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Who Cares About Regulations?

October 17, 2010 Leave a comment

American journalist Mignon McLaughlin once said that we humans are “…all born brave, trusting and greedy, and most of us remain greedy”. This has some truth to it, even if at certain levels of greed. For the most part though, the majority of individuals have control over their ‘greed’ (for a lack of a better word) by adhering to certain censorship codes, whether be it: religion, morals, ethics, social norms, etc. That doesn’t mean though, that there does not exist individuals who allow greed to consume them, and guide their decisions. With all the dangers surrounding the decisions taken by such individuals, perhaps the most of which, are those that have negative effects on other individuals. If we project such dangers onto the financial industry, then greedy decisions maybe referred to as systematic risk; “the unscrupulous actions of a few market participants could undermine public confidence in the entire financial system” (Levy and Post, p.896, 2005).

Given the potential fragility of financial markets, due to vulnerability from information asymmetry, agency problem, and transaction costs, lies the importance of regulating them. Regulations sometimes are viewed as tools, or deterrents, that “address systemic risk” (Schapiro, 2010). The main issue with financial markets is that incentives are misaligned on the “micro-level;  which [could result] in numerous potential conflicts of interest” (Kumpan, 2009). Regulations of financial markets are especially important in our current times, as when “financial institutions get bigger, markets move faster and investments grow more complex” (Schapiro, 2010), introducing potential cracks that ill-guided individuals may exploit. But one must not latch onto such negative view of regulations, as the main reason they are put there is to bring along with them added benefits to the financial industry; regulations are not closed doors. They attempt to align interests, effectively promoting for more efficient markets. They may also act as springboards in promoting more connected and expanded markets. The net effect is further industry stablility and stronger economies.

In deciding how much regulation should be put in place, one has to understand the reasons behind regulating the financial industry, and the implications that may be brought along with it. The benefits have been discussed above; which simply boil down to providing a better market platform that offers stability, efficient movement of capital and potential of growth. Many authors coined the term economic safety in describing such benefits. But “economic safety is more elusive than military safety …. too much safety undermines the very stability that safeguards promise” (Amity, 2010). Issues that should be taken into account when deciding on the level of regulation to be put in place, include:
> Available infrastructure: would a country’s given financial market infrastructure support such regulations? Whether the the answer is a yes or a no, how much will it cost to have such regulations put in place?

> Acceptability of local financial market: do such regulations actually benefit the players in a given financial market? [the point of these regulations in the first place is to benefit such users of the financial market — not burden them with no added benefits]

> Foreign investors: Given the interconnectedness of international financial markets, as a result of globalization trends, any regulation put in place by a specific country’s financial market could bare effects on other international markets. Thus, when drafting such regulations, financial market synergies along with foreign investors must be take into account; else the regulations would solve a specific issue while introducing more problematic issues.

> Market transparency and efficiency: the effect of such regulations on the market’s transparency and efficiency.

> Culture: on a more non-financial level, the regulations have to take into account social and cultural norms. These regulations, and the authorities who issue them, may find themselves in the spotlight, if for example, foreign investors are favoured over what is socially acceptable.

> … and many more issues

The degree of how much regulation should be put in place may seem like an simple task; one can argue that it borrows a page from the it ‘costs versus benefits’ theme. At the end of the day, there must exist certain goals and objectives for a given country’s financial industry; much like the goals and objective of companies. Regulations should promote and facilitate the achievement of such goals. For the most part, this is true, but what is different here is that the both internal and external environment that the financial industry interacts with is ever changing. And this change is a result of many variables, a lot of which are unknown territory for us: for example, our interpretation of the financial industry with advancements in technology, our definition of incentives, our understanding of ethics, etc.

“… it is managements’ job to organise, manage and control their businesses in a way which meets a set of high level principles … to safeguard the interest … and secure the safety and fairness of [financial] markets” (Tiner, 2005). Regulations are there to make sure that happens.

— Youssef Aboul-Naja

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The Pros & Cons of Financial Globalization

October 10, 2010 4 comments
Kofi Annan, the seventh Secretary-General of the United Nations, once stated that “… arguing against globalization is like arguing against the laws of gravity”. “From a historical perspective … globalization is not a new phenomenon” (Schmukler, 2004); though given the technological advancements in the most recent decade or two, globalization has manifested itself in all fields, “flattening the world” (p.51)  as Thomas Friedman called it. Technological advancements facilitated cheaper means of communication and transportation, effectively bridging the distance disparities between nations. From a financials’ industry perspective, this brought good news to both investors and businesses alike; or so it appeared from first glance!

There is no denying the advantages that are brought upon by financial globalization. Due to the interconnectedness of the world markets, a given country’s market will gain a “deeper degree of financial integration” (Schmukler, 2004). This translates to further market stability and regulation, strengthening investors’ trust in a given country’s market. Thus, businesses seeking to raise funds, will have a larger pool of investors to chose from. Due to the access of a larger pool of investors, “increased competitiveness” (Moldovan, 2010) will drive down the cost of funds for businesses. So not only will businesses have access to more funds, but the cost of raising the funds will be lower. From a global perspective, this will lead to “better allocation of capital” (Moldovan, 2010). From a specific business perspective, this may lead to businesses raising their required capital at the very least; it might even accelerate the business’s growth plans and funding requirements. This is most notable in low income countries, where a study conducted by the International Monetary Fund shows that private flows have “grown more than fourfold since the 1980s” (Dorsey, 2008).

 

 

 

 

 

 

 

(Dorsey, 2008)

 

 

Financial globalization also bares benefits to investors.  For example, it does promote for a “better financial infrastructure” (Schmukler, 2004). As a result, lenders and borrowers operate in a financial system that is more “transparent, competitive, and efficient” (Schmukler, 2004). This leads, from the investor’s perspective, to more trust in the financial system. It also enables the investor to make varied investments; allowing for the spreading of risk via  diversification.

But just like falling to the ground due to gravity, globalization has its dark side. Kofi Annon continued elsewhere to say that although “… globalization is a fact of life … we have underestimated its fragility”.

As the financial markets of the world become ever connected due to globalization, if a problem occurred in one part of the globe, it would “cascade [and echo] uncontrollably” (Beinhocker et al., 2009) in other corners of the world. The latest of such crises is the housing bubble burst in the United States. Therefore, the risk of financial globalization is market disturbance due to factors beyond that of the domestic market. What this may mean for businesses seeking capital at such times, is that it will not find any; or if it does, it will be at a very high cost. This will always be true, even in the case if a given country’s government takes necessary precautionary measures to support its financial market in times of needs

For example, Saudi Arabia has been preparing its yearly budget with the assumption that the price of the oil barrel is USD 40; though in reality, the oil barrel was being sold for over USD 100.  This created a lot of surplus for the Saudi government. When the housing bubble burst in end of 2008, the Saudi government tried to inject a lot of liquidity in its market. And although, Saudi Arabia was able to recover much quicker than other countries, the truth of the matter is that liquidity dried up in the country, and businesses seeking capital at that time, had to pay a higher premium to obtain it.

One benefit that was cited in regards to financial globalization is that capital, on a global scale, is distributed in the most efficient manner. But this same benefit may be viewed in a negative light by some business owners whom are seeking capital, due to the emerging trend of “imbalances in trade and financial flows” (Wyss, 2009). To such business owners, financial globalization dried up their pool of potential investors; or increased substantially their cost of capital.

Looking at things from an investor’s point of view, it can be argued that globalization of financial markets aid in spreading their risk via diversification, but when a crisis does occur, no financial market or industry is shielded. Thus, the spreading of risk efforts would be dampened due to globalization of financial markets. Sort of a double edge sword.

Another aspect that must be analyzed, from an investor’s point of view, is that due to the globalization of financial markets, capital is allocated in the most efficient manner; irrespective of other non profit oriented criteria. Rarely is a criterion such as the likes of morality, humanitarianism and environmentalism are incorporated in the definition of efficiency. Thus globalization of financial markets will penalize investors who don’t regard profits as their only priority.

— Youssef Aboul-Naja