Implementation of Market Regulations - Essay Example

?Implementation of Market Regulations to prevent Financial Crisis Introduction Financial markets are imperfect markets (Heremans, 1999). “A disruption to financial markets in which adverse selection and moral hazard problems become much worse, so that financial markets are unable to efficiently channel funds to those who have the most productive investment opportunities” is defined as a financial crisis (Mishkin, 1992). Governments intervene in financial markets “primarily” to prevent such crisis situations and stabilize financial & banking systems in the country. Nevertheless as pointed out by various authors the true motives behind controlling the components of financial systems such as the interest rates are ambiguous (Friedman, 2009). Moreover, researchers have pointed out sever limitations in the policy instruments which are used to regulate the financial markets. The current paper attempts to answer “why and how the world financial markets must be regulated to minimize the adverse effects of crisis to the world economy.” The specific objectives of the current study are (1) to assess the need for regulating the financial markets and (2) to propose an effective framework for managing the financial systems. For this purpose four selected research publications which are focused on “financial market regulations” are thoroughly reviewed in terms of the rational, mechanisms, limitations and risks presented in each study. Next in relation to the essence of the above studies, the management framework of the EU zone banking and financial crisis, 2008 is evaluated. Beginning of the Financial and Banking systems failure National Bank Act and state banking laws which were imposed after 1933 restricted the activities of commercial banks to specific geographic locations and heavily used Federal deposit insurance and Federal Reserve funding to protect the banking system against risk and uncertainty. The above financial markets were largely stable and fairly profitable however, there was limited space for evolving the system. Towards the late 1960s depositors and investors found the above financial system inefficient in providing their dynamic and complex needs. Development of a “shadow banking system” which integrates the traditional lending activities and capital markets activities began during the early 1970s. Shadow baking system heavily adopted “securitization and derivative instruments” in place of real money. Traditional linkage between the depositors and commercial banks in lending activities largely deteriorated in shadow banking system. Recent financial crisis is viewed as an after math of exploding the above system (Tarullo, 2012). Organization of the Report Part 1 of this paper describes the characteristics of the financial markets, need for regulating and regulatory mechanisms used by the governments. This section of the paper is largely based on “Regulation of Banking and Financial Markets” by Dirk Heremans (1999) and “Regulatory Reform since the Financial Crisis” by Daniel Tarullo (2012). In the part 2, limitations and risks of regulating the world financial markets are described by using the “A crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure” study by Jeffrey Friedman (2009) and “The Bailout through a Public Choice Lens: Government-Controlled Corporations as a Mechanism for Rent Transfer” study by J.W. Verret (2010). Part 3 contains implications of the above arguments in relation to the real world scenarios. Finally, the conclusions drawn from the literature review and examining the real world case scenarios are outlined in “Conclusions.” Part 1 Characteristics of Financial Markets and the Need for Regulating According to Dirk Heremans, 1999, financial markets are imperfect and contain “unique” characteristics (i.e. risk & uncertainty, information asymmetry, heard behavior and influence on money circulation) which demand systematic government intervening (pp 953). Risk and uncertainty in the financial markets are created by the prominent linkage between financial operations and the future. Commodities circulating in the financial markets such as currency, treasury bills, bonds and deposit checks store “value” and transfer such values to the future. Financial operations and transactions thus involve expectations from the arbitrators in the economy. Therefore risk and uncertainty can be named as the driving forces in financial markets. Information asymmetry is created between borrowers and the lenders in financial markets. Investors in the economy are more informed regarding the risks and uncertainties associated with specific business ventures compared to the lending agency. Similarly, banks are more informed regarding its risk portfolio compared to the depositors. Thus the lender may fail to allocate the financial resources in the most profitable business ventures due to the adverse selection and depositors fail to save their money in the optimal methods. However, optimum allocation of the limited financial resources and efficiently acting as the middle agent between savers and the borrowers are essential services expected from the financial markets. Thus the effectiveness of financial system can be suboptimal due to its very nature. Moreover, the moral hazard cost which is incurred by the lenders while monitoring and supervising the business activities of the burrowers is a “dead weight loss” to the society (Heremans, 1999, pp 953). Heard behavior of the financial institutes is observed due to their large interdependency in the economy. Example: U.S. subprime mortgage losses cause BNP Paribas SA bank in France, to froze investment funds. “Market parties adjust suddenly and collectively their expectations leading to high volatility in financial markets. Events in one financial market or institution may then have important effects on the large financial system. Failure in one market or institution may create a financial panic and end up in a systemic crisis, due to the international capital mobility it may become a worldwide financial crisis” (Heremans, 1999, pp 957). Amount of money circulating in the economy reflects the value of goods and services that are been exchanged in the economy. If excess money is created than the actual value of the goods and services produced in a given economy, inflation will be resulted. Money is a commodity which is created within the financial system. Thus it is important to supervise the financial markets and intervene by the government where appropriate. In general the governments’ intervention in markets is primarily lead by consumer protection goals because the consumers are imperfectly informed regarding the market supply of goods and services. Such information asymmetry can create market imperfections leading to monopoly and monopsony. Accordingly regulating the financial system can “prevent banks from assuming unacceptably high risks which may endanger the interests of the deposit holders and savers” (Heremans, 1999, pp 951). Next, the governments’ intervention may also aim at achieving specific policy objectives. Example: provision of low interest loans to the small businesses and rural entrepreneurs to increase the per-capita income of the middle and low income category individuals in the country. Moreover, vital economic indicators such as the cost of burrowing, returns for investments and real exchange rates of a given country are determined in financial markets. Therefore the effective government intervention is required to achieve the long term development goals of the country. As described above financial markets are imperfect and highly volatile while its activities are significant to the economy at large. The activities of the financial system may have secondary effects on multiple sectors in the economy including the producers, consumers and intermediaries. Bankruptcy of an individual institute can create a viral effect on the other institutions, resulting in collapsing of the national financial and banking system. Such national level financial crisis can affect the capital transfer across the borders and eventually resulting in global financial system failure. Heremans describe this as “Financial market failures and instability eventually leading to a systemic crisis not only affect individual savers and depositors, but the health of the whole economy. Public policy intervention then is not only a microeconomic question of protecting individual savers and investors, but becomes a macroeconomic issue” (pp 958). Therefore the governments’ are required to intervene in financial markets at an optimum degree. Part 2 Market Regulating Strategies Applied to the Financial Systems Market regulation mechanisms adapted by the governments to control financial systems can be categorized into 2 groups namely; ex post and ex ante interventions. These approaches for controlling the financial markets are described below. Historically, government controlled the liquidity provision in the financial system via Central banks i.e. ex post interventions. Accordingly, they provide credit (bailout packages) to the financial intermediaries in times of bankruptcy. This is recognized as the role of Central banks in financial markets as the lender of last resort. Such interventions can impede the “contagious transmission of financial problems among the financial intermediaries in the economy and prevent the failures of financial institutions, in particular when they are considered to be too big to fail” (Heremans, 1999, pp 961). Next the deposit insurance can protect the individual depositors against information asymmetry. It was introduced to USA after the Great Depression in 1930s. Accordingly, the government provides protection to the individual investors who are less informed about the quality of the banks’ assets. The ex ante interventions can influence structure of the financial systems i.e. structural interventions (example: Restrictions on entry to the market and on business activities, Regulation of interest rates) or the operations of the financial system i.e. prudential interventions (example: capital adequacy standards, asset restrictions and diversification rules, liquidity adequacy requirements, Disclosure standards and reporting requirements). Structural interventions can prevent the unhealthy expansion of the financial sector. Example: in the Cypriot bank crisis it was observed that country’s banking sector had “ballooned” approximately 4 times larger than the economy. Bank capital reserves are largely beneficial for the stability of financial systems. According to Tarullo, 2012, bank capital reserves are maintained to full fill the following; Tier 1 capital would be available to absorb losses so as to allow the firm to continue as a going concern, Tier 2 capital would be available to absorb losses if the firm nonetheless failed. The Bank for International Settlements (BIS) states a minimum of 8 percentage proportion capital to risk weighted assets ratio is required to be maintained by all the international banks. Tarullo, 2012, states “While robust bank capital requirements alone cannot ensure the safety and soundness of our financial system, they are central to good financial regulation, precisely because they are available to absorb all kinds of potential losses, unanticipated as well as anticipated” (pp 4). In addition to the above Tarullo, 2012, also states that market regulating mechanisms in the financial markets should address the following. Various capital measurements can complement and protect the investors, counterparties, regulators, and the public against a larger proportion of the market risks. Interconnectivity between the various capital requirements and banking laws need to be considered in formulating an efficient regulatory mechanism. There are large financial institutes which can significantly influence the stability of the global economy. Such institutes must be regulated separately from the other financial intermediaries. Ex post interventions of the governments have been so far restricted to bailouts entities that are too-big-to-fail. During the recent financial crisis such bailouts had been provided to countries example: Greece, Cyprus and Spain by the International Monetary Fund. Ex post interventions must also focus on non-bank financial intermediaries in the system and the “shadow banking” system. Risks of Governments Intervening in Financial Markets A literature review conducted by Jeffrey Friedman in 2009 revealed that there are non-economic causes for the recent global financial crisis and it was not a result of limitations that present within the financial system only. In fact some authors are in the view that, government interventions which are lead by political interests fueled the USA “housing bubble” which eventually spread across the boards leading into a world financial system collapse. Example: “Stiglitz’s paper suggests that the Fed might not have needed to pump up aggregate demand with such low interest rates had not the Iraq war, which began in 2003, driven up the price of oil” (Friedman, 2009, pp 138). Jeffrey Friedman identified in the above paper, that deflation of the subprime loans as the most proximate cause of the 2008 financial crisis. When the cost of borrowing is decreased while the return to investments is increased, the financial intermediaries face a higher risk of bankruptcy. Thus certain government interventions can be detrimental to the financial system stability. Jeffrey Friedman identified five Federal policies which induced housing bubble in the USA namely, Housing and Urban Development (HUD) directives to Fannie and Freddie, beginning in 1994, which produced a gigantic spate of government-insured subprime and nonprime lending and securitization. The innumerable regulations that had, since 1936, “canonized by decree” the judgments of the rating firms. The 1975 S.E.C. decision to confer legally protected status on the three extant rating agencies. The loose-money policies of the central banks (not just in the United States, as Taylor shows), which, in sparking the overall housing boom, also created a large but fragile subprime bubble. “No-recourse” laws, entitling mortgagors to suffer little consequence if they defaulted (pp 141). In August 2007, BNP Paribas SA which is the largest bank in France, froze three investment funds of approximately 1.6 billion euros worth, as the “U.S. subprime mortgage losses roiled the credit markets” (Boyd, 2007). Consequently, the European stock index declined by 1.9 percentage proportion. This is marked as the first sign of a financial crisis appeared in the EU zone. And the currently unfolding collapse of Cypriot financial system can be considered as the most recent stage of EU zone financial crisis. It is widely believed that the EU group was ill-prepared to manage the affects of global economic recession on an integrated “EU” financial market. There was limited transparency between the main financial institutes and the public across the zone (Ferry and Sapir, 2009). Failing of the banking system in 2007, alarmed the policy makers and called for an urgent financial crisis management framework. Nevertheless even by the end of year 2009 formulating of such an effective crisis management framework had been barely progressed (Ferry and Sapir, 2009). Unfolding of the world financial crisis 2008 as described above depicts the danger of unsuitable government intervening in the financial markets. Jeffrey Friedman concludes in the above literature based study “Thus, we know enough from the papers in this volume to be able to say not only that the regulators allowed the crisis; but, furthermore, that the regulators encouraged the crisis” (152). Furthermore, J.W. Verret (2010) describes the danger of providing bailout supports by the governments in managing the financial crisis. Author describes “how the government is likely to put political pressure on firms taking bailout support through its equity voting power.” According to the above author the political actors and bureaucrats obtain unprecedented level of control over the productive resources in the economy via bailed-out firms. And such firms will then act upon directing the resources to the groups of political interest. Bailouts comprise a significant proportion of the rescue packages currently used for managing the crisis situation. Example: crisis management framework currently implemented in the EU zone. The main objectives of the crisis management framework which is currently adopted by the EU zone can be listed as; (1) protecting the stability of the financial system in all EU countries (2) Management of cross-border crisis based on the common interest for all member states affected. If public resources are involved, direct budgetary net costs are shared among affected member states on the basis of “equitable and balanced criteria” (3) Full participation in management and resolution of a crisis will be ensured at an early stage for those member states that may be affected through individual institutions or Infrastructures and (4) Policy actions in the context of crisis management must comply with EU competition and state-aid rules (Ferry and Sapir, 2009). Example: IMF Rescue Package to Cyprus. Cyprus officially requested a rescue package from IMF in June 2012. Negotiations regarding the terms of the rescue package proceeded until March 2013 between the Euro-group and the Cypriot government. Eventually both parties agreed to the following; downsizing of the financial sector (with the domestic banking sector reaching the EU average by 2018), strategic fiscal consolidation, structural reforms and privatization in the banking sector. In order to achieve the above, “Laiki Bank of Cyprus” which is the second biggest bank in the country will be closed, rate of tax on withholding capital income and the statutory corporate income will be increased, Bank of Cyprus will be re-capitalized through a deposit/equity conversion of uninsured deposits with full contribution of equity shareholders & bond holders and the country will receive 10-billion euros bailout from the International Monetary Fund (Cyprus MoU, 2013). Currently a maximum withdrawal limit is being formulated for the depositors. To prevent funds going abroad, a restriction has been imposed upon the travelers leaving the country as 3,000 euros maximum. Hence in the real world the financial markets are highly regulated and bailout supports are massively provided despite their severe limitations as pointed out by the advocates of free market theory and public choice theory. Part 3 Need for government intervention in the financial markets and the limitations of the current intervention procedures were described in the part 1 and 2 of this paper. Given the fact that financial markets are “imperfect” and the commodities which are exchanged in the financial markets (i.e. money) are “synthetic” the “proper” government regulation is essential. Furthermore, the internal factors of the financial institutes that may trigger system failure needs to be supervised by the governments. Example: Gunsel, 2007, revealed that inadequate capital, poor asset quality, high interest expenses, low profitability, low liquidity and small asset size are significant variables that determine the likelihood of failing the financial and banking systems in the European zone. Black, 1995, revealed that poor risk analysis by the banks especially during the expansion phase of the business cycle can trigger banking crises. Inefficient internal credit control systems may fail to monitor the amount and quality of bank loans. Hoenig, 1999, revealed that connected lending or lending to the companies or development projects connected with the bank owners or managers despite their limited profitability as a major cause of bankruptcy in the region. Banks which lack capital assets are more susceptible to the shock of an economic downturn. High leverage can affect the profitability of any business venture. If the bank is operating below the minimum of 8 percentage proportion of the capital to risk weighted assets ratio, such capital can lose value by slight changes in the interest rate. Similarly if the borrowers are relying mainly on bank loans for financing businesses such may experience sever financial losses due to a small rise in interest rate (Huang ve Vajid, 2002). According to Demirguc-Kunt and Detragiache, 1998, low GDP growth, high real interest rates and inflation also can increase the likelihood of systemic banking crises. Financial crisis and banking failure are also observed as twin effects periodically occurring in the world economy. And collapsing of the world financial system is usually followed by the recession period in business cycle (Safakli, 2003).Therefore the governments’ intervening in financial markets requires to be aimed at improving the above factors and ensuring the system stability. Conclusions Finical crisis can begin due to low economic growth rate, detrimental policy interventions and internal factors. Some authors view bailout supports which are largely used in managing the recent financial crisis as a means of exerting political pressure on productive resources in the economy. Although the free market is considered “ideal” in economics, government intervention is important to the financial markets as they are imperfect, involves high risk & uncertainty, information asymmetry, heard behavior and influence on money circulation and comprise a shadow market. Hence an efficient and effective framework for managing the financial markets is essential to the growth and stability of the world economy. References Black, F. “Hedging Speculation, and Systemic Risk.” Journal of Derivatives 2 (1995). Web. 25 April 2013 Boyd, Sebastian. “BNP Paribas Freezes Funds as Loan Losses Roil Markets.” Bloomberg L.P.4. N.p. 9 August, 2007. Web. 25 April 2013 Daniel Tarullo: “Regulatory Reform since the Financial Crisis”, 2012. Speech Demirguc-Kunt, A. and Detragiache, E. “The Determinants of Banking Crises in Developing and Developed Counties.” IMF Staff Papers (1998): pp.83. Ferry, J.P. and Sapir, A. Banking Crisis Management in the EU: An Interim Assessment. Tilburg University, 23-24 Oct. 2009. Web. 25 April 2013 Friedman, J. “A crisis of Politics, Not Economics: Complexity, Ignorance, and Policy Failure”, Critical review 21. 2-3 (2009): 127-183. Print Gunsel, Nil. “Financial Ratios and the Probabilistic Prediction of Bank Failure in North Cyprus.” European Journal of Scientific Research 18.2 (2007): 191-200. Web. 25 April 2013 Heremans, D. “Regulation of Banking and Financial Markets”, Encyclopedia of Law and Economics, Edward Elgar Publishers, Cheltenham (1999): 950-986 Hoenig, Thomas. “Financial Regulation, Prudential Supervision, and Market Discipline: Striking a Balance.” Conference on the Lessons from RecentGlobal Financial Crises. Federal Reserve Bank of Chicago, 1 October 1999 Huang, H. Ve Wajid, S. K. “Financial Stability in the World of Global Finance.” Finance & Development (2002): 13-16. Verret, J.W. “The Bailout Through a Public Choice Lens: Government-Controlled Corporations as a Mechanism for Rent Transfer”, Seton Hall Law Review 40.4 (2010): 1521-1579. Print Read More