Financial Industry Regulation the Recent

Financial Industry Regulation

The recent recession was precipitated in part by a bubble in the housing market, but the problem spread beyond real estate markets when the financial industry created and purchased mortgages in the form of commoditized debt obligations. These instruments spread the risk inherent in a housing bubble fueled by irrational lending through the global financial system. The result was not only recession, but the failure of over 100 American banks, and TARP bailouts to many more. If nothing else, the last recession highlighted the need to regulate the financial system. Without regulation, the recession could have become a depression, and it could have become fully global in scale, as thousands of banks could have collapsed, bringing with them all sense of consumer confidence and hundreds of other banks around the world.

There are several compelling reasons for financial industry regulation. The recession illustrates some of them - market failure, systemic risk, moral hazard, confidence and consumer demand for regulation (Llewellyn, 1999). The market failures in the recession are self-evident. The irrationality of market participants drove up mortgage prices, encouraged by abnormally low interest rates that left banks flush with cash and willing to lend irrationally. Buyers of commoditized debt obligations purchased the products without understanding their structure or risk. The principles upon which efficient markets are built were violated multiple times. Increased regulation could have curtailed some of this irrational activity.

Systemic risk is another reason for increased financial regulation. Decades ago, the crisis would have largely been limited to those banks whose lenders ignored risk parameters and gambled on subprime mortgages. In this decade, those mortgages were bundled into securities that were then sold to a wide range of investors, including other banks. Risk that in the past would have been firm-specific has now become systemic. Any one bank can fail, but the entire system cannot. Regulation of systemic risk in the banking system was poor prior to the collapse of the housing market, but such regulation is now being considered by lawmakers.

The failure of the financial system is anathema to any government. The very function of the U.S. economy demands that the nation have robust, reliable financial system. Many banks fall into the "too big to fail" category. As such, a portion of financial institutions and the industry as a whole are subject to bailout at taxpayer expense in the event that bankruptcy becomes imminent. Given that the industry is essentially backed by the American taxpayer, there is moral hazard inherent if government does not take steps to curtail risk-seeking behavior in the industry (Hellmann, 2000). Indeed, risk-seeking is pervasive in the financial industry, as competition compels banks to seek higher returns. Regulation such as capital requirements can help to reduce risk-seeking behavior, although the negative affect such regulations have on value can ultimately encourage at least some degree of risk-seeking. Despite this unintended potential consequence, regulation serves to neuter overly aggressive bankers and reduces risk in the banking system. Reducing the risk in the banking system is congruent with the government's objective of making effective use of taxpayer money.

A fourth consideration is that consumers demand regulation. While this does not constitute an economic case for regulation, it must be understood that governments are not motivated by purely economic considerations. Consumers want to know that their deposits are safe and that they can access money when needed for homes, vehicles and small businesses. Consumer demand, while irrational, is a key driver in the level of regulation in the financial industry.

Lastly, confidence in the banking system must be maintained. If confidence is lost, consumers and businesses will pull savings from the system, while would begin a cycle of economic contraction. The government, as part of its mandate to manage the nation's economy, must be wary of the degree of confidence in the banking system. This has, in part, compelled the government to extend substantial financial backing to the system, as this show of support helps to spur confidence.

Each of these factors will contribute to the degree of regulation seen in the financial industry. A conservative government will prefer a low-risk system, even if it means a low level of financial innovation. Canada and Australia are examples of nations with high levels of banking regulation, and while neither has a dynamic banking industry both countries fared well during the global economic downturn. By contrast, some governments will prefer looser regulation because of the innovations that occur, and because it unlocks untapped profit potential within the system.