Question

Prior to the GFC, former FED chair Alan Greenspan argued efficient financial markets do not need to be regulated. Explain why he was wrong and how you would propose to regulate banks. [Consider how money is created, bank behavior, and historical examples in your response].

Answer 1

Alan Greenspan relied upon the efficient market hypothesis that consumers have all kinds of private, public and historical information and it is reflected in their decisions. So, it will act as a self-correction and there is no need of financial market to be regulated. But, this approach cannot work in real world, as sharing of private information such as insider trading is already prohibited not only by SEC in the USA, but also in different parts of the world. Further, efficient market does not tell the moral hazard, adverse selection problem and agency issues taking place in the organization. To resolve these problems that can lead to market failure, there is a requirement of the regulation that can regulate the banks and other financial institutions. It will help to bring stability in banking operations, prevent moral hazard and adverse selection, and maintain the investors’ confidence in the overall banking system.
For example, it was the deregulation that made the banks to opt for speculating buying of the real estate assets that turned bad. Later on, the banks created different financial instruments of high risk that first caused the investors to buy it and later on, they lost their money. It led to the financial crisis of 2008. Such kind of greed, speculative buying and adventurous structuring of the risky assets only took place when these financial institutions were operating under the deregulation. Hence, deregulation brings higher scope of wrong decisions whose after effects are faced by investors, depositors, majority of employees, their families and the economy as a whole. It makes regulations to be a necessity for a broader interest of the banking sector and the economy as a whole.