Government intervention is when a government regulates the activities of a certain sector. The rationale for governments to do this in financial markets, may be due to the fear of, or in reaction to, market failure such as the financial crisis (2007), which generally stems from externalities, asymmetric information, moral hazard and the principal-agent issues.
A financial institution (FI), a “company engaged in the business of dealing with monetary transactions” (Investopedia, 2017) links users (deficit units) and lenders (surplus units), which means if there is a problem with intermediation between the two then it affects both units as well as the FI and therefore the whole market which only occurs in the financial sector creating an externalities problem.
In the financial crisis of 2007, subprime loans were given to people with no income and no job [NINJ]. These extremely risky loans were sold with other less risky loans in CDO (collateral debt obligations) and MBS (mortgage based securities) as asset based securities (ABS) for investors. Investors were extremely interested in these due to increasing house prices. However, FI’s couldn’t pay investors (surplus units) due to defaulted loans (deficit units). Financial institutions failed causing the problem of externalities. The consequences of this included a $700bn bailout package from the US federal government (Mother Jones, 2017) which was a similar response of many other governments around the world as well as “2.25 million home foreclosures in 2010”. (Investopedia , 2017). An negative impact on the whole financial market, due to externalities, is a big rationale for government intervention in financial markets.
The principal – agent problem is when directors/managers are agents for shareholders. The directors are paid with performance related pay and so may work to gain an increased pay while reducing dividends of shareholders creating a conflict of interest. In the financial crisis rating agencies were hired by FI’s to give credit ratings on ABS. A low rating, meant that FI’s would receive increased costs, so rating agencies gave higher ratings for ABS’ than what they were worth with risky assets. This inaccuracy kept customers for rating agencies but meant ABS’s failed leading to market failure (Investopedia, 2017). If true ratings were given, ABS’s wouldn’t have been sold which may have had a reduced effect of the financial crisis. This shows the principal-agent problem is good rationale for government intervention in financial markets.
Within a company, directors and managers will have information on the company which other people (including their investors) cannot get a hold of for example, their next move or investment. This can lead to insider dealing where the directors or managers will use, sell or even hide the information, for personal benefit. This is a problem of asymmetric information. The impact of illegal insider trading is bad for investors, financial markets and economy. This is due to the fact it ensures no fair play is involved and no fair demand and supply of stocks (Rediff, 2009). However, there are insider trading laws stopping this from becoming a reality. Nevertheless, asymmetric information can affect the economy, even if it wouldn’t directly lead to market failure and can be a rationale for government intervention in financial markets, which is already the case as there is government intervention in the form of insider trading laws.
Moral hazard is when insurance is provided against an event and it becomes more likely to occur due to increased risks being taken as individuals know they are insured and become careless. FI’s experience moral hazard when they take higher risks knowing that the government may bail them out or help with any major losses that will affect the whole financial system. In the financial crisis (2007) Freddie and Frannie Mac, (federal mortgage and home loan associations), were bailed out when they began to fail which if they did would’ve affected the whole financial system. (Ramlall, 2013). The government bailout wouldn’t be necessary if they didn’t take unnecessary risks with loans which occurred due to moral hazard. Moral hazard, in financial markets occurs in even the biggest institutions which can create a huge impact on the economy and is therefore rationale for government intervention in the case of market failure.
All four of these problems can cause market failure and are rationale for government intervention. In my opinion externalities, and the principal agent problem are the main rationales as they relate to how the financial system operates. There is already some form of intervention for moral hazard and asymmetric information which are therefore not a huge concern.
These four factors are rationale for government intervention. However, when a lack of or improper government regulation leads to market failure such as the credit crunch of 2008 regulatory reform is necessary. Although in this case regulatory reform faced some key issues.
As well as having affected the USA and the UK, many other countries around the world were affected and in need of reform. For example, Australia had to provide a (AUD)$8bn to help non-bank lenders as well as stock markets crashing globally due to people panicking in the crisis. This meant many countries had created their own ways of regulatory reform to help their own countries’ economies, such as the Dodd Frank act in the USA and EMIR and AIFMD in the UK/EU. However, governments need to work together on how their separate reforms will fit together in the ‘global regulatory architecture’ so that all countries can work together to stop the credit crunch from occurring again (Shearman & Sterling LLP, 2016). This is a key issue, because if every country isn’t on the same page in terms of regulation it could lead to another financial crisis.
Another key issue, is the role of rating agencies in the credit crunch. This is because, even though the rating agencies were regulated by the SEC (securities and exchange commission), they still contributed to the credit crunch by finding a way around regulation. They did this by rating lower risk traunches well and didn’t rate riskier assets. As the two were packaged together, useless ABS’ were given good ratings. This was so that rating agencies could get away with giving good ratings for bad securities and the SEC didn’t realize, but it also meant they had customer loyalty which they prioritized due to strong competition between the three key agencies (Moody’s, Fitch and S&P) (Pilbeam, 2010). Therefore, a key issue in regulatory reform for this sector in financial markets is to stop competition and therefore stopping rating agencies from evading regulations which was amended when the consumer protection act of 2010 gave the SEC more regulatory powers (Investopedia, 2017).
Another key issue for regulatory reform is the complexity of both the regulatory framework and the actual financial market. In the regulatory framework, many institutions were not certain on who the regulatory body is. For example, in the UK at the time, the regulatory framework included the Bank of England, Financial services Authority (FSA) and the treasury. So when northern rock was to be dealt with, the treasury had stepped in where it should have been the FSA (Pilbeam, 2010). Also with ABS’ the whole system of financial intermediation became too complex as many people were not able to easily analyze what was going on and therefore couldn’t stop the credit crunch from happening. Therefore, an issue with regulatory reform is reducing this complexity of financial intermediation making it easier to solve issues efficiently as well as stopping securities such as ABS’ to get too complex.
In addition, a consequence of the credit crunch was that globally governments bailed out many FI’s. Due to this, a moral hazard problem formed where FI’s could continue with predatory lending as they did before the credit crunch. This creates a moral hazard problem as FI’s will take higher risks since they know they may be insured if the risk fails as the government may bail out the institution and is costly to all parties due to the externalities problem. Also, when predatory lending occurs it creates a liquidity issue as it did in the financial crisis as it’s hard to reflect the degree of risk in liquidity. This creates an issue for regulatory reform to put in regulations and credible threats to stop FI’s from continuing with risks that create problems of externalities, moral hazard and liquidity issues, which can be difficult because if a major FI does continue, the government is forced to bail the FI out so that the whole countries economy and financial markets don’t fail as was the case with Freddie and Frannie mac.
In conclusion, there are many issues for regulatory reform in the light of the credit crunch in 2008, all of which are just as important as each other. However, even if these problems are resolved, we will only know if the regulatory reform has worked if the same issue arises again, which could show it worked or we may face the consequences of the 2008 credit crunch all over again.
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