatory reform. Villanova Law Review , 55, 743-772. Robert, B., Cave, M., & Lodge, M. (2012). Understanding Regulation : Theory, Strategy and Practice . Oxford: Oxfrod University Press. Shahchera, M. (2010). Regulation and Financial Crisis in OECD Countries. International Review of Business Reesarch Papers , 6 (2), 132-149. Stigler, G. J. (1974). The Optimum Enforcement of Laws. In G. S. Becker, & W. M. Landes, Essays in the Economics of Crime and Punishment (pp. 55-67). UMI. Wheatly, M. (2013). Policy Briefing : Twoards Twin Peaks : The UK's emerging Regulatory Landscape . The Chartererd Insurance Institute . Read More