The concept of regulatory capture was first coiled by Richard Posner, an economist who postulated that regulatory rules are often passed by the powerful elites with the aim of promoting their own self interests, and that the measures do not serve any public interest. This paper aims at demystifying the role played by this concept in the infamous global financial crisis that occurred between the year 2007 and 2009. Al though the regulatory measure is portrayed by those who champion it as having more good to the economy than negative results, this paper highlights the negative results witnessed by the global economic players as a result of this measure.
In its simplest terms, regulatory capture refers to an instance whereby the regulated parties in an economy capture the regulators. This relationship, as most economic experts have found out, was central to the economic meltdown witnessed back in 2008. Such an intervention is usually because of identification of weak parts in an economy and introducing measures to alleviate its effects in the economic and social welfare (Salvatore, 2010). During this era, the government, for instance, the US, acted as an invisible helper acting on behalf of the society as a whole. However, as we shall find out, this intervention had effects that are more negative.
In the wake of the year 2007, there was speculation of possible economic meltdown that could spell doom in the world’s economy. To counter the possible effects of this meltdown, most industry players, policy makers, governments, and companies sought to cushion themselves against these effects. However, regulatory capture, as studies have shown played a significant role in fuelling the global financial crisis. For instance, the lack of leverage regulation played a significant role in aggravating the menace. For the case of investment banks, Salvatore postulates that between 2001 and 2007, there was an unprecedented rise in capital assets over equity by about 8%. This was a rise from 22% in 2001 to 30% in 2007. Secondly, the problem of too big to fail witnessed by investment firms. In the last 16 years, some big investment firms could increase their market share by a whopping 40%. Consequently, this massive shift could not draw a distinctive line between commercial banking and investment banking.
To start with, the issue of too big to fail firms had a devastating effect on the economy in that, despite the deteriorating economic situations, the firms continued to venture in to potentially high risk businesses simply because in case of a possible failure, the government would always come to its rescue. During this period, as a means of salvaging these firms from turmoil, the government introduced a number of countermeasures. For instance, the monitoring agent for all big financial firms was given the authority to close down other failing firms while recovering the cost from creditors and not the taxpayers. This approach included involved directing banks to introduce a new form of funds called contingent capital.
Monster firms such as AIG were exceptional in the regulatory framework. For instance, they engaged in the use of high-end analytical models to come up with financial derivatives. This measure was marred by speculation of high returns on their investments and a remarkable increase in their profits. However, this was not without a downside. As a result, they lost some sizeable amounts of funds in addition to development of Black Swans. Evidently, some of the big firms took on these relatively economically risky measures with the thought that the government would step in and rescue as they form the backbone of the country’s economy, thus too big to fail and the government would do everything it can to salvage it.
Secondly, the concept of weak leverages is to blame for the infamous financial crisis of all time. The implication was that it caused a tendency of basic leverage to climb with the fall of default risks. The leverage used in the housing market and mortgage securities. Leverage is a powerful tool during financial booms but during worse scenarios, as was witnessed in the financial crisis of 2007 and 2009, it can be hugely detrimental to the economy. For instance, during the financial crisis, the fall of large business empires such as the AIG, Merrill Lynch, Lehman brothers among others, can be attributed to inappropriate leverage.
During this period, most investment banks had a leverage ratio of 30:1. This translated to millions instead of thousands. This was further aggravated by the high prices for users financed by bank loans, which served the purpose of collateral measures. The consequence is that this lead to magnification of losses. This meant that FIs borrowed more than the capital they had at hand in order to venture into other financial investments backed by mortgage securities (Salvatore, 2010). Excessive leverages, in addition, left most firms exposed to revenue shocks whose nature was uncertain. This resulted in insolvency of most of these firms prompting the government to step in and rescue them through bail-outs. Consequently, it pushed these firms and the public from one economic misfortune to another.
Bail-out is another factor to be blamed squarely on the recent financial crisis of the century. This was a measure adopted by the government through central banks and the IMF. It was aimed at reliving to firms that failed to recoup their losses. This was given free of charge and it mean that the government through financial institutions engaged in reckless loaning. As a result, this cost was transferred to the public leading to the issue of moral hazard. Moral hazard implied that profits accrued to these firms were private but in the event of losses, the taxpayers shouldered the burden. In the US, for instance approximately US$800 billion was appropriated by the congress to bail-out the Troubled Asset Relief Program. In this model, the government was forced to channel more funds in order to avoid severe effects of global recession. In addition, the government spent another crazy US$957 billion in form of fiscal stimulus in 2008. This meant in increase in expenditure compared to low tax revenue during this economic meltdown. As a result, the US federal fiscal deficit widened from about US$500 billion to about approximately US$1.5 billion in 2010 .
In addition to this massive estrangement of the taxpayer, the crisis led to contagion from financial institutions to finances. The opposite is true in weak economies. The results have been a desperate measures leading to vast unemployment, and slow economic resurgence. Finally, recent findings have found out that not all the funds appropriated by the Congress to bail-out the falling firms were not exhaustively utilized, but some figures are unaccounted for.
In view of the findings, it suffices to say that, to some extent, the effects of financial crisis that struck would have been lessened significantly had the regulatory capture been adopted in a different manner. For instance, the effects caused leverage would have been cut down by setting its limits to serve as a remedy to prevent reckless lending. In addition, improving the framework for resolution is measures that ought to have been adopted in order avoid the use of taxpayer money in bail-out for failing firms. An expansion of financial regulatory would also have been paramount in order to bring all sources of risks to the regulatory net.