POST CRISIS SECURITIES REGULATION

AND MARKET DISCIPLINE

Kashif Ghani1

Abstract

This paper describes how our ideals of financial regulation failed to prevent yet another financial

crisis. It lays emphasis on the lessons we have learnt from the Global Financial Crisis (GFC)

and the realization that our new measures aimed at preventing a crisis might fail to prevent the

next crisis. It has been argued that market discipline and regulation must be balanced in a

manner that they complement each other in order to achieve the objectives of regulation. The

paper discusses the changes required to be made in the financial regulations framework that

may help reduce the likelihood and impact of future crises, the degree to which market discipline

and disclosure regime can be relied upon to achieve the objectives of regulation and the type of

crises that are likely to challenge the stability of our financial systems in future.

JEL Classification: G01, G18, G28,

Key words: Global Financial Crisis, Financial Regulation, Securities Regulation, Market

Discipline, Financial Stability, Disclosure

1 Kashif Ghani is Deputy Director at Securities & Exchange Commission of Pakistan (SECP). The views expressed in this paper are the views of the author and do not represent the position of the authors employer. Email: kashifgm105@hotmail.com

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1. INTRODUCTION

The Great Recession now ranks as the most serious financial crisis we have

seen since the great depression. It has shaken publics confidence in the

financial systems considered extremely robust only a couple of years back.

The crisis brought the world financial system almost to the brink of collapse.

Financial markets were only able to continue performing their functions as a

result of expensive rescue of public sector banks.

IMFs Global Financial Stability Report (2011) point out that despite some

signs of improvement in economic growth, the global financial stability is yet

to be achieved. According to IMF, although the financial markets have shown

signs of stability, risks and challenges still remain that need to be addressed. In

advanced economies, governments continue to be indebted and the financial

institutions are struggling to recover from shocks.

Indeed the Great Recession has reminded us of many forgotten lessons. The

most important being the need to rethink our financial regulations framework.

One thing that the crisis has not changed is the basic objectives of regulation.

Even after the crisis, the objectives of securities regulation remain unchanged.

Regulators still need to focus on maintenance of investor confidence,

promoting fair and transparent markets and minimizing risks threatening the

stability of the financial system. However, much rethinking is required for

determining which tools and techniques must be employed in order to achieve

the objectives of securities regulation.

For the purposes of this paper, securities regulation is meant to include the

regulation of equities, bonds, collective investment schemes, derivatives and

other similar financial products.

Existing Literature

A large amount of literature exists on the causes of financial crises, the role of

market discipline and disclosure; on how regulation should respond to the

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financial crisis and how the financial crises have changed the way regulators

must design and implement rules and standards.

An important study in this context is one by Zingales (2009) who advocates a

series of reforms directed toward improving corporate governance, putting

renewed emphasis on protecting unsophisticated investors and development of

set of rules aimed at minimizing the regulatory gap between private and public

equity markets. This study is unique as it gives an historical account of how

securities regulation has evolved over time and how present day regulators

may benefit from regulatory success stories of the past.

Another significant contribution was made by Poser (2009) in his study that

highlights how regulators lost sight of their basic objectives of regulation and

failed to respond to the changing market dynamics in the period leading up to

the financial crisis. Specifically, it gives a history of SEC USA, its evolving

focus over time, the debacles that are termed SECs failures and the reasons

why SEC failed to prevent two major crises in 2008. Poser (2009) argues that

the regulators were unable to prevent these crises primarily due to their

obsession with market deregulatory philosophy. He proposes that SEC USA

needs to restore its activism of the 1930s and 1960s along with keeping itself

familiar with new financial instruments and entities through in depth studies of

particular segments, activities and players in the market.

A recent study by Erskine (2010) focuses on the changes required in the

regulatory mindset and the financial regulation framework in the post crisis

period. Erskine (2010) provides a detailed review of policies and principles

that were conventional wisdom before the crisis and that eventually turned

out to be contributors to the crisis. This study also proposes a shift from a

deregulatory mindset and stresses the need for avoiding over-relying on

financial markets to self-stabilize. The author further argues that the need of

the hour is the adoption of a wider view that takes account of systemic risks to

financial stability.

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A very important study with reference to the crisis in banking is the FSAs

report called The Turner Review (2009), which covers in great detail the

causes of global banking crisis and how bank regulators should respond to the

changing scenario after the lessons learnt from the crisis. It proposes a large

set of reforms aimed at averting a future crisis in banking, including

improvements to the capital adequacy framework, institutional and

geographical coverage of regulations, changes to the regulation of gatekeepers

(e.g. credit rating agencies) and changes in the regulators supervisory

approach, among other things. There are a number of other studies on various

areas of securities regulations, market discipline and the impact financial crisis

is likely to have on financial regulation.

This paper attempts to add to the existing literature on financial regulation in

the post-crisis-era by focusing on how our ideals of financial regulation failed

to prevent a crisis. What lessons we have learnt from the Global Financial

Crisis (GFC), the changes in regulatory framework that may reduce the

likelihood - and more importantly, the impact of future crises and the

realization that our new measures aimed at preventing a crisis might also fail

to prevent the next crisis. An effort has been made to emphasize that financial

regulation and market discipline should be thought of as complementing each

other, rather than being substitutes. Hence, this work stresses the need to strike

the right balance between regulation and the measures to promote market

discipline. The limitations and benefits of market discipline as a regulatory

tool are touched upon. The major focus is on the changes required to be made

in the financial regulations framework, the degree to which market discipline

and disclosure regime may be relied upon to achieve the objectives of

regulation and what type of crises are likely to challenge the stability of our

financial systems in future.

The remaining part of this paper is structured as follows: Section 2 discusses

the lessons learnt from the financial crises and how they have changed our

thinking about the ways markets should be regulated. Section 3 highlights the

uses and limitations of market discipline and disclosure as an aid to financial

regulation. Section 4 describes the shifting focus of financial regulations to

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meet the needs of the post crisis scenario. Section 5 gives a brief description of

the types of crises we are likely to face in the future despite our best efforts.

Section 6 concludes the discussion.

2. LESSONS WE HAVE LEARNED (OR NOT LEARNED)

What went wrong?

Financial crises are centuries old phenomena and the first crises are traced

back to the beginning of capitalism (Bordo, 2007). Various explanations have

been presented as to the causes of the present crisis; including overrating the

value of market deregulatory and self-stabilizing approach, over-reliance on

disclosure for achieving market efficiency, the failure to assess systemic risk

etc (Erskine 2010). It must be understood here that the great recession was

primarily caused by a credit shock that eventually resulted in a banking crisis

and recession. However, securities markets being part of the interconnected

financial system could not be insulated from the effects of the crisis. The

ultimate outcome was increasing defaults on corporate bonds and decline in

equity prices. The securities markets also played their part in the present crisis

as Credit Default Obligations (CDOs) and Credit Default Swaps (CDSs) (a

type of derivative product) are considered to have made a significant

contribution to the present crisis. It may be noted that derivatives are generally

supposed to be regulated by securities regulators, though CDOs and CDSs

were largely unregulated.

Many attempts have been made to analyze the factors and circumstances

leading up to the GFC. One theory suggests that macro imbalances played a

significant role in the factors leading to the GFC as the oil exporting countries

and Asian giants like China and Japan had huge current account surpluses in

the period leading up to the GFC and countries like UK and USA had large

current account deficits (The Turner Review, 2009). Very high saving rates

existed in countries having current account surpluses while some developed

countries like UK and USA had very low real risk free rate of interest. This

meant that in USA and UK the investment avenues promising higher expected

rates of return became very attractive for the investors. This led to an increase

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in demand for innovative products offering higher yields and as a result

emerged a large number of structured products that offered the investors

varying levels of risk, return and liquidity options compared with traditional

fixed return instruments. The development of a large number of structured

products that were largely unregulated; combined with growing size of the

financial sector, increasing leverage, increasing interconnectedness of

financial intermediaries and inability of these structured products to insure

against the risk of default, eventually led to the emergence of current financial

crisis on a global scale.

Similar views have been expressed by others such as Martin (2009) who

observes that securitization of subprime mortgages, the decline in real estate

prices, the complexity of the products that were being introduced (with

accompanying lack of information) and mark-to-market accounting issues

contributed significantly to the credit crisis.

Lessons we learnt from the crisis

In the pre-crisis period markets were considered to be self-equilibrating and

rational and it was believed that economic efficiency and stability could be

ensured by market completion (Turner, 2010). Innovation in finance and

increase in trading activity were to be always welcome as these were

considered pro-growth.

Various reasons for failure of national regulators have been elaborated. For

instance, staff conflict of interests, lack of training, budgetary constraints and

fragmented regulatory system have been cited as the reasons for the failure of

SEC USA to prevent major debacles. But the most important factor that stands

out is the anti-regulatory climate (Poser, 2009). It was widely believed that a

pro-market, deregulatory mindset had led to fluctuations in growth and

inflation being moderate. The existence of relative financial stability was seen

as evidence that the deregulatory approach was indeed working effectively

(Erskine, 2010). It is said that SEC in USA had moved, in the pre-crisis

period, from an investor protection approach to protecting the companies and

investment firms that it regulated. Regulation was thought to be hampering

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growth of financial markets and considered costlier than the benefit it

provided (Poser, 2009).

Lack of trained and experienced staff of the regulatory organizations is

another reason cited for spread of crisis situation. Regulatory staff often lacks

the required incentives to pursue in depth investigations. The relations with

market players (some of them are seen as potential future employers) are also

at stake providing further disincentive to the staff working with the apex

watchdog. Frequent hopping of jobs between the regulator and the institutions

being regulated also works against effective regulation of these entities due to

the so called revolving door problem. Shortage of training for staff members

of the regulatory agencies and higher remuneration in the private sector also

hinder the regulators ability to develop and retain valuable human resources.

3. MARKET DISCIPLINE, FINANCIAL STABILITY AND

DISCLOSURE

Market discipline is the mechanism (constituting information, incentives and

controls) to monitor and discipline excessive risk taking behavior of market

participants. Market discipline is considered complementary to, rather than a

substitute of, supervision and regulation in present times. Information

asymmetries between regulator and the financial institutions, combined with

the problem of political considerations or weak legal systems augments the

need for market discipline as an aid to regulation. Other factors enhancing the

need for market discipline include increasing complexity, innovation and

globalization of financial institutions. Regulations, among other things, should

be aimed at enhancing the power of markets to discipline themselves.

Financial stability may be achieved through the formulation of sound policies

and institutions in order to prevent, manage and resolve financial crises. It

must be understood that we cannot eliminate the possibility of crises; we must

accept there would be failures but failures should not lead to a systemic

collapse.

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It is widely believed now that market discipline failed to limit risk taking

behavior of market participants within acceptable parameters during the GFC.

In the pre-crisis period disclosure framework and a set of rules were thought to

be sufficient to prevent excessive risk taking and encourage banks and other

intermediaries to act in a way that promoted confidence of their customers

(investors) in their services and in financial markets generally. Market

gatekeepers were expected to adhere to highest professional standards as their

reputations were supposed to be at stake; however, this was essentially a

simplistic view which the crisis has proved to be incorrect. Some scholars hold

that market discipline did work but its effect was too little too late to avert a

disaster. Even in that case, there would still be need for taking further steps for

strengthening the mechanics for stronger market discipline.

The regulators now face the challenge of restructuring financial markets in a

way that promotes financial stability, without compromising on efficiency.

Regulators must make efforts to limit the undesirable, destructive competition

and excessive risk taking by market participants. However, to promulgate

countless new rules and regulations in an attempt to cover every possible

aspect of the behavior of financial institutions would be inefficient as well as

ineffective. Inefficient because doing so will also require increase in the staff

required for enforcement of those rules; and inefficient because covering each

possible aspect is humanly impossible, especially in this era of financial

innovation and ingenuity. Thus such detailed rules would ultimately fail to

prevent the next crisis and all efforts in designing those detailed rules will

prove fruitless. In this context, putting in place a robust system of market

discipline is likely to prove more beneficial.

On the other hand, the idea of banning every product that is considered evil,

dangerous or vaguely suspicious for the unsuspecting investors and for the

financial markets at large, is impractical. Regulators, therefore, need to place

more emphasis on the discipline coming from within the market

(Shanmugaratnam, 2001).

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Thus market discipline needs to be strengthened (by adopting means such as

improved disclosure requirements) but it should not be solely relied upon to

avert a future crisis. Regulation should strengthen and reinforce market

discipline. As argued by Shanmugaratnam (2001) there ought to be a system

of laws, rules and regulations to aid and assist the market disciplining

mechanism. Rules should be framed in favor of companies that follow high

corporate governance standards and adopt adequate disclosure policies.

Whereas those who adopt suspicious practices and are involved in market

manipulation should be punished. Conflict of interest situations need to be

handled carefully to ensure they do not work to the detriment of market

discipline.

Stephanou (2010) has proposed a framework2 based on four pillars:

1) Information and disclosure

2) Market participants

3) Discipline mechanisms

4) Internal governance

The first pillar stresses the need for availability of adequate and reliable

information on the financial performance and risk exposures of financial

institutions for making timely and informed decisions.

The second pillar underlines the need for existence of independent market

participants possessing the ability to accurately process the information and

the right incentives to monitor the risk exposures of the financial institution.

The third pillar stresses the need for existence of disciplining mechanisms/

instruments that may be used by market participants to exercise discipline or

penalize excessive risk taking. Ideally, the market should provide sufficient

solvency signals for instrument holders or creditors to demand change of

management or for the regulators to intervene.

2 A similar model has been proposed by Crocket (2001)

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Finally, the organizational and governance structure, remuneration of

executives, board composition, independence and qualifications are crucial for

the effective functioning of market discipline.

These pillars serve to outline the pre-requisites for existence of an effective

market disciplining mechanism. However, a more pertinent question now is

what practical steps can be taken from a regulatory perspective to increase the

effectiveness of market discipline for averting a crisis. The steps that can be

taken to improve the market discipline framework include:

- lowering the cost of monitoring by market participants, by putting in

place additional, carefully thought out disclosure requirements and by

provision of reliable and timely information

- Encouraging the monitoring by market participants, by ensuring that

required incentives are in place. This may include redesigning safety

nets and assuring that executives of poorly managed financial

institutions will not go unpunished (the least amount of punishment

being loss of jobs). On the other hand, investors must share some

burden for their poor investment decision.

- Improving the corporate governance environment at the financial

institutions to ensure that management has sufficient interest and

incentive to respond to market signals effectively

The merits and limitations of disclosure as a regulatory technique

Inadequate disclosure has been termed as one of the major contributors to the

global financial crisis. It has been argued that investors failed to understand

the risks involved in investing in structured securities primarily due to

insufficient disclosures. Furthermore, common investors often lacked enough

information about the functioning of the credit rating agencies and

repercussions of excessive executive compensation.

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The basic premise behind the presumed effectiveness of disclosure as a

regulatory instrument was that investors are primarily rational, who, when

provided with sufficient information, make optimal resource allocation

decisions aimed at wealth maximization. Being a part of the deregulatory

mindset, framing rules for disclosure of plenty of information was a major

focus of regulators as it would result in investors making informed, rational

decisions and markets essentially regulating themselves. An important

question that needed to be addressed was whether investors would be able to

process (i.e. make sense of) the mass of information being disclosed and be

able to make rational decisions? The quality and relevance of information and

the ability of the investors to process that information are important

considerations (Avgouleas 2009).

It is argued that many of the risk factors that eventually led to the advent of

financial crisis were disclosed in considerable detail in various documents;

however, the users of information were unable to understand the true

implications of such risk factors and the effect these were likely to have on

their investments. Even more difficult it would have been for an investor to

fully comprehend the combined effect of these factors on the financial

markets.

Product complexity also contributes to diminishing the utility of disclosure as

the quantity of documents required to be read and understood by the investors

keeps increasing with increasing complexity (Schwarcz, 2008). Innovation in

financial markets and products makes their understanding much more

cumbersome. Other socio-psychological factors such as performance

pressures, herd behavior and cognitive biases also play their part in reducing

the effectiveness of disclosure as a regulatory technique.

It is important that Regulators understand disclosures inherent limitations.

One of the limitations is the way information is presented to the prospective

users of information. Framing of information in a leading manner may serve to

defeat the very purpose of a disclosure regime. The less sophisticated, less

informed users of information are at greater risk of being mislead due to

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framed disclosures (Tversky and Kahneman 1986). Even sophisticated

institutional investors may struggle to free themselves from the effects of such

framed information and the regulators have limited control over such framing.

Despite its limitations, disclosure as a regulatory technique offers many

benefits including allowing market participants to battle market abuses and

aiding decision making. Regulators need to consider the timing, frequency,

content and format of such disclosures keeping in view the limitations of

disclosure and the objectives to be achieved. These considerations regarding

disclosure need to be guided by experimental and empirical studies that test

and measure the impact and effectiveness of information disclosed, as

suggested by Gerding (2006) and Avgouleas (2009). However, there have

been experiments that have shown that changing the volume of information

disclosed may have minimal effect on investors decisions (Choi et al, 2010).

More experimental evidence is essential to further our understanding of the

subject.

The issue of product complexity is already being tackled by the regulators by

focusing on product standardization and improvement of clearing and

settlement systems. Further considerations include whether complex financial

products should be allowed to be market to the less sophisticated investor. An

important reflection in this respect would be the use of soft paternalism

mechanism (Avgouleas, 2009).

Conflicts of interest (CoI)

Eliminating all conflict of interest situations may not be practically possible

for any regulator. However, conflicts of interest are to be managed in a way

that their effects are minimized. Complete elimination of conflicts of interest

situations would only be possible under the theoretical perfect competition and

absence of asymmetric information. COIs are of special interest to regulators

because exploitation of conflicts of interest situations by market players may

have negative consequences for the confidence investors have in the financial

markets.

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Regulators have been criticized for being too lenient on market intermediaries

and failing to properly deal with conflict of interest situations. They are now

faced with the task of devising regulations to address conflict of interest

situations that endanger the health of our financial system. Market

intermediaries are naturally at an advantage in terms of access to information.

Market imperfections and asymmetric information are the key reasons which

may lead the intermediaries to exploit such situations. The regulators are again

faced with the uphill task of balancing regulations as too lenient regulations

would permit exploitation by market intermediaries at the cost of their clients.

On the other hand, too harsh regulations run the risk of inhibiting growth by

disallowing activities that may otherwise be appropriate. Regulations should

ideally focus on encouraging the development of internal controls that help

control such conflicts of interest (Emerging Markets Committee of IOSCO,

2010).

Moreover, as with any set of rules and standards; the implementation and strict

enforcement of laws is as important from regulatory point of view as the

regulations themselves. Regulators also need to develop required capabilities

and technical expertise to carry out investigations and take effective

enforcement action with reference to COI situations. Rules and regulations

should be primarily aimed at changing the behavior of firms concerned as

avoidance of COI situations inevitably involves exercise of best judgment by

the management of these intermediaries. As conflict of interest situations can

take many different forms; it is practically not possible to devise a set of rules

for each type of COI situation. Thus rules should be targeted at developing

higher level rules for guiding the behavior of management of financial

intermediaries, combined with strong monitoring by the regulators. The

methodology to be adopted by the regulators may include encouraging firms

to engage senior management of the entities in the decisions involving COI

situations.

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4. THE REGULATION OF SECURITIES MARKETS POST

CRISIS?

Regulators have started rethinking securities regulations after the lessons

learnt from the financial crisis. Thus many of the measures proposed in this

paper are currently under consideration of regulators or already in the process

of being implemented. However, a pertinent consideration at this point in time

the formulation of plans that are well thought-out and the willingness to stick

to those plan during the times of resistance and criticism.

i) Focus on Principles based regulations

Principles based regulations (PBR) are the need of the time. Principles based

regulations means broad set of standards focusing on the final goal to be

achieved rather the mechanics of it. These standards would be aided by set of

guidelines on how to achieve the desired outcomes. PBRs mean focusing less

on chalking out detailed rules and prescriptions on how firms should operate.

Instead the PBR give the firms more independence to operate within the set

regulatory principles.

Principles based regulations are preferable over the more detailed rule based

regulations on the grounds that prescriptive standards have not been effective

in complete prevention of market misconduct (Committee on Capital Markets

Regulation, 2009). Detailed rules and regulations are burdensome for the

regulators to devise and cumbersome to follow for the regulated entities.

Detailed rules also fail to capture the changing nature of the financial sector

and regulations often struggle to keep pace with innovations in products and

range of services offered. Regulations based on principles are more likely to

create an environment conducive to such innovations and advancements. The

expectation that rules and regulations would always keep pace with these

innovations is unrealistic and is likely to create hindrance to novelty in

products and services. As the complexity of financial market and products

increases, so will the complexity of rules to be followed.

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Detailed rules and regulations make compliance more difficult especially for

the smaller companies that lack dedicated resources having expertise in legal

and regulatory matters (The Financial Services Authority, 2007). Sometimes

elaborating such details may also have negative effect of both regulator and

the regulated entity being engrossed in ensuring compliance with the law in

letter, but unable to follow its true spirit.

The risk-based regulation focusing on principles rather than detailed rules, is

likely to contribute to better understanding and compliance of law in its true

spirit and would also contribute towards the reduction in human resources

employed in framing of laws and ensuring compliance.

However, it must be understand that this shift of focus does not mean

complete elimination of rules and regulations. There will always be need for

detailed rules in some areas which will be required to be in place. This

approach aligns well with the participatory role of the regulator as it makes

following the law less cumbersome for the regulated entities.

In this context, the concept of cost-benefit analysis of regulations needs more

emphasis from regulators. Regulators need to focus on the accurate

measurement of the costs that institutions have to incur in order to comply

with regulations for the reason that most of these compliance costs would

eventually be passed on to the clients/ shareholders of those institutions.

ii) Reducing Systemic Risk

Instruments such as Credit Default Swaps (CDS) have been blamed as

contributors to the GFC. However, the proponents of these instruments opine

that the instruments are not evil by substance and changes in the way these

instruments are traded may magnify their utility as tools for diversifying credit

risk. However, the current CDS market has potential to destabilize the

financial system as it is susceptible to a chain of counterparty defaults

(Committee on Capital Market Regulation, 2009).

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The recent financial crisis has indeed exposed the credit, operational and

systematic risks inherent in an unregulated CDS market. Some of these

inherent risks can be mitigated by making CDS instruments subject to

centralized clearing.

Anabtawi and Schwarcz (2011) have proposed a three-pronged approach for

dealing with systemic risks. The authors argue that in order to manage

systemic risks, three inter-related factors must be controlled; namely conflicts,

complacency and complexity. These are considered to be factors that the

market participants cannot be expected to address by themselves.

Regulations directed towards managing systemic risks must take into account

behavioral factors that lead market players to take decisions that would not

pass the test of rationality. Behavioral biases lead individuals to make errors of

judgment regarding the risks involved in their investments thus contributing to

enhanced systemic risk. Encouraging companies to provide their risk

managers with reasonable degree of independence and authority to question

excessive risk taking behaviors by decisions makers is one way of handing this

problem. Furthermore, companies may be encouraged to perform qualitative

analysis of risks, in addition to the use of quantitative models.

Agency problems lead managers to take excessive risks or the risks that

shareholders do not want the company to undertake. Regulators can play their

part by encouraging companies to align executives remuneration with

companys long-term performance. Furthermore, regulators must also consider

the ability and willingness of market participants to appreciate risks inherent

in their investments. Complex financial products sometimes make it difficult

for decision makers to fully appreciate the risks involved in their investments.

This leads to enhanced threat to the stability of the financial system.

iii) Need for enhanced International Cooperation

Enhanced international cooperation among regulator would be required in the

post-crisis period as the financial markets become global and more inter-

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connected. This cooperation will reduce the opportunities for regulatory

arbitrage available to some financial firms. Regulators would also benefit from

exchange of information and insights gained from local regulatory experiences

which will aid in devising policies.

iv) Other considerations

Carvajal and Elliott (2007) argue that:

a combination of factors, including insufficient legal authority, a lack of

resources, political will and skills, has undermined the regulators capacity to

effectively execute regulation. This weakness is more acute in areas of

increased technical complexity such as standards for and supervision of the

valuation of assets and risk management practices.

The regulators need to re-adopt the policy of active regulation with strong

regulations focusing on investor protection and market stability. Regulators

must keep themselves abreast of developments taking place in the financial

markets, train and equip their staff members to better regulate complex and

innovative financial products being introduced from time to time. Regulators

need to strike the right balance between promoting growth of financial

markets and achievement of market discipline and stability. The staff members

at the securities regulators must be provided proper training along with a

career path that incentivizes them to pursue a long term career with the

regulator. This will reduce likely conflicts of interest caused by the fact that

market participants could be possible future employers for staff members. This

may also mean grooming of staff members and preparing them for

appointment at senior most positions (e.g. Commissioners) in the regulatory

bodies.

The regulators need to rediscover their focus on optimal corporate disclosure,

corporate governance and auditing & accounting oversight. The regulatory

framework must be made less complicated in order to minimize the room for

regulatory arbitrage or the possibility that a specific type of market player or

product could evade the ambit of regulation. This will lessen the likelihood

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that one particular area would remain unregulated owing to unclear

demarcation of responsibility between regulators.

The regulators must appreciate their roles in restoring public confidence in

financial markets and institutions. Necessary steps for restoration of that

confidence include not only development but strict enforcement of rules that

assure the investing public that necessary controls have been put in place and

anyone who defrauds investors will be taken to task.

It has also been proposed that in order to achieve the goal of investor

protection; the regulators should consider aiming to dissuade unsophisticated

investors from investing directly in the security markets (instead encourage

investment through mutual funds). This may done, for instance, by including a

disclaimer similar to ones given by mutual funds, in the broker contract that

investing directly in securities markets involves considerable risk and is

suitable for well knowledgeable investors only (Zingales, 2009). This will

allow regulators to focus more on asset managers and mutual funds and

possibly eliminate the need for detailed rules intended to protect unsuspecting

individual investors. Removal of some of the tedious rules may also encourage

more companies to offer their securities to the market.

The conventional goal of educating investors must be brought to the fore-front

with the increasing complexity and innovation of in financial markets and

products. Investors must be made aware of the risks involved in different type

of financial products keeping in view the ultimate goals of investor protection

and controlling systemic risk. The drawbacks of the present system of investor

education must be assessed and current investor education programs revamped

to make them more effective in the post-crisis environment. The focus should

go beyond fraud education to include education on risky investment avenues,

risk assessment mechanism, functioning of credit rating agencies and rights of

shareholders etc.

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5. WHAT KIND OF CRISES CAN WE EXPECT IN FUTURE?

HOW CAN WE DEAL WITH THEM?

It needs to be emphasized that no set of financial or macro regulations can

completely eliminate the possibility of occurrence of financial crises. By

improving the regulatory framework, however, we aim to reduce the impact of

these crises as and when they occur and also decrease the likelihood of such

crisis leading to complete financial turmoil by not being able assess or manage

the systemic risk.

Price bubbles have been at the forefront of many of the crises in recent times

and excessive risk taking and herd mentality will probably continue to produce

price bubbles in years to come. Gerding (2006) has done extensive work on

the financial crises, price bubbles and on the decay of securities regulations.

His argument revolves around two basic premises. First, a period of financial

growth generally creates or strengthens political pressure in the favor of a

framework inclined towards deregulation. In a period of financial growth

culminating in a bubble, market players lobby for less stringent securities laws

citing prevailing financial stability and growth. Rules and regulations

restricting excessive risk taking are portrayed as impediments to the growth of

the financial sector. Thus policy makers are persuaded to consider diluting

securities regulations with an aim to promote growth. The resistance by

market participates may also include resistance against new proposals that

address excessive speculation and risk taking. A period of growth and relative

financial stability thus becomes non-conducive to imposition of limits on the

risk taking of institutions. Secondly, bubbles tend to enfeeble even those

regulations that remain unaffected by political pressures. This can be caused

by several factors, including increased work load and pressures to finalize

impending deals - performance pressures that may lead to industry wide

decline in professional norms and weakening status of compliance with laws

and rules.

Many different theories aimed at preventing asset price bubbles and

minimizing the systemic effects of bursting of price bubbles have surfaced.

20 | P a g e

One of the possible solutions could be, as suggested by Gerding (2006), to

politically insulate the regulators so that the impact of political pressures on

the decisions of regulators would be minimal. However, practically insulating

regulators from political pressures is not an easy task. Allen and Gale (199)

have proposed a theory that emphasizes the relationship of credit availability

and asset price bubbles. This theory proposes that central banks should try to

avoid unnecessary expansion of credit as well as the uncertainty regarding

future credit expansion. The authors suggest that if central banks can control

the level and volatility of credit, it is likely to help prevent asset price bubbles

as, according to this theory, high current credit levels as well as expectations

of higher future credit levels can contribute to price bubbles.

Financial institutions and their managers are under pressure during periods of

sustained economic growth to report profits, comparable or better than

competition. These performance pressures lead managers to assume excessive

risks in anticipation of higher profits which results in greater systemic risks.

Managers unable to keep pace with competition are considered under-

performers and often end up getting below par remuneration. Companies that

succumb to this performance pressure often expand at a faster pace using

higher leverage. This works without much trouble during the periods when

asset prices are on the rise, stock markets are performing well and there are

few defaults on the bond market with sufficient liquidly in the system.

However, as the boom nears its end, liquidity dries up especially for highly

leveraged firms who have already started experiencing higher defaults partly

due to lower standards of credit assessments used during the period of

aggressive growth. Thus booms and busts follow each other in a cycle and

prohibiting the use of particular products would do little to prevent the next

crisis (Goodhart, 2009).

Liquidity, credit and banking crises might continue to occur every now and

then in one part of the world causing trouble elsewhere in this increasingly

interconnected financial world. The task for regulators is tough as they battle

to find the right policy response to these recurring crisis situations.

21 | P a g e

The reliance on complex mathematical models and theorems is already being

criticized as some experts believe that a broader understanding of macro

economy may prove more beneficial for stabilizing our financial markets

(ALDE Workshop, 2008).

6. CONCLUSION

Securities markets regulations can greatly benefit from the increasing

emphasis and focus on relevant research. Regulatory authorities need to

realign their research budgets so that in-depth research on the issues affecting

the stability of our financial system is conducted and appropriate policy

recommendations are formulated. Dedicated human resources specializing in

research on regulations and policy issues should be developed for this purpose.

The recommendations from these researchers should be given due weight-age.

One of the lessons learned from the financial crises experience over the years

is that regulators must discontinue being over-reactive to market events.

Sarbanes Oxley Act was enacted in 2002 in response to major corporate

scandals such as Enron and Worldcom. Checks on executive remuneration

were introduced immediately after expensive bailouts of troubled banks; and

there have been calls for complete banning of CDS after credit crisis. Far from

commenting on the merit of some of these actions, this paper argues that

regulators need to stick to the principles of regulations during the periods of

growth and during crises, rather than being lax during a bubble and over-

stringent after a bust.

As suggested by Barr et al (2009); regulations must be behaviorally

informed. Regulators must consider the limitations of disclosure and market

discipline due to behavioral factors and the design of all future policies should

take into account the complex mix of rational choice and behavioral biases

which inherently reduce the predictability of these regulatory choices. Policy

makers must have the realization that market players do not always act in their

own interest (i.e. due to complexity, complacency and conflict as suggested by

Anabtawi and Schwarcz, 2011). Thus market players cannot be expected to,

automatically take into account the collective interest of the whole market.

22 | P a g e

This is due in part their inability to see the complete picture (as also suggested

by Gorton (2009)).

Regulators would also contribute to improving the stability of our financial

system by renewing their focus on investor education. We have seen time and

again that the complexities and conflicts of modern day financial markets

make it hard for even the sophisticated investors to make rational decisions.

This further amplifies the need for enhanced efforts for carrying out

comprehensive investor awareness programs that warn unsuspecting investors

of the real risks of entering the financial markets. These efforts will go a long

way towards reduction of systemic risk and hence achievement of the

objectives of financial regulation.

The history of financial crises over the last two centuries enlightens us that the

causes common to most crises were excessive risk taking, failure to limit

systemic risk, imprudent lending, lack of understanding of complex financial

products (a more recent phenomenon) and conflicts of interests (ALDE

Workshop, 2008). Regulators must realize that crises have occurred despite

our best efforts and this fashion is likely to continue in years to come. The

belief that future crises are likely to possess similar characteristics to the ones

we have seen in the past, is indeed a silver lining as it provides guidance to

regulators and policy makers in their quest to minimize the likelihood and

impact of such crises.

23 | P a g e

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