Pros and Cons of Bank Regulation and Deregulation - Research Paper Example

Pros and Cons of Bank Regulation and Deregulation and their Effects on Global Economy Introduction Banks play an important role in economic growth, which is mainly through their contribution in payment and credit systems. Across the globe, banks are closely regulated to ensure continuity in financial flow. Banks require to be regulated since they finance their operations using government-insured deposits. If not regulated, bank managers could get involved in too risky deals since losses can be governed using public funds. Capital regulation ensures that banks internalize losses. This helps guard deposit insurance fund reducing chances of losses by the deposit insurer. The recent economic crisis, which was associate with credit crunch started with the melt down of subprime mortgage, which is directly dependent on how banks are regulated. In the United States, the move by Clinton and Republican congress to deregulate the banking sector is liable for igniting the 2008 crisis. This paper focuses on the pros and cons of bank regulation and how it relates with global economics. The paper will also address the pros and cons of deregulation in the banking sector as well as how it relates with global economics. Additionally, the paper will analyze the effects of bank regulation and deregulation on and the financial crisis of 2008. Pros and Cons of Regulation in the Banking Sector The regulation process in US is such that a bank is supposed to take immediate moves to reinstate its capital ratio in case Losses occur. In case of losses, banks restore their capital by raising fresh capital or shrinking their asset base. The regulators force the banks to take either of the steps, which prevents instances of failure (Roubini 1-3; Delaney Web). Since United States resulted from confederation of states, there exist dual regulatory systems where banks are regulated by both the state as well as the federal government (Barthy, Liy and Lu 1-5). The 2008 economic crisis triggered numerous changes in bank regulation within United States. The bank regulators increased their inspection on banks particularly on capital and reserves. Additionally, the congress is expected to implement reforms aimed at increasing regulation and make changes on the regulatory systems (Pellerin, Walter and Wescott 1-4). Bank regulation entails chartering and authorizing banks to start business and examination of the activities of the banks through frequent auditing. The banks regulators in United States include Comptroller of the currency, State Banking Authority, Federal Reserve, and Federal Deposit Insurance Corporation (FDIC) (Pellerin, Walter and Wescott 6-7; Roubini 6-8). Pros of Bank Regulation Like mentioned above, banks regulate their capital by asset shrinkage or raising fresh capital. Each of these moves has its pros and cons. In case of asset shrinkage, the effect could be either credit crunch or fire sale. Shrinking of assets through reducing lending, the interest rate increases, which make it hard for firms to borrow money for investments. This results in eventual decrease in employment, which is detriment to the economy (Pellerin, Walter and Wescott 10). Bank regulation helps in protection customers and the taxpayer. The government agencies concerned with regulation of banks supervise the operations of financial institutions preventing them from abusing taxpayers. They ensure that taxpayers are not denied access to deposit insurance as well as loans (Roubini 7). The Federal Reserve ensures that the central bank provides loans to banks. In case of financial crisis, the Federal Reserve inflates the safety net or increases the ease with which banks can access loans from the central bank. Therefore, safety net help to safeguard banks from bank runs reduces systemic risk in addition to reducing the cost of evaluating the health of financial institutions (Pellerin, Walter and Wescott 11-13). Another importance of bank regulation is to ensure safety and soundness regulation. The regulation agencies ensure that banks do not engage in extremely risky deals. The regulation agencies thus decide the appropriate risk, which banks cannot go beyond. Depending on the bank’s capital, the regulatory agencies decide the undertakings of the bank preventing them from unusually risky actions. The agencies limit banks with weak capital from giving large loans to single borrower and restrict the banks from investing in stock, which is considered a risky undertaking for failing banks (Pellerin, Walter and Wescott 15-16; Caruana 2-4). Additionally, the legislature ensures that the regulation agencies play the role of consumer and investor protection (Alamos Alliance Web). This requires agencies to protect consumers from deceitful behavior by firms. Additionally, the firms are obligated to provide dependable accounting information on their financial situation to enable investors make apposite decisions (Caruana 16-20). Having a decentralized regulatory system like in US ensures that there are different viewpoints such that the decisions made on financial regulation are not abused. A decentralized regulatory system enables consolidation and effective execution of lender of last resort function (Alamos Alliance Web). Bank regulation helps reduce systemic risks. Government intervention in protecting liability holders particularly in large financial institutions reduces the probability of the spreading of financial difficulties to other financial institutions. This is because financial institutions tend to be interconnected such that failure of one institution may result in failure or difficulties in other connected institutions. A good example happened in 2008 when Lehman Brothers’ failed and affected numerous financial institutions that were exposed to its mutual funds. Therefore, bank regulation agencies prevent failing of interconnected financial institutions by monitoring the level of risk that large financial institutions undertake (Tran Web). The regulation agencies and deposit insurance aid the small savers monitor their savings. It would be hard and expensive for small savers to evaluate performance of banks they have invested in. Most of the small savers do not have the relevant skills to monitor the financial situations in banks where they hold deposits. The presence of the bank regulation system and the regulation agencies is advantageous since the small savers can rely on them for accurate evaluation of the banks (Alamos Alliance Web; Barthy, Liy and Lu 16-18). Another benefit of bank regulation is the protection of the investors and the investors. Regulators of financial firms ensure that financial institutions offer beneficial products. The Truth in Lending and Truth in Savings Acts aid the regulator in ensuring investors and customers get truthful information regarding financial situations of banks. Additionally, the regulation process obligates banks to disclose terms of transactions such as the interest rates. Truth and Lending Act enables regulation such that customers can cancel loans after agreeing to it if they feel it may affect them negatively. The Securities and Exchange Commission (SEC) ensures that financial institutions and other firm provide trustworthy information to enable investors make sound decisions. Additionally, the commission can sue firms that fail to do so. This enhances the regulation process since failing institution can be detected early (Alamos Alliance Web; Tran Web). The Cons of Regulation in Banking Sector There are advantages associated with Bank regulation. One of the disadvantage or con is that it encourages banks to engage in wicked practices. The safety net provided by the Federal Reserve is that it encourages banks to engage in riskier deal than they would without it. This is because insured depositor such as Federal Reserve offers loans to financial institutions without considering the level of riskiness of the institution. US banks are thus likely to engage in extremely risky deal since they are assured of access to loans from Federal Reserve. This leaves the taxpayers vulnerable (Tran Web). The asset shrinkage by several bank greatly contributed to the 2008 economic crisis. This is because the shrinkage affected illiquid securities such as mortgage-backed securities. Rapid decline in such securities results in fire sale. Fall in mortgage securities results in increased returns to potential buyers which results in increased borrowing. Fire fall manifest themselves by causing deterioration in credit crunch. The regulation process is disadvantageous since it leads to loss of privacy of the financial institutions. The institutions are obligated to report their financial statements and other operation to the regulation agencies. The regulators are non-affiliate and are thus equivalent to third parties. If other parties access the data through the regulatory agencies, they may use it to conduct activities that are against the banks (Delaney Web; “Financial crisis shows bank regulation is broken” Web). The Models of securitization that govern the regulation process diminishes the incentive for financial institutions to assess the creditworthiness of borrowers. This results in transfer of credit risk to individuals with less capability of understanding the credit risks. A good example is the mortgage credits where the originator of the mortgages repackages the MBSs into CDOs, CDO-cubed, and CDOs of CDOs before transferring the risk to investors. All the intermediaries involved earn some income but the investor ends up bearing the risk. Regulation of banks is minimal while that of non-bank financial institutions such as broker dealers and hedge funds results in regulatory arbitrage. Such institutions are at a risk of bank-like runs and are likely to face the difficulties similar to those faced by banks. The regulation process thus does not prevent banks from possible difficulties since they are interconnected with non-bank financial institutions (Delaney Web; “Financial crisis shows bank regulation is broken” Web). Another con of the regulation process is duplication of the supervisory activities, which results in misuse of resources. The supervisory is done by six regulatory agencies, which include the Federal Reserve, Commodity Futures Trading commission, Securities and Exchange Commission, the Federal Deposit Insurance Corporation (FDIC) and the financial consumer Protection Bureau and Financial Stability Oversight Council. The regulation process is poorly defined and the regulators lack a specified pattern of supervisory process. This results in jurisdictional conflicts. Additionally, there is a lot of overlapping in the supervision resulting in duplication or negligence in some instances. Many financial institution are likely to take advantage of the Federal Reserve may use it as a safety net and undertake greater risk (“Financial crisis shows bank regulation is broken” Web.) Regulation of Banks and the 2008 Economic Crisis Banks play a major role in reducing transaction costs, providing liquidity in addition to monitoring investors. The 2008 economic crisis resulted in question on the role of bank regulating agencies in the crisis. This crisis started in the banking sector when the prices of houses went down. The banks started offering extremely risky mortgages even to person who were incapable of repaying the loans. The risk spread through the entire financial system and the financial system could not regulate itself. This resulted in instabilities in the financial market. The financial crisis in Citigroup can be attributed to inappropriate regulation system since the system had identified Citigroup as financially stable a month before the crisis. The government had relaxed the regulation process in the 1970s. Additionally, the regulatory system failed to conform to changes in the mortgage industry (“Financial crisis shows bank regulation is broken” Web). Like mentioned earlier, the regulatory system does not regulate non-bank financial systems such as mortgage brokers. This results in possibility of an individual borrowing from multiple lenders. Since brokers are connected to banks, crisis in their systems are often reflected in the banking sector. This was the case in 2008 crisis when brokers submitted applications that were misleading to help their clients obtain loans. Additionally, the regulatory agencies failed to regulate the mortgage backed securities appropriately. In 2007, most banks were reported to have lent more money than their deposits allowed them to. The regulatory system failed to take precautions and banks continued with this risky process resulting in collapse of several of them. Due to the interconnection between financial institutions, the crisis spread rapidly to the entire financial market. Since the global economy, depend on the US economy, the crisis in the United States eventually spread across the globe (Delaney Web; “Financial crisis shows bank regulation is broken” Web). The Pros And Cons Of Deregulation In The Banking Sector As It Deals With Global Economics And The Financial Crisis Of 2008. In 1980, President Jimmy Carter, signed the Depository Institutions Deregulation and Monetary Act which paved the way for the deregulation process. Deregulation is the process by which the government removes barrier or relates the control systems enhancing competition in resource regulation across the banking system. The deregulation process was enhanced by Clinton’s government and resulted in lifting of almost all restraints on operation of monopolies, which control the financial system. Clinton administration and the congressional Republicans proposed the Financial Services Modernization Act that was aimed at removing all the existing barriers on banking, insurance as well as stock trading. The restrictions had been enforced by Glass-Steagall Act of 1933, which separated brokerages, insurance, and banks into different sectors. The three were prevented from venturing into each other’s industry. Across the globe, deregulation has been witnessed in European financial sector especially from 1980s. Deregulation takes different forms but results in reduced control of the financial system. The Pros of Deregulation in the Banking Sector The deregulation enabled commercial banks, brokerage firms, pension funds, institutional investors, insurance companies, and hedge funds to intermix such that they could invest in each other’s business. Additionally, the different institutions were free to integrate their financial operations. This benefitted the institution since they could assess each other performance, which resulted in increased competition (Murphy Web). Deregulation leads to moderation of rules governing companies. The companies can easily break down business that are not doing well and expand those that are successful. Unsuccessful businesses are eliminated from the market leaving the prosperous ones. This results in efficiency and a more productive economy (Sherman 2-4). Another advantage of deregulation is that it ensures that banks make their own decisions depending on their plans. The financial institution thus makes decision that benefits them and their shareholder increasing the chances of success. The institutions are more likely to work towards their success. This is different from cases where there is regulation since institutions have less freedom to decide on their operations (Swift and Hopkins 539-541). Deregulation increases competition, which results in more contests. For institution to succeed, it has to be very efficient (Berlau Web). Deregulation is beneficial in that it increases opportunities. Deregulation results in removal of controls, which opens up new opportunities for creation of new businesses, increases competition. This results in eventual decrease in the prices of commodities. Deregulation results in a more proficient apportionment of resources. This results in increased economic growth. In case of bank deregulation, the restrictions are removed (Sherman 6-11). Additionally, the interest rates are reduced allowing banks to expand their operations and lend anywhere. Banks can also open up braches in other regions of the world resulting in increased growth. In United States, bank regulation prevented banks from expanding to other states. However, deregulation allowed banks to operate across different states (Berlau Web; Swift and Hopkins 540-544). The Cons of Deregulation in the Banking Sector Banking deregulation entails allowing large financial institutions to take over the finance industry since they are capable of handling several facets in the financial industry. The deregulation process increased the poser of the financial giants at the expense of the small financial institutions. The deregulation exposed financial institutions to financial manipulation. If not regulated, giant financial institutions end up strangling the small businesses, which can lead to overshadowing of the economy (Barker Web). Through deregulation, the Wall Street giants eliminated the competing banking institutions. Deregulation results in displacement of State level banks, which are often bought. This results in eventual collapse of smaller financial institutions. In the 2008, the banking deregulation resulted in overtaking of small companies by the large ones (Barker Web). Deregulation result in weakening of the powers of regulation agencies. In the United States, the deregulation resulted in reduction of the powers of the Federal Reserve Board. Without any form of regulation, financial institutions are likely to engage in illegal and risky operations with the aim of maximizing their profits. Additionally, the completion between companies results in rivalry as they try to outdo each other. This is unlike the case of regulation where the small institutions are protected from extreme rivalry (Berlau Web; Sherman 7-11). Deregulation results in instability in the banking sector by increasing risks and volatility. In case of regulation, banks bailout failing financial institutions, however, in deregulated system, government intervention is minimal and activities such as bailing out of financial institutions are almost non-existent. With deregulation, most banks are likely to fail in case of economic crisis. If a crisis occurred in a deregulated banking system, most banks would collapse resulting in loss of jobs. Loss of jobs results in poor livelihood (Barker Web; Murphy Web). Another disadvantage of deregulation of the banking system is degradation of the quality of services. Reduced government results in increased number of competitors. Increased number of competitors results in reduced quality of services since there are several service providers. Cases of corruptions are likely to increase. In case of banking, several banks will open up and will involve themselves in extremely risky actions. This can result in losses of the customers’ money. The deregulation process resulted in lessening of the requirements for acquisition of funds from the Federal Reserve banks. This is partly to blame for the 2008 crisis that was partially caused by increased borrowing of banks from the Federal Reserve (Barker Web). Supporters of deregulation argue that it lead to increased competition which is advantageous in the economy. Additionally, deregulation results in increased interest rate by banks, which encourages investors. In addition, competition results in reduction on the conditions imposed on borrowers enabling small businesspersons to borrow (Barker Web). Deregulation and the 2008 Economic Crisis Deregulation played a major role in the 2008 economic crisis. United States financial regulatory authorities relaxed their laws to an extent that deregulation seemed to have taken over. Mortgages prices decreased which were somehow under the government’s regulation. The recent financial crisis was triggered by what can be considered as deregulation. This was because it resulted due to reduced control of financial systems by the financial regulators (Berlau Web; Murphy Web). During the 2008 economic crisis, most banks in US were unregulated. This is due to the notion by most banks that they did not require to be regulated in order to operate efficiently. They engaged in dangerous deals by using their uninsured deposits in the stock market. Eventually, the stock market collapsed which resulted in great losses by the bank (Murphy Web). Deregulation and Financial Derivatives Financial derivatives are agreements between two parties that are based on financial tools such as stock or commodities. Derivative help in hedging risks in addition to being helpful in speculating the prices of securities. Financial derivatives are quite risky and can result in loses if executed inappropriately. In deregulated financial system, the level of risks is quite high. Investors make use of derivatives to ensure they maximize on their profits and manage the level of risk. Financial derivatives may include stocks, bonds, and futures contracts. (Barker Web; Sherman 6-10). Conclusion Banks play a critical role in the economy. There is thus need to regulate their operation to ensure that they do not engage in risky operation leading to losses. The bank regulation system supervises and examines the operation of the bank ensuring their activities are genuine. The United States regulatory system comprises of six agencies that oversee the operations of the banks ensuring that they report their activities. Bank regulation is advantageous since it ensures that investors are informed of the financial status of banks they may want to invest. Additionally, it ensures that banks do not collapse since their failure is detected earlier and amended. However, the regulation system fails to supervise non-bank institution, which exposes banks to possible failure since such institutions obtain funds from bank. Poor regulation of banks contributed to the 2008 crisis since banks engaged in risky lending resulting in bankruptcy. Financial deregulation, results in reduced control of banking institutions enabling them to operate freely. Deregulation was implemented during Clinton’s governance and resulted in reduced control of the government over financial institutions. This resulted in removal of barriers and different financial institutions such as banks and brokers could invest in each other’s business. Additionally, the giant financial system started dominating over the smaller ones and became manipulative. Banks started engaging in risky operation since they were not been regulated which resulted in financial difficulties that culminated in the 2008n financial crisis. The recent financial crisis is partly attributed to financial deregulation. When the price of the houses declined, banks started offering highly risky loans, which resulted in eventual collapse of the banks since most of the borrower could not repay their loans. Most people defaulted paying their loans when mortgages were reset higher. This resulted in spread of mortgage-backed securities to other financial sectors affecting the entire financial system. Works Cited "Financial crisis shows bank regulation is broken." The Telegraph (2008). Web. Alamos Alliance. "Banking Regulation after the Global Financial Crisis." Don Brash (2010). Web. Barker, David. Is deregulation to blame for the financial crisis? 7 Feb 2012. Web. . 18 Oct 2012. Barthy, James, Tong Liy and Wenling Lu. "Bank Regulation in the United States." CESifo Economic Studies (2009): 1-29. Berlau, John. "To save Obama, Clinton ignores his own deregulation moves." Fox News 5 Sep 2012. Web. Caruana, Jaime. 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