Financial regulation deals with the overall oversight and/or supervision of financial institutions through enforcement of specified requirements, restrictions and guidelines as laid down in the law. These restrictions are enforced with the sole purpose of ensuring the integrity of the financial system. According to Williams (2009: 8), financial regulation entails the enactment of laws and rules that govern the actions of financial institutions including banks, brokers and investment companies. He further states that financial regulation is generally spearheaded by government-sanctioned regulators and other internationally accepted groups that help protect people’s investments besides ensuring the orderly running and stability of the financial sector.
The crisis served as a wake-up call to concerned authorities to put in place mechanisms that will check risky trading and closely monitor financial transactions to protect both investors and the economy. One such move was the enactment of the Dodd-Frank Act in the United States which was signed into law by President Obama in 2010. This discussion will comprise of two parts with the first part focusing exclusively on the pros and cons of financial regulation and the second part focusing on the same but from the Dodd-Frank Actâs point of view.
Experts agree that regulation in the financial industry is necessary to maintain the soundness of the system. However, despite the advantages associated with financial industry regulation, supervision and oversight can only work to a certain extent. Too much regulation may prove counter-productive and may in the long-run muzzle growth of the industry-leading to catastrophic effects. In the following section, the discussion will concentrate on the rationale behind the justification of financial industry regulation and thereafter, it will focus on the views of opponents of regulation.
Financial industry regulation is necessary for controlling and checking systemic risk. There is sufficient evidence pointing to the conclusion that costs from the failure of the financial institutions-both bank and non-bank â will easily produce an adverse ripple effect on the economy and other concerned parties. For instance, the social costs resulting from such crises as the global financial crisis will most likely exceed private costs (Dodd et al, 2009: 77).
The need for regulation of the financial system especially banks stems from the fact that banks play an important role in payments and clearing, they pose serious systemic dangers through bank runs and their debt normally contracts both sides of the balance sheet. Regulation is therefore justified considering the depth of costs collapse of the banking system is likely to inflict on the overall economy.
Banks and other financial institutions operate in an imperfect market with a lot of externalities that only regulation can deal with. In fact, externalities such as under-provision of liquidity, risk shifting, and excessive leverage are among the major causes of systemic failure that is mentioned above. Brown (2010: 89) asserts, that lack of regulations in an imperfect market full of failures will eventually cost the consumer or investor because an unregulated market will operate at a sub-optimum level. An acknowledgement of the market imperfections and failures, therefore, justifies laying the groundwork for regulation that will protect the consumer by correcting the imperfections and associated market failures. Regulation will effectively create a conducive environment that will avail more information that stakeholders especially consumers need for decision making.
Besides market imperfections, Vinten cites the nature of contracts that financial institutions enter with clients as a major justification for regulation of the industry (2005: 23). It is a fact that most customers understand little of the contract content. There have been cases where bankers and other industry dealers have taken advantage of contract loopholes to fleece investors off their money. Besides, financial institutions keep coming up with different products and few financial managers care to explain to their clients what the product contracts contents entail.
According to Hillman (2011: 67), the imperfections provide sufficient grounds for continued monitoring of the behavior of financial institutions and the products that they sell to their customers. A case in point is the trading in futures and derivatives that saw millions of Americans take loans more than once without sufficient knowledge of what they were entering into. Many analysts agree that had there been closer regulation of the futures and derivatives markets, the financial crisis could have been averted.
One of the long-term benefits of financial industry regulation is the restoration and maintenance of consumer confidence. Consumer confidence is crucial to the sustainability of markets since it is directly related to consumer spending. Regulation is needed to ensure financial institutions are run soundly effectively boosting consumer confidence. Any perception that a crisis is brewing normally leads to risk-averse customers to hold back spending, a move that is likely to starve off the economy much needed liquidity for economic growth. Dodaro (2010: 12) sums up that regulation is necessary as it gives consumers and other investors, independent assurance on the soundness and integrity of the financial system, the safety of assets that underpin them and the quality of advice received to encourage savings and investments.
Concerning consumer confidence, regulation is necessary to ensure some compliance failures are done away with. There have been cases where firms focus on short-term profit interests at the expense of the ignorance of the consumer (Dodd et al, 2009: 89).
In such cases, firms adopt risky strategies for short-term advantages leading to the accumulation of excess risk in the system. Due to competition and focus on profits, some financial institutions who are otherwise ethical may be forced to adopt the same culture leading to corruption of the entire system In such cases, there is the likelihood of the occurrence of a gridlock problem when authorities and consumers discover of such dealings effectively tainting the entire industry including ethical firms. Panic withdrawal of funds from financial institutions with catastrophic repercussions to the economy is the most likely scenario, justifying close regulation of the system.
As mentioned earlier, regulation of the financial industry is not without its demerits. There is concern that the extent of regulation that most governments have embarked on after the global financial crisis is far too restrictive and may easily strangle the industry. Many of the opponents of regulation contend that principles informing the regulation of the financial industry are not in line with the basic tenets of capitalism and free enterprise (Prasad & Kawai, 2011: 120).
There is concern that there is too much government involvement in the running of the financial industry. Opponents of regulation advocate for self-regulation of the industry by allowing the industry to bottom out before rising again. In essence therefore these opponents are calling for minimum regulation that will only facilitate a financial industry largely regulated by market forces. In other words, institutions caught in circumstances such as the global financial crisis must be left alone to find their way out.
Additionally, there is concern that too much regulation will in the long run affect the creativity and innovativeness of the financial industry like the one that existed in pre-global financial crisis levels. The reasoning is that bodies such as the Financial Stability Oversight Council (FSOC) and Consumer Financial Protection Bureau (CFPB) may take a cautious approach to sanction new products for fear of ending up like the mortgage products that generated the financial crisis.
Furthermore, opponents claim that the restrictions that are placed on the financial industry will gradually eat to the profits that financial institutions make. Precisely, the regulation puts in place regulatory curbs especially on earnings from credit cards and fees from overdrafts that have effectively shut financial institutionsâ revenue streams. Some of the arguments for and against regulation above are debatable while others are not. The Dodd-Frank Act however provides a better platform to understand financial regulation, especially in the post-global financial crisis setting. Because of the specifics of regulation enshrined in the act, it is easier to examine the pros and cons of financial regulation.
The Dodd-Frank Wall Street Reform and Consumer Protection Act popularly referred to as the Dodd-Frank Act is a United States federal law that gives the government sweeping powers and mandate to regulate the American financial industry. The enactment of the law was in response to the global financial crisis which nearly led to the collapse of the American and world financial systems. The law puts in place mechanisms aimed at ensuring transparency accountability and high levels of consumer protection so that another crisis similar to the global financial crisis does not occur.
A keen observer will note that the Dodd-Frank Act seeks to increase regulation on large banks by putting in place stringent regulation mechanisms that will mitigate negative effects against banks and other financial institutions that initially were perceived as âtoo big to failâ. One of the notable creations of the law is the Financial Stability Oversight Council (FSOC) office which is charged with identifying crucial issues affecting the financial industry and coming up with ways to address them effectively averting another crisis of the global financial crisisâs nature (Prasad & Kawai, 2011: 117). Contained with the law is the requirement for banks to have plans for a shutdown in case a bank or financial institution is about to become insolvent thus avoiding burdening taxpayers with a bailout.
Besides the FSOC, the act created the Consumer Financial Protection Bureau (CFPB) which primarily aims at protecting consumers and investors from big and unregulated financial institutions. Specifically, the Consumer Financial Protection Bureau (CFPB) works with other regulators to ensure large banks do not engage in risky practices that in the end put consumersâ money at risk. Besides, the CFPB avails genuine financial information to customers to help them make decisions (Masciandro & Eijffinger, 2012: 109). Before the financial crisis, many banks and financial institutions had withheld crucial information on the corporations’ financial health as well as credit ratings thus misleading consumers when making important investment decisions.
The Dodd-Frank Act does address most of the causes of the financial crisis, especially in the United States. For instance, the notion that some financial institutions are too large to fail is effectively dealt with through the introduction of leverage limits in such institutions that specify how investors will get compensated in case the institution collapses. In other words, the mechanisms in place to address the liquidity of market utilities is sufficient in cases a company becomes insolvent.
One of the pros for regulation cited in this discussion was the prevalence of systemic risk. The law effectively recognizes the danger of systemic risk, hence the creation of FSOC to address excesses of the financial markets (Healey et al, 2011: 149). In essence, the FSOC is complimenting the Federal Reserve in scanning for trouble spots in the system so that they can be addressed before they generate a full-blown crisis.
The law does provide for the creation of a body or exchange specifically aimed at trading derivatives. Before the crisis, most consumers did not have enough access to information on derivatives trading and few unscrupulous financial managers did engage in illegal trade with the derivatives. In line with the arguments of the pro that call for regulation to check for short term trading of derivatives, the exchange will provide a regulated environment for their easier trading while giving room for their inclusion and growth in the new regulated financial order.
However, some experts warn that the law may impede innovations in the industry that will otherwise help the economy, increase costs for banks and eat into revenues. This could mainly come from the prevailing âparanoiaâ of the last crisis that may make the FSOC be a little âoverbearingâ in their approach to new banking industry innovations.
Additionally, there is a real danger of negative effects in the absence of correct implementation (Pellerin, 2010: 88). For instance, it makes perfect sense to raise the capital requirements of commercial banks. However, there is a possibility that in time of a crisis; the many regulations that come with the law may hinder banks from lending effectively starving the economy of much-needed capital for investment and spending.
There is also in the law an acute lack of acknowledgement of the imbalances present in the world financial system. The law is very biased only towards the US deliberately ignoring the fact that the world financial system has become integrated and external shocks or externalities like the European crisis can easily affect the US financial system.
Another weakness that is associated with the law is the âobsessionâ with the banking industry. There are few provisions on the housing industry which many experts was also at the center of the crisis as well as the insurance industry that is filled with unscrupulous companies offering products that donât meet required standards.
In conclusion, when the integrity of the financial system is ensured, the financial calamities of the Global Financial Crisis nature will be averted easily. There is consensus among financial leaders that the global financial crisis was partly due to failure to or limited regulation of the financial sector, especially in the United States. Increased risk-taking coupled with less oversight of the dealings of the financial institutions especially on futures and derivatives trading was the genesis of the financial crisis. Regulation, therefore, is necessary to guard against such occurrences in future.
References
Brown, O (2010) Financial Regulation: Clearer Goals and Reporting Requirements could enhance Efforts by CFTC and SEC to harmonize their Regulatory Approaches, Routledge, New York.
Dodaro, G (2010) Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernise the US financial System: Congressional Testimony, Willey & Sons, New York.
Dodd, R et al (2009) The Perimeter of Financial Regulation, Taylor & Francis, New York.
Healey, T et al (2011) New Directions in Financial Services Regulation, Cengage Learning, New York.
Hillman, R (2011) Financial Regulation: Recent Crisis Reaffirms the Need to Overhaul the US Regulatory System: Congressional Testimony, Cengage Learning, Chicago.
Masciandro, D & Eijffinger, S (2012) Handbook of Central Banking, Financial Regulation and Supervision: After the Financial Crisis, Cambridge University Press, Cambridge.
Pellerin, S (2010) Consolidation of Financial Regulation: Pros, Cons, and Implications for the United States, Springer, Chicago.
Prasad, E & Kawai, M (2011) Financial Market Regulation and Reforms in Emerging Markets, Springer, New York.
Vinten, G (2005) Financial Regulation, Thomson Learning, Melbourne. York.
Williams, O (2009) Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated US Financial Regulatory System, Sage Publications, London.