Necessity is the mother of financial regulation

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They say that necessity is the mother of invention.

Financial regulation
Financial regulation is a necessity for the proper functioning of the marketplace – if only to help prevent ‘predation’ and the occasional recession. Photo: Prayitno/Flickr

There must be a need and some level of demand, in order to create a supply chain for a good or a service, which then aggregates into a ‘value chain’ behind the product or service.

A perfect example of this, is the fact that we now have tablet computers that we did not have a few short years ago, which means that people wanted to move on to the next generation of computing devices. From mobiles, to smartphones, to tablets, their success shows that there was indeed an untapped market. Each of those products started with some level of demand, then supply, which created a value chain as a consequence of the entirety of the supply/demand equation.

In the same way there is a demand and supply relationship in the financial markets. There must be a need for a product or service, in order for it to be created or provided, once it becomes created and provided, we then have a supply/demand market for that product or service.

That hunger in the market allows the creator to sell the product, recover costs and make a profit — while consumers benefit by gaining the use of the product. The difference between the real world and the financial markets, is in the product testing. There are quality control organizations that test products or services by taking the most extreme cases and seeing how the product reacts. A new drug for example, must have drug trials, while special certification is required for others.

Regulators are always able to keep tabs on new innovations and make certain the release is a product which is harmless to citizens. Even if some sort of a harmful product is launched, there are mechanisms to recall them in order to protect the people. There are proactive and reactive mechanisms to cover a plethora of situations.

Financial markets on the other hand, are a whole different ball game.

Financial products are released, untested, and even the gatekeepers responsible for them may experience conflicts of interest. Financial products that are built up over time can be complicated and uniquely customized. Two parties can come to an agreement to pay each other different payments based on a fixed or variable rate for each of the next 6 months. These are called swaps and these are used by different parties to manage their cash flows.

Financial regulation is a necessity for the proper functioning in the marketplace

A company can hedge its exposures to the market and prevailing interest rates by using these kinds of products. This is where the demand is generated at a fundamental level. The good and evil of the system happens at this juncture.

If a company “A” can find another organisation, let’s call it company “B” that is looking to have the exact opposite cash position to itself, then it too, will be able to get what it wants and both companies will benefit. For example, imagine that a person is looking to take out a loan of USD 1000. at interest of 5 percent with a term of 2 years. He finds another person who is looking to provide a loan of USD 1000. at the same interest rate over 2 years.

But matching two parties like this in a huge financial market is difficult and unlikely. This is where a third party steps in and decides whether to take the extra risk of getting involved and tailoring a deal for company “A” at a price, that price is called the “spread”. In this example, a bank is willing to give its depositors a 4 percent rate of return — while lending the money at 6 percent netting a 2 percent profit (the “spread”) for the risk it takes. The system works fine for a time, but then due to profit, more and more intermediaries become involved.

Financial products meet their customer’s needs, but could they pass a stress test?

The structure becomes like a house of cards stacked on top of each other and the original risk that was supposed to be nullified, can become magnified! In other industries, regulators would step in and require conditions so that citizens cannot be unduly disadvantaged. As many of the financial products are customized and not part of the mainstream market, they pass by unnoticed.

And in order to defer their own risk to other parties, the product keeps taking a more complicated and morphed form at each juncture. Someone is always willing to take some extra risk and as one of the parties offloads it, someone else takes it on.

This means that even if regulators try to clamp down on one part of the product, a new one has already superceded it. The CDS mess of 2008 is an example where regulators were always a step behind. Lastly, the rating agencies, which should be keeping a close watch on how things are being run and how they rate different products, become overwhelmed trying to stay up-to-date on multiple transactions, placed and replaced many times over.

Ratings agencies can be ‘gamed’ by their own customer base

Companies pay ratings agencies to rate their products and rather than keep a check on the company, the companies are able to start a price war between the rating agencies — nullifying any defense mechanisms that the rating agencies have. This also eliminates any stress testing or checking on the financial products by the rating agencies, and so, the product is launched without thorough trials. The financial industry needs to realize that the function rating agencies and regulators perform are important, not only to consumers, but within business groups such as exporters or stock exchanges, for example.

If there were no banks or fund transfers, the economy w0uld crumble. But more effort needs to be made towards self-regulation and external auditing to make sure that the system is as uncorrupted as possible. The alternative is a complete loss of faith in the markets, the banking sector and the larger economy over time. Which is bad news for everyone.

© Zain Naeem

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