Figure 1 Impact of financial regulations on economy............................ 20
Figure 2Impact of financial regulations in banking sector..................... 21
Figure 3Financial regulations and impact on lending............................ 22
Figure 4Impact of financial regulations on financial markets of GCC.. 41
Figure 5Impact on performance of UK financial market....................... 42
Figure 6Affect performance of US financial market.............................. 43
Most of the times an economy considered to be based on the consumer industries and the effect of consumer industries on the economy have been widely discussed over the years. As important these industries are, the financial markets in an economy cannot be undermined. The role of financial markets in the development of an economy is essential. As it is seen the consumer products markets, as freer the market would be, the more appropriately it would work, but even then, the governmental interference is inevitable. The reason behind this interference is the fact that determinants of markets are not always controlled by free market regulatory control is needed. Similarly, when it comes to the financial markets, a financial regulation is always required in order to make transactions smoother and regulate the financial aspects of the markets. The past events like the financial crisis have greatly emphasized the need of financial regulation and policies, which can perform more than an overview of the financial markets. (Financial regulation, 2015).
This paper is based on the introduction of financial regulations and their impact on the economies. In order to do so, the history of financial regulation must be discussed so that the origin of financial regulations can be determined. The emphasis on financial regulation after the financial crisis is not the only part of the story, as the financial regulations have been in the scene for way before the financial crisis struck the economies. Thus, the history of financial regulations goes back into early 1960s. The paper would represent the transitional changes of the financial regulations and their prominent features and failures. (Brunnermeier, Crocket , Goodhart, Persaud, & Shin, 2011).
The very first monetary control was established in early 1960s named as the Bretton Woods system, which was intended to monitor the monetary transactions and devise rules for financial and commercial relations for the independent states like the United States of America, Canada, Western Europe, Australia and Japan. The establishment of Bretton Woods Systems was intended for monetary management in the independent states. The Bretton Woods Systems has some certain features for managing the monetary order in the independent economies, which was appreciated afterwards. (MILESTONES: 1969–1976: Nixon and the End of the Bretton Woods System, 1971–1973, 2013). The Bretton Woods Systems has tied up the currency of each state with the gold in order to restrict these states to adopt policies to maintain an exchange rate. In addition to that, an important feature of the Bretton Woods Systems was enhancing the ability of IMF to bridge the lapse of imbalance of payments in these states. This system had to dissolve due to the inefficiencies regarding the monetary policies for maintaining the exchange rate as after the Vietnam War, the overvaluation of the dollar trigger this inefficiency. The breakdown of the Bretton Woods Systems has predicted a vacuum in the rapid growth of economies, which was later discouraged by the free floating of the currencies. As the free floating currencies against other currencies was a relatively smoother transaction. The flexible exchange rates have provided a smoother environment for the exchange rate to change against the external shocks like the oil prices etc. (Garber, 1993.)
After the collapse of the systems, the transitional change has led the countries to focus on a more liberal financial control. Technological contribution and globalization has played an important role in this transition as the countries have found the need of financial liberalization. However, the markets get freer through the financial liberalization, which emphasized on the deregulation but the government involvement was required to actually re-regulate the financial markets and bring the financial stability. After the Bretton Woods Systems, the new regulation has focused on actual prudential regulation policies. These prudential regulatory standards include the capital requirements, investment policies, investor protection policies, and the risk management regimes. As the large economies were incorporating together a policy regime for the financial stability, the failure of this regime has led to the institutional forums like BCBS, IASB, IOSCO, and EMU. These institutions has provided a wide range of financial regulations and contributed immensely toward the financial stability. Before, the financial crisis in 2007-2010 the financial regulations was based on micro prudential regulations.
Micro prudential regulations are part of a big strategic financial planning on behalf of the global cooperation. The micro prudential regulations were more focused on the financial health of individual institutions. The reason behind was to avoid the effect of failure of individual institutions on the other financial institutions. The importance of the prudential regulations for the financial stability cannot be ignored as by maintaining individual institutions’ financial health, the overall financial stability of the region can be ensured. These micro prudential regulations were introduced in 1970s and they settled for good 2-3 decades. The micro prudential regulations contributed toward the betterment of financial institutions like banks and securities firms likewise. The contribution of micro prudential regulations toward the banking sector and the securities firms is invaluable as the risk of failure of insolvency for the banks is brought down to an acceptable level under these regulations. The link between the banking sector and the securities firms is relevant as the failure of banks and the brokers and dealers can bring the financial system down. The failure of brokers and dealers imply that the settlement and clearance of the transactions is in jeopardy, therefore, it can lead to the failure of the banks. Thus, the prudential regulations ensured the financial stability by lying out the rules for capital adequacy and other measures for the safety and soundness of the banks and their operations. The prudential regulations have illustrated the rules and regulations for the banks as well as for the securities firms. In order for the banks to ensure their safety and soundness against any financial crisis, the prudential regulations provide a deposit insurance system. In addition to that, the protection of investors and consumers is as essential for banks as any financial transactions. Therefore, to protect them from any inconvenience and to protect their right the prudential regulation suggested disclosure requirements, and the regulations for regulating the business conduct.
In the event of financial crisis, improvement in the micro prudential regulation is not considered enough. The need of macro prudential regulations are significant for the Europe region due to their single market strategy as this has increased the risk for the system as a whole and for the risk of connectedness of the regions. Identification of the systemic risk was the first step for introducing the macro prudential regulations. The data for the banking transactions for the European region was collected where the results showed that the half of the international bank transactions was occurred in the developed European countries. The systemic risk was estimated based on the large banking institutions’ stock returns. In addition to that, institutional reforms had also taken place in the Europe region.(Hanson, Kashyap, & Stein, 2010)
The prudential regulations have covered a wide range of aspects in order to maintain standards for financial stability. Thus, these wide range aspects can be presented as the characteristics of the prudential regulations. These characteristics of the prudential regulations are discussed briefly in the next section so that their impact can be determined and the role of these characteristics can be established in the event of financial crisis of 2007-2010.
Capital Adequacy to Reduce Risk: This characteristic of the prudential regulations for banking is stemmed from the efforts of the BIS and IOSCO. Representatives from each country’s central bank are included in BIS and if the central bank is not a banking supervisor then the representative from the supervisory authority should be included in BIS. According to the prudential regulations, the capital adequacy ratios were determined for the banks operating internationally. The reason for doing this is to reduce the credit risk, which is usually associated with the lending process. The Basel I consisting under the prudential regulation was not appreciated due to several reasons, one of which was the lack of measures for the market risks.
Incorporating Market Risk: In order to incorporate market risks into regulations, the BCBS and IOSCO has been working together. However, this corporation was stressful for countries disturbing their regulatory system but the result comes up with a functional approach to prudential regulations, which was definitely not true initially as the prudential regulations had an institutional approach.
Creditworthiness: The creditworthiness was another issue left out by the Basel I that should be accounted for while illustrating the capital requirements. For purpose of incorporating the credit risk management, a new framework is presented which resulted in Basel Accord, Basel II in 2004. The implementation of this regulatory framework was due in 2007. This version of Basel was based on three basic rationales, which were supervisory review process, the minimum capital requirement and market discipline.
The micro prudential regulations provide a great insight for the efforts of international community and their emphasis on the financial regulation for financial stability. Unfortunately, these regulations were not good enough and the inefficiencies of these regulations led to the worst financial crisis to date of 2007. The next section of this paper is focused on the event of financial crisis. The causes of financial crisis and the responses of inefficiencies are discussed comprehensively.
Financial Regulations of USA
Safety-and-soundness, or solvency, regulation looks to forestall financial organizations with settled sum loan bosses from getting to be ruined. Since government regulation can't keep all insolvencies, on the other hand, governments have made instruments to ensure at any rate little settled sum loan bosses from any misfortune when a safe establishment, insurance agency, or financier firm has gotten to be ruined—that is, has "fizzled." These systems, for example, store protection, protection assurance assets, and speculator security assets, can appropriately be seen as an item guarantee for solvency regulation. That is, they secure settled sum loan bosses against misfortunes when the "item," regulation, which should ensure altered sum lenders, neglects to keep a financial organization's insolvency.
Solvency regulations are authorized by analysts who evaluate the estimation of an establishment's benefits and decide the extent of its liabilities, an especially essential capacity in property and setback insurance agencies. A financial foundation can get to be bankrupt (its liabilities surpass the estimation of its advantages) in the event that it endures a vast sudden misfortune or a maintained time of littler misfortunes. In like manner, an apparently dissolvable bank or insurance agency can end up being wiped out if analysts find concealed misfortunes—resources have been exaggerated or liabilities have not been perceived. All the time, misrepresentation is the fundamental reason for those misfortunes.
Compliance regulation tries to guarantee "reasonable" and nondiscriminatory treatment for clients of financial organizations and to keep financial foundations from being utilized for criminal or terrorist purposes. Compliance regulation has as of late turned into a noteworthy obligation regarding the controllers and a noteworthy expense trouble for financial establishments.
Congress has authorized various assurances for clients of governmentally controlled financial foundations; some of the time these insurances reach out to different sorts of financial firms, for example, little credit organizations. These laws incorporate the Truth in Lending Act, the Truth in Savings Act, the Fair Credit Reporting Act, the Real Estate Settlement Procedures Act, the Expedited Funds Availability Act, and different security insurances, to give some examples. In late decades, Congress likewise has sanctioned enactment excepting segregation in bank loaning, including the Equal Credit Opportunity Act, the Home Mortgage Disclosure Act, the Consumer Credit Protection Act, and the Community Reinvestment Act. Each new law expands compliance costs for banks and other financial foundations.
Financial Regulations of UK
The Financial Conduct Authority (FCA) is money related administrative body in the United Kingdom, yet works freely of the UK government, and is financed by charging expenses to individuals from the budgetary administrations industry. The FCA directs money related firms giving administrations to customers and keeps up the uprightness of the UK's budgetary markets. It concentrates on the regulation of behavior by both retail and wholesale monetary administrations firms. The Prudential Regulation Authority (PRA) is in charge of the prudential regulation and supervision of around 1,700 banks, building social orders, credit unions, back up plans and significant speculation firms. It sets models and oversees monetary foundations at the level of the individual firm.
The PRA's part is characterized by three statutory destinations: i) to advance the wellbeing and soundness of its organizations; ii) particularly for back up plans, to add to the securing of a proper level of assurance for policyholders; and iii) an auxiliary target to encourage successful rivalry. The Banking (Special Provisions) Act 2008 (c 2) is an Act of the Parliament of the United Kingdom that went into power on the 21 February 2008 with a specific end goal to empower the UK government to nationalize high-road banks under crisis circumstances by auxiliary enactment. The Act was acquainted all together with nationalize the coming up short bank Northern Rock after the bank was bolstered by Bank of England credit and a private-part arrangement was regarded "not to give adequate worth to the citizen" by the UK government.
Restriction to the Act by the Conservatives depended on: the Bill giving an exception to the Freedom of Information Act 2000, the substantial liabilities to the citizen and the charged absence of autonomy from the legislature. The Bill was likewise adequately generally attracted to permit the nationalization of any monetary establishment, prompting the worry that different banks may be in money related difficulty. After the nationalization of Northern Rock, the Act took into consideration the nationalization of the home loan and individual advance book of Bradford and Bingley on 29 September 2008.
Financial Regulations of Gulf Countries
Lately, the focal money related powers of some Gulf Cooperation Council nations have rolled out a few administrative improvements with a specific end goal to accomplish social and monetary objectives. The financial powers of these nations have fortified prudential standards. Resource arrangements and provisioning standards have drawn nearer to worldwide gauges. Banks are required to keep up money to hazard weighted resources proportions of 8 for each penny required by the BIS. Neighborhood banks take after International Accounting Standards. In spite of the fact that the focal money related powers of the GCC nations are dynamic in directing and observing their regulations on financial organizations, yet not rapidly. In a worldwide financial business sector, Islamic‐banking controllers that work Islamic banks ought to consider the similarity of the administrative setting. Through a profound comprehension of the way of the Islamic managing an account business and the late western keeping money supervisory structure, Islamic saving money controllers will have the capacity to build up a sound saving money framework without losing its own qualification.
In above paragraphs, financial regulations in the USA, UK and Gulf countries have been briefly described. The importance and comparison of financial regulation of the USA, UK and Gulf countries will be discussed in the coming parts of the dissertation in due detail.
The financial regulatory bodies for any country perform roles and responsibilities and try to incorporate the financial regulatory framework into the markets. The role of financial regulators in regulation is important as these regulations are primarily suggested by the regulators. Therefore, the control of regulators over the institutions in order to practice these regulations must be high. Financial regulators are the agencies under the federal and state governments in all developed and under developing countries in order to regulate the financial markets and the financial institutions like banks. The role of these agencies within a country is very specific and each agency performs its specific duties. The objective of establishing these agencies is similar though they differ in their responsibilities and duties. These regulatory bodies work independent of each other and hence, try to achieve the similar goal of financial stability of the financial markets. To name a few financial regulatory bodies, the following are the general regulators.
- Federal Reserve Board
- Federal Deposit Insurance Corporation
- Office of controller of the Currency
- Office of Thrift Supervision
- Commodity Future Trading Commission
- Financial Industry Regulatory Authority
- State Bank Regulators
- State Insurance Regulators
- State Securities Regulators
- Securities and Exchange Commission
The impact and control of the financial regulations over the financial markets is different when it comes to the national financial regulations. However, the objective of the financial regulation is similar in all the countries but the intensity of these regulations and the role of regulatory bodies can be quite different in developed and developing countries. Before going into the origin of the financial regulations, the role of financial regulations is discussed for the developing countries. Before the financial crisis of 2007, the major concern for the regulators in the developing countries was the effect of highly volatile capital flow on the financial systems. The effect of financial liberalization in these countries did not seem to be working at all. ( Rojas-Suarez , 2004)However, the reforms took place in the developing countries concerning the financial liberalization but these reforms did not mean to bring back the effect of controlled financial markets or the closed capital accounts from the past. In addition to the fact of volatile cash flows, this factor is highly associated with the macroeconomic policies in the developing countries. The implication of prudential regulations in the developing countries was quite evident in two respects. The first perspective of this regulation is the control over the financial aggregates and second perspective of these prudential regulations is the risk management by avoiding risk taking activities. (Light touch no more, 2012).
After the financial crisis in 2007, though the impact of this crisis was most seen in the European countries but developing countries like the Asian region were also struck by the crisis though the intensity was low. This event has made the developing countries to be more cautious regarding their financial regulations and financial markets. On the other hand, the international financial institutions advised these countries to keep on deregulating but a slower pace so that the any after effects of the financial crisis in the region can be handled appropriately. Though, many researchers find it more appealing that the re-regulation must be enhanced so that the system wide failures can be avoided. (Chowdhury, 2012)
The global financial crisis was not a result of only policy factors but the market factors are responsible equally. The boom and bust cycle in United States was the main reason behind the global financial crisis. As the aggravated condition of this boom and bust cycle in the credit market was actually the reason, there were several issues aroused in the credit market. The credit availability in the market was excessive, the liquidity and the lending practices with no actual credit assets were a few of many those issues. In addition to that, as this credit market boom and bust was happening, the lack of financial supervision was highly evident. The ineffective risk measures and the inaccurate pricing of the assets led to such a huge disaster. As discussed previously, the financial regulation and policy framework nothing seemed to be playing a role in improving the situation. The financial crisis can be categorized into two aspects, which are the failure of subprime mortgage loan market, and the contributing factors discussion led to the make it a global financial crisis.
The failure of mortgage loan market in U.S. was the actual reason behind the collapse and the financial crisis. The stream of events started to happen with the U.S. government’s policy of low interest rates. As the interest rates become lower, the situation of excessive credit availability occurred. As the U.S. government policy of low interest rate was purely based on the economic situation of deficit of balance of payments, the excessive credit availability made the choices harder. Financial tools such as the credit default swaps and the collateralized debt obligations are the instruments in which the credit risk is traded. As more and more people started to involve in the mortgage loans, the asset prices started to increase. Thus, the low default rate was resulted due to the excessive credit availability and the asset prices. At this point, the role of regulatory authorities and regulatory monitoring was significant, but the regulatory monitoring was lacking at that point. As the more people were involved in the mortgage loans, and the regulatory monitoring were lacking, the standards for credit worthiness of the borrowers were at their lowest. The income of borrowers was not even considered while filing them for mortgage loans. In this manner, the fraudulent activities on behalf of the borrowers and in the lending process were made possible under such circumstances. Lack of the regulatory monitoring and financial supervision had led to insufficient supervision for risk originated actors and insufficient protection for the investors in the market.
However, the failure of the mortgage loan market was initially in the U.S. financial market, but there were a few factors, which made this one financial market collapse as the biggest global financial crisis. Several factors contributed to this while the main factor is considered to be the inability of the financial supervisory to take into accounts the risk of introducing new financial instruments and products in the financial markets. The risk of introducing financial instruments apparently does not seem to make a difference but different aspects of this factor have been established which went wrong during the financial crisis. The first aspect is the informational asymmetry, which is the inability of monitoring bodies to make knowledgeable decisions and regulations. (Goodhart, 1998)The process of securitization involves a chain of transactions and processes, which is called the OTD originate-to-distribute chain. This chain involves many participants, which create the problem of asymmetry of information. Another aspect of the financial instruments was the heavy reliance of the financial regulations on the external credit rating agencies for credit assessment of the banks’ internal models. The conflict of interest arose due to these credit rating agencies. Like the credit rating agencies cannot give bad assessment to the banks handling the accounts of those agencies, therefore a biased opinion and assessment of the banks’ internal models led to the misleading financial instruments. The third aspect of introducing new financial instruments was the capital requirements and its risk-weighted measures. Lastly, the impact of risk measurement to other financial markets was a significant aspect of the factors contributing to the global financial crisis. The impact of the monitoring of the risk on the financial markets on whole is crucial and one can affect the other. (Levine, 2012)
This discussion has provided with the invaluable information regarding the cause of the financial crisis and the reasons behind the collapse of an individual market becoming the most stressful global financial crisis. This discussion has given a great insight of the financial regulations and the impact of these regulations on the financial markets and the financial stability of the economies. As the financial regulations have been proven significant for the financial stability, the inefficiencies of financial regulations and the lapse in these regulations are important as well for future improvements. As the before and during of the financial crisis in perspective of financial regulation is discussed in the paper, it would be appropriate to include the after effect of the financial crisis as the responses of the regulatory authorities would be beneficial. The next section of this paper would include the amendments into the financial regulations and the aspects, which has been improved in the regulatory monitoring.( Adrian, 2010)
After the financial crisis, the micro prudential regulation needed a thorough make out in the light of the financial crisis. This implies that the risk management is focused comprehensively. The monitoring of the banks both quantitatively and qualitatively was enhanced by the regulators. The focus after the financial crisis was managing the risk by implementing the internal monitoring of banks, banks’ own risk management measures and appropriate supervision of bank’s operation etc. The regular amendments of level of capital adequacy were put on second and internal monitoring is focused mainly. In addition to the risk management related to the qualitative and quantitative aspects, the financial instruments are also assessed for high risk and the capital adequacy or capital charges are suggested to be higher for such financial instruments. As far as the financial regulation amendments are concerned, the micro prudential regulations are reviewed and monitoring in context of risk management is enhanced. This is not the only response, which was established by the regulatory authorities after the financial crisis but the regulatory authorities have come up with the idea of macro prudential regulations and a macro prudential regulation framework is presented for greater good in the future. (Harrington, 2009)
As the importance of financial regulations has been discussed in this paper and the impact of financial regulation before and after the financial crisis is illustrated in detail. Toward the end of this paper, the linkage between the financial regulations and the economic growth of the countries must be described so that the role of financial regulation for economies can be determined as well. The concept of growth with equity is rather interesting in this regard as it has become the most significant objective of the economies overall. The EMEs, which are the economies where the proportion of poor is still sizeable, are the economies where the equity growth matters the most. The broad objective of the equity growth is subjected to the financial policies so that these policies can best serve this purpose. However, the economists have not been unanimous over the importance of financial regulations and economy but the financial crisis in 2007 has provided the world with plenty of evidence that the financial regulations are greatly concerned as far as the two broad objectives of growth and equity are needed to be met.
Figure 1 Impact of financial regulations on economy
Hence, the evidence has suggested that the EMEs i.e. emerging market economies are focused on implementing the Basel I and Basel II regulations as these regulations would contribute toward the strengthening of their banking systems. In addition to that, development objectives in these countries emphasized to be achieved by following the financial regulations in order to strengthen the economy itself. Thus, the importance of the financial regulations cannot be undermined for the development of economies.(Sinha, 2011)
There is a clear distinction between different financial regulations in terms of securities and regulations relating to banks. The primary justifications for regulations by banks involve the elimination of financial loss as well as systematic risks. (Acharya, 2001)The regulations by securities exchanges are aimed to protect the investors while enhancing the market efficiencies. In addition, investor protection, efficiency enhancements and avoidance of systematic risks are not merely the main purposes of these two financial institutions because it also includes wider social goals like facilitating domestic ownerships as well as other regulations and its justifications. The basic aims of these two financial institutions are termed to be protection of retail depositors and investors, elimination of systematic risks, attainment of wider social goals and improving the efficiencies of such institutions.