President Obama has announced that further regulation of the financial sector is necessary to prevent another collapse of the system. In new legislation, the government would, for the first time, regulate derivatives.
Derivatives are a financial contract that ties its value to some other financial event, instruments or conditions. Such financial tools were central, in some aspects, to the failure of the bank system under the pressure of faulty subprime mortgage lending practices.
In that case, the banks’ liabilities derived their value from these subprime mortgages. When the mortgages lost their value, the liabilities likewise lost theirs. As banks increasingly lent mortgages to individuals who could not afford them, financial instruments that were linked to the housing industry began to fall. Since these derivatives were tied to the banks, the banks quickly failed.
Many argue that overregulation was the cause of the banks to fail, not a lack of it. In another blog, I argued that because the government offered to bailout banks if lent mortgages went under, it created a precedent of faulty business practices that ultimately kicked the taxpayer in the butt.
However, this argument hinges the definition of “government regulation”. I would amend my statements from before and say that this was not a form of government regulation, but a form of government intervention that ultimately failed.
Therefore, can it be said that government regulation is always the enemy? No. I would argue that if the government had regulated derivatives, and stopped intervening in the wrong ways, the financial industry might be stronger for it. The government surely has a role in the economy, but the trick is to find the red line between safe intervention and all out regulation.
Without having seen the bill, however, it has yet to be seen what President Obama means by “regulation of derivatives”. It is worth pointing out that the government will not be able to monitor every market instrument and see every financial meltdown coming, but it might be worth trying to regulate blatantly bad business practices. On the other hand, government intervention also perpetuated the banks’ faulty business practice.
Bottom line is that we need smarter regulation, not necessarily more of it.