Regulatory Intervention in the US Post 2008 Crisis - Assignment Example

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Discuss the regulatory intervention that took place in the US post 2008 crisis Table of contents ............................................................................................................................3 Introduction………………………………………………………………………...........4 Potential Reasons leading to the financial crisis……………………………….............5 Advantages and disadvantages of the crisis…………………………………………….7 Regulatory Interventions…………………………………………………………………9 Dodd-Frank Wall Street Reform……………………………………………………….10 Dodd-Frank Wall Street Reform- Focus on consumers………………………………10 Dodd-Frank Wall Street Reform- Ends Too Big to Fail Bailouts…………………….11 Dodd-Frank Wall Street Reform- Mortgage business………………………………...13 Dodd-Frank Wall Street Reform- Credit Agency Reforms…………………………...14 Recommendations………………………………………………………………………..18 Conclusion………………………………………………………………………………..18 Abstract Policies are most essential feature within the government of any nation and their implementation is required to be foolproof for the development of nations. The great financial crisis which took place in United States in 2008 was the most dangerous crisis after the Great Depression in 1930. One of the major reasons for the financial crisis has been due to the policy crunch and implementation failure. After crisis broke, regulatory intervention has been made with a stringent manner by the US government. The paper deals with the policy intervention by the Federal government of United States of America post crisis of 2008. Focus is entailed majorly on the Dodd-Frank Wall Street Reform directed towards neutralizing the crisis situation. Introduction The Nobel Laureate and American economist Milton Friedman stated that the policies should be such that they should not be evaluated by their agendas or intentions but by their outcomes1. The worst financial crisis striking the United States of America (U.S.) in the herald of 2008 after Great Depression in 19302 made a perpetual adverse impression on the global economy and can be deemed primarily as a collapse of policy and regulatory interventions. Financial crisis with imprudent policy ramifications led to the loss of 8 million jobs, business failure, stupendously declining house process3, and wiping away personal savings of people leaving the global economy and especially the US economy in a complete jeopardy4. The importance of policies is highly significant in the sense that regulation, policy formulations and their subsequent implications directly correlate with their effect5. Now it is also to be noted that according to common conscience where there is right, presence of wrong is indispensable. By assuming the financial crisis as a wrong and faulty mechanism, it is essential to analyze the policy formulation and their implementations as an endeavor to stabilize the economic conditions post crisis. It is required to realize that the new policies thus developed as coping strategies are fruitful to what extent or it is required to know the time frame in which the economy has been able to stabilize and reach a position of strong financial ground. This will help to realize the effectiveness and dynamism of policies6 But first of all it is strongly imperative to explore the causes that led to crisis generation. A wide array of factors, led to the generation of this financial crisis and to name a few of them are housing sector crash, credit mania, imperfect economic forecast and so on7. Now these factors are to be explored first and then the analysis of the regulatory intervention is to be analyzed to judge its effectiveness. In this paper the main target is to explore the regulatory intervention taking place in the US post 2008 crisis. Let us begin our discussion through the causes that led to the economic crisis and make a flashback review. Potential Reasons leading to the financial crisis The time frame from 1994 to 2001 can be regarded as a period of expanded home ownership8. The percentage points of home ownership rates expanded by a rate of 3.8 and real house prices saw an increase by 29 percentage9. As a subsequent phenomenon, house prices increased to a great extent and this can be attributed to the aftermath of economic recovery which the country faced from 1990-91 recessions10. Among the other factors, low mortgage interest rates in the mid 1990s as compared to 1980s11, broadly based income growth in the mid to late 1990s, expanded the lending spree to low and middle income households and even to people who did not qualify for a loan. There was also adoption of automated underwriting tools that led to the increase in efficiency of the underwriting of the mortgage. After 9/11, the fluctuations in the market drove the Federal Reserve in drastically reducing the short term rate of interests12. This led to the increase in credit in the market which as a ratchet effect led to the increase in the prices of the house to unimaginable levels. Data reveals that in the first quarter of 2006, the prices of the houses reached at a level which was around 87 percent13 greater as compared to the records in 1994 and 54 percent higher as calculated in the year 2001. From the period of 2001 to 2006, USA entered into a dimension where there was an increase in the cash out refinancing, banks provided quick loan to anybody who were interested in purchasing home with very minimal concern associated with creditworthiness. The private asset managers developed an idea that since the big financial institutions like Freddie Mac and Fennie Mac were implicitly secured14, they also thought that they were also insured at the same time. The large scale use of credit beyond the limit led to the decline in the balance sheets of the households of the country staggered with large increase at unbelievable rates15. The balance sheets of the business also deteriorated throughout the period with businesses taking tremendous risks and this was especially the case in the broker dealer sector which includes investment banks. The changes within the business sector included four times increase in the broker dealer assets and also exaggerated the level of other business asset. The financial institutions invested in the long term assets with the usage of significant short term funding creating earnings through the exploitation of a mismatch of maturity between the assets and liabilities. The investment banks as well as the other financial applied mortgage backed securities for the creation of earnings with an underlying assumption that there would be an indefinite rise in the house prices16 (Diamond, 2008, pp. 2-3). Guided by too much self interest motives Wall Street collapsed in 200817. It occurred through the combined complacency of single minded politicians, bankers as well as speculators18. Advantages and disadvantages of the crisis The disadvantages of the financial crisis far outweigh the advantages (anticipated). A Large number of people have lost their homes with several areas of the country facing tremendous foreclosure rates19. People have been tremendously suffered from the growth loss with interest rates of savings declining in a sharp manner20. This has led the US citizens struggle hard to keep up with savings that will protect them from creeping inflation. Individual investors faced mammoth hurdles with stocks of companies falling down rapidly. The fall in the company stocks affected adversely the people who planned a comfortable post retirement life. The vulnerability the stock price fluctuations signaled these individuals to either cut down their retirement expectations or work for a longer period of time. In the macroeconomic forefront, the unemployment rate of the country escalated to 10.1 percent in the year 2009 which was the largest as compared to 1983. Finding a new job became an almost impossible endeavor. Competition augmenting with high unemployment rates led the companies very much reluctant in hiring new people and it was also encountered that high rates of student debt imparted serious problems to the American youth. Borrowing became a much tougher phenomenon hitting really hard the lowest income group with rising inequalities. In the year 2007, the richest one percentage of the country possessed ownership of around 34.6 percentage of the total wealth of the nation. By the year 2009, their share rose to 37.1 percentages. Now in the subsequent paragraph the advantages will be discussed21. Before the crisis hit the United States, the country basically saved less and consumed more22. On the other hand the trade surplus countries saved more and consumed less. More than proportionate savings of the trade surplus countries led production and exports at the expense of domestic consumption through keeping currencies in an undervalued position as compared to the countries which possessed major export markets like the United States. The agricultural sector hampered a lot in the United States. It has also lowered farm employment and income. Advantage lies in the sense that it has not affected all the agricultural producers in the same way. With the decline in the world energy prices there has been also decline in the prices of many bulk crop prices due to bio-fuels relationship but it has benefited the livestock sector from lower feed costs. Currency is subjected to fluctuations. Now in the long run, the US dollar may appreciate or depreciate and if the latter occurs then at the end of the crisis the continuation of the world growth will create a high foreign demand for US agricultural goods23. Now we will directly move into the discussion of the regulatory interventions made by the United States of America post 2008 crisis. Regulatory Interventions It is of no doubt that the crisis was extraordinarily complex due to the unfortunate supervision of the regulators in a timely manner, however major emphasis on immediate regulatory interventions were made in order to neutralize the situation and save the country as well as the global economy from facing further bottlenecks. Interventions have been made by the Federal Reserve of the country which also incorporates a critical factor for Congress in delimiting the gaps in regulation and provide the supervisors with more stringent tools utilized for anticipating as well as managing the systematic risks24. The crisis pointed out that threats to the financial systems can occur not only from the banks but it can also emerge from various other financial firms like that of investment banks or insurance companies which in a traditional method was not subjected to regulation and supervision which were applied to the bank holding companies. The Federal government sought that big complex firms that do not own a bank but impart risk to the overall financial system must be put into broad and effective supervisory paradigm. Recognition of the necessity of supervision for the systematically important institutions was deemed to be omnipotent for the protection of the firms as well as bringing stability in the total financial system. There was also emergence of urge developed so that incentives of the firms in growing beyond limit at which it could be perceived as too big to fail25. Dodd-Frank Wall Street Reform In 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act was introduced by the Senate as a legal framework. The law was basically destined towards the reform of the Wall Street but a lot of provisions of the framework were targeted at reducing fraud and safeguard the consumers from financial practices that are abusive. From the words of Chairman Chris Dodd of the Senate Committee on Banking, Housing, and Urban Affairs (2010) the prime “intent of the law was to create a sound economic foundation to grow jobs, protect consumers, rein in the Wall Street, end too big to fail and other financial crisis”26. Dodd-Frank Wall Street Reform- Focus on consumers President Barack Obama stated that the Dodd-Frank Wall Street Reform and Consumer Protection Act demonstrate the strongest consumer financial protection in history. The agendas of the act are fragmented into different important parts which include “Consumer Protections with Authority and Independence, Ends Too Big to Fail Bailouts, Advance Warning System, Transparency & Accountability for Exotic Instruments, Executive Compensation and Corporate Governance, Protection of Investors, Enforcing Regulations on the Books”27. A Bureau of consumer financial product is created for the purpose of identifying and addressing systematic risk and supporting office of financial research. The legislation helps the government in providing more power for stepping in and releasing the financial firms which are failing and also provide more oversight within the derivative market and also aimed at protecting individual investors28. The Consumer Financial Protection Bureau (CFPB) is a central functioning body which targets at forming markets for consumer financial products and the services that will work for the Americans in cases where they apply for mortgage, whether they are applying for mortgage, credit cards and so on. The secondary functions of the CFPB is directed towards conduct rule making, enforcement of Federal consumer financial protection laws, restriction of unfair, deceptive practices, creation of a center in taking the complaints of the consumers, researching the consumer behavior, monitoring of financial markets associated with new risks to the consumers, enforcing laws that will rule out discrimination as well as other unfair treatment in the transactions of the consumers29. Dodd-Frank Wall Street Reform- Ends Too Big to Fail Bailouts In this legislative dimension, the provision is such that the taxpayers will be allowed in writing a check to bail out different financial firms which stands in the way of threatening the economy and thus developing a safe platform for liquidating the failed financial firms with imposition of tough new capital and that of leveraging requirements which will cut its desire to grow beyond limits. It would also allow updating the authority of the Federal government for allowing a system wide support with establishment of stringent standards for protecting the economy and the American citizens, investors and the businesses30. President Barrack Obama states that Dodd-Frank stands in the way of preventing tax payer funded bailout. Governor Mitt Romney states that Dodd-Frank institutionalizes too big to fail. Dodd-Frank designate eight banks in US as systemically important financial institutions (SIFIs) with the motive of undertaking annual stress tests and also to stick to the leverage limits through increased risk based capital requirements. It is also noted that the financial systems whose failure becomes a threat to the financial system of the country will be dissolved through an Orderly Liquidation Fund with funding from other large financial institutions. The Dodd Frank rules state that, “…financial companies put into receivership under [the Orderly Liquidation Authority] shall be liquidated, [and n]o taxpayer funds shall be used to prevent the liquidation of any financial company under this title”31. The Volcker rule in this respect can be taken into consideration. Section 619 of the Dodd-Frank Act which is commonly known as the Volcker Rule states that banks and bank holding companies and their affiliates including the US operations of foreign banks and foreign bank holding companies are prohibited from entering into proprietary trading or that of sponsoring or investing in hedge funds or that of private equity funds. The exceptions in this rule include activities like that of market-making related activities, risk mitigating hedging, underwriting and that of trading on behalf of the customers. The financial stability oversight council (FSOC) developed a supervisory framework for the implementation and prohibition on the proprietary trading consisting of programmatic compliance regime which includes policies, procedures, internal controls, record keeping and that of reporting and so on. For the restrictions on proprietary trading, the study the highlights the close association between impermissible proprietary trading and that of other permitted activities. The legislative supervisory framework directs at leveraging industry compliance efforts which involve data review and metric analysis with the examination as well as testing by the SEC with other financial regulatory agencies for enforcing compliance32 . For the prevention of the bank runs, Federal Deposit Insurance Corporation (FDIC) have the provision of guaranteeing debt of solvent insured financial institutions but after fulfilling of some solemn necessities which include two third majority of the Board and there should be determination by the FDIC board if there is a threat to the financial stability, the Treasury Secretary targets at the approving of the terms and conditions through the setting of cap on the overall amounts of the guarantee activated by the President for the purpose of congressional approval33. Dodd-Frank Wall Street Reform- Mortgage business The Dodd-Frank provisions are also applied in the mortgage industry. The mortgage brokers, bankers as well as the direct lenders will be served in a well fashioned manner impacting the mortgage industry. The provisions include close monitoring of the rulemakings under the purview of Dodd-Frank Act especially with respect to Title XIV which will require as much lead time required for the purpose of planning and implementation. As for instance, once the definition of qualified residential mortgage has been finalized then there will be consideration of feasibility of tailoring the underwriting criteria for the future mortgages for the purpose of the complying with the regulatory standards for the purpose of qualification of exemption from the requirements of risk retention. There should be execution of periodic compliance audits implemented for ensuring compliance with the new regulations. There shall be also performance of a business impact analysis vis-a-vis the anticipated requirements of risk retention. There should be also determination of whether the assets originated by the business are subjected to exemption or not and in case of non compliance there should be an operation of scrutiny for the notice and comment period for the rulemaking. In case of the non bank mortgage companies there shall be assessment of various relative merits of becoming affiliated with a depository the institution along with the notion keeping in mind that preemption from the state consumer financial laws will no longer be available to the operating subsidiaries of the national banks as well as that of the Federal thrifts. For the mortgage companies which are currently operating subsidiaries of any national banks or that of the Federal thrift will be considering the costs and benefits to the business with regards to rolling of the operation of company’s mortgage directly within the national bank or that of Federal thrift parent in order to preserve potential ability of the organization on relying upon preemption. This option includes the assessment of the benefit of being able to conduct various activities through separate incorporated entity. The national banks as well as the Federal thrifts when consider this option will be have at least 6 months and up to 12 months but it will be no more than 18 months maximum after the enactment of the Dodd-Frank Act before the preemption provisions which will affect the activities of operating subsidiaries of the national banks as well as the Federal thrift taking into effect34. Dodd-Frank Wall Street Reform- Credit Agency Reforms Through the title IX of Dodd-Frank Act aims at significant expansion of the oversight of the Securities and Exchange Commission credit rating agencies with simultaneously altering the application of credit ratings within a broad range of regulations as well as impacting the public disclosure of the credit ratings in the securities offerings. There has been commencement of rule making from the commission for implementation of oversight authorities through an array of rules associated with the required disclosures in association with the credit ratings, activities that are prohibited, governance, internal controls as well as that of conflict of the interest. Many Federal agencies have incorporated the rules that reference credit ratings and are also in the process of substitution of alternative creditworthiness standards in place of these ratings. In the oversight, the act demands the commission in establishing an office of credit ratings that will be responsible for the rules of commission applicable to the credit rating agencies. In June 2012, there has been an appointment of director by the commission and the commission will be liable for conducting an annual examination of each nationally recognized statistical rating organization (NRSROs) and also execute its inspection reports by making them available publicly. Examination of ten NRSROs in the first round was completed in the mid of 2011 and its summary report was published on the month of September, 2011. In the liability dimension, there has been elimination of the rule that allowed the exemption from the consent filing requirements for registering the statements provided to NSROs in the securities Act of 1933, Rule 436(g) related to Section 11 liability. The Act creates a provision of duty in reporting violations of law to the appropriate authorities. There has been also provision of enforcement as well as penalty provisions of the Securities Exchange Act of 1934 which applies to the Credit Rating agency statements to the extents that they apply to the statements as made by public accounting firms or that security analysts. There has been also modification in the ‘state of mind’ requirement for the private securities fraud actions against CRAs for the money damages. In the governance perspectives the board of directors of the NSROs has also specifically mandated oversight responsibilities in association with the policies and policies that determine ratings, conflict of interests as well as internal hiring as well as promotion. There is also a provision that at least half of board of directors of NRSRO must comprise of the independent directors with a portion of such directors for including users of ratings. The independent directors are mandated for serving a fixed and non renewable term which should not exceed five years with compensation which will be not associated with performance of the business of the NRSROs. In the transparency paradigm, the commission have modified various rules for addressing several aspects of the credit rating agency through the rules proposed in May 2011 which include internal control and procedures, conflict of interest, methodologies of credit ratings, transparency, performance of the ratings, training of the analysts, credit rating symbology and that of disclosures which will be accompanying credit ratings publications. Effective from July 2012, the Act states the Federal agencies in reviewing and modifying various regulations for removing references to or reliance on credit ratings and also in the substitution of alternative standards of creditworthiness. The commission in its adoption of final rules has eliminated references to credit ratings in many of the regulations as eligibility criteria in the short form registration statements. The commission has still to adopt the final rules in relation with the usage of ratings in certain of its regulations such as that of Regulation M. The banking agencies have also proposed certain norms that would be eliminating most of the references within its capital rules. As for instance, securitization exposures will no longer be risk weighted on the basis of specific credit ratings and instead it will be risk weighted on the basis of algorithm directed on the subordination level of exposure or with the utilization of the current gross up approach. The proposals include the credit ratings in at least one respect however a corporation may also issue a guarantee that the agencies will be recognizing as mitigating risk of credit in case the corporation possess an outstanding debt security which is investment grade35. In June 2012 there has been a capital rule approved by the banking agencies of the government which determines the risk weights for securitization as well as re securitization positions. These positions will be concentrating on risk weighted method with the application of same algorithm utilized for risk weighted similar position outside the purview of the trading book. The office of the Comptroller of currency in a recently published final rules which is to be made into effect from January 2013 which would be targeted at the removal of credit ratings from the regulation associated with investment securities , securities offerings as well as foreign bank capital equivalency deposits. In July 2011, there has been a published report of commission through section 939A on the review of reliance on ratings in the regulations. In July 2011, the Board delivered the report on credit ratings. In the month of January 2012, the government Accountability Office made a publish on the study required by the Act on alternative compensation models for rating agencies designed in mitigating the conflict of interest emerging in the issuer pay model. There was also requirement of the commission in conducting a study on assigned credit ratings associated with structured finance products36. Recommendations As recommendations, it can be stated that the policies should properly identify the affected individuals, organizations or groups and mitigate their problems in the medium and long term. The policies should be focusing on rationalizing and targeting social protection interventions as well as expenditure directed towards attracting the priority needs. Growth in the medium term and promotion of macro-economic stability should be the prime targets of the policy interventions. The policies should target the promotion of inequality neutralization. Conclusion The financial crisis that broke in USA took away 8 million jobs, business failure and sweeping away mammoth personal savings with faltering home market. The reasons for the crisis have been the overconfidence of the bankers and misinterpretation of policies. The introduction of the Dodd-Frank Wall Street Reform concentrates on consumers at first so that they are insulated from any potential frauds and then focusing on the firms so that they do not enlarge in size so that they cannot be reduced and subject to failure. Hedging of funds is the prime target. For mortgage and non mortgage business strict prohibitions and benefits are modified with strict scrutiny. Modifications in the credit rating agency are also mentioned so that they are stand in the way of conflict of interest. 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