Financial Policy to Combat Market Imperfection in the

Financial System
Financial system are said to be the heart of the economy. They pump money,
distribute it from those who have an excess to those who need it. Without a good financial
system, consumption will be slowed, innovation will be impeded, and development will be
halted. But how can we get a good financial system? Some country like US decided to let the
market fully shape the financial system. They minimize the government intervention in
controlling the financial system. But the result is not desirable. In 2008, the financial crisis hit
the real economy and millions of people losing their jobs and assets. The source comes from
the US with its subprime mortgage market crashing down. There is a market imperfection;
home price didnt really reflect their intrinsic value. The crisis in 2008 give us a very
important lesson, the financial system cant entirely be decided by the market. Government
must intervene by creating regulatory policy to help stabilize the financial system. So how
would the government decide what regulation it should use? First, it must identify the
problem in the financial market, and then remedy the problem through regulatory policy.
The first problem in the financial system that can cripple the entire economy
originated from reckless borrowing and lending. Borrowers that can get loan with an initial
low cost take out loans on a large scale, even though they cant afford to pay it off. It is
lenders responsibility to give loans only to those who can afford it. But that mechanism didnt
work in 2008, where subprime borrowers can get their hands on a loan to buy their dream
house and banks give them happily. Why is it so? It is because the invention of securitization,
bank gives loans, they slice and dice the loans then passing them to unsuspicious investor.
Even credit rating agencies whose job is to determine the risk level didnt quite understand
complicated securities and end up giving bad loans(like the synthetic CDOs in 2008) a triple
As ratings, the same ratings as government bond which is loans that essentially have zero
risk.
Reckless borrowing and lending arise from bank perverse incentives which are
allowed by regulatory policies. Bank have an incentive to make loan as much as possible
without calculating the risk then pass it into investor. Their incentive is to maximize profit
from the fee of creating loans. They create complicated loan that will be given triple As
rating from the rating agency so they can sell it to investor that have been regulated to only

hold triple As securities such as pension funds and money market funds. If the bank
incentive can be shifted so its in accordance to investor incentives, then reckless lending will
be averted.
The second problem in the financial system is that financial intermediaries are too big
and too interconnected, and their failure can brought down the entire financial system. It has
been proven by the financial crisis in 2008 in which the failure of Lehman Brothers, the
fourth biggest investment bank at the time, create a panic in the entire financial markets. As
such, government cant help but to bail out big financial intermediaries so it didnt bring the
financial system down with it. Such bailout can create a moral hazard in which financial
intermediaries can engage in a risky bet without being afraid of the consequences because
they guaranteed a bailout from taxpayers.
Such problem, commonly called too big to fail, emerge because the policy created by
regulators allowed such entity to exist. In fact, too big to fail entities exist because the
regulators encourage big financial intermediaries. Their argument to support it is the lower
cost advantage of too big to fail institutions. Their lower cost comes from the economics of
scale and economies of scope. Economies of scale dictate that enterprise that has bigger scale
of operation have lower average cost, while economies of scope state that bigger scope of
goods or service produced by an enterprise will have lower cost. While its maybe true that
big financial intermediaries offer lower cost for borrowing, they can achieve so while holding
a big risk for the financial system. A risk that eventually must be paid by taxpayers when they
fail, like what happened in 2008.
In the current state of financial policies, the existence of too big to fail entities thats
harmful to the entire financial system is still allowed and rather encouraged. The example is
the Riegle-Neal act that allowed banks, under certain circumstances, to acquire banks or set
up branches in other states without creating a separate subsidiary (Farlex financial
dictionary, 2009). Another example of regulation is the Gramm-Leach-Bliley act which
created a new category of financial holding companies that are authorized to engage in any
activities that are financial in nature, incidental to a financial activity, or complementary to a
financial activityincluding banking, insurance, and securities (Johnson and Kwak, 2010).
Such regulations cause big bank to be bigger and hinder small bank to compete because of
their higher cost.

While some of the problems in US have been answered by the Consumer Financial
Protection Act (CFPA), it still has various gaps in regulating the financial system. It still
doesnt answer the incentives and too big to fail problem. The CFPA only answer problems
like creating CFPB so investors and borrowers have better information about loans they give
or take from financial markets. Its true that better information available can minimize a
financial failure like what happened in 2008 but its not enough. Banks can still search for
another way in placing their risky bets as long as their incentives are not adjacent to the social
benefit as a whole.
The applications of macro-prudential and micro-prudential policy are important to
achieve financial stability. Macro and micro-prudential policy will fill the gap from
macroeconomic policies in ensuring the stability of financial system. Cap on Loan-to-Value
ratio and Debt-to-Income ratio for example, will impede excessive risk taking by lenders and
ensure that borrowers can make due their loans. Cap on leverage will limit the disturbance of
some financial intermediaries failures to the entire system. In short, macro and microprudential policy will minimize the risk that can harm the financial stability.
However, the source of problem from the financial crisis must be answered to ensure
economic stability. Too big to fail institution must be broken down so it wont be able to
harm the entire system. In doing so, it will solve the problem of moral hazard which make
banks take excessive risk. They will act responsibly because they didnt have the government
to receive their loss. Bank will act as intended, giving loans only to borrowers who can pay
their due. Broken down financial institution will also create higher competition, and with
strict regulation it will make the cost of borrowing lower without harming the financial
stability.
In conclusion, the financial system has market imperfections that impede them to
achieve economic prosperity. Reckless borrowing and lending and too big to fail problem
prevent the market from achieving financial stability. Government must carry out their role as
regulator to fix the market imperfections that exist in the financial system. The most
important policy reform to attain financial sustainability is to stop the existence of too big to
fail institution, as it can create moral hazard and while in trouble can bring the entire
economy in jeopardy. While this essay answer financial problem based solely on the US, the
lessons can be applied to every country if they want to achieve financial sustainability.

Bibliography
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