The global financial system was in the verge of collapsing during the fall of 2008, which imposed significant effects on the global credit system. This resulted to increasing calls for significant adjustments to be implemented in the financial regulatory system. During 2010 July, the United States Congress enacted a bill that aimed at increasing the role of the government in the financial markets (New York Times 45).
One of the core contributors to the recent global financial crisis can be attributed to poor banking policies that resulted to a restructuring of financial products and services, the willingness of the lenders to undertake significant amount of risks, and the adoption of low interest rates. Johnson (14) notes that the situation was worsened by the greed of the financial investors for the increasing high yields.
This poses the need for policy measures by the national and international policy makers to regulate the frequency of banking without imposing any negative consequences on the global economy (Economist Staff 47).
The focus of this research paper is to analyze the banking regulation during 2008, and how the bad regulations failed to protect the financial system. The paper also analyses the banking regulation after the 2008 Financial Crisis and what banking regulations should be like in the future to prevent unnecessary financial crises.
Analysis of the banking regulation during 2008
Economic crises are usually a reflection of the failures in the financial system, and the 2008 financial crisis was not an exception with significant flaws in the financial system being evident in the private and public sector. The 2008 financial crisis represented enormous breakdown of risk management in the financial sector and a neglect of what many economists would refer to as common sense in most financial institutions.
The most notable shortcoming that culminated to the crisis was government regulation in the financial markets and the financial institutions. Evidence that point to this include subprime mortgages, liquidity, unavailability of credit and questionable practices by the financial institutions. The outcomes associated by lack of government regulation in the financial sector resulted to an increase in specific asset prices such as the residential real estate in the United States.
At the time of the 2008 financial crisis, the regulatory system in the finance sector had witnessed growth that transformed from the diverse capital market options towards forms of financing, which was arguably evident through a relaxation of some of the limitations implemented on bank activities and almost all forms of restrictions that applied on the affiliations between the banking institutions and other non-banking firms in the financial sector.
Instead of laying emphasis on the restrictions, financial firms laid much emphasis on credit and risks of the financial markets. The fact was worsened by the fact the existing large financial firms deployed security laws as a form of regulation. Johnson (15) concludes that prudential regulation was lacking in the financial sector, which culminated towards the 2008 financial system.
One of the principal issues associated with the 2008 banking regulation relates to the quality of lending and poor risk assessment by financial firms. It is arguably evident that financial institutions did not take into account the quality of mortgage lending. The initial phase of the 2008 financial crisis was characterized by lack of incentives to ensure that financial institutions engaged in sound lending and effective risk management approaches.
The second principal issue of concern during the 2008 financial crisis relates to the effectiveness of supervision of the various financial institutions in the United States. Ineffective supervision resulted reckless lending in the housing finance sector in the United States. This questions the availability and effectiveness of the regulatory frameworks and guidelines to aid the regulators of financial institutions.
Tarullo (30) notes the unavailability of safety nets aimed reducing the failure of financial systems and reducing potential effects of failures of financial system. A notable failure of the regulatory frameworks during the 2008 financial crisis is their inability to ascertain the financial weakness of the banking institutions in order to avoid insolvency.
Analyzing the regulatory frameworks requires a comprehensive detail of the structure of the financial system and regulators, such as the type of institutions that have the role of regulating the financial services sector at their predefined levels.
The regulatory framework deployed during 2008 failed to achieve the stability of the United States financial system due to subsequent failures build up and complicated vulnerabilities. Tarullo (29) asserts that banking regulation during 2008 was not effective in addressing the effects of activities in the capital markets and financial trading on the banking system.
In the light of this, the notable deficiencies in the financial system was rooted in the inadequacies of macro-prudential regulatory frameworks, issues relating to boundaries in the financial and banking activities and the infantry stage of the macro-prudential strategies that were deployed to supplement the security laws used for regulation by the financial institutions. These failures of the financial system denote the significance of banking regulation in ensuring the stability of the financial system.
Fender (105) offers a policy measure to regulate the frequency of banking and financial crisis that argues for the use of the fiscal policy tools to regulate the financial sector of the economy. One of the fiscal policy tools that can be used to regulate the frequency of banking and the financial crisis is the use of the discount rate, which rate refers to the rate that is charged to commercial financial institutions and depository institutions for loans that they are given by their district lending bank, usually referred to as the lending window (Johnson 16).
Discount rate is a form of deposit insurance for the financial institutions in a country. The discount rate should be set at a rate that serves to encourage banking institutions in a country to look for other source of funding while making the Central Bank as the last resort to lending (Sorkin 147). The Discount rate and the interest rate adopted by a country’s Central Bank usually have an effect on the prime rate, which in turn plays a significant role in reducing sub-prime lending.
Caruana (65) argues that the discount rate can effectively address the issues that are imposed by banking panics, instances of bank runs are due to the fact that it is a requirement for the banking institutions to retain a percentage of the money belonging to their depositors in the Central Bank (Economist Staff 15). This is known as fractional-reserve banking. Because of this banking, institutions invest most of the money from their depositors.
There are rare cases that many of the depositors will withdraw their money to impede the operations of a bank. This policy measure can be adopted at the national level because it entirely depends on the functioning of a country’s central bank and its respective policies that are adopted to address the imbalances in the economy (Financial Crisis Inquiry Commission 50).
Shin (115) recommends the reinforcement transparency among the financial institutions in a country to regulate the frequency of banking and the financial crisis. This implies that financial institutions, especially in the banking sector must be precise regarding their goals and financial activities. It is arguably evident that there is a notable difference between the missions of banks (Wessel 47). The underlying argument is that banks with different missions and business strategies should not compete.
For instance, financial institutions that are established to fund infrastructure or Small and Medium Enterprises should not compete with financial institutions that are operating at a global scope (Shin 102). As such, small scaled financial institutions should adhere to their business level strategies and concentrate in investing in complex structured financial products. In addition, the risk management systems of the financial systems should be applied properly to address any risks in the financial markets and the banking sector of a country.
The financial institutions should accurately respond to the credit rating agencies according to the established criteria, and ensure that they disclose accurate information to the financial investors (Financial Crisis Inquiry Commission 47). This serves to ensure that there is competition in the financial and banking sector and addresses the conflicts of interests among the players in the financial and banking sector of a country. The ultimate goal is to foster transparency in the financial and banking sector (Caruana 55).
The policy measure proposed by Tarullo (45) to address the frequency of banking and the financial crisis is to strengthen the present regulatory and supervisory frameworks in the financial and banking sectors. This requires the adoption of collective regulation. It is evident that the present state of financial systems reveals that the banking institutions cannot be differentiated from the securities market (Putnis 452).
As such, the best solution to address this problem is to establish a collective regulatory and supervisory framework that integrates both the financial and banking sector. The present credit-squeeze in the financial markets and the banking sector of different countries has indicated that risk is allocated to any market participant that has the capacity of bearing it (Tarullo 48). This implies that individual regulation of the financial institutions will not reveal the gaps in the regulatory frameworks that are currently deployed (Caruana 54).
Strengthening regulatory and supervisory frameworks can also be attained through coordination of the supervision and regulation activities. Putnis (440) asserts that the present state of affairs reveals that there are diverse financial institutions that operate at different national jurisdictions. The globalization of the financial markets implies that systematic risks can no longer be concern at the national or regional level (Tran 4).
Strengthening the current regulatory and supervisory frameworks should also be implemented by the establishments of markets that are structured for the existing financial products. The effects associated with sub-prime causes during the financial crisis were accelerated by the fact that a liquid market for the complex structured financial products was lacking (Putnis 472).
In conclusion, the paper has presented the regulation policy measures that can be used to regulate the frequency of banking and the financial crisis. They include use of the fiscal policy tools to regulate the financial sector of the economy, reinforce transparency among the financial institutions in a country and strengthen the present regulatory and supervisory frameworks in the financial and banking sectors. An integration of the above policies guarantees the stability of the banking sector and the financial sectors.
New York Times. “Financial Regulatory Reform News – The New York Times.” Times Topics The New York Times. The New York Times, 2011. Web.
Caruana, Jaime. Lessons of the Financial Crisis for Future Regulation of Financial Institutions and Markets and for Liquidity Management. [Washington, D.C.]: International Monetary Fund, International Capital Markets Dept., 2009. Print.
Economist Staff. “Banking Regulation: Capital Punishment The Economist.” The Economist -World News, Politics, Economics, Business & Finance. The Economist, 2011. Web.
Johnson, Simon. “Op-ed: The Future of Banking: Is More Regulation Needed?” Peter G. Peterson Institute for International Economics. Peter G. Peterson Institute for International Economics, 2011. Web.
Putnis, Jan. “Chapter 35.” Banking Regulation Review. [S.l.]: Law Business Research, 2010. 434-72. Print.
Shin, Hyun Song. “Reflections on Northern Rock: The Bank Run That Heralded the Global Financial Crisis.” Journal of Economic Perspectives 23.1 (2009): 101-19. Print.
Tarullo, Daniel K. “Speech: Financial Regulation in the Wake of the Crisis.” Peter G. Peterson Institute for International Economics. 2009. Web.
Tran, Mark. “Wall Street Crisis: Time to Return to Financial Regulation | Business | Guardian.” Latest News, Sport and Comment from the Guardian | the Guardian. The Guardian, 2011. Web.
Fender, Hordahl. “Overview: Credit Retrenchment triggers liquidity squeeze.” BIS Quaterly Review (2005).
Financial Crisis Inquiry Commission. The Financial Crisis Inquiry Report. Washington: Cosimo Inc, 2011, Print.
Sorkin, Andrew Ross. Too Big to Fail: Inside the Battle To Save WallStreet. New York: Penguin Books Ltd, 2011, Print.
Wessel, David. In FED We Trust: Ben Bernanke’s War on the Great Panic. New York: Crown Publishing Group, 2010, Print.