Let us start with a simple definition of financial regulation:
Financial regulations are a form of regulation or supervision, which subjects financial institutions to certain requirements, restrictions and guidelines, aiming to maintain the integrity of the financial system. This may be handled by either a government or non-government organization.
Source: Wiki
In general, the purpose of regulation is to create a check and balances system against human behavior. These behaviors can range from following misplaced incentives to falsifying accounting data to overtly legal but destructive actions such as putting people into loans they knew were likely to default. In general, regulation serves the purpose of protecting us against innate human behaviors that usually causes problems.
This is the same reason why the founding fathers of the United States created a system of checks and balances in the Constitution. They knew the natural tendencies of human behavior and that something had to be done to keep it under control.
Efficient Market Hypothesis advocates would like to see no regulation. However, all it takes is a quick glance at history to see the results of little or no regulation.
Why are completely free markets not efficient?
Simple. The core foundation of theories such as the Efficient Market Hypothesis lies on the premise that we have:
*Perfect Information
*Perfect flow of capital, labor, and information
*Perfect Competition in all markets
*Perfectly Rational Investors
Now, if you haven’t noticed, none of those bullet points seem to be completely true.
I am not trying to say that markets are bad. In general, a free market economy is the best type of economy you can have; however, my point is that you need a balance between free markets and regulation. Due to the imperfections that our free markets are build upon, we need to check some of the risks. This involves regulating financial institutions and not letting them do things that may be to their benefit but not to the overall economy and public.
Examples:
*Give loans to people who can’t pay them and then securitize the loan into a security and sell them.
*Become a systemic risk in the economy
* Create a partial or complete fraud of their operations.
Summary
The point of this post is to assert that our economy needs some regulation to align the interests of everyone in the economy. Additionally, we need a better check and balances system to overlook natural behaviors that are not beneficial. This ranges from fraud to bad risk management to greed.
In general, we need to find the balance between free markets and government regulation so we can have innovation and also avoid problems such as the current crisis. We need to stop with the bumper sticker lines thrown out everywhere about how regulation only creates problems. As we have seen, no regulation seems to create problems too.
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