Financial regulation
The financial crisis that hit the world cannot be dissociated from the banking operations. Although some scholars have described the just-concluded economic meltdown as a “Minsky” moment, there are a number of key factors that indeed influenced the financial crisis.
This explains why adequate regulation of the financial sector cannot be ignored by concerned government authorities. Perhaps, the New Deal offered a better framework for regulating the financial system. As it stands now, it might not be very clear on how financial regulation can be undertaken to minimize or even eliminate the possibilities of economic downturn (Kregel par. 5).
The successful banking reforms that took place in the 1930s can be largely attributed to the attributes of the New Deal. The theory put forward by Minsky could not be dismissed as a momentous theory. It is crucial to mention that this theory offered the most comprehensive approach for controlling the activities of financial institutions.
In a global environment which is highly liberalized, it might not be an easy task to streamline the operations of financial services. Nonetheless, the regulatory conditions can be adopted in advance so that all players in the financial sector are aligned to the operational requirements. Most of the changes executed by the proposals of the New Deal were highly structured and systematic.
Long-term chronological changes should first be understood before the adoption of a particular framework for regulation. The Financial Services Modernization Act also injected many changes in the financial system. Scholars in the financial sector have attempted to explore major changes that took place since the New Deal era.
The sources of these changes are also instrumental in discussing the global financial crisis. To some extent, internal processes eroded the New Deal reforms bearing in mind that protectionist measures were generally interfered with by commercial banks.
The latter had express rights to take deposits from customers. In other words, commercial banks operated solely in the process of taking deposits. On the other hand, substitute instruments were provided by unregulated financial institutions.
Growth of the financial sector
The rapid growth of the financial sector in the contemporary economies cannot be doubted. Some critics argue that the financial sector has extremely grown to a level that regulators are no longer able to manage it (Smaghi par. 4).
After the 2007/2008 financial crisis, some key players in the financial services sector saw the need to take a paradigm shift in order to avoid a similar occurrence and also cushion the affected business organizations. In a speech by Lorenzo, it is evident that monetary policies should be tightened across the board.
Lack of regulation or poor regulation of the financial services sector was perhaps the main cause of financial crisis experienced across the world. In order to fast track sound monetary policies, it is crucial for commercial banks to adhere to three main factors. These include when to begin tightening the policies, the pace at which the tightening process should be carried and when to stop the entire strict regulation process (Scannella 37).
However, it is not recommended to wait for a very long time before the regulation process begins. Proper timing is necessary. In particular, low interest rates should be a pointer that regulation is necessary. Inflation should not go beyond the raising rates.
In addition, a wide set of indicators should be employed in the regulatory approach. Strengthening financial architecture should be a priority of regulators in this sector owing to the fact that myriads of risks face financial markets on a daily basis.
As much as the key market players were largely aware of the latent risks in financial markets, little was done to control the situation. The emerging markets heavily contributed towards economic slow-down (Semenova 245). Due to the large number of the emerging markets (that are also largely unregulated), the global financial regulators lacked a proper mechanism to handle the situation.
When a financial crisis is left to thrive for too long, it becomes extremely difficult to address it after some time. Although most of the emerging markets are not controlled, they present a major impact in the global financial development.
This implies that when resources are pulled together by emerging markets, it directly impacts the global financial system. Any element of indecisiveness by the financial markets is quickly taken advantage of by the robust emerging markets. Contrary to the popular belief, not all democracies are in a position to offer logical and efficient solutions when it comes to financial services.
Expediting the process of making decisions can enormously save governments from engaging in risky or wasteful financial operations. Needless to say, market trends tend to enforce themselves especially when democracies fail to make crucial decisions at the right time.
As financial markets continue to grow at an unprecedented rate, democracies are proving the fact that they are unable to cope with the emerging financial markets. It is also crucial to mention that not all incentives lead to distortions in the financial market. Some incentives are helpful both as regulating mechanisms and
Shadow banking system
The economic journey of Hyman Minsky vividly illuminates the shadow banking system in the contemporary financial environment. Creative financing facilitated both positive and negative performance of the financial markets. Nevertheless, it has never been understood how creative financing can take place.
This type of financing took place away from the controlled financial services sector. In other words, creative financing occurred in the absence of regulated banking system. One of the ways to comprehend creative financing is shadow banking system. Although shadow banks operated within the law, they were hardly under any regulation. Consequently, lending boom rapidly grew out of proportion.
This was especially witnessed in the mortgage industry (Helder, Mendon, José and Falci 385). Hyman P. Minsky attempts to offer a lucid explanation of how shadow-banking system led to the worst financial crisis ever experienced in history (McCulley 7).
Rating agencies and regulators were supposedly on the forefront in regulating banking operations. While real banks can readily access governmental safety nets, shadow banks do not enjoy the same advantage. This implies that the minimum regulatory constraints faced by the real banks are not applicable to shadow banks. One of the most sensitive areas worth exploring is the size of liquidity at any given time.
While the latter is a crucial and mandatory requirement imposed to regular banking systems, shadow banks are free from such constraints. Minsky explored the hypothesis of financial instability by comparing conventional and shadow banks. Through the hypothesis, it is possible to appreciate why shadow banks were exclusively blamed for the gross magnitude of the global financial crisis (Nidhiprabha 116).
Explanations and discussions
It is prudent to take advantage of the international financial and monetary regulations of the financial sector. Regulation can be defined as the presence, in a system like the global of stabilization mechanisms that ensure proper operation.
For example, when the exchange rates of major currencies tend to diverge excessively, central banks intervene in order to stabilize the exchange rate. This action is called “regulatory” as opposed to an act of coercion, such as the prohibition of currency conversion, or total inaction.
From the readings, it is clear that the purpose of regulation is to ensure harmonious development of a given system (Pakravan 24). This implies the existence of ‘rules of the game’ allowed in a common interest. Enforceability of the rules is also part of regulation.
First, what is the significance of international financial regulation? The answer is deceptively simple: regulation assists in economic and financial globalization. The latter is the source of economic progress (Bhattacharya 42).
However, it may be accompanied by major failures whose effects are devastating especially in developing and poor countries. However, this response is not adequate because it is necessary to use regulation rather than other solutions such as full laissez-faire or implementation constraints imposed globally to all stakeholders.
Second, what are the current systems for crisis prevention and stabilization of the global financial system? It is vital to analyze the operation of existing systems and to highlight their shortcomings if any. How can governments improve financial regulation? These are some of the pertinent questions that possibly emerge from the readings and which are explained and discussed in the remaining part of the essay.
The importance of regulating international finance and cash-flow cannot be overemphasized. There are explicit merits of regulating financial system (Ryder and Chambers 79). As much as a number of contrasting effects emerge when financial systems are regulated, it does not refute the fact that the process is fundamental.
The idea of financial and monetary regulation is not obvious. In pure economic theory, strict market forces should lead to an equilibrium corresponding to the optimum level. However, the need for regulation appears in the light of two facts.
First, financial flows and changed monetary volume. Second, the recent crises have shown that the markets could not independently ensure a rapid return to equilibrium (Bancel and Mittoo 211).
The development of financial markets
The liberalization of financial markets began with the collapse of the international monetary system based on a generalized system of fixed exchange rates adjustable in the early seventies. The dismantling of national controls on capital movements in the eighties (especially in developed countries) increased liquidity in financial markets.
This trend increased with the opening of emerging markets to foreign capital in the early eighties. Financial globalization has been marked by the emergence of new markets and new major players in the international financial game (Kemme, Schoors and Vennet 213).
On the same note, deregulation of financial markets allowed, but also encouraged the rise of innovation and financial engineering as well as the diversification of financial products. The operations of shadow banks and the poorly regulated traditional banks have attracted the attention of monetary authorities in different countries on the risk that the development of products could pose to the international financial system (Liapis 309).
The rapid growth of derivative markets can be explained by structural and cyclical factors. Derivatives are born of market reaction to the volatility of interest rates, uncertainty and risk for investors. They make it possible to cover all or part of the risk associated with this uncertainty by providing arbitrage opportunities and sophisticated and inexpensive management.
The expansion of products has been highly favored by the increasing volatility of exchange rates and interest rates during the last decade (Mohamed 16). The introduction of new products and the development of financial engineering have also fostered the growth of derivatives and provision of increasingly complex products. Besides, the development of information technology has led to a significant decrease in transaction costs.
The role of derivatives in the development of financial crises and price volatility has been disputed by a number of economic theorists. Indeed, it is undeniable that the products have a significant influence on the process of price formation in financial markets, due to the ties that bind, through arbitrage, spot markets and derivative markets.
Nevertheless, economic theories concur that derivatives improve the consideration of information and thus enhance the efficiency of global financial markets. In addition, decentralization and diversification of international funding spread risks and reduce losses. Hence, the risk of a systemic crisis in the creditor countries can be minimized considerably in regulated financial markets (Mohsen, Abdulla, and Jalal 105).
The complexity of derivatives does not often allow precise measurement and control of risks. Derivatives are nevertheless likely to lead to excessive risk-taking. Bankruptcies of financial institutions that marked the last decade are thus linked to excessive risk on derivatives markets.
These markets are the main tools of investment hedge fund investment. They can provide considerable leverage effects with a very low capital requirement. Institutional investors involved in these markets (pension funds, collective investment funds and insurance companies in particular) have become major players in the financial markets and led to a profound change in the management of assets worldwide.
The development of financial markets and derivatives in particular, is of great significance for the definition of economic policies by individual jurisdictions. Deregulation and lowering transaction costs have greatly facilitated the mobility of capital and led to an opening up and integration of all global financial markets (Buga, Gherghinescu and Vânatoru 59).
The masses of capital traded daily on the financial markets are now well above the intervention capacities of states. Therefore, any government can find the hostage markets since its policy is perceived negatively. Derivatives also delay the effect of monetary policy on the real economy since actors can limit the impact of changes in interest rates by altering the characteristics of debt.
The development of the international financial and monetary activities meets a growing need for risk coverage by helping to reduce investor uncertainty.
Regulation has led to a better risk coverage
The market economy is characterized by risk, consideration of profit, and liberalization of capital movement. Two main categories of risks can be distinguished at this point namely those attached to the operators of a transaction (credit risk or risk of default of the operator) and those attached to variables transactions (market risks such as price , exchange rates and interest rates).
Financial products should initially be developed based on the aforementioned risks in order to boost certainty levels of stakeholders. The latter can reduce risk factors of uncertainty and create a favorable environment for investment and trade (Baber 240).
Derivatives make it possible to manage all potential risks markets, and open the possibility to calibrate the balance offered by a given market. When derivatives are handled well, it can assist in lowering the risk of financial crisis from the local level. Of course, financial instruments do not entirely eliminate these risks.
Regulation has fostered the growth of world trade
The gradual reduction of barriers to trade in goods and services has taken many forms in the global financial market. The development of world trade since the end of World War II is a reality; the scale is different in various states. In 1948, world exports accounted for an equivalent of $ 23 billion; in 1968, they amounted to $ 238 billion; the early 1970s and the 1980s marked two periods of stagnation of world trade which, however, experienced a strong recovery in 1983.
Between 1983 and 1990, world merchandise trade increased by 6% per year on average against 34% of global Gross Domestic Product (GDP). The development of cross-border financial circuits facilitates and enhances the development of criminal financial circuits which are cross-border in nature.
The low tax territories
The origin of the phenomenon is a pursuit that is not criminal in itself. However, it may swiftly lead to criminal dimensions. For example, the desire to escape tax levies on lawful activities elsewhere is a common practice among several multinational corporations. This scenario is common in the case of funds or highly leveraged hedge funds.
Sophisticated investors, high net worth individuals or companies often pursue profit margins that are higher than those of other financial players (Jovovic 69). Some of the funds are overwhelmingly located offshore. Some major operators in the global platform argue that offshore activities are essentially meant to avoid tax, and are not related to attempts to escape prudential regulation or control of operations.
With more than $ 100 billion in assets (about $ 400 billion for all funds leveraged in the world), most hedge funds managed from the United States are established in a tax haven. They have nothing mischievous about them because there is a lot of information disseminated to the public and in particular a business directory detailing their methods of intervention and all contact information (Ramskogler 284).
In spite of this argument, most of the low tax territories are believed to have massively contributed towards the recent global financial crisis.
Holders tend to attract criminal funds
Criminal financial channels usually create a haven for mass of financial flows that accompany the internationalization of capital markets. Liberalization of capital movements and removal of exchange controls to facilitate legal flow also promote illegal flows.
For instance, the single currency encourages discretion of intra-continental transactions involving funds from dubious origins.
Criminal financial circuits are likely to promote financial crises
The development of criminal financial circuits is harmful in itself. Do these financial flows affect proper functioning of the legal financial channels? Are they likely to play a role in the international financial crises? The amounts involved and progress of their activities are inherently poorly known from the systematic economic studies conducted on this area.
It is therefore very difficult to assess the possible effects of financial illegality in the economic and financial systems of the world (Amri, Prabha and Wihlborg 325).
Summary
Two conclusions can be drawn from the above discussion on global financial crisis. To begin with, emerging markets that were affected by the crisis generally suffer from high levels of corruption while the least corrupt states were not grossly affected. Second, the transparency of financial flows is required for better risk management and sound asset allocation.
A high level of corruption is associated with vulnerability to major financial crises. Besides, proper regulation of all financial markets including conventional and shadow banking systems should be given priority in the management of balanced global cash flows.
Works Cited
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