Oversight and Regulation of Financial Institutions Article Critique

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Oversight & Regulation of Financial Institutions

In the article entitled "How Financial Oversight Failed & What it May Portend for the Future of Regulation," economist Richard J. Herring identifies the government policies he believes contributed to the current financial crisis. These policies include:

Credit rating outsourcing.

Government housing.

The call for investment banks to form holding companies.

Basel I and Basel II minimum capital requirements.

After describing the policies and the financial repercussions of each in detail, Herring presents three arguments in favor of the policies, followed by three refutations of these arguments. From there, Herring goes on to address the principal/agent problems surrounding the financial crisis in both the private and public sectors, and then concludes with the description of two incentive plans -- contingent capital and resolution policy -- he believes will encourage "greater market discipline" (Herring, 2010).

Regarding credit rating outsourcing, Herring argues that outsourcing caused a "regulatory-induced increase in the demand for highly rated assets . . . [of] investment grade or higher" (Herring, 2010). The result of this demand was an imposed pressure on credit rating organizations (CROs) to rate institutions more liberally than they otherwise might have been inclined to. An institution whose credit rating would at one time have been rated average or slightly below average, was then being rated as slightly above average, which in turn skewed the perception of the institution's stability or lack thereof, resulting in a rapid decline credit rating standards. It is here that Herring puts forth his thesis statement: "What began as an attempt to improve the supervision of credit risk ultimately had the unintended consequence of exposing the financial system to a devastating credit shock" (Herring, 2010).

Regarding the government housing policy, Herring argues that imposed requirement for Fannie Mae and Freddie Mac to provide affordable housing options for even the poorest Americans resulting in heightened for low-interest government loans, thereby placing pressure on banks to meet the demand for low interest -- and in some cases no interest -- loans.

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Add to this the emergence of "Fair Lending Best Practices Agreements" in 1994, and it was suddenly possible for low-income families to purchase to homes they would otherwise never have been able to afford -- and in reality, could not afford. Says Herring of the government housing policy:

A series of presumably well-intentioned government programs to meet the housing aspirations of poor Americans (albeit, by compelling other entities to subsidize the loans) led to a huge decline in the quality of mortgages issued in America. Rather than helping poor Americans to buy housing they could not afford by subsidizing down-payments, (which would have had to be reflected as an expenditure on the Federal budget) Congress and two Administrations chose to make it possible for lower income Americans to become very highly leveraged, which, of course, left them highly vulnerable to any decline in their own incomes or any fall in housing prices. The only way such lending could have been sustainable was to project a high rate of growth in housing prices into the indefinite future, an assumption that now looks hopelessly naive, but was widespread. Thus government housing policy intended to help the poor led to a personal catastrophe for many of the intended beneficiaries and a financial crisis that quickly became global. (Herring, 2010)

Meanwhile, investment banks responded to the European-imposed pressure to form holding companies by pushing for the Securities Exchange Commission (SEC) to be recognized as equivalent to the Federal Reserve as a regulatory body. Unfortunately, the SEC had neither the necessary experience or even the interest in assuming….....

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