How Financial Regulation Can Prevent Financial Crisis

Subject: Economics
Type: Argumentative Essay
Pages: 8
Word count: 2109
Topics: Microeconomics, Finance, Macroeconomics, Management

Table of Contents

The world has been hit been hit by many financial crises of which the one that occurred in 2008 was very severe. Therefore the paper will briefly touch on some aspects of 2008 financial crisis and later shed light on whether the regulations that are in implemented in the finance sector can help prevent the crisis form happening in future In this case the if there was a strict adherence to the financial regulations such crisis would not have taken place as the factors that could cause it could have been readily controlled and suppressed (Porter, Glauber and Healey, 2011). Additionally, the practices that were unethical could have been exposed and reported to the authorities.

Some of the practices that caused the 2008 financial crisis that could have been regulated include;

Subprime loans

The subprime loan borrower refers to an individual who lacks or has minimal income. Additionally, the credit history is also not favorable, and these make the rates of interest in this kind of loan to be high, unlike the normal prime loan. In most cases, we find that subprime loan borrowers have the less than 640 as the FICO score. At that time due to securitization, the brokers of the mortgage did not worry about the consequences of subprime loans (Glaeser and Sinai, 2013).They only focused their attention on the profits from these venture since the more sales they made brought high profits. In this perspective, the banks had some idea on how the CDOs and the ABS operate on borrowers’ principal as well as interest that is paid, were well informed that failure would be realized and critical problems will accompany the investors. However, the crisis became strengthened as the subprime loan givers made investments in the CDO and the ABS market. Additionally, the Wall Street’s banks which were in the mainstream were not financially ethical. They did not practice the reasonability in handling the cash of the individuals they invested with them loans (Glaeser and Sinai, 2013).In this case, they carried out insecure swapping of credit defaults when they were offering subprime loans so that they could hold of profits that were short-term and never caring about the investors.

Securitization is how to generate and have the debt securities insured or the bonds that their interest and their principal payments originate from the cash flows that are created from the pools of assets that are separate from each other. The assets that are not liquid can be sold for profits by the ABC, or the asset-backed securitization (Glaeser and Sinai, 2013). In this case, the cash flows of the future, for instance, the loan can turn into positions by the issuer. They will have the levels classified according to the riskiness. Additionally, diversification of the portfolios has to be done in that there exist varied qualities and maturity. They are papers of the capital market that are negotiable. The asset-backed securitization investors are paid by the issuer according to the interest rate and principal payments. If the borrowers cease the liability payments, it will mean there is the failure of ABS and the extra payment will not be received by the investors.

As far as the process of securitization is concerned, it has three aspects namely tranching of the assets from the pool, asset polling as well as the separation of the risk of credit of an asset pool that is collateral from the issuer to an SPV, a special purpose vehicle in full. The sponsor of the special purpose vehicle is the originator. A sale can be used to describe this type of transaction. According to studies the asset-backed securities are issued by the SPV and issuer gets the proceeds. In this situation, the value of the purchase is usually lower than the cash flow face value. The receivables have been subdivided into tranches which are equity, mezzanine, and senior. This division as per the risk of each asset that it is exposed to. The highest risk is involved in Equity tranche, and it has no rate. Regarding the mezzanine tranche, the asset has a higher risk with the low rate. If one invest in this, the returns are better as compared to senior tranche. Due to the returns that are high, the equity tranches are purchased by hedge funds, and we find that in the 2008 crises these tranches underwent critical problems. Securitization was also beneficial to the banks. This is because they could have their portfolio diversified and their ability to lend will also increase. By selling the ABS or the CDO, they could get a lot of profits. It is reported that most banks with investment in the CDOs whereby they had hidden their SPV of the off balance when the crisis was over.

Shadow Banking

This is a system of banking whereby the banks no deposits are made. They are in most cases act third parties between the borrowers and the investors. They make the provision of capitol and credit to clients so that they can profit form rates of interest as well fees. Due to shadow banking activities, the firms that had carried out the securitization could not be controlled or even regulated. This activity was that was done by many shadow banks who were in possession of the home loans that were economically toxic, are to blame for the financial crisis. The normal banks that have been in existence were in competition with these shadow banks (Jenkins and Collins, 2012). Therefore the extent of regulations that these shadow banks had was minimal as compared to normal banks. From this perspective, we find that this new breed of banks rendered the normal system of banking vulnerable as it almost made the financial sector to have their regulations phased out. As a result of the vice, it made the crisis to be inevitable as the regulation in the financial sector had been damaged as well as the in ability of the Federal Reserve to detect the mortgages that were toxic and weed them out before bringing massive trouble (Jenkins and Collins, 2012).

The individuals who were in charge of coming up with new financial policies were caught up in the crisis as they were also not ready. The failure of them not being well versed in the system that they were tasked to be in charge of also lead to the made the crisis to be severe. Additionally inappropriate application of ethics and accountability made the sector to take roots while normal or traditional banking got rapid swallowed. Another mistake that caused the vice to grow rapidly was the failure of the regulators to prevent the key shadow banks from innovating and implementing their frameworks that were complex be easily understood by the regulators. This made the risks investments to affect the investors and lastly harming the economy due to their hidden nature.

From the aspects that we have seen in the 2008 crisis, there is a likelihood that if the institutions that deal with finance operate under full regulations, the worst effect will not be felt. For instance, the countries like Denmark and Norway did not face the worst effect because there is no room of questionable practices in their financial frameworks, unlike other nations that were adversely affected that and yet they are states that survive through welfare (Edgar, 2009). These nations are very keen on how public spending is carried out by their governments as it impacts their economy. Therefore a reasonable regulation can help eliminate the consistent recklessness that happens in the finance firms.

As far as the financial crisis is concerned, it does not fully have to do with critical factors and how the financial institutions behave. It is imperative also to take a look at the frameworks of economy whereby they are sustainable and in a global environment that competitive will be a solution to curbing the future financial crisis. In this case, planning strategically with a good taste of execution will also make the financial sector to be firm.

Another way financial regulation can help curb crisis is through putting some regulation on how the firms, households and event state borrows funds from banks. The bodies which are involved in regulation can make this work by rising the borrowing cost so that if some have to borrow, he/she will have to decide on the prudent basis.

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Secondly, we find that the behavior of humans has been easy to be regulated by the state. This is through the regulations, and the laws that exist in an organization and every individual that works in that institution should be able to follow. However, the topic behind this is the speculative behavior whereby when the financial crisis is approaching an investor will not be in a position to get assured by an employee of a financial institution.

Another contention is that, if the financial institutions are subjected to more elevated amounts of regulation, and are compelled to make every single accessible data on levels of hazard accessible to the FSA occasionally, the impact would without a doubt be more prominent straightforwardness, and would make it harder to go out on a limb. The controllers could likewise utilize a carrot and stick arrangement (Green, 2011). The motivation put before the bank could be tax reductions for the organizations which can as often as possible demonstrate that they are attempting to constrain the level of hazard they go up against and can adjust this against the need to make a benefit. The probability is that such a framework, were it to be executed, and would likewise deliver more noteworthy proficiency in the organizations, as they try to expand benefits.

 The thump on the impact of this is probably going to be more noteworthy soundness in the area realized by more noteworthy certainty and eagerness to put resources into organizations which are believed to be the most secure wagers. The stick in this illustration could be a report distributed by the controllers at regular intervals, or like every now and again as is expected to impart trust in the market, which would rank the banks and money related foundations on the premise of security, much in the same route as schools and colleges are set allied tables in light of accomplishment. In theory, this speaks to a profitable thought. It would imply that the banks would have no real option except to comply with a wellbeing initially approach, or hazard being at the base of a class table which would be accessible in people in general area, which could thus prompt speculators in specific banks moving their advantages for those banks which were meeting destinations.

At the core of this exchange is the equilibrating idea of human objectivity. This is the thing that has been the center feedback of administrative oversight to the extent it makes auxiliary rigidities which mutilate the regular results of rivalry. For instance, direction can fundamentally expand the expenses of obtaining and running budgetary establishments which like this mutilates the costs of credit (McNeil and O’Brien, 2010). Obviously, that isn’t to disregard the critical part that the state apparatus plays in making occupations, opening up entire swathes of the economy to rivalry and making security by hamstringing rebel components inside the private area that try to exploit any escape clauses. It has been recommended that the genuine part of the administration is oversight instead of miniaturized scale administration. In that sense, the conceptualization of direction involves degree and degree instead of absolutes of control. A valid example of reform is the act of consumer protection of America as well as Dodd-Frank. To some extent it tries to make solidness and soundness yet, it has been scrutinized for only making new hindrances to an officially finished troubled business group. 

To wind up, there is no doubt of totally wiping out the state from the lead of business undertakings. The private division has just indicated abundantly on the confirmation of the current monetary emergencies that if left unchallenged; it can make, proliferate, spread and fuel money related emergencies. It, therefore, presumed that the most down to earth approach are the most fitting. To begin with, that there is a type of the budgetary framework to screen and keep the acceleration of the results of monetary indiscipline. Furthermore, that there should be a rebuilding of the significant economies keeping in mind the end goal to make them more receptive to the modalities of universal rivalry(Cao, 2014). At long last were conceivable; the administrative system should remunerate judiciousness and rebuff indiscretion in the direct of business especially if the market structures are too ease back to respond.

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  1. Cao, J. (2014). Banking regulation and the financial crisis: Routledge.
  2. Edgar, R. (2009). The Future of Financial Regulation: Lessons from the Global Financial Crisis. Australian Economic Review, 42(4), pp.470-476.
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  4. Green, C. (2011). The financial crisis and the regulation of finance. Cheltenhem: Elgar.
  5. Jenkins, D. and Collins, M. (2012). Shadow banking and its role in the financial crisisHauppauge, N.Y.: Nova Science.
  6. MacNeil, I. and O’Brien, J. (2010). The future of financial regulation. Oxford: Hart.
  7. Pakravan, K. (2011). Global financial architecture, global imbalances and the future of the dollar in a postcrisis world. Journal of Financial Regulation and Compliance, 19(1), pp.18-32.
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  9. Vázquez, F. and Federico, P. (2012). Bank funding structures and risk. [Washington, D.C.]: International Monetary Fund.
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