Market Reform

Market Reform

Market Reform

To help put the proposals for reform in perspective, it is necessary to review how and why the global liquidity difficulties came about. In broad outlines, the problems began with the US mortgage market. Many home buyers, buoyed by years of easy credit, became financially overstretched; some bought homes they in fact could not afford. Over the years easy credit became even easier with the help of sunny optimism of the housing boom, the increasingly sophisticated structured products that supposedly transferred credit risks away, and the enthusiasm of the rating agencies. With easier credit came ever lower lending standards and ever more overstretched home buyers. As a result, the risk of widespread home buyers' delinquency and defaults became reality. Home foreclosures are on the rise. Coupled with falling property prices, the mortgage market froze up which then led to a general credit-market seize-up (Pesaran 1997).

The general credit-market seize-up led to at least three immediate problems for financial institutions. First, unable to sell their mortgage loans, financial institutions found their balance sheets unduly burdened. Secondly, the value of asset-backed securities previously acquired became significantly depressed, forcing the widely publicised asset write-downs by banks. Thirdly, the business model of financial institutions that relied on raising finance in the wholesale money markets became a recipe for failure. We have seen the outcome of this credit crunch: the prospect of bankruptcy loomed over many financial institutions.

Rationale for special bank insolvency regime

There were many discussions regarding the benefits and detrimental consequences of financial liberalizations, however the issue is still subject to continuous debates and no ultimate solution have been reached at. The main issue of the debate is that there are significant positive effects of international capital surges into developing economies, but negative consequences can quickly overshadow these benefits if short-term inflows are allowed to reach unsustainable levels. The potential costs, and possible solutions to such problems, must be weighed against the benefits in order to determine whether short-term capital should be allowed to flow, without restriction, over international boundaries.

In light of the recent turmoil in global financial markets and criticisms of the performance of the regulatory system, Sir Howard Davies-who prior to his current appointment as Director of the London School of Economics was Chairman of the Financial Services Authority, the UK's single financial regulator-gives a preliminary assessment of where there is a case for change in the rather complex global regulatory system. He identifies seven interesting and difficult questions for central banks and regulators concerning the financial markets upheaval: Did the Fed cause the problem? Is this a broader crisis of Anglo-Saxon capital markets? Is there a fundamental problem in the subprime mortgage market in the United States? Is there a fundamental problem with the credit ratings agencies? Do we need a new approach to liquidity? Is the UK's regulatory system fundamentally flawed? Does the crisis reveal flaws in the international regulatory system? His answer to the latter question is a qualified ...