Better regulation or better risk management?

As banks are coming under legal attention for the loans made during the financial crisis, many politicians are wondering what the next steps are in order to prevent something like the Great Recession from happening again. But one economist explains that instead of working to create more regulation in the banking industry, perhaps stronger risk management tools should be employed. 

In an article in American Banker, Clifford Rossi, a teaching fellow at the Robert H. Smith School of Business at the University of Maryland explained that a lack of risk management is what is at fault. 

"When risk disasters arise it is easy to jump on the bandwagon for tighter regulation, such as bans on proprietary trading," he wrote. "However, addressing the governance structure of risk management could significantly reduce if not eliminate many banking missteps."

Before the crisis, though financial institutions had risk management tools in place, they either ignored or worked around these tools. Then, by lending to the unqualified borrowers instead eventually caused the collapse. Banks have definitely begun using these same tools much more thoroughly, for the same reasons that more regulations are in place – to ensure the practices don't happen again. But, as Rossi explains, it's important to have a strong base of credit and risk management in practice to ensure that these tools are not overlooked when lending and banks grow bigger. 

The increase of government regulation, often higher capital requirements and more transparency within the financial institutions can also protect lenders from hurting when the loans created are not profitable. However, as Rossi said, with stronger risk management tools, avoiding making these loans in the first place – to unqualified borrowers – is also not something to be overlooked. 

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