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Financial regulations, risk management and value creation in financial institutions: evidence from Europe and USA

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par Agborya-Echi Agbor-Ndakaw
University of Sussex - Master of Science 2010

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2.8 Definition and Meaning of Financial Regulations

Financial regulation is often reactive with new regulations sealing up leakages in the financial system usually caused by a crisis. As a result of this, it is recommended that regulators should focus on the principal issues that the regulation is intended to address.

Financial regulations are laws and rules governing financial institutions such as banks and
investment companies. Financial regulations aim at maintaining orderly markets, enforcing

applicable laws, prosecuting cases of market misconducts, licensing providers of financial services, protecting clients, promoting financial stability and maintaining confidence in the financial system. However, note that the principal aim of financial regulation is to protect investors who may not be able to protect themselves if left on their own. All these centre on the fact that the recurrent theme in every regulatory report on the causes of the global crisis is the role of lax risk management controls within financial institutions. As such, current financial regulation helps in policing the amount of risk that can be incurred by a financial institution and how that institution manages that risk. The regulatory activities range from setting minimum standards for capital and conduct to making regulatory inspections to investigating and prosecuting misconduct.

Some prominent key advisers (economists, journalists and business leaders) including President Barack Obama have succeeded in introducing a series of regulatory proposals. They also succeeded in mapping out a number of steps that need to be taken in revamping these regulatory systems dealing with financial institutions. Some of these regulatory proposals include consumer protection, expanded regulation of the shadow banking system and bank financial cushions. These are bent on minimizing the impact of the current global financial crisis as well as to try to prevent its recurrence in the nearest future.

The present financial crisis portrayed the inadequacies of financial regulations both at the national and global levels because they failed to license and supervise the financial services providers at all times. A case in point is the boom and collapse of the shadow banking system which according to Krugman, was the core of what happened to cause the crisis. He argued that the shadow banking system expanded to rival conventional banking in importance. As such, politicians, as well as some government officials should have realized they were recreating the kind of financial vulnerability looked upon in the 1930s as one of the causes the Great Depression. This implies these government officials should have responded by

extending some regulations and financial safety so as to protect the new institutions. Therefore, financial regulations should have at least been imposed on all banking-like activities. As if that is not enough, the IMF Managing Director (Dominique Strauss-Kahn) also added that the financial crisis originated as a result of failure on the part of financial regulations to guard against excessive risk-taking in the financial system. Never the less, excessive regulation has also been cited as a possible cause of the crisis. For instance, the Basel II accord has been criticized for requiring banks to increase their capital when risks rise which might result in their decreasing lending when capital becomes scarce. As such, the financial markets only survived after extensive and costly public rescues from the governments and some big banks.

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