This paper attempts to show how imposing more regulations will help eliminate the numerous flaws in the global finance market. I shall explain the possible merits and short comings of financial regulation and how it contributed to the last financial crisis, suggest improvements for better regulation and lastly support my argument on whether or not we need more regulation to avoid another financial crisis with some theoretical examples and day to day current events.
Rose and Marquis, 2008, define global finance as one of the most important creations of modern society; "its primary task is to move scarce loanable funds from those who save to those who borrow to buy goods and services and to make investments in new equipment and facilities so that the global economy can grow and increase the standard of living enjoyed by its citizens" [1] .
The chart below explains how the global finance system works:
Flow of loanable funds (savings)
Suppliers of funds (mainly households)
Demanders of funds (mainly businesses and governments)
Flow of financial services, incomes and financial claims
The most recent financial crisis is blamed on the sub-prime mortgage market. The sub-prime mortgage market brought together two groups of people; home owners and investors. Home owners represent their mortgages and investors their own money. The mortgages represent houses while investors represent large institutions e.g. pensions funds and insurance companies; these groups are brought together by the financial system.
After the September 9/11 attack in the USA, interest rates have been very low, as low as one percent, Japan's interest rate was zero percent and China still has a fixed exchange rate. In the past, investors tend to invest in treasury bills because they are the safest; they have a rating of AAA [2] . Due to the low interest rate, investors invested less in treasury bills but on the other hand banks could borrow money from the Federal Reserve at one percent. This led to an abundance of cheap credit, therefore borrowing became cheap and easy.
A combination of aggressive asset growth led banks to start up a mortgage market for high risk borrowers known as the subprime market. Banks had so much money but instead of lending to responsible homeowners they started lending to less responsible ones in order to spread risk. Subprime mortgages borrowers tend to be high risk customers with a bad credit history, in order to compensate for the risk involved, banks charge a high interest rate. After a while, these owners defaulted on their mortgages which affected the banks. The banks took over their houses but as more banks took over people's houses the supply of houses became bigger than its demand; this led to a fall in price. People with big mortgages faced with a fall in the value of their house did not see any sense in keeping to their contract so they vacated their houses but the banks still couldn't find buyers for these available houses. These events led to the financial crisis.
According to James, H. 'future of financial regulation', "what began as a house price correction transmuted into a general widening of spreads on risky assets, then a liquidity squeeze and now looks well on the way to becoming a full scale credit crunch". Martin Wolf, Chief Economics Commentator of the Financial Times, has also talked of "revulsion" in capital markets, as investors in all types of asset-backed securities have rushed to the exit.
Hence, there has been a lot of cry for more regulations to be imposed due to the existence of market failure (most notably, a lack of perfect information in the market) and negative externalities.
Benefits of financial regulation:
The global finance sector is already highly regulated, therefore before more financial regulations can be introduced; the regulatory body has to first of all identify some problems that have led to externalities and market failure in the finance market. After the causes of these problems have been identified, it can then tailor its new regulations towards solving these problems.
The benefits of financial regulation can be measured in two ways; the benefit the consumer gets and the benefit the firm receives by being more efficient due to the regulation. More regulations could solve the problem of reduced choice for consumers; create better choice. If there are any elements of monopoly or oligopoly in the market the regulation might help break these firms down. Some financial companies are very large; firms like these are usually known to be inefficient, they limit the choice of the consumer due to inadequate research, set prices in order to drive competitors away from the market and in most cases refuse to share information with their competitors. In addition, since the finance market is globalised the action of one large financial institution can affect other financial institutions or even the whole global market. E.g. the collapse of northern rock caused uncertainty in the UK banking sector and other countries. "A lack of perfect information is asymmetric information - the ignorance of consumers or producers in highly technical markets" [3] . Therefore regulation is needed to ensure firms do not become "too large".
A market without regulations can be compared to a country without law. For there to be order in the finance market, there has to be some law in the form of regulation. If there was no regulation in place, firms might have a lassie faire attitude towards their customers and also towards their rivals in the market. Regulation acts as a guide for firms in the market to follow, it creates a form of unity in the market because all the firms realise that they are all been controlled by the same rules. It can also eradicate any likelihood of cheating; this will give firms some confidence and as a result encourage them to take some risk which is good for the market in general. For example, if the regulator introduces a regulation that forces firms to keep a secured record of all their customers, customers will trust these firms more because they know that any information kept about them by the firm is secure. In the long run this will build a very good rapport between firm and customer; customers will become more loyal, leads to more business activity and results in more profit for the firm. Therefore regulation acts as a good practice guideline for firms in the market.
Could you find one more merit? [cant fink of one right now, so hard. Im workin on it tho].
Costs of financial regulation:
According to the financial times, "regulation will cost business an estimated figure of £13 billion in 2009" [4] . Regulation can reduce the economies of scale a firm has (when it breaks down monopolies) and thus reduces the efficiency with which financial markets help to allocate the economy's scarce resources, however regulation is very important in global finance because the market is a very complex one. These regulations help prevent market failure and negative externalities amongst many other problems however, there are some difficulties. Over the past few decades there has been of a lot of cry for deregulation [5] . These demands have been supported by the development of the 'economic theory of regulation' [6] which stresses a number of undesirable features of regulation, some have also compared the highly regulated financial market to a closed economy e.g. a communist regime where there is duplication and bureaucracy which leads to inefficiency . The economic theory of regulation derives from the idea of agency capture [7] . I shall use this theory to further develop my point about the short comings of more financial regulation.
The financial market is very sensitive; therefore, introducing more financial regulation can cause moral hazard [8] . For example, when the government financially supports a bank that is inefficient; people believe a bank supported financially by the government wouldn't go bust therefore people feel safer depositing their savings in such an organisation. These inefficient banks end up attracting customers from other very efficient banks or building societies. As a result, the efficient banks suffer and at worse fold up leaving the inefficient banks to take control of financial activities. For example, in the case of Northern rock, Marco Onado, 2009, "while there is no doubt that Northern Rock's business model was extreme; one can argue that its underlying philosophy was shared by many other banks" [9] . In some cases government intervention can put the market in a worse state than it was prior to the government intervention -government failure. For example, "For many years, governments have tried to increase social mobility, to ensure that the children of the poor have as many opportunities to better themselves as the children of the rich. Yet the evidence shows that social mobility, far from increasing, has actually fallen in recent years." [10] To prevent government failure, the government should restrain from interfering in the market if it does not have perfect information. In a financial crisis, it is sometimes better to cleaner up the market by letting the inefficient firms fold up.
According to Stigler's theory of regulation, a major short coming of financial regulation is self interest by the regulators. The people who make these regulations are usually ex-practitioners who used to work in this market or they aspire to one day have a career in this market therefore, they do not want to offend the industry. When regulators are after their own self interest it is not possible for them to make regulations that will benefit both the customer and the producer. A self regulator might be better than a government approved agency. Peter Howells and Keith Bain, (2008) "the industry has an incentive to protect its own reputation and so members will be prepared to pay to achieve this, thus overcoming one of the principal market failure arguments for government regulation".
Regulations can increases cost for producers. When more regulations are introduced, in most cases the firm has to retrain its staff and adjust its market activities in order to comply with the demands of the new regulation. In an uncompetitive market, firms tend to pass on the cost to their customers which results in higher prices and lower output. However if the market is competitive, these costs will not be passed down to the customer therefore, output in the form of financial service will not be affected. More regulations can also act as a barrier to entry for new firms coming into the market. Sometimes new regulations are very complex and can be very difficult to interpret; therefore to avoid any hefty penalties some entrants are not willing to take any risk.
How regulation can be improved
"Could the crisis not have been prevented? Were the regulators asleep at the wheel? - A common cliché which is proudly trotted out by politicians at these times, as if freshly minted" [11] .
In order to improve regulation and for the regulator to do its job more efficiently, there has to be a good relationship between the regulator and the finance market. The regulator has the task of making the finance market open up to it so it can understand how it works and ways to make it function better.
The regulator should consolidate ideas from firms in the finance market and their customers before enforcing regulation policy and avoid rushing. "It may well have some merits, but almost all observers would acknowledge its inflexibility and unintended consequences. It was certainly legislated in haste and American markets have now been repenting for a while. So it is quite important not to be seduced into new regulations and controls by market panic, controls which might in the long run be very costly and deliver insufficient benefits" [12] .Coming up with a new regulation in haste or during a time of crisis is very dangerous; it can upset the market even more. For example the Sarbanes-Oxley Act in the United States.
Conclusion
In the past few decades the world economy has becomes more integrated due to more bi lateral agreements between countries and also the emergence of trading blocs like the European Union and African Union; better technology has also played a part in globalising the financial market. There has also been a few booms and bust in the past decades e.g. the Oil crisis in the 70's, the September 9/11 attack on the USA and most recently the sub-prime mortgage market meltdown. The financial market has proven its strength by recovering from these crises. (The UK financial market has not fully recovered but the financial market in other countries like France and Germany have recovered). The number of investors has also not reduced significantly evidence?; this proves that people trust the financial market. The boom and bust of the financial market in recent years compliments the economic cycle of boom and bust.
In a market that has grown very quick over a short period it can be difficult for the regulator to always make the right decision in terms of regulation policy however, more regulation is still very important. In order for more regulation to stop another financial crisis especially in countries with bilateral trade agreements or countries in the same trading bloc, it is important that the financial regulators of these countries merge together and act as one regulator instead of working individually and coming up with different policies that contradict each other.
Here you could emphasis the need for revised regulation (as you suggested) in light of the rapidly changing financial market.
The global finance market is very complex; more regulation can play a role in stopping another financial crisis but its success depends on many other factors. It should also be considered that regulation can restrict competition in the global financial market and it also contradicts with the fundamental values of capitalism. It is important to note that more regulation cannot guarantee there will not be another financial crisis. For example, the September 9/11 attack in the USA that caused a financial crisis could not have been stopped by any regulation; this crisis was caused by an exogenous factor. An extra policy might not have any effect at all or little effect on its own but if it is a part of other complimentary regulations it might have a big impact.
On the other hand, less regulation does not guarantee that there will not be another financial crisis but it still can open the market to more competition or even make it more efficient. However, regulation policy can work both ways.
It is very vague to think that financial regulation is the solution the global financial crisis. However in a market that keeps getting bigger everyday and more complex, more regulation is needed.
