financial policy to combat market imperfection in the financial system

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Financial Policy to Combat Market Imperfection in the Financial System Financial system are said to be the heart of the economy. They pump money, distribute it from those who have an excess to those who need it. Without a good financial system, consumption will be slowed, innovation will be impeded, and development will be halted. But how can we get a good financial system? Some country like US decided to let the market fully shape the financial system. They minimize the government intervention in controlling the financial system. But the result is not desirable. In 2008, the financial crisis hit the real economy and millions of people losing their jobs and assets. The source comes from the US with its subprime mortgage market crashing down. There is a market imperfection; home price didn’t really reflect their intrinsic value. The crisis in 2008 give us a very important lesson, the financial system can’t entirely be decided by the market. Government must intervene by creating regulatory policy to help stabilize the financial system. So how would the government decide what regulation it should use? First, it must identify the problem in the financial market, and then remedy the problem through regulatory policy. The first problem in the financial system that can cripple the entire economy originated from reckless borrowing and lending. Borrowers that can get loan with an initial low cost take out loans on a large scale, even though they can’t afford to pay it off. It is lenders responsibility to give loans only to those who can afford it. But that mechanism didn’t work in 2008, where subprime borrowers can get their hands on a loan to buy their dream house and banks give them happily. Why is it so? It is because the invention of securitization, bank gives loans, they slice and dice the loans then passing them to unsuspicious investor. Even credit rating agencies whose job is to determine the risk level didn’t quite understand complicated securities and end up giving bad loans(like the synthetic CDOs in 2008) a triple A’s ratings, the same ratings as government bond which is loans that essentially have zero risk. Reckless borrowing and lending arise from bank perverse incentives which are allowed by regulatory policies. Bank have an incentive to make loan as much as possible without calculating the risk then pass it into investor. Their incentive is to maximize profit from the fee of creating loans. They create complicated loan that will be given triple A’s rating from the rating agency so they can sell it to investor that have been regulated to only

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My essay on crucial financial policy that must be addresed

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Page 1: Financial Policy to Combat Market Imperfection in the Financial System

Financial Policy to Combat Market Imperfection in the

Financial System

Financial system are said to be the heart of the economy. They pump money,

distribute it from those who have an excess to those who need it. Without a good financial

system, consumption will be slowed, innovation will be impeded, and development will be

halted. But how can we get a good financial system? Some country like US decided to let the

market fully shape the financial system. They minimize the government intervention in

controlling the financial system. But the result is not desirable. In 2008, the financial crisis hit

the real economy and millions of people losing their jobs and assets. The source comes from

the US with its subprime mortgage market crashing down. There is a market imperfection;

home price didn’t really reflect their intrinsic value. The crisis in 2008 give us a very

important lesson, the financial system can’t entirely be decided by the market. Government

must intervene by creating regulatory policy to help stabilize the financial system. So how

would the government decide what regulation it should use? First, it must identify the

problem in the financial market, and then remedy the problem through regulatory policy.

The first problem in the financial system that can cripple the entire economy

originated from reckless borrowing and lending. Borrowers that can get loan with an initial

low cost take out loans on a large scale, even though they can’t afford to pay it off. It is

lenders responsibility to give loans only to those who can afford it. But that mechanism didn’t

work in 2008, where subprime borrowers can get their hands on a loan to buy their dream

house and banks give them happily. Why is it so? It is because the invention of securitization,

bank gives loans, they slice and dice the loans then passing them to unsuspicious investor.

Even credit rating agencies whose job is to determine the risk level didn’t quite understand

complicated securities and end up giving bad loans(like the synthetic CDOs in 2008) a triple

A’s ratings, the same ratings as government bond which is loans that essentially have zero

risk.

Reckless borrowing and lending arise from bank perverse incentives which are

allowed by regulatory policies. Bank have an incentive to make loan as much as possible

without calculating the risk then pass it into investor. Their incentive is to maximize profit

from the fee of creating loans. They create complicated loan that will be given triple A’s

rating from the rating agency so they can sell it to investor that have been regulated to only

Page 2: Financial Policy to Combat Market Imperfection in the Financial System

hold triple A’s securities such as pension funds and money market funds. If the bank

incentive can be shifted so it’s in accordance to investor incentives, then reckless lending will

be averted.

The second problem in the financial system is that financial intermediaries are too big

and too interconnected, and their failure can brought down the entire financial system. It has

been proven by the financial crisis in 2008 in which the failure of Lehman Brothers, the

fourth biggest investment bank at the time, create a panic in the entire financial markets. As

such, government can’t help but to bail out big financial intermediaries so it didn’t bring the

financial system down with it. Such bailout can create a moral hazard in which financial

intermediaries can engage in a risky bet without being afraid of the consequences because

they guaranteed a bailout from taxpayers.

Such problem, commonly called too big to fail, emerge because the policy created by

regulators allowed such entity to exist. In fact, too big to fail entities exist because the

regulators encourage big financial intermediaries. Their argument to support it is the lower

cost advantage of too big to fail institutions. Their lower cost comes from the economics of

scale and economies of scope. Economies of scale dictate that enterprise that has bigger scale

of operation have lower average cost, while economies of scope state that bigger scope of

goods or service produced by an enterprise will have lower cost. While it’s maybe true that

big financial intermediaries offer lower cost for borrowing, they can achieve so while holding

a big risk for the financial system. A risk that eventually must be paid by taxpayers when they

fail, like what happened in 2008.

In the current state of financial policies, the existence of too big to fail entities that’s

harmful to the entire financial system is still allowed and rather encouraged. The example is

the Riegle-Neal act that “allowed banks, under certain circumstances, to acquire banks or set

up branches in other states without creating a separate subsidiary” (Farlex financial

dictionary, 2009). Another example of regulation is the Gramm-Leach-Bliley act “which

created a new category of financial holding companies that are authorized to engage in any

activities that are financial in nature, incidental to a financial activity, or complementary to a

financial activity—including banking, insurance, and securities” (Johnson and Kwak, 2010).

Such regulations cause big bank to be bigger and hinder small bank to compete because of

their higher cost.

Page 3: Financial Policy to Combat Market Imperfection in the Financial System

While some of the problems in US have been answered by the Consumer Financial

Protection Act (CFPA), it still has various gaps in regulating the financial system. It still

doesn’t answer the incentives and too big to fail problem. The CFPA only answer problems

like creating CFPB so investors and borrowers have better information about loans they give

or take from financial markets. It’s true that better information available can minimize a

financial failure like what happened in 2008 but it’s not enough. Banks can still search for

another way in placing their risky bets as long as their incentives are not adjacent to the social

benefit as a whole.

The applications of macro-prudential and micro-prudential policy are important to

achieve financial stability. Macro and micro-prudential policy will fill the gap from

macroeconomic policies in ensuring the stability of financial system. Cap on Loan-to-Value

ratio and Debt-to-Income ratio for example, will impede excessive risk taking by lenders and

ensure that borrowers can make due their loans. Cap on leverage will limit the disturbance of

some financial intermediaries’ failures to the entire system. In short, macro and micro-

prudential policy will minimize the risk that can harm the financial stability.

However, the source of problem from the financial crisis must be answered to ensure

economic stability. Too big to fail institution must be broken down so it won’t be able to

harm the entire system. In doing so, it will solve the problem of moral hazard which make

banks take excessive risk. They will act responsibly because they didn’t have the government

to receive their loss. Bank will act as intended, giving loans only to borrowers who can pay

their due. Broken down financial institution will also create higher competition, and with

strict regulation it will make the cost of borrowing lower without harming the financial

stability.

In conclusion, the financial system has market imperfections that impede them to

achieve economic prosperity. Reckless borrowing and lending and too big to fail problem

prevent the market from achieving financial stability. Government must carry out their role as

regulator to fix the market imperfections that exist in the financial system. The most

important policy reform to attain financial sustainability is to stop the existence of too big to

fail institution, as it can create moral hazard and while in trouble can bring the entire

economy in jeopardy. While this essay answer financial problem based solely on the US, the

lessons can be applied to every country if they want to achieve financial sustainability.

Page 4: Financial Policy to Combat Market Imperfection in the Financial System

Bibliography Claessens, S. (2014). An Overview of Macruprudential Policy Tools. Retrieved September 25, 2015,

from IMF website: http://www.imf.org

Farlex Financial Dictionary. (2012). Reagle Neal Act. Retrieved September 19, 2015, from

http://www.financial-dictionary.thefreedictionary.com/Riegle-Neal+Act

Kwak, J., & Johnson, S. (2010). 13 Bankers: The Wallstreet Takeover and the Next Financial

Meltdown. New York: Pantheon Books.

Lewis, M. (2010). The Big Short: Inside the Doomsday Machine. New York: W. W. Norton &

Company.

Sorkin, A. R. (2009). Too Big to Fail: The Inside Story of How Wall Street and Washington Fought to

Save the Financial System—and Themselves. New York: Viking Press.

Stiglitz, J. E. (2010). Freefall: America, Free Market, and the Sinking of the World Economy. New

York: W. W. Norton & Company.