You are on page 1of 27

POST CRISIS SECURITIES REGULATION

AND MARKET DISCIPLINE

Kashif Ghani1

Abstract
This paper describes how our ideals of financial regulation failed to prevent yet another financial

crisis. It lays emphasis on the lessons we have learnt from the Global Financial Crisis (GFC)
and the realization that our new measures aimed at preventing a crisis might fail to prevent the
next crisis. It has been argued that market discipline and regulation must be balanced in a
manner that they complement each other in order to achieve the objectives of regulation. The
paper discusses the changes required to be made in the financial regulations framework that
may help reduce the likelihood and impact of future crises, the degree to which market discipline
and disclosure regime can be relied upon to achieve the objectives of regulation and the type of
crises that are likely to challenge the stability of our financial systems in future.
JEL Classification: G01, G18, G28,
Key words: Global Financial Crisis, Financial Regulation, Securities Regulation, Market
Discipline, Financial Stability, Disclosure

Kashif Ghani is Deputy Director at Securities & Exchange Commission of Pakistan (SECP). The views
expressed in this paper are the views of the author and do not represent the position of the authors
employer. Email: kashifgm105@hotmail.com

1. INTRODUCTION

The Great Recession now ranks as the most serious financial crisis we have
seen since the great depression. It has shaken publics confidence in the
financial systems considered extremely robust only a couple of years back.
The crisis brought the world financial system almost to the brink of collapse.
Financial markets were only able to continue performing their functions as a
result of expensive rescue of public sector banks.
IMFs Global Financial Stability Report (2011) point out that despite some
signs of improvement in economic growth, the global financial stability is yet
to be achieved. According to IMF, although the financial markets have shown
signs of stability, risks and challenges still remain that need to be addressed. In
advanced economies, governments continue to be indebted and the financial
institutions are struggling to recover from shocks.

Indeed the Great Recession has reminded us of many forgotten lessons. The
most important being the need to rethink our financial regulations framework.
One thing that the crisis has not changed is the basic objectives of regulation.
Even after the crisis, the objectives of securities regulation remain unchanged.
Regulators still need to focus on maintenance of investor confidence,
promoting fair and transparent markets and minimizing risks threatening the
stability of the financial system. However, much rethinking is required for
determining which tools and techniques must be employed in order to achieve
the objectives of securities regulation.
For the purposes of this paper, securities regulation is meant to include the
regulation of equities, bonds, collective investment schemes, derivatives and
other similar financial products.

Existing Literature
A large amount of literature exists on the causes of financial crises, the role of
market discipline and disclosure; on how regulation should respond to the

2|Page

financial crisis and how the financial crises have changed the way regulators
must design and implement rules and standards.

An important study in this context is one by Zingales (2009) who advocates a


series of reforms directed toward improving corporate governance, putting
renewed emphasis on protecting unsophisticated investors and development of
set of rules aimed at minimizing the regulatory gap between private and public
equity markets. This study is unique as it gives an historical account of how
securities regulation has evolved over time and how present day regulators
may benefit from regulatory success stories of the past.

Another significant contribution was made by Poser (2009) in his study that
highlights how regulators lost sight of their basic objectives of regulation and
failed to respond to the changing market dynamics in the period leading up to
the financial crisis. Specifically, it gives a history of SEC USA, its evolving
focus over time, the debacles that are termed SECs failures and the reasons
why SEC failed to prevent two major crises in 2008. Poser (2009) argues that
the regulators were unable to prevent these crises primarily due to their
obsession with market deregulatory philosophy. He proposes that SEC USA
needs to restore its activism of the 1930s and 1960s along with keeping itself
familiar with new financial instruments and entities through in depth studies of
particular segments, activities and players in the market.

A recent study by Erskine (2010) focuses on the changes required in the


regulatory mindset and the financial regulation framework in the post crisis
period. Erskine (2010) provides a detailed review of policies and principles
that were conventional wisdom before the crisis and that eventually turned
out to be contributors to the crisis. This study also proposes a shift from a
deregulatory mindset and stresses the need for avoiding over-relying on
financial markets to self-stabilize. The author further argues that the need of
the hour is the adoption of a wider view that takes account of systemic risks to
financial stability.

3|Page

A very important study with reference to the crisis in banking is the FSAs
report called The Turner Review (2009), which covers in great detail the
causes of global banking crisis and how bank regulators should respond to the
changing scenario after the lessons learnt from the crisis. It proposes a large
set of reforms aimed at averting a future crisis in banking, including
improvements to the capital adequacy framework, institutional and
geographical coverage of regulations, changes to the regulation of gatekeepers
(e.g. credit rating agencies) and changes in the regulators supervisory
approach, among other things. There are a number of other studies on various
areas of securities regulations, market discipline and the impact financial crisis
is likely to have on financial regulation.

This paper attempts to add to the existing literature on financial regulation in


the post-crisis-era by focusing on how our ideals of financial regulation failed
to prevent a crisis. What lessons we have learnt from the Global Financial
Crisis (GFC), the changes in regulatory framework that may reduce the
likelihood - and more importantly, the impact of future crises and the
realization that our new measures aimed at preventing a crisis might also fail
to prevent the next crisis. An effort has been made to emphasize that financial
regulation and market discipline should be thought of as complementing each
other, rather than being substitutes. Hence, this work stresses the need to strike
the right balance between regulation and the measures to promote market
discipline. The limitations and benefits of market discipline as a regulatory
tool are touched upon. The major focus is on the changes required to be made
in the financial regulations framework, the degree to which market discipline
and disclosure regime may be relied upon to achieve the objectives of
regulation and what type of crises are likely to challenge the stability of our
financial systems in future.

The remaining part of this paper is structured as follows: Section 2 discusses


the lessons learnt from the financial crises and how they have changed our
thinking about the ways markets should be regulated. Section 3 highlights the
uses and limitations of market discipline and disclosure as an aid to financial
regulation. Section 4 describes the shifting focus of financial regulations to
4|Page

meet the needs of the post crisis scenario. Section 5 gives a brief description of
the types of crises we are likely to face in the future despite our best efforts.
Section 6 concludes the discussion.

2. LESSONS WE HAVE LEARNED (OR NOT LEARNED)

What went wrong?


Financial crises are centuries old phenomena and the first crises are traced
back to the beginning of capitalism (Bordo, 2007). Various explanations have
been presented as to the causes of the present crisis; including overrating the
value of market deregulatory and self-stabilizing approach, over-reliance on
disclosure for achieving market efficiency, the failure to assess systemic risk
etc (Erskine 2010). It must be understood here that the great recession was
primarily caused by a credit shock that eventually resulted in a banking crisis
and recession. However, securities markets being part of the interconnected
financial system could not be insulated from the effects of the crisis. The
ultimate outcome was increasing defaults on corporate bonds and decline in
equity prices. The securities markets also played their part in the present crisis
as Credit Default Obligations (CDOs) and Credit Default Swaps (CDSs) (a
type of derivative product) are considered to have made a significant
contribution to the present crisis. It may be noted that derivatives are generally
supposed to be regulated by securities regulators, though CDOs and CDSs
were largely unregulated.

Many attempts have been made to analyze the factors and circumstances
leading up to the GFC. One theory suggests that macro imbalances played a
significant role in the factors leading to the GFC as the oil exporting countries
and Asian giants like China and Japan had huge current account surpluses in
the period leading up to the GFC and countries like UK and USA had large
current account deficits (The Turner Review, 2009). Very high saving rates
existed in countries having current account surpluses while some developed
countries like UK and USA had very low real risk free rate of interest. This
meant that in USA and UK the investment avenues promising higher expected
rates of return became very attractive for the investors. This led to an increase
5|Page

in demand for innovative products offering higher yields and as a result


emerged a large number of structured products that offered the investors
varying levels of risk, return and liquidity options compared with traditional
fixed return instruments. The development of a large number of structured
products that were largely unregulated; combined with growing size of the
financial sector, increasing leverage, increasing interconnectedness of
financial intermediaries and inability of these structured products to insure
against the risk of default, eventually led to the emergence of current financial
crisis on a global scale.

Similar views have been expressed by others such as Martin (2009) who
observes that securitization of subprime mortgages, the decline in real estate
prices, the complexity of the products that were being introduced (with
accompanying lack of information) and mark-to-market accounting issues
contributed significantly to the credit crisis.

Lessons we learnt from the crisis


In the pre-crisis period markets were considered to be self-equilibrating and
rational and it was believed that economic efficiency and stability could be
ensured by market completion (Turner, 2010). Innovation in finance and
increase in trading activity were to be always welcome as these were
considered pro-growth.
Various reasons for failure of national regulators have been elaborated. For
instance, staff conflict of interests, lack of training, budgetary constraints and
fragmented regulatory system have been cited as the reasons for the failure of
SEC USA to prevent major debacles. But the most important factor that stands
out is the anti-regulatory climate (Poser, 2009). It was widely believed that a
pro-market, deregulatory mindset had led to fluctuations in growth and
inflation being moderate. The existence of relative financial stability was seen
as evidence that the deregulatory approach was indeed working effectively
(Erskine, 2010). It is said that SEC in USA had moved, in the pre-crisis
period, from an investor protection approach to protecting the companies and
investment firms that it regulated. Regulation was thought to be hampering
6|Page

growth of financial markets and considered costlier than the benefit it


provided (Poser, 2009).

Lack of trained and experienced staff of the regulatory organizations is


another reason cited for spread of crisis situation. Regulatory staff often lacks
the required incentives to pursue in depth investigations. The relations with
market players (some of them are seen as potential future employers) are also
at stake providing further disincentive to the staff working with the apex
watchdog. Frequent hopping of jobs between the regulator and the institutions
being regulated also works against effective regulation of these entities due to
the so called revolving door problem. Shortage of training for staff members
of the regulatory agencies and higher remuneration in the private sector also
hinder the regulators ability to develop and retain valuable human resources.

3. MARKET DISCIPLINE, FINANCIAL STABILITY AND


DISCLOSURE

Market discipline is the mechanism (constituting information, incentives and


controls) to monitor and discipline excessive risk taking behavior of market
participants. Market discipline is considered complementary to, rather than a
substitute of, supervision and regulation in present times. Information
asymmetries between regulator and the financial institutions, combined with
the problem of political considerations or weak legal systems augments the
need for market discipline as an aid to regulation. Other factors enhancing the
need for market discipline include increasing complexity, innovation and
globalization of financial institutions. Regulations, among other things, should
be aimed at enhancing the power of markets to discipline themselves.

Financial stability may be achieved through the formulation of sound policies


and institutions in order to prevent, manage and resolve financial crises. It
must be understood that we cannot eliminate the possibility of crises; we must
accept there would be failures but failures should not lead to a systemic
collapse.

7|Page

It is widely believed now that market discipline failed to limit risk taking
behavior of market participants within acceptable parameters during the GFC.
In the pre-crisis period disclosure framework and a set of rules were thought to
be sufficient to prevent excessive risk taking and encourage banks and other
intermediaries to act in a way that promoted confidence of their customers
(investors) in their services and in financial markets generally. Market
gatekeepers were expected to adhere to highest professional standards as their
reputations were supposed to be at stake; however, this was essentially a
simplistic view which the crisis has proved to be incorrect. Some scholars hold
that market discipline did work but its effect was too little too late to avert a
disaster. Even in that case, there would still be need for taking further steps for
strengthening the mechanics for stronger market discipline.
The regulators now face the challenge of restructuring financial markets in a
way that promotes financial stability, without compromising on efficiency.
Regulators must make efforts to limit the undesirable, destructive competition
and excessive risk taking by market participants. However, to promulgate
countless new rules and regulations in an attempt to cover every possible
aspect of the behavior of financial institutions would be inefficient as well as
ineffective. Inefficient because doing so will also require increase in the staff
required for enforcement of those rules; and inefficient because covering each
possible aspect is humanly impossible, especially in this era of financial
innovation and ingenuity. Thus such detailed rules would ultimately fail to
prevent the next crisis and all efforts in designing those detailed rules will
prove fruitless. In this context, putting in place a robust system of market
discipline is likely to prove more beneficial.
On the other hand, the idea of banning every product that is considered evil,
dangerous or vaguely suspicious for the unsuspecting investors and for the
financial markets at large, is impractical. Regulators, therefore, need to place
more emphasis on the discipline coming from within the market
(Shanmugaratnam, 2001).

8|Page

Thus market discipline needs to be strengthened (by adopting means such as


improved disclosure requirements) but it should not be solely relied upon to
avert a future crisis. Regulation should strengthen and reinforce market
discipline. As argued by Shanmugaratnam (2001) there ought to be a system
of laws, rules and regulations to aid and assist the market disciplining
mechanism. Rules should be framed in favor of companies that follow high
corporate governance standards and adopt adequate disclosure policies.
Whereas those who adopt suspicious practices and are involved in market
manipulation should be punished. Conflict of interest situations need to be
handled carefully to ensure they do not work to the detriment of market
discipline.
Stephanou (2010) has proposed a framework2 based on four pillars:

1) Information and disclosure


2) Market participants
3) Discipline mechanisms
4) Internal governance

The first pillar stresses the need for availability of adequate and reliable
information on the financial performance and risk exposures of financial
institutions for making timely and informed decisions.

The second pillar underlines the need for existence of independent market
participants possessing the ability to accurately process the information and
the right incentives to monitor the risk exposures of the financial institution.

The third pillar stresses the need for existence of disciplining mechanisms/
instruments that may be used by market participants to exercise discipline or
penalize excessive risk taking. Ideally, the market should provide sufficient
solvency signals for instrument holders or creditors to demand change of
management or for the regulators to intervene.

A similar model has been proposed by Crocket (2001)

9|Page

Finally, the organizational and governance structure, remuneration of


executives, board composition, independence and qualifications are crucial for
the effective functioning of market discipline.

These pillars serve to outline the pre-requisites for existence of an effective


market disciplining mechanism. However, a more pertinent question now is
what practical steps can be taken from a regulatory perspective to increase the
effectiveness of market discipline for averting a crisis. The steps that can be
taken to improve the market discipline framework include:

lowering the cost of monitoring by market participants, by putting in


place additional, carefully thought out disclosure requirements and by
provision of reliable and timely information

Encouraging the monitoring by market participants, by ensuring that


required incentives are in place. This may include redesigning safety
nets and assuring that executives of poorly managed financial
institutions will not go unpunished (the least amount of punishment
being loss of jobs). On the other hand, investors must share some
burden for their poor investment decision.

Improving the corporate governance environment at the financial


institutions to ensure that management has sufficient interest and
incentive to respond to market signals effectively

The merits and limitations of disclosure as a regulatory technique


Inadequate disclosure has been termed as one of the major contributors to the
global financial crisis. It has been argued that investors failed to understand
the risks involved in investing in structured securities primarily due to
insufficient disclosures. Furthermore, common investors often lacked enough
information about the functioning of the credit rating agencies and
repercussions of excessive executive compensation.
10 | P a g e

The basic premise behind the presumed effectiveness of disclosure as a


regulatory instrument was that investors are primarily rational, who, when
provided with sufficient information, make optimal resource allocation
decisions aimed at wealth maximization. Being a part of the deregulatory
mindset, framing rules for disclosure of plenty of information was a major
focus of regulators as it would result in investors making informed, rational
decisions and markets essentially regulating themselves. An important
question that needed to be addressed was whether investors would be able to
process (i.e. make sense of) the mass of information being disclosed and be
able to make rational decisions? The quality and relevance of information and
the ability of the investors to process that information are important
considerations (Avgouleas 2009).

It is argued that many of the risk factors that eventually led to the advent of
financial crisis were disclosed in considerable detail in various documents;
however, the users of information were unable to understand the true
implications of such risk factors and the effect these were likely to have on
their investments. Even more difficult it would have been for an investor to
fully comprehend the combined effect of these factors on the financial
markets.

Product complexity also contributes to diminishing the utility of disclosure as


the quantity of documents required to be read and understood by the investors
keeps increasing with increasing complexity (Schwarcz, 2008). Innovation in
financial markets and products makes their understanding much more
cumbersome. Other socio-psychological factors such as performance
pressures, herd behavior and cognitive biases also play their part in reducing
the effectiveness of disclosure as a regulatory technique.
It is important that Regulators understand disclosures inherent limitations.
One of the limitations is the way information is presented to the prospective
users of information. Framing of information in a leading manner may serve to
defeat the very purpose of a disclosure regime. The less sophisticated, less
informed users of information are at greater risk of being mislead due to
11 | P a g e

framed disclosures (Tversky and Kahneman 1986). Even sophisticated


institutional investors may struggle to free themselves from the effects of such
framed information and the regulators have limited control over such framing.

Despite its limitations, disclosure as a regulatory technique offers many


benefits including allowing market participants to battle market abuses and
aiding decision making. Regulators need to consider the timing, frequency,
content and format of such disclosures keeping in view the limitations of
disclosure and the objectives to be achieved. These considerations regarding
disclosure need to be guided by experimental and empirical studies that test
and measure the impact and effectiveness of information disclosed, as
suggested by Gerding (2006) and Avgouleas (2009). However, there have
been experiments that have shown that changing the volume of information
disclosed may have minimal effect on investors decisions (Choi et al, 2010).
More experimental evidence is essential to further our understanding of the
subject.

The issue of product complexity is already being tackled by the regulators by


focusing on product standardization and improvement of clearing and
settlement systems. Further considerations include whether complex financial
products should be allowed to be market to the less sophisticated investor. An
important reflection in this respect would be the use of soft paternalism
mechanism (Avgouleas, 2009).

Conflicts of interest (CoI)


Eliminating all conflict of interest situations may not be practically possible
for any regulator. However, conflicts of interest are to be managed in a way
that their effects are minimized. Complete elimination of conflicts of interest
situations would only be possible under the theoretical perfect competition and
absence of asymmetric information. COIs are of special interest to regulators
because exploitation of conflicts of interest situations by market players may
have negative consequences for the confidence investors have in the financial
markets.

12 | P a g e

Regulators have been criticized for being too lenient on market intermediaries
and failing to properly deal with conflict of interest situations. They are now
faced with the task of devising regulations to address conflict of interest
situations that endanger the health of our financial system. Market
intermediaries are naturally at an advantage in terms of access to information.
Market imperfections and asymmetric information are the key reasons which
may lead the intermediaries to exploit such situations. The regulators are again
faced with the uphill task of balancing regulations as too lenient regulations
would permit exploitation by market intermediaries at the cost of their clients.
On the other hand, too harsh regulations run the risk of inhibiting growth by
disallowing activities that may otherwise be appropriate. Regulations should
ideally focus on encouraging the development of internal controls that help
control such conflicts of interest (Emerging Markets Committee of IOSCO,
2010).

Moreover, as with any set of rules and standards; the implementation and strict
enforcement of laws is as important from regulatory point of view as the
regulations themselves. Regulators also need to develop required capabilities
and technical expertise to carry out investigations and take effective
enforcement action with reference to COI situations. Rules and regulations
should be primarily aimed at changing the behavior of firms concerned as
avoidance of COI situations inevitably involves exercise of best judgment by
the management of these intermediaries. As conflict of interest situations can
take many different forms; it is practically not possible to devise a set of rules
for each type of COI situation. Thus rules should be targeted at developing
higher level rules for guiding the behavior of management of financial
intermediaries, combined with strong monitoring by the regulators. The
methodology to be adopted by the regulators may include encouraging firms
to engage senior management of the entities in the decisions involving COI
situations.

13 | P a g e

4.

THE REGULATION OF SECURITIES MARKETS POST


CRISIS?

Regulators have started rethinking securities regulations after the lessons


learnt from the financial crisis. Thus many of the measures proposed in this
paper are currently under consideration of regulators or already in the process
of being implemented. However, a pertinent consideration at this point in time
the formulation of plans that are well thought-out and the willingness to stick
to those plan during the times of resistance and criticism.

i)

Focus on Principles based regulations

Principles based regulations (PBR) are the need of the time. Principles based
regulations means broad set of standards focusing on the final goal to be
achieved rather the mechanics of it. These standards would be aided by set of
guidelines on how to achieve the desired outcomes. PBRs mean focusing less
on chalking out detailed rules and prescriptions on how firms should operate.
Instead the PBR give the firms more independence to operate within the set
regulatory principles.
Principles based regulations are preferable over the more detailed rule based
regulations on the grounds that prescriptive standards have not been effective
in complete prevention of market misconduct (Committee on Capital Markets
Regulation, 2009). Detailed rules and regulations are burdensome for the
regulators to devise and cumbersome to follow for the regulated entities.
Detailed rules also fail to capture the changing nature of the financial sector
and regulations often struggle to keep pace with innovations in products and
range of services offered. Regulations based on principles are more likely to
create an environment conducive to such innovations and advancements. The
expectation that rules and regulations would always keep pace with these
innovations is unrealistic and is likely to create hindrance to novelty in
products and services. As the complexity of financial market and products
increases, so will the complexity of rules to be followed.

14 | P a g e

Detailed rules and regulations make compliance more difficult especially for
the smaller companies that lack dedicated resources having expertise in legal
and regulatory matters (The Financial Services Authority, 2007). Sometimes
elaborating such details may also have negative effect of both regulator and
the regulated entity being engrossed in ensuring compliance with the law in
letter, but unable to follow its true spirit.

The risk-based regulation focusing on principles rather than detailed rules, is


likely to contribute to better understanding and compliance of law in its true
spirit and would also contribute towards the reduction in human resources
employed in framing of laws and ensuring compliance.

However, it must be understand that this shift of focus does not mean
complete elimination of rules and regulations. There will always be need for
detailed rules in some areas which will be required to be in place. This
approach aligns well with the participatory role of the regulator as it makes
following the law less cumbersome for the regulated entities.

In this context, the concept of cost-benefit analysis of regulations needs more


emphasis from regulators. Regulators need to focus on the accurate
measurement of the costs that institutions have to incur in order to comply
with regulations for the reason that most of these compliance costs would
eventually be passed on to the clients/ shareholders of those institutions.

ii)

Reducing Systemic Risk

Instruments such as Credit Default Swaps (CDS) have been blamed as


contributors to the GFC. However, the proponents of these instruments opine
that the instruments are not evil by substance and changes in the way these
instruments are traded may magnify their utility as tools for diversifying credit
risk. However, the current CDS market has potential to destabilize the
financial system as it is susceptible to a chain of counterparty defaults
(Committee on Capital Market Regulation, 2009).

15 | P a g e

The recent financial crisis has indeed exposed the credit, operational and
systematic risks inherent in an unregulated CDS market. Some of these
inherent risks can be mitigated by making CDS instruments subject to
centralized clearing.

Anabtawi and Schwarcz (2011) have proposed a three-pronged approach for


dealing with systemic risks. The authors argue that in order to manage
systemic risks, three inter-related factors must be controlled; namely conflicts,
complacency and complexity. These are considered to be factors that the
market participants cannot be expected to address by themselves.

Regulations directed towards managing systemic risks must take into account
behavioral factors that lead market players to take decisions that would not
pass the test of rationality. Behavioral biases lead individuals to make errors of
judgment regarding the risks involved in their investments thus contributing to
enhanced systemic risk. Encouraging companies to provide their risk
managers with reasonable degree of independence and authority to question
excessive risk taking behaviors by decisions makers is one way of handing this
problem. Furthermore, companies may be encouraged to perform qualitative
analysis of risks, in addition to the use of quantitative models.

Agency problems lead managers to take excessive risks or the risks that
shareholders do not want the company to undertake. Regulators can play their
part by encouraging companies to align executives remuneration with
companys long-term performance. Furthermore, regulators must also consider
the ability and willingness of market participants to appreciate risks inherent
in their investments. Complex financial products sometimes make it difficult
for decision makers to fully appreciate the risks involved in their investments.
This leads to enhanced threat to the stability of the financial system.

iii)

Need for enhanced International Cooperation

Enhanced international cooperation among regulator would be required in the


post-crisis period as the financial markets become global and more inter-

16 | P a g e

connected. This cooperation will reduce the opportunities for regulatory


arbitrage available to some financial firms. Regulators would also benefit from
exchange of information and insights gained from local regulatory experiences
which will aid in devising policies.

iv)

Other considerations

Carvajal and Elliott (2007) argue that:


a combination of factors, including insufficient legal authority, a lack of
resources, political will and skills, has undermined the regulators capacity to
effectively execute regulation. This weakness is more acute in areas of
increased technical complexity such as standards for and supervision of the
valuation of assets and risk management practices.

The regulators need to re-adopt the policy of active regulation with strong
regulations focusing on investor protection and market stability. Regulators
must keep themselves abreast of developments taking place in the financial
markets, train and equip their staff members to better regulate complex and
innovative financial products being introduced from time to time. Regulators
need to strike the right balance between promoting growth of financial
markets and achievement of market discipline and stability. The staff members
at the securities regulators must be provided proper training along with a
career path that incentivizes them to pursue a long term career with the
regulator. This will reduce likely conflicts of interest caused by the fact that
market participants could be possible future employers for staff members. This
may also mean grooming of staff members and preparing them for
appointment at senior most positions (e.g. Commissioners) in the regulatory
bodies.

The regulators need to rediscover their focus on optimal corporate disclosure,


corporate governance and auditing & accounting oversight. The regulatory
framework must be made less complicated in order to minimize the room for
regulatory arbitrage or the possibility that a specific type of market player or
product could evade the ambit of regulation. This will lessen the likelihood
17 | P a g e

that one particular area would remain unregulated owing to unclear


demarcation of responsibility between regulators.

The regulators must appreciate their roles in restoring public confidence in


financial markets and institutions. Necessary steps for restoration of that
confidence include not only development but strict enforcement of rules that
assure the investing public that necessary controls have been put in place and
anyone who defrauds investors will be taken to task.

It has also been proposed that in order to achieve the goal of investor
protection; the regulators should consider aiming to dissuade unsophisticated
investors from investing directly in the security markets (instead encourage
investment through mutual funds). This may done, for instance, by including a
disclaimer similar to ones given by mutual funds, in the broker contract that
investing directly in securities markets involves considerable risk and is
suitable for well knowledgeable investors only (Zingales, 2009). This will
allow regulators to focus more on asset managers and mutual funds and
possibly eliminate the need for detailed rules intended to protect unsuspecting
individual investors. Removal of some of the tedious rules may also encourage
more companies to offer their securities to the market.

The conventional goal of educating investors must be brought to the fore-front


with the increasing complexity and innovation of in financial markets and
products. Investors must be made aware of the risks involved in different type
of financial products keeping in view the ultimate goals of investor protection
and controlling systemic risk. The drawbacks of the present system of investor
education must be assessed and current investor education programs revamped
to make them more effective in the post-crisis environment. The focus should
go beyond fraud education to include education on risky investment avenues,
risk assessment mechanism, functioning of credit rating agencies and rights of
shareholders etc.

18 | P a g e

5. WHAT KIND OF CRISES CAN WE EXPECT IN FUTURE?


HOW CAN WE DEAL WITH THEM?

It needs to be emphasized that no set of financial or macro regulations can


completely eliminate the possibility of occurrence of financial crises. By
improving the regulatory framework, however, we aim to reduce the impact of
these crises as and when they occur and also decrease the likelihood of such
crisis leading to complete financial turmoil by not being able assess or manage
the systemic risk.

Price bubbles have been at the forefront of many of the crises in recent times
and excessive risk taking and herd mentality will probably continue to produce
price bubbles in years to come. Gerding (2006) has done extensive work on
the financial crises, price bubbles and on the decay of securities regulations.
His argument revolves around two basic premises. First, a period of financial
growth generally creates or strengthens political pressure in the favor of a
framework inclined towards deregulation. In a period of financial growth
culminating in a bubble, market players lobby for less stringent securities laws
citing prevailing financial stability and growth. Rules and regulations
restricting excessive risk taking are portrayed as impediments to the growth of
the financial sector. Thus policy makers are persuaded to consider diluting
securities regulations with an aim to promote growth. The resistance by
market participates may also include resistance against new proposals that
address excessive speculation and risk taking. A period of growth and relative
financial stability thus becomes non-conducive to imposition of limits on the
risk taking of institutions. Secondly, bubbles tend to enfeeble even those
regulations that remain unaffected by political pressures. This can be caused
by several factors, including increased work load and pressures to finalize
impending deals - performance pressures that may lead to industry wide
decline in professional norms and weakening status of compliance with laws
and rules.

Many different theories aimed at preventing asset price bubbles and


minimizing the systemic effects of bursting of price bubbles have surfaced.
19 | P a g e

One of the possible solutions could be, as suggested by Gerding (2006), to


politically insulate the regulators so that the impact of political pressures on
the decisions of regulators would be minimal. However, practically insulating
regulators from political pressures is not an easy task. Allen and Gale (199)
have proposed a theory that emphasizes the relationship of credit availability
and asset price bubbles. This theory proposes that central banks should try to
avoid unnecessary expansion of credit as well as the uncertainty regarding
future credit expansion. The authors suggest that if central banks can control
the level and volatility of credit, it is likely to help prevent asset price bubbles
as, according to this theory, high current credit levels as well as expectations
of higher future credit levels can contribute to price bubbles.

Financial institutions and their managers are under pressure during periods of
sustained economic growth to report profits, comparable or better than
competition. These performance pressures lead managers to assume excessive
risks in anticipation of higher profits which results in greater systemic risks.
Managers unable to keep pace with competition are considered underperformers and often end up getting below par remuneration. Companies that
succumb to this performance pressure often expand at a faster pace using
higher leverage. This works without much trouble during the periods when
asset prices are on the rise, stock markets are performing well and there are
few defaults on the bond market with sufficient liquidly in the system.
However, as the boom nears its end, liquidity dries up especially for highly
leveraged firms who have already started experiencing higher defaults partly
due to lower standards of credit assessments used during the period of
aggressive growth. Thus booms and busts follow each other in a cycle and
prohibiting the use of particular products would do little to prevent the next
crisis (Goodhart, 2009).

Liquidity, credit and banking crises might continue to occur every now and
then in one part of the world causing trouble elsewhere in this increasingly
interconnected financial world. The task for regulators is tough as they battle
to find the right policy response to these recurring crisis situations.

20 | P a g e

The reliance on complex mathematical models and theorems is already being


criticized as some experts believe that a broader understanding of macro
economy may prove more beneficial for stabilizing our financial markets
(ALDE Workshop, 2008).

6. CONCLUSION
Securities markets regulations can greatly benefit from the increasing
emphasis and focus on relevant research. Regulatory authorities need to
realign their research budgets so that in-depth research on the issues affecting
the stability of our financial system is conducted and appropriate policy
recommendations are formulated. Dedicated human resources specializing in
research on regulations and policy issues should be developed for this purpose.
The recommendations from these researchers should be given due weight-age.

One of the lessons learned from the financial crises experience over the years
is that regulators must discontinue being over-reactive to market events.
Sarbanes Oxley Act was enacted in 2002 in response to major corporate
scandals such as Enron and Worldcom. Checks on executive remuneration
were introduced immediately after expensive bailouts of troubled banks; and
there have been calls for complete banning of CDS after credit crisis. Far from
commenting on the merit of some of these actions, this paper argues that
regulators need to stick to the principles of regulations during the periods of
growth and during crises, rather than being lax during a bubble and overstringent after a bust.
As suggested by Barr et al (2009); regulations must be behaviorally
informed. Regulators must consider the limitations of disclosure and market
discipline due to behavioral factors and the design of all future policies should
take into account the complex mix of rational choice and behavioral biases
which inherently reduce the predictability of these regulatory choices. Policy
makers must have the realization that market players do not always act in their
own interest (i.e. due to complexity, complacency and conflict as suggested by
Anabtawi and Schwarcz, 2011). Thus market players cannot be expected to,
automatically take into account the collective interest of the whole market.
21 | P a g e

This is due in part their inability to see the complete picture (as also suggested
by Gorton (2009)).

Regulators would also contribute to improving the stability of our financial


system by renewing their focus on investor education. We have seen time and
again that the complexities and conflicts of modern day financial markets
make it hard for even the sophisticated investors to make rational decisions.
This further amplifies the need for enhanced efforts for carrying out
comprehensive investor awareness programs that warn unsuspecting investors
of the real risks of entering the financial markets. These efforts will go a long
way towards reduction of systemic risk and hence achievement of the
objectives of financial regulation.
The history of financial crises over the last two centuries enlightens us that the
causes common to most crises were excessive risk taking, failure to limit
systemic risk, imprudent lending, lack of understanding of complex financial
products (a more recent phenomenon) and conflicts of interests (ALDE
Workshop, 2008). Regulators must realize that crises have occurred despite
our best efforts and this fashion is likely to continue in years to come. The
belief that future crises are likely to possess similar characteristics to the ones
we have seen in the past, is indeed a silver lining as it provides guidance to
regulators and policy makers in their quest to minimize the likelihood and
impact of such crises.

22 | P a g e

References
Allen, F. and Gale, D. (1999); Bubbles, Crises and Policy; Oxford Review of
Economic Policy; Vol. 15, No.03
Alliance for Liberals and Democrats for Europe (ALDE) (2008); Workshop
titled International Financial Crisis: Its causes and what to do about it;
Liberals and Democrats Workshop, February 27th, 2008
Anabtawi, I. and Schwarcz, S. L. (2011); Regulating Systemic Risk: Towards
An Analytical Framework; Duke Law Faculty Scholarship; Paper 2305.
http://scholarship.law.duke.edu/faculty_scholarship/2305 (accessed on May
12, 2011)
Avgouleas, E. (2009); What Future for Disclosure as a Regulatory Technique?
Lessons from the Global Financial Crisis and Beyond; Available at:
http://ssrn.com/abstract=1369004 (accessed on May 19, 2011)
Barr, M.S., Mullainathan, S. and Shafir, E. (2009); The Case for Behaviorally
Informed Regulation, in New Perspectives In Regulation; David Moss & John
Cisternino ed. 2009.
Bordo, M.D. (2007); Growing Up To Financial Stability; Working Paper
12993,

March

2007;

JEL

No.

N00,

N2

(available

at

http://www.nber.org/papers/w12993; accessed on: April 20, 2011)


Carvajal, A. and Elliott, J. (2007); Strengths and Weaknesses in Securities
Market Regulation: A Global Analysis; IMF Working Paper No. 07/259,
2007;

Available

at:

http://www.imf.org/external/pubs/ft/wp/2007/wp07259.pdf; (accessed on May


15, 2011)
Choi, J. J., Beshears, J., Laibson, D. and Madrian, B. C. (2010); How Does
Simplified Disclosure Affect Individuals Mutual Fund Choices?, available at
http://www.som.yale.edu/faculty/jjc83/summaryprospectus.pdf; (accessed on
May 10, 2011).
23 | P a g e

Committee on Capital Markets Regulation; (2009) The Global Financial


Crisis:

plan

for

regulatory

reform;

available

at:

http://www.capmktsreg.org/pdfs/TGFC-CCMR_Report_(5-26-09).pdf;
accessed on May 19, 2011)
Crockett, A. (2001), Market Discipline and Financial Stability, BIS
speeches,

23

May

2001

(Available

at:

http://www.bis.org/speeches/sp010523.htm : accessed on: May 07, 2011)

Emerging Markets Committee of IOSCO (2010); Guidance for Efficient


Regulation of Conflicts of Interest Facing Market Intermediaries (October
2010), International Organization of Securities Commissions; (available at:
http://www.iosco.org/library/pubdocs/pdf/IOSCOPD342.pdf;

accessed

on:

May 07, 2011)

Erskine, A. (2010); Rethinking Securities Regulation After The Crisis: An


Economics

Perspective,

(9

July

2010);

Available

at:

http://www.asic.gov.au/asic/pdflib.nsf/LookupByFileName/RethinkingSecuriti
esRegulation-20100709.pdf/$file/RethinkingSecuritiesRegulation20100709.pdf; (accessed on May 11, 2011)

Enders, Z. and Hakenes, H. (2010); On the Existence and Prevention of Asset


Price Bubbles; available at: www.coll.mpg.de/pdf_dat/2010_44online.pdf;
(accessed on: May 15, 2011)

Gerding, E.F. (2006); The Next Epidemic: Bubbles and the Growth and Decay
of Securities Regulation; (February 2006); Connecticut Law Review 38(3), pp.
393-453
Goodhart, C, et al (2009), The Fundamental Principles of Financial
Regulation, Geneva Reports on the World Economy 11; (available at:
www.princeton.edu/~markus/research/papers/Geneva11.pdf;

accessed

on:

May 13, 2011)


24 | P a g e

Gorton, G. (2009); Slapped in the Face by the Invisible Hand: Banking and the
Panic

of

2007

(May

09,

2009);

available

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1401882;

accessed

at:
on:

May 07, 2011)


International Monetary Fund - IMF (2011); Global Financial Stability Report
(April

2011);

(available

at:

http://www.imf.org/external/pubs/ft/gfsr/2011/01/index.htm; accessed on May


07, 2011)

Martin, J. D. (2009); A Primer on the Role of Securitization in the Credit


Market

Crisis;

(January

7,

2009)

(available

at:

http://ssrn.com/abstract=1324349; accessed on May 07, 2011)

McCarthy, C. (2006) Speech by Chairman, FSA (31 October 2006) at


Financial Services Skills Council 2nd Annual Conference (Available at:
http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2006/1031_c
m.shtml; accessed on: April 18, 2011)

Moshirian, F. (2010); The Global Financial Crisis and the Evolution of


Markets, Institutions and Regulation; (August 29, 2010). Journal of Banking
and

Finance,

Vol.

36,

No.

1,

2011;

available

at:

http://ssrn.com/abstract=1667824

Poser, N. S, (2009); Why the SEC Failed: Regulators Against Regulation;


Brooklyn Journal of Corporate, Financial & Commercial Law, Vol. 3, Spring
2009; Brooklyn Law School, Legal Studies Paper No. 132. (Available at:
http://ssrn.com/abstract=1348612; accessed on May 07, 2011)
Shanmugaratnam (2001); Regulating the capital markets: making market
discipline work; Speech by Tharman Shanmugaratnam, Deputy Managing
Director of the Monetary Authority of Singapore at the StanChart-ReutersBusiness Times Investment Awards ceremony, Singapore (16 Feb 2001)

25 | P a g e

(available at: http://www.bis.org/review/r010220b.pdf accessed on: May 10,


2011)

Stephanou, C. (2010) Rethinking Market Discipline in Banking - Lessons


from the Financial Crisis World Bank Policy Research Working Paper Series,
(available at: http://ssrn.com/abstract=1565988; accessed on: April 20, 2011)
Schwarcz, S. L. (2008); Disclosures Failure In The Subprime Mortgage
Crisis; Utah Law Review, p.1109, 2008; Duke Law School Legal Studies
Paper No. 203; (available at: http://ssrn.com/abstract=1113034; accessed on:
May 10, 2011)
The Financial Services Authority (2007); Principles based regulation
focusing

on

the

outcomes

that

matter;

(Available

at:

http://www.fsa.gov.uk/pubs/other/principles.pdf; accessed on: April 18, 2011)

Turner, A. (2010), Economics, Conventional Wisdom and Public Policy, UK


Financial Services Authority, Speech to the Institute for New Economic
Thinking, Inaugural Conference, Cambridge, (April 9, 2010); (available at:
http://www.fsa.gov.uk/pages/Library/Communication/Speeches/2010/0409_at.
shtml; accessed on: April 18, 2011)
Turner Review, The (2009); A regulatory response to the global banking
crisis; March 2009 (The Financial Services Authority (FSA) United
Kingdom);

(available

at:

www.fsa.gov.uk/pubs/other/turner_review.pdf;

accessed on: April 25, 2011)


Tversky, A. and Kahneman, D. (1986) Rational Choice and the Framing of
Decisions The Journal of Business, Vol. 59, No. 4, (Available at:
http://links.jstor.org/sici?sici=00219398%28198610%2959%3A4%3CS251%3ARCATFO%3E2.0.CO%3B2-C;
accessed on May 07, 2011)

26 | P a g e

Zingales, L. (2009); The Future of Securities Regulation; Chicago Booth


School of Business Research Paper No. 08-27; FEEM Working Paper No.
7.2009;

(available

at:

http://papers.ssrn.com/sol3/papers.cfm?abstract_id=1319648; accessed on:


April 19, 2011)

27 | P a g e

You might also like