Can financial regulation prevent a financial crisis

Can financial regulation prevent a financial crisis

Can financial regulation prevent another financial crisis similar to the one in 2008?

 

 

 

Introduction

The origins and manifestations of the financial crises which intensified around 2008 are directly linked to the use of unethical and unsound credit practices by certain institutions. It then follows that strong regulation and oversight could possible prevent future crises of that nature (Gevurtz, 2010). However, that does not address the other problems of the financial crises which are separate from access to credit and rating mechanisms. These may include speculative investment, herding mentalities and contagion through globalization (Kovacevich, 2014). 

1.0 What caused the 2008 financial crisis?

Market fundamentalists may argue that the true cause of the financial crisis was deficit spending and unsustainable sovereign debt as was the case in Greece, Spain, Portugal and Northern Ireland (Zingales, 2010). Others may yet argue that the real cause of the financial crisis was the move away towards manufacturing and export promotion meaning that the affected countries lost their competitiveness in the international political economy (Haltom, 2013). There is yet another perspective which argues that financial crises in many cases are part and parcel of a globalized economy and therefore should not be treated as some anomaly which requires drastic preventative measures (Harrington, 2009). 

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2.0 Can financial regulation prevent another 2008 financial crisis?

The real question then is whether a stringent application of financial regulation could have effectively controlled most of the factors that led to the 2008 financial crisiss. Superficially at least; it is possible that once financial institutions are regulated then they are not likely to engage in questionable practices which expose them to later collapse (Claessens & Kodres, 2014). For example the Nordic nations of Sweden, Norway and Denmark managed to avoid the worst effects of the 2008 crisis despite the fact that they are largely welfare states in which public spending is a significant part of the economy (Gevurtz, 2010). In fact their manufacturing base is not as high as that of Germany or China. In any case even those countries that have a great balance of trade were affected. It then follows that preventative action must necessarily include financial regulation (Ackermann, 2010). The problem with this type of thinking is that it ignores the limitation of the state in controlling the activities of banks even in the most egregiously command economies like China (Maijoor, 2014). The free market (a model that is preferred in the global political economy today) necessarily means that banks and other financial situations must be given the leeway to compete without undue state interference. A much more pragmatic view is that regulation can mitigate some of the worst excesses of recklessness amongst the institutions but the real solution lies in a complete restructure of the economy (Zingales, 2010). 

In reality a financial crisis is the intersection of a number of complex factors that are not just to do with the behaviour of credit-offering financial situations. These dynamics include the growth foundations of the economy (Haltom, 2013). It then follows that the design of an economic system that is realistic and sustainable within a wider global competitive environment is the key to preventing financial crises. Therefore it is more of a planning and execution function than a regulatory framework that ensures financial stability. 

The second critical dynamic is that of human behaviour (Harrington, 2009). Although the state has been successful in regulating human behaviour by way of laws and regulations as part of an overall institutional framework; in this case we are talking about speculative behaviour. It is very difficult to reassure jittery and finicky investors when they get wind of an impending financial crisis (St. Louise Federal Reserve, 2011). 

The third and perhaps most controllable element is that of borrowing by the state, households and other segments of the private sector. This is where regulatory authority can work to increase the cost of borrowing so as to at least make it more prudent to reconsider the decision (Brunnermeier, et al., 2009). Of course the state is well placed to control its own spending and borrowing; subject to political pressure to provide public/social services. It then follows that a combination of these elements are a far more effective antidote to financial crisis than mere stringent regulation. 

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At the heart of all this discussion is the equilibrating nature of human rationality. In fact this is what has been the core criticism of regulatory oversight in as far as it creates structural rigidities which distort the natural consequences of competition (Gevurtz, 2010). For example, regulation can significantly increase the costs of borrowing and running financial institutions which in turn distorts the prices of credit. Of course that is not to ignore the important role that the state machinery plays in creating jobs, opening up whole swathes of the economy to competition and creating stability by hamstringing rogue elements within the private sector that seek to take advantage of any loopholes (Harrington, 2009). It has been suggested that the true role of the government is oversight rather than micro management. In that sense the conceptualization of regulation is a matter of degree and extent rather than absolutes of control. The Dodd-Frank Wall Street Reform and Consumer Protection Act in the USA is a case in point in as far as it seeks to create stability and rationality but has been criticized for merely creating new obstacles to an already over-burdened business community (Salsman, 2012). 

Conclusion

In conclusion, there is no question of completely eliminating the state from the conduct of business affairs. The private sector has already shown (amply on the evidence of the recent financial crises) that if left unchallenged; it can create, propagate, spread and exacerbate financial crises. This essay therefore concludes that the most pragmatic approach is the most appropriate. First, that there is some sort of the financial system in order to monitor and prevent the escalation of the consequences of financial indiscipline. Secondly, that there ought to be a restructuring of the major economies in order to make them more responsive to the modalities of international competition. Finally were possible; the regulatory framework should reward prudence and punish imprudence in the conduct of business particularly if the market structures are too slow to react.  

 

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