Ch3: Regulation Flashcards
Aims of regulation (4)
What they want to do
- Correct any perceived market inefficiencies and to promote efficient and orderly markets
- Protect consumers of all financial products
- Maintain confidence in the financial system
- Help reduce financial crime
Cost of regulation (direct and indirect)
Description:
* Regulators must attempt to develop a system that can achieve its aims at minimum cost and hope that the benefits (difficult to measure) outweigh the costs
* Optimal level of regulation = marginal benefits of regulation equal to marginal costs
Direct costs:
* On regulator: Administering regulation (collection and examination of info and monitoring)
* On regulated firms: Complying with regulation (maintaining records and submission of required information)
* In practice these costs are ultimately borne by the consumer through higher taxation or charges
Indirect costs:
* Alteration of behaviour: Consumers have false sense of security and providers may feel they do not have to be as cautious
* Undermining of sense of professional responsibility among advisors and intermediaries
* Reduction in consumer protection mechanisms developed by the market itself
* Reduced innovation (certain products that may have been atrractive not allowed)
* Reduced competition in market (price regulation)
Need for regulation in financial markets
- Importance of confidence in the financial system due to possible sytemic risks - failure of one institution leading to the failure of the whole market (ensure that failure of one party does not threaten the entire system)
- Assymetric information bewteen policyholders and insurers since better informed party could potentially use informational advantage for its own benefit (expertise, negotiating strength)
Functions of the regulator (6)
How they do it (what they do)
- Influencing and reviewing government policy
- Vetting and registration of firms and individuals authorised to conduct certain types of business
- Supervising the prudential management of financial organisations
- Supervising the conduct of financial businesses and taking enforcement action where appropriate
- Enforcing regulations, investigating suspected breaches and imposing sanctions
- Providing information to consumers and the public
Information assymetry definition
Situation where at least one party has relevant information which the other party does not have
Dealing with informational asymmetry (5)
Disclosure and education
* Require service provider to disclose full information about its products or itself in understandable form
Conflicts of interest
* Knowledge held by provider about third parties can be restricted to that which is publicly available by insider-trading regulations and by ‘chinese walls’
Negotiation
* Weakness of individual in negotiating a deal may be addressed by price controls or by regulation of selling practices
* Customer’s position can be strengthened with right to terminate or ‘cooling off’ period in which termination can be done with no penalty
Unfair features of insurance contracts
* Consumer protection legislation to address unfair terms in insurance contracts
* Provider has expertise in designing contracts and legal teams to ensure wording is in their favour
Treating the customer fairly
* Regulation to ensure providers consider interests of customers
* Whistle-blowing if actuary believes provider is acting in an unfair way
* Benefits and charges should not be too dissimilar from what policyholder’s believe
Dealing with maintaining confidence (5)
Capital adequacy
* Protect consumers and reduce systematic risk through regulation to hold sufficient capital reserves to cover liabilities
Competence and integrity
* Individuals may need to proove competence by obtaining specified qualifications or membership of professional body
* Regulators may also prevent individual from working in industry if not deemed to be a ‘fit and proper’ person
Compensation schemes
* Funded by industry or by government with provide recompense to investors who have suffered losses
* Cover lossess such as fraud, bad advice, default of provider
* Healthy companies pay for unhealthy companies
Other protection for investors
* Security market regulators seek to ensure market is transparent, orderly and provides proper protection to investors
Stock exchange requirements
* Listed companies have to fill certain criteria regarding financial stability and need to fulfil oblogations such as disclosure of information
* Likely to be regulations governing issues of new shares and takeover bids
Forms of regulation (3)
Perscriptive
* Detailed rules setting out what may or may not be done
* Greater costs, close supervision
Freedom of action
* Freedom of action but with rules on publicity so that third parties are fully informed
Outcome-based
* Allow freedom of action but prescribe the outcomes that will be tolerated
* Concerned with the end result
Types of regulation (5)
Include advantages and disadvantages
Unregulated
* In some markets costs of regulation outweigh the benefits
* All parties well informed
* Examples might be markets in which only professionals operate
* Or commodity products are sold only on price with guaranteed benefits
Voluntary codes of conduct
* Advantages:
* Reduced cost of regulation
* Rules set out by those with greatest knowledge of the market
* Might have marketing potential
* Disadvantages:
* Vulnerable to lack of public confidence or few rogue operators who refuse to co-operate
* Greater incentive to breach voluntary code since less severe penalties than any statutory regulation
Self-regulation
* Operated by participants in market without government intervention
* Incentive is that regulation is economic good and consumers and providers are willing to pay for the benefit
* Another incentive is threat of government intervention and statutory regulations if self-regulatory sytem is not satisfactory
* Advantages
* Implemented by people with greatest knowledge of market
* Greatest incentive to achieve optimal cost-benefit ratio
* Most to lose if consumers lose confidence in system
* Should be able to respond rapidly to changes in market needs
* May be easier to persuade firms to co-operate than with a government bureaucracy
* Disadvantages
* Danger with closeness of regulator to industry it is regulating
* Possibility that regulator accepts industry’s point of view and less in tune with views of third parties
* Possible low confidence from consumers even if its is operating effectively
* May inhibit new entrants to the market
Statutory regulation
* Government sets out rules and polices them
* Advantages:
* Lees open to abuse and greater consumer confidence
* May be economies of scale through grouping of activities through function
* Disadvantages
* More costly and inflexible
* Market participants arguably best to decide
* May impose rules that are unecessarily costly and does not achieve desired outcome
* Economic good best developed by market
Mixed regimes
* In practice, most regulatory regimes are a mixture of all systems
* Often developed by market-driven private institutions as well as governments
Central bank function (7)
- Control the money supply
- Determine or influence interest rates
- Determine or influence inflation rates
- Determine or influence exchange rates
- Target macroeconomic features such as economic growth and unemployment
- Ensure stability in the financial system
- Lender of last resort to commercial banks
Aims of climate change related regulations on financial institutions (6)
- Consider climate risks in business decision making and strategic planning
- Effectively disclose and report on climate-related risks and opportunities
- Adopt consistent and reliable means of assessing, pricing and managing climate-related risks
- Incorporate environmental, social and governance (ESG) factors into investment management decisions
- Incorporate financial risks from climate change into existing risk managemnet processes
- Use scenario analysis to inform risk identfication and to estimate impact of financial risks arising from climate change
