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Are Banking Regulations Heading In The Right Direction?

The financial crisis of 2008 forced everybody to look at the bank regulations more carefully. There is one side which believes that over the period US banking industry was de-regulated which led to a lot of reckless risk taking. British banking regulator Donald Kohn, a former Fed vice chairman, told British lawmakers he had abandoned his belief that bankers’ self-interest would keep markets safe.  “I placed too much confidence in the ability of the private market participants to police themselves”.

Time and again other regulators across the world have expressed similar concerns.  Public opinion has also been against banks. In a March 2011 national poll conducted by Bloomberg, only 19% respondents said that banking regulations were too strict. 76% said that current rule were too soft and should be tightened.

On the other hand, some people believe that all the reaction and allegation about the role of banking companies in 2008 crisis is baseless. The newly appointed Chair of American Bankers Association, Frank Keating thinks that there were a lot of non-bank actors that contributed to the crisis. In his opinion, from pay-day lenders to Government Sponsored Entities such as Freddie Mac and Fannie Mae are all to blame for the crisis. In an interview recently he said “if you analyze the crash of 2008, most of it was the result of non-bank recklessness and the actions of the unregulated. The Consumer Financial Protection Bureau focusing in on, for example, payday lenders and mortgage brokers and the like — the non-bank sector — that’s not inappropriate and certainly jurisdictionally it’s legal. The average person doesn’t know that the banks represented around this table had zero to do with the collapse of the economy..”  It is often argued that these regulations would raise the cost of credit which ultimately would hurt businesses and industry.

However, in these big debates, we are forgetting some basic issues that might have contributed to the housing bubble. Here are some issues that need to be carefully considered in this debate:

  1. How did banks fail to see what the true value of a real estate was? Banks are supposed to have a better sense of valuations than common bank.
  2. Who regulates real estate professionals, loan originators, appraisers and other input providers in a credit decision and what are their incentives? Did State Appraisal Boards ever look at inflated housing prices that form the basis of mortgage backed securities? Do these input providers face significant penalties for bad inputs? Did they help inflate home values and equity?
  3. Did deregulation of banking also accompanied with perverse incentive system for bank executives? For example, stock-based pay generally encourages executives to greater risk-taking. This could become more severe if these executives also have others’ money to play with. Banks enjoy a lot of this financial leverage. Did this leverage coupled with stock-based pay and low regulations encouraged them make highly investments?

What do you think? Please share your thoughts in the comment section below!

Arun Upadhyay, Ph.D.

Arun Upadhyay, Ph.DDr. Arun Upadhyay teaches finance courses in the College of Business at University of Nevada Reno. His primary teaching area is corporate finance. Before moving to academic world, Dr. Upadhyay worked for several years with a commercial bank in the area of credit analysis and international banking. He received Ph.D. in finance from Temple University. Dr. Upadhyay’s research focuses on corporate governance issues. He studies corporate leadership structure and executive compensation. He has published articles on board structure in high quality finance journals such as Financial Management, Journal of Corporate Finance and Journal of Business Finance and Accounting.