Financial Sectors Should Be Regulated

Introduction
The major function of financial institution is to move idle funds from savers, who have less
investment opportunities, to investors who can better utilize the money to generate revenue.
This mobilization of money is necessary for the growth of the economy, and overall makes it
efficient. However, everything comes at a cost. If the funds are transferred to the wrong party,
the smooth flow of money will be affected. This goes against the purpose of financial
institution. This will lead to a mistrust in the financial institution and eventually lead to it is
failure.
Financial regulations came about after some of the worst financial crisis that completely shook
the economy in several countries. This led to the formation of some rules that will protect both
the investors and the borrowers. Major crisis in history will explain that most regulatory
measures, whether good or bad, were imposed to protect people’s money. Therefore, financial
regulations are introduced to make financial markets stable and encourage smooth circulation
of capital to earn higher returns.
In this report, I will discuss the importance of regulation on financial markets by analyzing the
two major financial crises in history. The Great Depression and The Global financial crisis.
During both periods, countries around the globe entered recession and were in deep financial
stress. We will discuss the causes and how the changes in regulation played its part.

The Great Depression (1929-1946)

The U.S stock markets enjoyed incredible growth from 1921 to 1929. Equity prices kept
increasing until asset prices reached its peak and no investor could afford to buy the stocks.
Eventually, the New York Stock Exchange bubble burst took place and the suddenly the prices
of stocks crashed. This crash had a ripple effect and made its way towards Europe. The
unemployment rate increased from 3.2% in 1929 to 24.9% in 1933 in the United States. While
the crash was the major reason behind the crisis, some change of rules perpetuated it.
After 1921, The Federal Reserve increased the money supply and decreased the interest rates.
Money supply increased by $28 billion. This excess supply of money and low rates made the
US dollar “cheap”. People had money to invest and, therefore spent this excess cash on stocks
and real state. In no time, both markets took a plunge. After this fall, the Fed curtailed its money
supply by almost 33%. This policy led to liquidity crisis as many banks became short of cash.
In 1932, President Hoover increased Federal spending and created Reconstruction Finance
Corporation. This corporation was created to provide loans to failing banks and other
businesses. President Hoover did not want the wages to decrease. To maintain a minimum
wage, he refused to lower the prices of goods. But, how can people in this suffering economy
pay such high prices? Nonetheless, President Hoover signed The Smoot-Hawley Tariff Act in
1930 that raised duties on foreign goods by 50%. As a result, other countries also increased
import duties on American goods. Eventually, international trade decreased by 66%. As a
result, economy became more strained.
In 1933, the new elected President Roosevelt initiated “The New Deal”. This New Deal created
regulations focused on Banks and stock markets. “The Emergency Banking Act 1933” insured
people $2500 if banks fail to return their savings. “Glass-Steagall Act 1933” prohibited
commercial banks from engaging in investments in securities. This act separated investment
banks from commercial banks. “The Securities Act 1933” ensured that investors receive
enough information about the securities in the market and forbade fraud. All this re-instilled
some of people’s trust on financial sectors; however, the New Deal was not completely
successful in ending the crisis. It was after WWII that international trade was reestablished,
and soon, the world came out of crisis.

Regulations and its importance.

The Great Depression gave rise to new laws and regulations to regain public’s trust on financial
institutions. Some regulations were revoked; however, other regulations, like “The Securities
Exchange Act 1934” are still practiced.
“The Securities Exchange Act 1934” was followed by the “The Securities Act 1933”. This act
created the Securities and Exchange Commission, that now exercises its authority on all
securities industry. This act enables the SEC to regulate brokerage firms, clearing agencies and
self-regulatory organizations like, NASDAQ stock market. It also maintains discipline with a
proper code of conduct in the market and demands continuous reporting of publicly traded
securities.
Financial Industry Regulatory Authority was also an outcome of Securities and Exchange Act
of 1934. It oversees firms that trade securities with the public. Moreover, it trains financial
services professionals, give licenses and resolves disputes between customers and brokers
through arbitration.
The Glass-Steagall Act of 1933 created the Federal Deposit Insurance Corporation. The main
goals of FDIC were to reestablish public’s trust in financial institutions and prevent bank
panics. To do this, it insures savings, checking and deposit accounts to up to $250,000. It also
supervises 5250 banks.

The SEC has developed confidence in the US stock markets by several methods. Because of
transparency on traded securities and company’s performance, the investors could estimate a
fair value of a stock. All bonds and stocks sold are registered with the SEC, which ensures that
they met a certain criterion. Moreover, they prohibit insider trading and if it is discovered, will
act against it. Because of these reasons, The New York Stock Exchange is the most efficient
and reliable stock market. It also attracts more companies to become public and enjoy a better
and faster growth. It makes investing easier by offering transparency as well as basic training
on how the financial markets function.

The Glass-Steagall act 1933 took measures to protect public savings. The commercial banks
used customers’ savings and deposits and invested in the stock market. Therefore, when the
stock market crashed, so did the financial institutions as they did not have funds to return the
deposits. Consequently, a bank run took place and most depositors took out their leftover
money from banks. This resulted in too many banks going bankrupt. The Glass Seagal act 1933
separated investment banks from commercial banks. It allowed commercial banks to drive only
10% percent of their revenue through trading securities. Investment bank could however deal
in securities but, their source of funds should not be deposits and savings.
This act also gave power to Federal Reserve to regulate commercial banks and implement
better monetary policy. Furthermore, the FDIC prevents bank panics so that banks remain
functioning. If a bank fails, it sells it to another bank and transfers the depositors to that bank.

Global Financial Crisis (2007-2008)

Th Global Financial crisis was another period of financial stress that has an impact on the
financial sectors today. After the Glass-Steagall act was lifted from banks in 1999, the
commercial banks again started to invest people’s deposit in derivatives. Also, the Commodity
Futures Modernization Act removed regulations from trading of derivatives and Credit default
swaps because both were quite popular. Banks started to trade in these complex derivatives and
soon became “too big to fail”. That is, if they are to fail, they will have a large impact on the
global economy.
Moreover, banks started to sell derivatives like Mortgage Backed Securities, securities that are
backed by mortgages, and Collateralized Debt Obligations, repackaged individual loans, to
hedge funds. The hedge funds sold to the investors. Investors were willing to take such risks
because they thought they were secured by Credit Default Swaps. These swaps guaranteed
them repayment if a bond defaulted. These derivatives were quite profitable and so to sell more
of them, the bank started to lend to people who had no jobs, no income and bad credit history.
Furthermore, the Securities and Exchange Commission allowed five major investment banks
to lever up to 30 percent of their investment. This offered them more liquidity and opened doors
for further lending to risky customers and selling of risky derivatives.

After the 2001 recession, the Fed decreased the interest rate from 6.5% to 1.75% and it became
as low as 1% in 2003. This decreased in interest rate encouraged subprime borrowers to borrow
loans to buy new homes. As the demands for houses kept increasing, so did the prices. Investors
started to buy houses to sell it later for higher price and earn profits. This peak in house prices
was creating an asset bubble.

The loans to the subprime borrowers were given on an adjustable mortgage rate. This allowed
the borrower to pay at a lower interest rate in the first few years. Later, the rate increased. The
Fed started to increase the interest rates until it reached 5.25% in June 2006. At the same time,
house prices reached its peak and the housing bubble burst took place and the prices declined.

With low house prices and high interest rate, people started defaulting on their loans. Therefore,
more than 25 subprime lenders were bankrupt including the popular New Century Financial
Services. Again, a ripple effect ensued, and the problem spread throughout the world.
Eventually, the government pitched in and Central Banks of all countries started to resolve the
liquidity problems for banks. Furthermore, in 2008, the Fed reduced the federal fund rates to
1%. On top of that, the governments introduced various bail out packages including the
National Economy stabilization Act 2008 that enabled secretary of treasury to purchase up to
$700 billion worth of mortgage backed securities and other assets.

Regulation and its Importance.

The primary reason behind the Global Financial Crisis was deregulation. Banks appealed for a
revocation of the Glass-Steagall Act 1933 so that they can compete with foreign financial
institutions. Thy assured that they will not invest in high risk securities. However, they started
to invest in risky derivatives like mortgage backed securities and collateralized debt
obligations.

On the other hand, we had individuals who had a dream of owning a house. After the Fed
decreased the interest rates, these individuals got an opportunity to finally live their dream.
Competition amongst banks was increasing and they started to lend more and more to subprime
borrowers to maximize profits. Because of strong US economy and rising house prices, banks
did not consider mortgage backed securities to be very risky. Furthermore, fraud was prevalent.
Borrower’s income was inflated, and fake assurance was given to investors about the safety of
the mortgage backed securities.

Moreover, the Securities and Exchange Commission lowered the capital requirement for five
investment banks named, Lehman Brothers Goldman Sachs, Merrill Lynch, Bear Sterns and
Morgan Stanley. This increased their financial leverage to 30 times. Therefore, excessive,
interbank borrowing started to take place.

In addition, hedge funds had a major contribution in the financial crisis. They are largely
unregulated. This lack of regulation allows hedge fund managers to invest imprudently in risky
derivatives. It also becomes difficult to evaluate what securities are traded in hedge funds. In
the 2008 financial crisis, they bought a lot of mortgage backed securities. Since they were
protected by credit default swaps issued by the American International Group, they did not
worry much about borrowers defaulting on loans. But, the default happened on such a large
scale that the insurance company became unable to pay back. Bank stopped lending and it
became difficult to receive credit.

Many banks also had hedge funds sub-sections like, The Lehman brothers and Bear Sterns.
Both banks invested in low-mortgage loans and utilized a huge amount of leverage. After
borrowers started to default so did both the entities. The government did not bail out The
Lehman Brothers. Because of this, they could not pay back to their lenders and that caused its
stock price to fall.

Furthermore, the Commodity and Futures Modernization Act 2000, separated a commodity
from a security. It decreased regulations on trading of derivatives. The act promoted the
speculative use of the over the counter derivatives.

The G-20 asked United States to increase regulations of hedge funds. However, United Nations
refused saying, these restrictions will make US companies less competitive than other
companies around the globe. However, in 2010 the Dodd-Frank Wall Street Reform Act was
established. It is a consumer protection act that regulates the financial markets. Under this Act,
banks are required to increase their capital to sustain against losses. It also prevents company
from becoming too important for the global economy.

The functions of the Dodd Frank Wall Street Act are as follows,
 1) Oversee financial firms and hedge funds. The Federal Reserve asks firms to increase
their capital requirements to stop them from becoming too big. This prevents
institutions from liquidating their investments.
2) Prohibit banks from owning hedge funds and use their depositor’s money to invest in
it. They can only use hedge funds if their depositors allow them.
3) Regulate the transaction of risky derivatives. To ensure that these derivatives are
transacted in public, the setting up of a clearing house is encouraged.
4) To assess the types and risks of underlying assets of derivatives, it is mandatory for
hedge funds to register with the Securities and Exchange Commission. This way the
SEC can evaluate the overall market risk of these assets and regulate them better.
5) Many credit rating agencies gave false ratings to derivates. Because of this, investors
could not estimate that some debts would default. The Act will oversee these agencies
and make sure no faulty agency should remain registered with the SEC.
6) It regulates credit cards and debit cards, credit fees and consumer loans. It requires
banks to confirm a consumer’s source of income and credit history.
7) To prevent another American International group from emerging, the act requires
regulations of insurance companies.
8) It gave Government Accountability Office authority. The GOA audited the loans made
by Federal Reserve during the crisis and can oversee new emergency loans. The
Treasury will approve any new emergency loans.

Limitations of Financial Regulations.

While regulation ensures safety of public’s savings and resolves principal agent problems, it
can also hinders a free market trading. A free market economy is an economy free of
government intervention. Proponents of this type of economy argue that it gives buyers more
political freedom, encourages competition and lowers the prices of goods. There are some
regulatory failures that support their view. For instance, after the Sarbanes Oxley Act 2002,
companies started to list their initial public offerings outside the United States where this act
was not imposed; for example, in the London Stock Exchange.

Richard W. Rhan in his article, “Financial Regulatory Limitations”, on www.cato.org, blames

the Federal Reserve for creating more monetary instability. He argues, before the Fed was
created in 1913, the value of dollar at the time was almost the same as it was in 1793. However,
the value of dollar now is one-twentieth of its value in 1913. He also asserts that major bank
failures started to occur after the Great Depression, because Fed started to interfere in the
financial system.

According to the article, “Financial regulation: Rein in the banks, or let the market work?”, on
www.marktwatch.com, government interference opens room for more undesirable
consequences because of their lack of knowledge about the financial markets. For example,
the government encouraged the idea of homeownership, which became the reason behind house
bubble burst in 2007. Furthermore, the Volcker’s Rule has deprived banks’ from seeking more
opportunities to make profits and hinders easy buying or selling in financial markets.
In addition, the regulation on swaps have moved its market oversees, away from the United
States. Also, regulations stop financial sectors from employing new technology and digital
tactics that can assist them in providing better services. Advocates of lesser rules also oppose
the Consumer Protection Financial Bureau, that oversees consumer-finance markets and
protects consumers from abusive financial institution like banks, so that lending and borrowing
becomes easier.

Current Scenario and Future outlook.

Trumps administration is set out to deregulate the financial sectors. The government is making
several changes in the Dodd Frank Reform Act that was created to maintain financial stability
after the 2008 crisis.

The United states government now wants the Fed to stop administering large firms. It wants
the Financial Stability Oversight Council from labelling companies like AIG as “too big to
fail”. They want banks to equally compete with the global market. Moreover, they want to
eliminate the Volcker’s Rule and allow banks to use people’s deposits for risky investment.
Consumer Protection Financial Bureau can no longer investigate the financial institutions.

Furthermore, a bank’s stress test was required every year to check if they have the capital to
function in a crisis. The new administration has extended the period to every two years. Banks
also practiced “redlining” of neighborhoods and did not loan to any household that belonged
to that neighborhood. However, after the Community Reinvestment Act, the law is to loan to
any household based on income and not on the financial condition of the overall a
neighborhood.

In the article, “Next Crash Will Be Worse than ‘Great Depression’: experts”, from the
www.nypost.com, John Aiden Byrne, presents facts on how the failure of US economy will be
caused by high levels of debt. The national debt has doubled to $21 trillion. There is also a rise
in other loans. The household debt in the US is now $13.3 trillion; out of which $9trillion is
from the mortgage loans. Student loans are 1.5 trillion; in 2008 they amounted to $611 billion.
Auto loans are almost $1.25 trillion. Finally, the Global Debt has reached $247 trillion; which
is 2.5 times the global economy.

On top of this, the relaxation of rules by the Trump administration will further promote the
debt levels to rise. They are repeating the same mistakes made before the Global Financial
Crisis. In May 2018, the Congress approved the bank to now hold $250 billion in assets instead
of $500 billion. This low capital requirement induced Lehman Brothers to go bankrupt.
Another bill was passed in July 2018, in which insurance companies are exempt from
assessments that evaluate if a firm can withstand a financial crisis. This can give rise to another
AIG which became entangled with the securities trading.

Furthermore, The Consumer Financial Protection Bureau protects consumer from banks that
can exploit them. It provides $700 million to consumers inflicted by illegal practices by credit
card services. It also imposed the rule of “Know Before You Owe” forms that are easier to use
and provides clear information about the mortgage loan process. The Bureau also finds out
entities that trick consumers into taking loans and takes measures against them. However, now
with lower authority, the banks and other lenders will again seek out preys for their loans and
deprive consumer of all that protection. All this deregulation may set us up for another financial
crises.

In conclusion, with an analysis of the two recent and major crises, The Great Depression and
The Global Financial crisis, we can determine that deregulation can create havoc. Lenders set
no limits on how much they can borrow and how much they can lend. Reckless investments in
the stock exchange becomes prevalent. Increased competition between banks and other
financial institutions give rise to complex financial products like mortgage-backed securities.,
Credit default swaps and collateralized debt obligations. It also encourages banks to lend more
to NINJAs, individuals with no income, no job and no asset. And, the assets backing the
securities become vulnerable to the price changes. Hedge funds and other over the counter
markets become popular. Imprudent use of depositor’s money starts to take place. Eventually
a tower of debt is constructed. In no time, one borrower defaults and the tower finally crashes.
Large companies go bankrupt; millions of people lose their jobs and huge amounts of savings
are lost. Therefore, effective regulations and proper implementation of those regulations can
only protect us from going into another recession.

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