7 (Econ) - Economics of Regulation

Question 1

Why/when are regulations needed?

Answer 1

Regulation is needed in the presence of informational frictions, externalities, weak competition, or to achieve specific social objections.

Question 2

Informational Friction

Answer 2

An occurrence when information is not equally available or distributed.

Question 3

Information Asymmetry

Answer 3

A situation when some market participants have access to information that is unavailable to others.

Question 4

Externality

What do externalities typically deal with?

Answer 4

Costs and benefits that affect a party that did not choose to incur that cost or benefit. Externalities typically deal with the provision of public goods.

Question 5

What can weak competition lead to?

Answer 5

Fewer choices, higher prices, and lack of innovation. Antitrust regulations seek to mitigate this problem.

Question 6

Explain the purpose of social objections in regulation?

Answer 6

Typically deals with the provision of public goods. People share in the consumption of public goods but don’t necessarily bear the costs that are proportional to consumption so regulation is needed to ensure an optimal level of production of such public goods.

Question 7

Prudential Supervision

What does prudential supervision include?

Answer 7

The regulation and monitoring of financial institutions (e.g. banks, etc.) to reduce system-wide risks and to protect investors.

This includes diversification of assets, an adequate capital base, and risk management activities of such financial institutions.

Question 8

What are examples of regulations that cover commerce?

What is the result of regulating commerce?

Answer 8

1. Company law
2. Tax law
3. Contract law
4. Competition law
5. Banking law
6. Bankruptcy law
7. Dispute resolution systems

This type of regulation may either facilitate or hinder commerce.

Question 9

What is the goal of antitrust regulation?

Provide an example of antitrust regulation.

Answer 9

Antitrust regulation seeks to promote competition amongst domestic businesses. They promote domestic competition by monitoring and restricting activities that reduce or distort competition. Antitrust regulation also seeks to hinder foreign competition thus protecting domestic businesses.

Antitrust regulators will often block a merger/acquisition that would lead to an excessive concentration of market share and as a result, weakened competition in a specific industry.

Question 10

What are example of anticompetitive behavior?

Answer 10

1. Discriminatory pricing
2. Price collusion
3. Bundling
4. Exclusive dealing

All of which are often prohibited by antitrust regulation.

Question 11

What does security market regulation include? What does security market regulation seek to mitigate?

Answer 11

Security market regulation includes protecting investors by requiring firms to provide adequate disclosures.

This regulation effort mitigates agency conflicts and protects smaller (i.e. retail) investors.

Question 12

What are the three major goals of financial/security market regulation?

Answer 12

1. Protect investors
2. Create confidence in the markets
3. Enhance capital formation

Regulation of such markets ensures the stability of the financial system and maintains the integrity of markets.

Question 13

Statues

Answer 13

Laws made by legislative bodies.

Question 14

Administrative Regulations

Answer 14

Laws issued by government agencies or other bodies authorized by the government.

Question 15

Judicial Law

Answer 15

Laws based on findings of the court.

Question 16

Independent Regulator

Answer 16

Regulators are given recognition by government agencies and have the power to make rules and enforce them. However, they are usually not funded by the government and hence are politically independent.

Question 17

What is the difference between Self-Regulating Bodies (SRBs) and Self-Regulating Organizations (SROs)?

Answer 17

SRBs are private organizations that represent as well as regulate their members. They are not given government recognition and authority to enforce.

SROs are the same as the above except they are recognized by the government and given enforcement powers. Given their government recognition, they are independent regulators.

Question 18

Outside Bodies

What are examples of outside bodies?

Answer 18

Not regulators themselves but their products tend to be referenced/used by regulators.

Examples include FASB and IASB as regulators will reference their protocols, etc.

Question 19

Where are SROs most prevalent?

Are SROs typically successful?

Answer 19

In common-law countries (e.g. USA or UK) rather than civil-law countries.

When they are properly supervised by regulatory agencies, SROs have been effective in carrying out the objectives of such regulations.

Question 20

FINRA

What is its primary goal?

Answer 20

Financial Industry Regulatory Authority.

SRO that is recognized by the SEC (a government agency) in the USA.

FINRA regulates broker-dealers in the USA and its primary objective is to make sure they are operating fairly and honestly and, in turn, protect investors by maintaining the fairness of the US capital markets. They can enforce security laws and regulations.

Question 21

Regulatory Capture Theory

Who is this more likely to be a concern with?

Answer 21

The theory that, regardless of the original purpose behind its establishment, a regulatory body will, at some point in time, be influenced or even possibly controlled by the industry that is being regulated. The rationale behind the theory is that regulators often have experience in the industry and this experience affects their ability to render impartial decisions.

This is more likely to be a concern with SROs or SRBs than with government agencies.

Question 22

Regulatory Competition

Answer 22

Regulators compete to provide the most business-friendly regulatory environment.

Question 23

Regulatory Arbitrage

Answer 23

When firms exploit the difference between regulatory differences between jurisdictions. Can also be when firms exploit the difference between real economic substance and an interpretation of a regulation.

Question 24

What are the three major regulatory tools available to regulators?

Answer 24

1. Price mechanisms - taxes, subsidies, etc.
2. Restricting or requiring certain activities. - disclosures, etc.
3. Provision of public goods or financing of private projects - examples would be national defense, SMB loans, student loans, etc.

Question 25

Regulatory Burden (aka government burden)

Answer 25

The cost of complaint for the regulated entity.

Question 26

Sunset Clause

Answer 26

A measure within a statute, regulation, or other law that provides for the law to cease to be effective after a specified date. Unlike most laws that remain in force indefinitely unless they are amended or repealed, sunset provisions have a specified expiration date.

Question 27

What do sunset clauses require?

Answer 27

They require a cost-benefit analysis to be done before a regulation should be renewed.

Question 28

What needs to be considered when doing a cost-benefit analysis of a certain regulation?

Answer 28

the indirect costs of that regulation on the industry, economy, or society.

Question 29

Why is regulation important in financial analysis?

Answer 29

Regulation can have a material impact on industries and companies. Certain industries have more exposure to certain types of regulations than others.

An analyst should always be considering the impact of current and proposed regulations as regulators can have a large impact on valuations for a particular company or industry.