Financial liberalization has been linked to a greater incidence of financial crises. In order to protect consumers from negative externalities, new regulations must be imposed. Focal points of these regulations include: compensation of traders and bank personnel, product regulation, transparency in the financial market, asymmetric information and moral hazard. These must all be considered in the context of the current macroeconomic environment, which is fraught with potential risks. A concern about the nature of financial intermediation, including its scope and size is also potent issue going forward.
In my opinion, the most important issue is finding a balance between regulations protecting non-professional consumers and supporting innovative ideas. Part of the 2008 financial crisis resulted from a misrepresentation of investment products to the consumer. Leading up to 2008, regulators were either inattentive or choosing to ignore the riskiness of certain investment products. Since 2008, new regulations (for instance, Basel I, II and III) have been structured and implemented. But, with aggressive regulation arise worries that innovation will be reduced. How much regulation is appropriate? Similarly, how should the marketing of new products be regulated in order to protect the consumer?
By preforming an in depth analysis of new financial products, some of this risk can be addressed. Investments should have their risks clearly stated, with companies being fined for misrepresentation. If a percentage of sales from products sold were partitioned to pay for this analysis, this examination would not result in a deficit for the regulatory body. Similarly, by making it more difficult and costly for companies to bring investment products to market, banks will be more likely to conduct due diligence on investments they wish to sell. For instance, if a product does not make it to market, time and money will have been wasted. While regulations like this may result in a slow down of new products entering the market place, they will also result in increased safety for investors and increased stability in the financial sector at large.
Inappropriate remuneration schemes were a significant contributor to the 2008 crisis, and another important regulatory issue. While regulatory bodies are loath to involve themselves with private sector remuneration, regulation could reduce associated moral hazard and create a safer, more stable financial sector.
Current compensation structures are inconsistent with risk management, as the variable component (bonus) of executive pay encourages short-term gain over long term stable growth. Instead, regulatory bodies should insist that executive compensation be linked to long-term performance indicators. These indicators should be revealed in annual reports, along with information regarding how the compensation level was arrived at. This increased transparency may minimize fraudulent behaviour by executives, and encourage shareholder involvement. Similarly, extending the period that performance is measured may further reduce moral hazard. By withholding pay for two to three years after the bonus is “earned,” incentives to manipulate earnings in the short term will be reduced. Confiscating payments to the executives in a company that does not follow these requirements, and fining the company will help enforce these rules.
One should note that these regulations emphasize the banking sector alone. Yet, going forward, regulatory bodies will have to ensure they address all industries and all sectors. Changing the capital standards and maturity transformation regulations of banks, for example, may result in the transfer risks from banks to insurance companies and the shadow banking system. Also, cross border concerns are increasingly relevant, as boom/bust cycles differ from country to country. If regulations are not global in nature, a bust in one nation will simply result in a transfer of transactions to another country, which will perpetuate and increase any problems.