This is the second part of the educational series on the flaws of the current financial system. Here is the link to the first part.
4. Relying on Market Discipline
In the recent past, regulatory regimes have moved in the direction of emphasizing self-regulation and market discipline instead of strict regulations. One argument for this type of policy is due to the belief that financial innovation is always ahead of regulation; therefore, rigid regulation would slow down financial innovation.
This market discipline has led to a reliance on a firm’s own risk assessment and independent rating agencies. However, as mentioned before, the short-term incentive on executives to take excess risk may distort their risk management. As for the rating agencies, the inherent conflict of interest in the system also creates concerns.
5. Capital Requirements
This one is pretty self explanatory. The excessively low capital requirements for banks even though they are faced with large amounts of risk is bound to create problems. The risk is typically hidden through “off-balance” sheet items and other accounting tricks.
That’s all for now
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