The Regulatory System Before the Financial Crisis

In the light of recent financial crisis, what are the lessons to be learnt and the implication for the regulation? Compare the regulatory system in Trinidad and Tobago with United States and Canada.

The regulatory system before the financial crisis

According to F. Mishkin and S. Eakins (2012) in Financial Markets and Institutions, a financial crisis is a “major disruption in the financial markets characterized by sharp declines in asset prices and firm failures” (p. 203).

Background on the recent financial crisis

The period between the years 2007 and 2009, is well known as the period of the global financial crisis. It was the collapse of the Lehman Brothers, a huge global bank, in September 2008 that almost brought down the world’s financial system. Governments around the world struggled to rescue giant financial institutions from the fallout of the housing and stock market collapse. It took huge taxpayer-financed bail-outs to save the failing financial industry. Nevertheless, the following credit crunch turned what was already a nasty downturn into the worst recession in years, since the ‘mother of all financial crisis: the great depression’ which began in 1928 in the United States of America (“Crash Course”, 2013).

Mishkin and Eakins (2012) believe that there were three main causes of the global financial crisis, which were as follows: the role financial innovation played in the mortgage markets, the agency problems in the mortgage markets, and the role credit rating agencies played in deteriorating asymmetric information in the financial system (p. 211).

In the case of developments in financial innovation in the mortgage markets, advances in computer technology and statistical techniques were used to evaluate the credit risk of risky residential mortgages and predict the likelihood of defaults on loan payments. This led to “a flood of irresponsible mortgage lending” where loans were handed out like candy to “subprime borrowers with poor credit histories who struggled to repay them”. To make matters worse, the advances in computer technology allowed these small residential loans to be bundled up together into “supposedly low-risk securities”. These 'funky' securities, also known as collateralized debt obligations (CDOs), led to a surge of debt being entered into the financial markets, which ultimately contributed to its collapse (“Crash Course”, 2013).

The second contributing factor to the global financial crisis was the agency problem in the mortgage markets. The agency theory is one which seeks to explain the relationship between principals and agents in business as one characterized by conflicting self-interests. In that, even though the agent is specifically hired to represent the principal and act on his behalf (the agency relationship), where the goals and the desires of the principal and agent are in conflict, the agent will ultimately act in his own self-interests at the expense of the principal’s, giving rise to an agency problem. By handing out loans to “subprime borrowers” like candy, these mortgage brokers obviously did not make a strong effort to evaluate whether or not the borrower could pay off the loan. As in their minds they would quickly sell off these loans anyway to investors in the form of these 'funky' securities or CDOs. The mortgage brokers were supposed to act as agents for the investors of these securities (the principals), but ultimately they did not have the investors’ best interests at heart, as they had no consideration if the “subprime borrowers” would make good on their payments. To these mortgage brokers, the more 'funky' securities sold, the more money was made. This scenario created the perfect incentive for the mortgage brokers to encourage regular “households to take on mortgages that they could not afford or to commit fraud by falsifying documents on a borrower’s mortgage applications”, to ensure the borrower's qualification for the loan (Mishkin and Eakins 2012, p. 212). This problem was further compounded by the lax regulation of the commercial and investment banks, which in the end were “earning large fees by underwriting mortgage-backed securities and structures credit products, like CDOs” (Mishkin and Eakins 2012, p. 212).