Discourse on Finance & Economics (2nd Article)
REGULATING THE FINANCIAL SERVICE INDUSTRY
INTRODUCTION
The financial industry has a long history of booms and busts resulting in swinging between regulation and deregulation. The cycles tend to occur usually between every ten to twenty years where a fundamental shift in regulation policies is brought about.
A brief summary of these incidents;
--------------------------------------------
Timeline & Events
1907 - Outrage among progressive over J.P. Morgan's role in bailing out markets in the Panic of 1907 led to the creation of the Federal Reserve to handle monetary issues.
1920s - During the post-World War I boom of the 1920s, the U.S. moved to a dominant position in international trade and global business. President Calvin Coolidge took a hands-off approach to markets.
1930s - Amid the Great Depression, President Franklin D. Roosevelt implemented the New Deal and new regulatory agencies. Republican President Dwight D. Eisenhower oversaw a further expansion of federal power by funding the interstate highway system.
1970s-1980s - Stagflation of the late 1970s due to poor government policies led to the Reagan-era canonization of the free market and a series of anti-inflation and anti-big government policies, as well as tax cuts
1990s - The government took a backseat to the market's needs and desires during much of the tech-powered expansion of the 1990s -and in the subsequent stock-market bubble
of the late 1990s.
2000s
2007-08 - The Enron and WorldCom scandals dealt a heavy blow to the Reagan revolution of deregulation and smaller government, and the Sarbanes-Oxley law in 2002 subsequently increased regulation and oversight of U.S. companies.
The collapse in the housing market and the battering of financial institutions prompted the public to call for more regulations in the financial industry and the markets looked to the government for direction.
------------------------------------------
The current industry is in a mess as a result of the recent subprime mortgage crisis. As a result, the public and affected parties are calling for stricter regulations and greater transparency in bank operations.
Regulation of the industry is not a simple task. The public fail to see is that a holistic approach has to be taken when dealing with such sensitive issues. The objective of regulation is to limit the amount of unsystematic risks the bank takes while still allowing flexibility to operate profitably. Overly strict or inept regulation retards growth and creates stagflation reminiscence of the late 1970s where as inefficient or lack of regulation results in the current problem.
A knee jerk reaction is often taken as evident throughout history that whenever anything fails, the afflicted parties beat at the symptoms of the problem but not the root. If regulation (or deregulation) is feasible solution, history will not otherwise be an indicator where the governing bodies constantly shift between regulation and deregulation.
However, this is not to say that all suggestions by the public are short sighted. Good proposals are indeed made by the public as well.
THE QUESTION OF REGULATON
I believe the problem does not lie with the question of whether the government should regulate or not but rather, how the industry regulates themselves.
Regulations can be mandated by the government but it can still be flaunted. A good example would be the Enron scandal where there was a blatant fraud in the reporting of their financial status. Implementation of regulations would only encourage the financial institutions to minimize their risk but they may still find ways to sideline the rules and utilize loopholes in the regulation.
This is not to say that regulation should not be done at all or that regulation is ineffective but rather the fact that it should be done with ample prudence. Regulation should take a broad perspective to the issues involved and solve the root of the problem.
The issues which require addressing are financial knowledge, transparency in bank operations to a reasonable extent and proper adherence to the current regulations with minor adjustments.
Financial Knowledge
Financial knowledge should be at the fore front of solving the current crisis (and any future crisis as well!). Well educated investors will always consider the liabilities of financial products before investing. Unlike the securities of corporations, the asset-backed securities have been so complexly packaged that is difficult to redistribute the capital in the event of defaults.
A person well educated in the financial operations of securitization or at least, possess rudimentary knowledge of securitization will know the risks which he is involving himself in and will limit the risks or abstain from investing at all. Without a demand for these securities, the supply would diminish as it is non-profitable as well as risky to hold these securities in the port folio.
Transparency in Bank Operations
Information becomes more and more distorted as the banks repackage the mortgages into securities. If the investor could see the complexity of the processes, I believe it is highly unlikely that they would invest in it either from lack of; financial data or profile, accountability (due to its complexity and repackaging) or plausible contingencies in event of default.
The process of rating should also be made known as many fund managers invested in the asset-backed securities due to the triple A ratings given by credit rating agencies.
Adherence to current regulations
Adjustments should be made to the current regulations to make sense of the system. In the subprime mortgage crisis, mortgage brokers contributed greatly to the problem because they are issuing loans without examining sufficiently the borrower’s profile.
Common sense would dictate that one does not finance a borrower who is incapable of returning the loaned sum of money and this would be the case with banks as well when they consider corporations who approach them for loans. Part of the problem lie with the fact that mortgage brokers are not loaning out their own money which greatly reduces their stake in the matter and are paid commission for selling as much products (mortgages) as possible!
Mortgage underwriting was not in control of these as a significant amount (40%) was delegated to an automatic system. Whereas manual underwriting took up to a week to process with a full set of documentation, the automatic system does it in 30 seconds. Under a less-automated system these borrowers would never have made the cut which shows a lax in following existing regulations.
Besides the issues on the ground, the bank management should not have jumped at the profits and instead, reviewed those securitized mortgages as they would, a normal un-securitized mortgage. Likewise, sensibility should be taken when taking up leveraged positions and ensuring that growth in revenue is sustainable as well as sound and justified.
Related institutions such as credit rating agencies, lawmakers, etc are also at fault for contributing to the problem. As with before, they were placed in a position where there is a conflict of interest and acted unprofessionally without due heed for regulations.
Higher ratings were believed justified by various credit enhancements including overcollateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However the rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks, which put the validity of the given ratings at question.
New regulation is only justified if there has been a long history of errors because of a loophole in the system. The current case is mainly non-adherence due to greed. Stiffer penalties could be introduced to encourage the banks and financing institutions to comply more strictly with regulations and also, to update the regulations to cover new financial products which the industry is always developing.
IN CONCLUSION
Regulation of the financial service industry does not end at financial institutions. The speculators and investors, who invest in the financial products of the industry, have to regulated as well because they create the demand which the financial institutions are glad to supply.
Additionally, the government should look to itself that it does not encourage poor financial decisions through bad fiscal policies.
REGULATING THE FINANCIAL SERVICE INDUSTRY
INTRODUCTION
The financial industry has a long history of booms and busts resulting in swinging between regulation and deregulation. The cycles tend to occur usually between every ten to twenty years where a fundamental shift in regulation policies is brought about.
A brief summary of these incidents;
--------------------------------------------
Timeline & Events
1907 - Outrage among progressive over J.P. Morgan's role in bailing out markets in the Panic of 1907 led to the creation of the Federal Reserve to handle monetary issues.
1920s - During the post-World War I boom of the 1920s, the U.S. moved to a dominant position in international trade and global business. President Calvin Coolidge took a hands-off approach to markets.
1930s - Amid the Great Depression, President Franklin D. Roosevelt implemented the New Deal and new regulatory agencies. Republican President Dwight D. Eisenhower oversaw a further expansion of federal power by funding the interstate highway system.
1970s-1980s - Stagflation of the late 1970s due to poor government policies led to the Reagan-era canonization of the free market and a series of anti-inflation and anti-big government policies, as well as tax cuts
1990s - The government took a backseat to the market's needs and desires during much of the tech-powered expansion of the 1990s -and in the subsequent stock-market bubble
of the late 1990s.
2000s
2007-08 - The Enron and WorldCom scandals dealt a heavy blow to the Reagan revolution of deregulation and smaller government, and the Sarbanes-Oxley law in 2002 subsequently increased regulation and oversight of U.S. companies.
The collapse in the housing market and the battering of financial institutions prompted the public to call for more regulations in the financial industry and the markets looked to the government for direction.
------------------------------------------
The current industry is in a mess as a result of the recent subprime mortgage crisis. As a result, the public and affected parties are calling for stricter regulations and greater transparency in bank operations.
Regulation of the industry is not a simple task. The public fail to see is that a holistic approach has to be taken when dealing with such sensitive issues. The objective of regulation is to limit the amount of unsystematic risks the bank takes while still allowing flexibility to operate profitably. Overly strict or inept regulation retards growth and creates stagflation reminiscence of the late 1970s where as inefficient or lack of regulation results in the current problem.
A knee jerk reaction is often taken as evident throughout history that whenever anything fails, the afflicted parties beat at the symptoms of the problem but not the root. If regulation (or deregulation) is feasible solution, history will not otherwise be an indicator where the governing bodies constantly shift between regulation and deregulation.
However, this is not to say that all suggestions by the public are short sighted. Good proposals are indeed made by the public as well.
THE QUESTION OF REGULATON
I believe the problem does not lie with the question of whether the government should regulate or not but rather, how the industry regulates themselves.
Regulations can be mandated by the government but it can still be flaunted. A good example would be the Enron scandal where there was a blatant fraud in the reporting of their financial status. Implementation of regulations would only encourage the financial institutions to minimize their risk but they may still find ways to sideline the rules and utilize loopholes in the regulation.
This is not to say that regulation should not be done at all or that regulation is ineffective but rather the fact that it should be done with ample prudence. Regulation should take a broad perspective to the issues involved and solve the root of the problem.
The issues which require addressing are financial knowledge, transparency in bank operations to a reasonable extent and proper adherence to the current regulations with minor adjustments.
Financial Knowledge
Financial knowledge should be at the fore front of solving the current crisis (and any future crisis as well!). Well educated investors will always consider the liabilities of financial products before investing. Unlike the securities of corporations, the asset-backed securities have been so complexly packaged that is difficult to redistribute the capital in the event of defaults.
A person well educated in the financial operations of securitization or at least, possess rudimentary knowledge of securitization will know the risks which he is involving himself in and will limit the risks or abstain from investing at all. Without a demand for these securities, the supply would diminish as it is non-profitable as well as risky to hold these securities in the port folio.
Transparency in Bank Operations
Information becomes more and more distorted as the banks repackage the mortgages into securities. If the investor could see the complexity of the processes, I believe it is highly unlikely that they would invest in it either from lack of; financial data or profile, accountability (due to its complexity and repackaging) or plausible contingencies in event of default.
The process of rating should also be made known as many fund managers invested in the asset-backed securities due to the triple A ratings given by credit rating agencies.
Adherence to current regulations
Adjustments should be made to the current regulations to make sense of the system. In the subprime mortgage crisis, mortgage brokers contributed greatly to the problem because they are issuing loans without examining sufficiently the borrower’s profile.
Common sense would dictate that one does not finance a borrower who is incapable of returning the loaned sum of money and this would be the case with banks as well when they consider corporations who approach them for loans. Part of the problem lie with the fact that mortgage brokers are not loaning out their own money which greatly reduces their stake in the matter and are paid commission for selling as much products (mortgages) as possible!
Mortgage underwriting was not in control of these as a significant amount (40%) was delegated to an automatic system. Whereas manual underwriting took up to a week to process with a full set of documentation, the automatic system does it in 30 seconds. Under a less-automated system these borrowers would never have made the cut which shows a lax in following existing regulations.
Besides the issues on the ground, the bank management should not have jumped at the profits and instead, reviewed those securitized mortgages as they would, a normal un-securitized mortgage. Likewise, sensibility should be taken when taking up leveraged positions and ensuring that growth in revenue is sustainable as well as sound and justified.
Related institutions such as credit rating agencies, lawmakers, etc are also at fault for contributing to the problem. As with before, they were placed in a position where there is a conflict of interest and acted unprofessionally without due heed for regulations.
Higher ratings were believed justified by various credit enhancements including overcollateralization (pledging collateral in excess of debt issued), credit default insurance, and equity investors willing to bear the first losses. However the rating agencies are paid by the firms that organize and sell the debt to investors, such as investment banks, which put the validity of the given ratings at question.
New regulation is only justified if there has been a long history of errors because of a loophole in the system. The current case is mainly non-adherence due to greed. Stiffer penalties could be introduced to encourage the banks and financing institutions to comply more strictly with regulations and also, to update the regulations to cover new financial products which the industry is always developing.
IN CONCLUSION
Regulation of the financial service industry does not end at financial institutions. The speculators and investors, who invest in the financial products of the industry, have to regulated as well because they create the demand which the financial institutions are glad to supply.
Additionally, the government should look to itself that it does not encourage poor financial decisions through bad fiscal policies.
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