Lack of Regulation as a Cause for the Global Financial Crisis

The previous article had touched upon the lack of regulation as a cause for the global financial crisis. This article looks at this aspect in detail. To understand why the lack of regulation was one of the contributory factors for the crisis, one has to view the issue starting with the repeal of the Glass Steagall Act in the US in the late 1990s.

The Glass Steagall Act was passed in the aftermath of the Great Depression in the 1930s and the act separated commercial banking from investment banking and provided for safeguards against too much leverage and excessive risk taking. This was the high point of the regulatory push towards ensuring that the financial sector does not play around with peoples’ money. However, once the act was repealed, Wall Street Banks immediately started to consolidate leading to the phenomenon of the “Too Big to Fail” financial institutions in the present times. An example of this is the merger of Citicorp and Travelers Group along with Salmon Smith Barney which represented the triumph of high finance over other sectors.

Apart from this, the regulators allowed the derivatives market to flourish leading to the practice of trading derivatives over the counter instead of through a clearinghouse.

The point here is that trading of any securities and financial instruments is typically done through a centralized mechanism which means that regulators can track and clamp down on dubious practices.

For instance, think of the stock market as an example. Since the stocks are traded publicly through the mechanism of the market, the SEC (Securities and Exchange Commission) in the US and the SEBI (Stock Exchange Board of India) in India have the power of oversight and regulation over the trading and hence can sense if something is amiss and crackdown accordingly. Of course, this happens more in theory than in practice as any stock market participant knows.

However, even this mechanism which acts during crisis times was absent in the derivative market which meant that the “Wild West” was indeed being replayed in the derivative market with shotgun trades and free for all business practices. This meant that once the crisis struck, nobody had a clue about the exact size of the derivative market and this led to successive rounds of bailout of the banks since each phase represented a particular segment of the derivative market going bust.

No wonder the legendary investor, Warren Buffett called derivatives “Financial Weapons of Mass Destruction”. Indeed, as the global economy realized after 2008 and is still discovering, this characterization of derivatives is indeed true and factual.

Finally, apart from these factors, the regulators were also guilty of sleeping through the boom years as nobody wanted to pull the plug on an extended bull market.

Further, even the tiny minority of whistleblowers was effectively sidelined and their voices drowned in the roar of cowboy capitalism. These are some of the aspects in which the regulators failed in their duty as well as the aspects where they could not do much since the laws were amended to favor Wall Street.