Redefining Regulation Part II - Improving Market Infrastructure

The smooth functioning of the financial system is critically dependent on a sophisticated and evolving infrastructure comprising of payment, clearing, trading, information, settlement, messaging and legal systems which is often taken for granted. However, glitches and gaps in this ‘invisible’ part of the market have the capacity to seriously disrupt the financial system as was highlighted yet again through the problems caused by the lack of proper settlement in the Credit Default Swap market in the current crisis.

 

More often than not both financial institutions failures as well as financial system wobbles are driven by bad housekeeping which has become ever more important as the financial system has become more complex and inter-connected. Especially because such ‘back office’ systems are hidden from sight, governments and regulators need to be proactive in ensuring that such systems do not lag behind market innovations and are resilient.

 

Re-Defining Regulation Part I - Strengthen some regulations, expand their scope and increase international co-operation

The current financial and economic crisis owes party to the outdated model of regulation where governments tried unsuccessfully to regulate a global financial industry with a nationally focused and highly fragmented regulatory system. As a consequence of this, large swathes of the financial industry hid in the ‘regulatory cracks’ and was not being supervised.

This lack of supervision was reinforced by an ideologically driven deregulation based on a misplaced faith in the ability of markets to always self correct. Furthermore, even when regulations existed, they were not applied.
 
It was in this poorly regulated ‘shadow financial system’ comprising SIVs, Hedge Funds and other off balance sheet exposures that the crisis originated and its intensity was reinforced by the risks hidden in ‘shadow financial products’ such as Credit Default Swaps which were also unregulated.
 

A crisis of too little finance, not too much finance - some lessons for developing countries

The financial crisis, which originated in the developed countries starting with the United States, has by now fully engulfed both emerging economies such as China as well as LDCs such as Zambia. This despite the fact that the majority of developing countries had in place what have been widely touted as ‘responsible’ fiscal and monetary policies.

The channel of transmission was not the decline of asset prices and losses in the financial sector as in the case of transmission to other developed countries. Instead, the crisis has been transmitted through the now familiar ‘sudden stop’ mechanism where capital inflows to the developing world dry up. The drying of trade credit and reduced demand for developing country exports has helped exacerbate the impact on developing countries.

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