The value of financial regulation in preventing economic crisis

Pro-Regulation

Regulation in Accounting

Regulator Battle (The Economist, 2009)

The importance of regulation is often overlook or even mocked in society. Regulations and the regulators that administer them are often portrayed as something that slows progress and makes it difficult to navigate the complexities that adherence to the regulatory requirements require. It is easy for people to view regulations from this perspective because when regulations are effective and properly designed they may seem unduly burdensome. However, when regulations break down or are ineffective it is far easier to see the value of regulation. People commonly do not actually appreciate the value of regulation until they have an example in mind that stands in recent memory. This is summarized in a statement by Tim Geithner after the global recession emerged in 2009 which said, "You want to move at the point where people still have the memory of the trauma" (The Economist, 2009). Although effective regulation is easy to take for granted when no crisis is present, the overall health of a society is dependent on an effective regulatory environment ensuring that a society operates in a transparent and fair manner.

Financial Deregulation

One way to make a case for more regulation, or at least more effective regulation, is to examine an example of a case in which deregulation occurred. Fortunately, such an example is readily available. Beginning in the 1990s, there was broad trend of financial deregulation allowed the financial industry more leeway to operate in a plethora of different ways. One example of such deregulation was the repealing of the Glass-Steagall Act in the U.S. which specifically separated investment banks from deposit institutions. The deregulation measure allowed banks to take risks with depositors' money that was previously prohibited. Many believe that deregulation allowed banks to accept increased amounts of risk which was one of the main factors that eventually led to the financial recession; however this is heavily debated (Lowy, 2012).

The argument behind most deregulation is that the public would benefit from increased levels of competition in the market by allowing firms to have more control over their operations, markets, and investment activities. It was also believed that the market made most regulations effectively redundant because the market naturally regulates the industry through competition and consumer choice. Therefore, focusing on increasing competition would lead to innovation which would be governed by consumers as they chose the products and services that they valued (Gerardi, et al., 2007). Another argument was that technology also made more transparency possible through modernization of accounting systems and that could also decrease the need for strict regulations as well as transaction costs giving firms an incentive to achieve greater quantities of scale (Wyld, 2011).

Figure 1 - Timeline of Key Deregulatory Events in the U.S. (Sherman, 2009)

After the financial industry was heavily deregulated a wave of mergers and acquisitions allowed large firms to consolidate. Eventually the market became dominated by a handful of major players. Initially, it was clear that the consumer did benefit, at least in the short-term, from these acquisitions because there was a wave of new innovations such as internet banking that developed quickly. It was even argued that this trend increased the relative wage of the bottom bracket of unskilled workers (Thorsten, et al., 2010). However, these gains were undoubtedly limited to short-term advances as unskilled workers were some of the hardest fit during the recession.

Conclusion

Regulation is needed in society to ensure that the system is both sustainable and socially justifiable. Although deregulation can have short-term benefits for consumers, in the long run it destabilizes the system and creates an environment in which financial catastrophes are eminent. Through effective regulation, regulators can ensure that the playing field is geared toward maintain a level of competitiveness that benefits consumers and producers alike. Although most would not disagree with the fact that some regulations are unduly complex and need of revision, this does not justify deregulation. Furthermore, in the wake of a crisis, people generally realize the value of regulations given their salience even though they are likely to take them for granted when they are working to add stability to the economic system and largely go unnoticed.