Re-regulation of the financial system

Financial liberalization and deregulation was based on a widespread belief in the greater efficiency of market forces. This led to the creation of increasingly sophisticated financial instruments. Deregulation was in part a response to pressure from the financial sector, but it was also part of a generalized trend towards less government intervention in the economy. New financial instruments and continued liberalization in the financial system allowed speculative activities to expand significantly, so that gambling became an important feature of financial activities. This became a source of instability in many economies, threatening the entire international economic system. By contrast, it is difficult to find any new financial instruments that have improved the efficiency of financial intermediation for the benefit of long-term investment in real productive capacity.

 

Financial markets do not function in the same way as typical markets for goods and services. While most entrepreneurs participating in goods markets are concerned with the creation of new real assets that have the potential to improve productivity and increase all incomes in the future, many financial market participants are primarily concerned with the effective use of information advantages concerning existing assets. In goods markets, price discovery is based on information from a multitude of independent agents who act according to their own individual preferences, and opportunities for profit arise from individual pioneering actions based on the private, circumstantial information of the market participants. By contrast, in financial markets, especially those for assets which fall in the same broad risk category (such as equities, emerging-market currencies, and more recently, commodities and their derivatives), price discovery is often based on information related to a few, commonly observable events, or even on mathematical models that mainly use past information for making price forecasts.

 

The fatal flaw in the functioning of financial markets lies in the fact that the most profitable activities are often derived from herd behaviour (i.e. following the trend for some time and disinvesting just before the rest of the crowd does). Acting against the majority, even if justified by accurate information about fundamentals, may result in large losses. Thus prices in financial markets sometimes overshoot, sending the wrong price signals for extended periods of time. As herding dominates the scene, no single participant questions whether the underlying information is correct or can be rationally related to events and developments in the real economy. This phenomenon has been observed not only in securities and financial derivatives markets, but also in currency and commodity futures markets.

 

The deregulation of financial markets has also allowed an increased concentration of banking activities in a small number of very big institutions, as well as a shift in bank funding, from a reliance on deposits to a greater reliance on capital markets, and from lending to trading. Moreover, it has paved the way for the development of a largely unregulated shadow financial system, particularly in developed economies. By early 2008, the liabilities of this shadow financial system were almost twice those of the traditional banking sector. In addition, banks outsourced a large segment of their credit intermediation functions to associated companies in the shadow system. Some parts of this system (e.g. money market funds) played the same role as that of banks, but with virtually no regulation, while the volume of activities of such groups has always been backed by too little capital.

 

Much of the systemic risk in the financial system has derived from the systemically important financial institutions. Proposals to address this too-big-to-fail problem have concentrated so far on additional capital requirements and improved supervision rather than on restructuring. A more comprehensive approach should also include a special resolution procedure in case of crises, which should not place the burden on government resources, and the introduction of size caps. Further, much of the impetus for financial re-regulation has stalled in developed countries, and the renewed risks of a financial crisis associated with the ongoing European crisis, suggest that a new global financial crisis cannot be completely discarded.

 

In the absence of a global solution for financial market volatility, developing countries should promote alternative sources of finance and develop instruments to reduce the effects of external shocks. Capital controls, the accumulation of foreign reserves and the development of a more diversified banking sector with a bigger role for public, development and community banks might be prudent measures to deal with an unreformed global financial sector.