The lack of both government and non-government regulation is evidently exposed to the public since the 2008 financial crisis which was derived from subprime mortgage crisis in the U.S. In addition, financial innovation in terms of financial products and systems has caught attention of people since then. This paper will analyze issues regarding financial innovation and regulation after the 2008 financial crisis in the context of the UK.
2. Introduction
Due to the considerable enhancement of telecommunications, the fast-moving advances in theories of finance and the creative inventions of financial derivatives which are a kind of complex financial product, such as futures, options, financial markets underwent a significant revolution, numerous investors all over the world have obtained more opportunities to earn money and accumulate wealth through various financial products.
However, incentives behind the pursuit of wealth have caused several problems with regard to financial security. The 2008 financial crisis is a good case in point. Overuse of derivatives which are of both high profit and high risk is regarded as the original factor resulting in this crisis. Therefore, how to establish a comprehensive and efficient regulatory system in terms of both governments and markets is an urgent task. On the one hand, the risks embeded in financial derivatives themselves are a great challenge for participants in markets; on the other hand, it is argued that basic institutional hierarchy and infrastructure which can support the transaction of financial products are extremely indispensable (Meton,1995). And the traditional training and experience of many private-sector financial managers as well as regulators are also not fully suitable for the advent of financial revolution. It is stated that more attention should be paid because of the above two reasons. Because financial innovation is a very complex issue, this essay will focus only on financial derivatives which receive considerable attention from the public. As for the financial regulation, different countries have different situations with regard to political and economic systems and it is impossible to evaluate all the financial regulatory systems all over the world, so the regulatory system in the UK which is a traditional financial empire will be analyzed in the following text.
3. Definition
First of all, a definition of financial innovation should be clarified. Financial innovation refers to the design of new financial instruments based on improved telecommunications, advanced financial theories and mathematics models and to changing present financial systems in order to obtain potential profits and distribute risks. It is declared that this is a long term and developing process which aims at gaining enormous returns. Two different aspects are included in the process: 1) at a macroscopic level, financial innovation refers to an extensive scale including the innovation of financial system, monetary regime, financial services, management of financial institutions and so on. For example, the London Summit of 2009 was held in order to solve the problems which have emerged in the 2008 financial crisis and to establish a dynamic financial system which is more appropriate to the new financial markets all over the world. This essay contends that a very long time is required in this aspect and that the international financial markets are supposed to unite closely to accomplish the giant assignments. 2) At a microscopic level, financial innovation refers to the innovation of financial products, namely financial derivatives, such as derivatives aiming at improving liquidity and distributing risks.
Secondly, financial regulation is a synthesis of monitor and supervision which are conducted by governments or institutions with the purpose of guiding the behaviors of participants in the financial markets. Similarly, two aspects can be analyzed specifically: 1) at a macroscopic level, financial regulation mainly refers to regulation manipulated by the central banks and other governmental departments who are more likely to consider the whole national economy, such as the bank of England that is a dominant force in the financial market in the UK. This essay claims that this category of regulation tends to emphasize the macro economy. As a result, finance which is only a branch of economy may not be paid sufficient attention. 2) At a microscopic level, financial regulation mainly refers to the regulation conducted by non-governmental institutions which are members of financial markets, namely self-regulation. The Financial Services Authority (FSA) is also a primary organization which is an independent body that regulates the financial services industry in the UK. It is obvious that, compared with governmental regulations, non-governmental regulations usually operated by financial institutions might mainly emphasize financial industry. Therefore, financial problems seem to be correctly directed in much more specific ways.
4. Evaluation of financial derivatives
This essay will concentrate only on the issue of financial derivatives which is a microscopic aspect, because financial innovation in terms of financial systems is such an extensive issue that no agreements have been settled.
"Derivatives are contracts specifying rights and obligations that are based upon, and thus derive their value from the performance of some underlying instrument" (Comford, 1996). As can be seen from this general explanation, financial derivatives are extraordinarily complex syntheses based on fundamental financial products. So they are bound to possess both advantages and disadvantages.
4.1 Advantages
On the one hand, investors in financial markets have more opportunities to gain profits and evade losses by organizing the structure of a portfolio which consists of various financial derivatives. For example, because the price trends of a financial derivative are strictly identical with that of its underlying instrument, an investor can use a instrument of stock index futures as well as stocks at the same time to sustain or even improve profits by conducting an opposite transaction. In addition, financial derivatives undoubtedly generate efficiencies in the allocation of capital, the reduction of the cost of capital, and the contribution to economic growth worldwide.
4.2 Disadvantages
On the other hand, disadvantages should not be ignored. It is claimed that due to the inherent characteristics of these complex asset-backed securities, participants may have difficulty in valuing them correctly (Plosser, 2009). Once financial derivatives cannot be accurately and rationally assessed, people may make mistakes during the process of transaction. The subprime mortgage crisis (SMC) which involves credit risk, liquidity risk and default risk is a good case in point. The SMC stemmed from the deflation of the US housing bubble. Loan incentives, such as easy credit standards, low loan rates and attractive housing prices encouraged borrowers to pursue risky mortgages. Investors believe that they would quickly refinance in cheaper ways. However, once the U.S. housing prices started to fall gradually in 2006-2007, refinancing became more difficult. Defaults and foreclosure activities increased dramatically, home prices failed to increase as people anticipated. Foreclosures accelerated in the US in late 2006 and caused a global financial crisis through 2007 and 2008.
5. Financial regulation in the UK
It is declared that owing to the overwhelming revolution of the financial markets, regulation is bound to undergo a set of changes (Aran and Patel, 2006). It is absolutely true that financial regulation stands in a dominant position and should be altered on the basis of financial innovation since the accumulation of capital and the allocation of financial resources constitute an essential part of the process of the development of a nation.
5.1 Objectives of financial regulation
Three objectives may be considered with regard to financial regulation. The first objective of financial regulation is the pursuit of macroeconomic and microeconomic stability; the second one is transparency in the market and in intermediaries and investor protection; the third one is the safeguarding and promotion of competition in the financial intermediation sector. The writer believes that these three objectives are associated organically with each other and cannot be separated mechanically. Firstly, macroeconomic and microeconomic stability are a foundation without which the financial markets will lose their original driving force. Secondly, although the financial market is an essential part of economy, it cannot be insulated from the whole economy. Thirdly, it goes without saying that finance is an absolutely vital part of the whole economy. The collapse of finance might have serious effects on the whole economy, such as severe inflation and unemployment.
5.2 Self-regulations
Firstly, the self-regulation of non-governmental institutions will be illustrated. Two basic methods are commonly used: 1) managing equity capital and 2) controlling risk by hedging (Merton, 1995). Equity capital which is a kind of asset possessed only by a company has a brilliant capability to absorb risks for an institution. With abundant equity capital managers do not have to predict the source of loss, because equity protects the firm from all forms of risks; in that sense equity capital is very attractive for managing risks. Nevertheless, equity capital which is a perfect instrument for managing risks also can be quite expensive for that reason. Therefore, many institutions such as investment banks are forced to consider the costs if they decide to use equity capital to reduce the risks. Generally speaking, only a handful of firms are willing to choose this method. The other fundamental means for controlling risk is through hedging which is a method of financial transaction. Compared with equity capital which is perfect, hedging is a form of risk control that is more targeted. Merton offered a good example: a manager of an international airline can use futures, forwards, or contractual agreements to hedge the firm against unexpected changes in jet fuel prices (Merton, 1995). More generally, hedging is commonly used to protect firms against adverse changes in commodity prices, interest rates, and currency exchange rates. In order to hedge against risks, a firm must not only identify the risk but also the exact quantity of that risk since only by combining analysis in terms of both quantity and quality can a firm hedge against risks swiftly and efficiently.
5.3 Governmental regulations
Secondly, governmental regulations are very necessary because financial institutions are likely to disclose information and transact illegally with the purpose of attaining more profits. Aran and Patel believe (2006) that governmental regulations may hinder the functioning of companies. The writer claims that this viewpoint seems to be somewhat rather inadequate. Numerous cases proved that mere self-regulation is far from what is needed.
The collapse of giant financial institutions such as Barings Bank and Lehman Brothers Bank is an authentic example. Depending only on self-regulation is undoubtedly insufficient. Either various financial acts or financial public policies are brilliant safeguards for the financial markets. Of those, Basel Concordat is a very famous one which underwent three times of revisions and supplements by the Basel committee. It focuses on the supervision of banks and other financial institutions, including the category of capital, and methods of calculating the proportion of risks. Similarly, On Wednesday, July 21, 2010, President Obama signed the Wall Street Reform and Consumer Protection Act which aims at holding Wall Street accountable for everything it does, protecting American families from unfair financial practices, narrowing regulatory gaps in the financial system and maintaining the confidence in the US market and promote growth. It contends that the financial markets may not function smoothly without the protection of governments.
5.4 Analysis of the current financial regulatory system in the UK
The contemporary financial regulation system in the UK mainly consists of two parts: 1) the bank of England which is the central bank; 2) Financial Service Authority (FSA). Both of them are indispensable elements in the area of finance.
The Bank of England was founded in 1694, nationalised on 1 March 1946, and gained independence in 1997. Standing at the centre of the UK's financial system, the bank is supposed to promote and maintain monetary and financial stability. It acts as the banks' bank as well as a regulator who provides banking services to its customers, manages the UK's foreign exchange and gold reserves. In addition, the Bank has a monopoly on the issue of banknotes in England and Wales.
The Financial Services Authority (FSA) is an independent non-governmental body and given statutory powers by the Financial Services and Markets Act 2000. It mainly regulates most financial services markets, exchanges and firms and set the principles that the participants must abide by and can take action against firms if they fail to meet the required standards.
"The Financial Services Authority (FSA) will 'cease to exist in its current form', Chancellor George Osborne told the City of London." (www.bbc.co.uk /news/10326027). This essay will discuss the framework of current financial regulatory system rather than guess whether this possibility will be realized. Undoubtedly, there are several problems which exist in the current financial regulatory system. Especially after the 2008 financial crisis and 2010 European sovereign debt crisis, disputes appear widely in terms of financial regulatory system. Nonetheless, it is stated that the framework of current financial regulatory system which mainly consists of two parts: the central bank and FSA is proper for the health development of financial market. It is crystal-clear to separate the two bodies in terms of responsibilities. Therefore, each one can pay adequate attention to their own dominant tasks and do what ever they can to achieve goals. The bank of England emphasizes making monetary policy, issuing of banknotes and maintaining the stability of whole economy. FSA emphasizes reducing financial crime, managing the clearing and settlement systems and making standards of financing. However, it is the communication between the two parts that must not be borne in mind since monetary stability and financial stability are two sides of the same coin. So the bank of England and FSA are expected to collaborate with each other.
6. Conclusion
It cannot be denied that the prosperity the financial innovation brings generates efficiencies in allocation of capital, reduction of the cost of capital and contribution to the economic growth all over the world. However, according Plosser, every new invention cannot mature until it experiences numerous tests（Plosser, 2009）. So does financial innovation. Even in the markets for traditional goods and services such as industrial goods, it is impossible that every new product will succeed. Therefore, the financial derivatives should be adjusted and improved constantly to meet the demands of participants in the financial market. Although failures can be costly to investors and the whole economy, both winning and losing are important factors for a dynamic market. Accordingly, people should not cease financial innovation only because they are unwilling to or afraid of facing the consequence of failure. After all, success comes after failure.
In terms of financial regulation, this essay declares that financial markets cannot function smoothly without any one of government regulation and non-governmental regulation. Therefore, they should collaborate tightly with each other in order to further the efficiencies of financial markets and economy. In addition, governments should release enough space for them to grow under the condition that complete laws are made instead of restraining the function of markets. Correspondingly, the financial institutions, especially these which pursue profits, are expected to comply with moral principles and shoulder more social responsibilities rather than only to chase profits.
