Finance Theory & Markets

Topic - Global Financial Crisis and Changes to Financial Regulations

Since 2007-2009 the world has gone through a global financial crisis which has affected the entire world economy. The world has seen its stock markets fall, as companies and large financial institutions have collapsed or been taken over due to bankruptcy. Governments worldwide have been forced to bail out their financial institutions so that their financial systems do not collapse, in cases such as General Motors in the USA.

At this point, people are searching for answers, and thus, fingers are being pointed at everyone. Some blame the people who are unable to pay back loans; many argue that banks have not carried out sufficient background checks as to whether people would be able to pay back the loans. Others blame the Federal Reserves of the countries for allowing this situation to occur, because this crisis obviously did not occur overnight, and it is their job to make sure something like this does not happen.

This global financial meltdown has affected the livelihood of people all over the world. Moreover, in such an increasingly inter-connected world, the glitches in the global financial system have had a ripple effect on economies worldwide. This can be related to the situation in Asia, where there has been more exposure to problems stemming from the West.

There are several areas of regulations & supervisions that have to be changed to prevent such a catastrophic event from reoccurring. The key concepts to reform financial regulations and supervisions are:-

1. Enhancing risk management at financial firms.

Most financial firms' risk management systems were unable to capture the threats associated with their business models. To overcome this problem, risk management needs to be given higher priority which would help strengthen risk capture and build capital which is in proportion to the risk these business models involve.

2. Identifying misaligned incentives in business models & enhancing integrity and transparency of the market.

Transparency is an essential factor when looking at reforming a financial system. There has to be provision of higher levels of transparency and visibility for investor's, regulators and all other market participants. The market should ensure that there is disclosure of all financial activities to all concerned parties helping them in assessing and understanding all risks related to the organizations activities.

3. Broadening the regulatory scope with a view to systemic risk.

The current crisis has drawn attention to the impact non-bank financial firms can have on financial stability on the whole. Usually, the regulatory framework used to deal with systemic risk mainly focuses on the commercial banking sector to protect bank deposits and the payment system. Previously unregulated firms and markets have been forcing influence over the global financial system. Due to these developments, the G20 leaders decided to broaden the scope of regulation and supervision to cover all systematically significant institutions, products and markets.

4. Strengthening international cooperation among regulators.

Before the crisis occurred, the risks had been spread through the international markets to investors all around the world, thus, the measures to overcome the problem needed to be internationally consistent. The international institutions, which consist of G7, G20 and the Financial Stability Board (FSB) have helped in developing and coordinating policy response, as well as cross-border crisis management.

5. Macro prudential perspectives for supervision.

Low interest rates, the favourable macroeconomics environment and global imbalances made financial firms keen on searching for higher returns, which in turn led to excessive leverage and uncontrollable behaviour. There are many hidden risks in the market and as the market is interdependent the whole market would feel the effect. With liquidity dried up, pricing structure in a market is at a risk of becoming impaired this would then threaten the soundness of financial firms.

Recent information suggests that macroeconomics and market developments are as important to an organization as its own personal risks. Regulators need to identify common risk factors and create an analysis in their supervision. Traditional supervision will not be enough and a more in-depth analysis of the market developments and macroeconomics has to be taken looking into the reliability and behaviour of the market.

Analysis of the macroeconomic effect on the financial system and regulations should be taken targeting the fluctuations in the economy. Addressing procyclicality of the capital adequacy requirements can be seen as one of these macroprudential approaches in this broader sense.

Points to be kept in mind by regulators

There are a few important points regulators should bear in mind in advancing these regulatory changes.

  • The first is the recognition that the role of the financial sector in supporting the real economy is indispensable and remains unchanged. Well-functioning financial systems and financial markets are vital for the sustainable growth of the world economy. They are expected to provide good investment opportunities to investors and to supply fundraisers with adequate amount of growth capital.

  • Second, regulators must avoid impeding the vigour of financial business and innovations in financial markets by excessive regulation. They should be aware that good, genuine innovation increases economic welfare through promoting optimal allocation of resources. Financial regulation should therefore be designed to incentivise private sector efforts that would contribute to enhancing this public interest in our market economy.

  • And third, regulators need to implement both short-term crisis management measures and medium-term regulatory reforms in a balanced manner. On the one hand, if the policies lean too much toward crisis management with extraordinary public support, it could cause moral hazard in the marketplace or distort the financial system in the longer run. On the other hand, too hasty implementation of medium-term measures could rather exacerbate the current situation and make crisis management even more difficult.
  • Remarks by Dr. Takafumi Sato
    Commissioner, Financial Services Agency (FSA)

    Implications of the regulatory reform for financial sector in future

    I. Leverage in the financial system will be reduced significantly, as a result of more rigorous risk management and due diligence, as well as regulatory changes.

    II. With more emphasis placed on risk management, financial firms' decision-making process may be affected accordingly. This may mean that chief risk officers or the risk management section will play a more prominent role in decision-making. As a result, internal management costs may also be increased.

    III. Financial firms' business models will be based more on risk-adjusted profitability. It will be further enhanced if compensation schemes are modified so as to restrict excessive incentives to maximise short-term profits.

    IV. A more transparency-oriented market environment could promote more standardisation of financial products. This may be induced also by less investor appetite to opaque, complex financial products due also to the concerns about their market liquidity. A shift of transactions out of OTC to exchanges could be another related development.

    Remarks by Dr. Takafumi Sato
    Commissioner, Financial Services Agency (FSA)

    The regulatory system which was in place earlier failed to prevent the recent financial crisis. There were many areas in which this system failed. They include insufficient capital and liquidity requirements for banking firms, in adequate and fragmented supervision and regulation of bank and non banking firms which was a serious threat to the stability of the financial system.

    Source: Essay UK -

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