PROPOSAL FOR RE- REGULATION OF FINANCIAL SYSTEM

Every global financial crisis generates new regulatory responses. This economic crisis marks an
important turning point in the governance of international financial markets. Not only is there a
significant reregulation of international financial markets by the leading Western governments, but the
crisis is also unleashing centralized pressures that may lead toward a more decentralized and
fragmented form of international financial governance over the medium term. Global financial markets
were severely shaken by a series of crises emanating from developing countries. Policymakers largely
attributed those crises to mistakes in government policy. The afflicted countries had borrowed
excessively and had to be encouraged to exercise greater discipline. Their financial regulatory and
supervisory practices were deemed to be inadequate and to require improvement to meet international
standards. Risk taking in international financial markets through their backing of ever larger IMF rescue
packages was also a cause for the recent financial crisis. Assigning an increasing range of regulatory
functions to private financial actors such as banks, credit rating agencies, and accountants resulted in
the global crisis.

There is a strong consensus that the same market players who were previously assigned important
regulatory roles have been key culprits in triggering the current crisis. Private financial institutions and
markets have been particularly criticized for their failure to recognize the risks involved in various
market innovations associated with new models of securitization. Sub-prime mortgage loans were
transformed into securities, which were then converted into tradable portfolios with distinct risk
profiles. As credit risk was transferred and traded to parties far removed from the original source, its
quality became more obscure and was consistently under-priced by credit rating agencies and other
institutions. Once the crisis broke out, the diffusion of subprime mortgages also intensified the erosion
of confidence because of widespread uncertainties about who actually held these products and what
their levels of exposure were.

Particularly over-the-counter (OTC) derivative markets, including the enormous market for credit
default swaps were exposed very unclear manner. Here private players (highly leveraged hedge funds)
engaged in private bilateral deals without a formal clearinghouse or exchange that could minimize
counterparty risk and force margin requirements for all contracts. Making matters worse, banks had
created unregulated and highly leveraged "off balance sheet" structured investment vehicles to
participate in these new markets. In addition, other institutions involved in securities markets
including investment banks, bond insurers, hedge funds had become more systemically important but
were not covered by rules of prudential risk management.
Solutions:
1. Expand the scope of financial regulation. Investment banks and hedge funds have been able to
escape the minimal regulatory standards imposed on other financial institutions. Especially with
the government safety net -- including access to Federal Reserve funds -- extended beyond the
traditional banking sector, this regulatory black hole must be eliminated.
2. Impose much more robust standards for disclosure and transparency. Hedge funds, investment
banks and the off-the-books affiliates of traditional banks have engaged in complicated and
intertwined transactions, such that no one can track who owes what, to whom. Without this
transparency, it is impossible to understand what is going on, and where intervention is necessary
before things spin out of control.
3. Prohibit off-the-books transactions. What's the purpose of accounting standards, or banking
controls.
4. Impose regulatory standards to limit the use of leverage (borrowed money) in investments.
High flyers like leveraged investments because they offer the possibility of very high returns.
But they also enable extremely risky investments -- since they can vastly exceed an investor's
actual assets -- that can threaten not just the investor but, if replicated sufficiently, the entire
financial system.
5. Prohibit entire categories of exotic new financial instruments. So-called financial "innovation"
has vastly outstripped the ability of regulators or even market participants to track what is going
on, let alone control it. Internal company controls routinely fail to take into account the
possibility of overall system failure i.e., that other firms will suffer the same worst case scenario
and thus do not recognize the extent of the risks inherent in new instruments.
6. Subject commodities trading to much more extensive regulation. Commodities trading has
become progressively deregulated. As speculators have flooded into the commodities markets,
the trading markets has been divulged from the movement of actual commodities, and from their
proper role in helping farmers and other commodities producers hedge against future price
fluctuations.
7. Tax rules should be changed so as to remove the benefits to corporate reliance on debt.
8. Impose a financial transactions tax. A small financial transactions tax would curb the
turbulence in the markets, and, generally, slow things down.
10. Re regulation of the banking sector. In the current environment, banks are gobbling up the
investment banks. But this arrangement is paving the way for future problems. When the
investment banks return to high-risk activity at scale (and over time they will, unless prohibited
by regulators), they will directly endanger the banks of which they are a part.
12. Support governmental, nonprofit, and community institutions to provide basic financial
services. What needs to be emphasized as a policy measure, though, is a back-to-basics
approach.

Conclusion
Global financial crises often act as turning points in the governance of international financial markets.
The present situation is no exception. It is already clear that the crisis is catalyzing a significant
reregulation of international financial markets. Markets have to self-regulate, a trust that grew over
the past decade, has now been severely undermined. At the same time, reregulation may be
accompanied by a growing fragmentation of international financial governance over the medium term.
Although a more decentralized order may sit less comfortably with a liberal regime for the movement
of capital and financial services, it could prove more compatible with the diverse varieties of
capitalism in the world. Taken together, these trends suggest that the post crisis world will be quite
different from the one that emerged from the international financial crisis a decade ago.