Question

What role does weak financial regulation and supervision play in causing financial crises?

Short answer

There is no check on excessive risk-taking by banks and financial institutions which can result in bubbles. There can be complex products like Credit Default Swaps (CDS), the risk of which cannot be measured by unsophisticated investors, which can lead to uninformed investments and risk.

Step-by-step solution

Definition

Here we need to discuss the role of weak regulations and supervision in the financial market in causing the financial crisis. Especially most of the emerging economies face this problem. Generally, financial liberalization occurs through removing domestic restrictions on financial institutions and markets, and allowing financial firms from other nations to flow into the nation's economy, also known as financial globalization.

Explanation

Banking institutions in emerging market economies are inexperienced about screening and monitoring borrowers, and their supervisors generally do not have much experience in this area. As a result, after financial liberalization, lending booms sometimes result in a boom in risky lending.

Banks and financial institutions can indulge in risky lending as happened before the sub-prime lending crisis in which mortgage loans were given to people with low creditworthiness.

As a result of all of the risky lending, the economy begins to deteriorate, which then results in the financial sector freezing lending.

Final Answer

Hence due to the weak regulations and supervisions excessive risk taking sets in and finally credit boom turns to credit burst and eventually financial crises kicks off.