Lack of Regulation in Banking Industry

Topics: Bank, Subprime mortgage crisis, Banking Pages: 18 (4785 words) Published: October 9, 2010
What case can be made that it was the lack of regulation of the banking sector that led to the financial crisis of 2008-9? What are the new regulatory structures that are being proposed in the US and UK?

The preconditions of the 2008-9 crisis were high unemployment, high growth which was stimulated partially by foreign investment caused by imbalance of current accounts on the international arena (ie. Huge debt of US and the UK and surplus of China, Korea, Japan). Large part of the problem was caused by low inflation – in healthy economy house prices oscilate around the inflation rate. In this recession prices were raising faster than inflation. Finally, interest rates which were kept low after the dot com bubble (2004) in order to help the economy recover.

After the great depression in 30's Glass-Steagal Act (1932) has been imposed. It forbidden commercial banks from taking part in any risky activities. This tight regulation did not allow Banks holding public deposits to get involved in investment banking activities, speculation and insurance business with depositors funds.

In 1956 Bank Holding Act modified the original Glass-Steagal Act and increased the amount of allowed activities of the commercial bank. Those created holding companies, which owned two or more commercial banks and could, carry out activities “closely related to banking”. Fed was responsible for the list of those activities but they have never been allowed to get involved in Investment banking and Insurance.

Financial Services Modernization Act (1999) – allowed companies like Citigroup and Bank of America to become holders of subsidiaries involved in both investment and commercial banking. Under this act Goldman Sachs and Morgan Stanley began to operate Investment Banking. The risk in this act was that holding companies ran commercial banks that took a vital part of the economy as well as very risky hedge funds. The failure of those last ones would require a bailout from the government or otherwise the entire economy could face a systemic failure.

This deregulation started the creation of new bubble. Deregulated banks lending money to sub-prime – under the Community Reinvestment Act which encouraged financial institutions to grant loans to sub-prime market banks began to give loans to people with poorer credit rating. The mortgages initially were not just given up to the value of the property but in many cases the amount of loan was far greater than the value of the real estate behind that loan. These loans were and additional cash that could have been spent in any way not necessarily the way that would increased the value of the house (refurbishment or extention). People were spending that money on mostly imported goods fuelling the foreign investment even more.

House prices were going up stimulated by demand created by sub-prime buyers – self fulfilling prophecy and creation of the bubble. Banks by granting loans to another part of the market that previously could not afford the ownership, increased the demand for properties and its prices. Higher prices required even more lending. That created the euphoria on the market when investors believed they will have constant profits incorrectly anticipating that prices will grow indefinately.

That lead to financial abuses – granting loans despite low credit ability. Banks were lending money to anyone with assumption that even if borrowers default on their payments the value of house was going to rise and the property could be sold by the bank with profit. Lack of regulation and not effective implemenation of existing regulations allowed the involvement of banks in this sort of activity.

Credit rating agencies play an important role in rating debt created by the banks. They failed to correctly asses the securities with too optimistic approach. Holders of those securities did not actually know how risky their portfolio was. Securities and Exchange Comission (SEC)...
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