The Role of Regulation of Financial Institutions in 2007 – 2009 Global Financial Turmoil

The Role of Regulation of Financial Institutions in 2007 – 2009 Global Financial Turmoil

The 2007 – 2009 global financial crisis caused tremendous impact on the world’s economy and affected millions of investors. The crisis was peaked with the bust of housing bubble and bankruptcy of Lehman Brothers in the United States, causing global recession and loss of confidence by investors (Kim, Koo & Park, 2013). The regulatory agencies failed to take on effective regulations to control risky investment practices by financial institutions before the financial crisis. In response to the crisis, some new regulations were passed by supervisory institutions to strength the regulatory framework on financial institutions. The first part of the essay serves to discuss the problems of regulations taken on before the crisis, which probably led to the recent global financial crisis. After that, roles of regulations raised during the crisis in eliminating problems of the regulatory framework would be discussed.

The elimination of restrictions on financial institutions could be one of the causes of the financial crisis. The 1999 Financial Services Modernization Act allows various financial institutions including banks and investment firms to enter each other’s business activities. It also encouraged the merge and acquisition between financial institutions, creating more large and complex financial institutions. Since the failure of super-size financial institutions could cause significant negative impacts on the society, governments are highly likely to take on protection actions to stop large institutions from failure. Managers of large financial institutions are more likely to take on risky investment activities, increasing the long-term systemic risk. The Act also repealed barriers between investment and commercial banks in the United States. The combination of those institutions could reduce cost of capital by extending protection given to commercial banks (Butler, 2009). However, the combination increased the insolvency risk for financial institutions.

The lack of regulations on risky lending practices and innovative financial products also led to the financial crisis. Unlike depository banks, non-bank financial institutions including investment banks and hedge funds were not subject to strict regulations, so those institutions got involved in risky investment practices and built up excessive leverage. According to Graph 1, the leverage multiples of investment banks in the United States witnessed a rapid growth from 2004 to 2007, which could have exacerbated the financial crisis. Regulatory institutions also failed to keep up with the development of innovative financial products such as collateralized debt obligations and mortgage-backed securities. Those products are neither standardized nor transparent, which could lead to credit boom and asset bubble (Kim, Koo & Park, 2013).

The problematic capital adequacy requirements could be another cause of the financial crisis. Basel II was fully implemented in 2006, aiming at promoting banks’ capitalization, improving banks’ risk management and strengthening stability of financial institutions. However, the minimum capital requirement under Basel II is not enough for financial institutions to absorb losses during the crisis. The pro-cyclical capital adequacy formula could accelerate the depression (Saunders & Cornett, 2014). During blooming economic times, the capital requirement for banks would be lower, inducing banks to make more loans. During the recession, the capital requirements would increase as the credit rating for assets deteriorate. However, it is hard for banks to raise required capital during financial crisis, making the economic recovery more difficult.

In response to the financial crisis, new regulations were taken on to strength the supervision on financial institutions, assisting the recovery process from the crisis. The U.S. Congress passed the 2010 Wall Street Reform and Consumer Act to prevent similar crisis from happening in the future. Basel Committee identified the weaknesses in its current regulation and passed Basel 2.5 and Basel III to update the capital adequacy requirement (Saunders & Cornett, 2014). Many international regulatory reforms were issued to solve the crisis by international cooperation. Those regulations played an important role in raising investors’ confidences in financial institutions and enhancing stability of the financial system.