CH3 - Regulation

Question 1

What is the most important cause of market failure in the financial services market?

Answer 1

The lack of (perfect) information available, in particular to the investors about the services that they are buying and the risks taken by the institutions that they invest in

Question 2

What is the nature of the financial services products that make the extent of regulation greater in that market than in other markets

Answer 2

• They are long term
• They are complex
• They potentially have large sums of money involved

Question 3

What are the principal aims of regulation?

Answer 3

• To limit the likelihood and potential cost of failures of financial companies
• To limit the need for the government to step in as a lender of last resort
• To correct perceived market inefficiencies and promote efficient, orderly markets
• To protect the consumers of financial products
• To maintain the confidence in the financial system
• To help reduce financial crime

Question 4

How would consumers of financial services make the market inefficient

Answer 4

By making incorrect choices.
- This may occur due to the lack of information available and the expertise of private investors

Question 5

What is the optimal level of regulation?

Answer 5

The optimal level is one such that the marginal benefits of regulation are equal to the marginal costs of regulation
- It is important for regulators to come up with a system that has a minimum cost and hope that the benefits outweigh these costs

Question 6

What are the benefits of regulation?

Answer 6

They arise from the principal aims of regulation being met:
- Reduced financial crime
- Consumers are protected
- Reduced inefficiency in the market and orderly and efficient markets are promoted
- Confidence in the financial system is maintained

Question 7

What are the direct costs of regulation

Answer 7

• Administering Regulation
• Compliance for the regulated firms
• The costs borne by the customer in the form of higher tax to fund the regulator or higher charges or fees for services

Question 8

What are the indirect costs pf regulation

Answer 8

• Alteration in the behaviour of consumers who are given a false sense of security and reduced sense of responsibility in their actions
• An undermining sense of professional responsibility among the intermediaries and advisors
• Reduction in consumer protection mechanisms that are developed by the market itself
• Reduction in product innovation
• Reduced competition : The regulations may serve as a barrier to entry

Question 9

Why is the need for regulation greater in financial markets than it is in other markets

Answer 9

• Confidence
• Asymmetric information

Question 10

What is systemic risk

Answer 10

The risk of the failure of one financial institution leading to failure of another financial institution
- Causes difficulties for a third institution and so on

Question 11

How is a systemic collapse or loss of confidence prevented

Answer 11

By ensuring that the failure of one institution will not threaten the whole system

Question 12

What is asymmetric information

Answer 12

This is a situation where a better informed party will use its informational advantage for its own benefit and to the detriment of the other party

Question 13

What are typically the main functions of the regulator?

Answer 13

• Influencing and reviewing government policy
• Vetting and registration of firms and individuals authorised to conduct certain types of business
• Supervising the prudential management and conduct of financial organisations
• Enforcing regulations , investigating suspected breaches and imposing sactions
• Providing information to customers and the public

Question 14

Financial Services regulation would typically deal with which types of investment business?

Answer 14

• Dealing in investments as the principal or agent
• Arranging for a third party to make investments
• Managing investments for another person
• Giving advice on investments
• Operating collective schemes
• Assessing the solvency of investment business providers
• Specifying the design of investment products

Question 15

What difficulties are there in regulation being segregated by the type of financial business?

Answer 15

It may prove difficult where the providers of financial services provide more than one type of financial service or products have aspects of both/multiple types of business

Question 16

What institutions is it necessary to regulate?

Answer 16

• Deposit taking institutions (E.g retail banks)
• Financial institutions( pension schemes, insurance, etc.)
• Securities markets
• Professional advisors ( merchant / investment bank)
• Non -financial companies offering securities to the public

Question 17

Why is the asymmetry of information between the product provider and the end customer of most concern to regulators

Answer 17

• There is a difference in the expertise and negotiating strength that will exist in financial transactions
• The product provider will have access to more information and expertise than the customer
• Information concerning financial services is widely available, however, obtaining this information involves a cost.
• In most countries, the majority of the population is not educated in financial markets and finds the range of solutions offered to meet the needs are complex and confusing

Question 18

What does disclosure and education involve in dealing with information asymmetry?

Answer 18

• Requiring a service provider to disclose full information about it’s products or itself in an understandable form.
• Consumer education by the regulator

Question 19

What does the conflicts of interest aspect of dealing with information asymmetry involve?

Answer 19

• The knowledge held by a service provider about third parties can be restricted to that which is publicly available by insider trading regulations

Question 20

What does the negotiation aspect of dealing with information asymmetry involve?

Answer 20

• The weakness of an individual in negotiating a deal with a large institution may be addressed by price controls or regulating selling practices
• The customers position may be strengthened by devices such as giving them the right to terminate the sales process at any time or by providing a ‘cooling off’ period during which they can cancel the policy with no penalty

Question 21

What is whistle blowing

Answer 21

Where an actuary has statutory responsibilities, it includes the requirement to notify the regulatory authorities if they believe that a product service provider is acting in a way that would prejudice the interests of it’s customers

Question 22

What is PRE

Answer 22

These are the Policyholder’s Reasonable Expectations
The influences on policyholder expectation includes :
- Statements made by the product provider, especially those to the customers in the marketing literature
- Past practice of the product provider
- General practice of other product providers in the market

Question 23

What are the 5 areas addressed by regulation in maintaining confidence?

Answer 23

1) Capital Adequacy
2) Competence and Integrity
3) Compensation Schemes
4) Other Protection for investors
5) Stock Exchange Requirements

Question 24

What forms do the statutory requirements related to the coverage of liabilities take?

Answer 24

• Assets must be equal to a specified proportion of liabilities, with both assets and liabilities being valued using the same prescribed basis
• Sufficient assets must be held to ensure that the probability of insolvency over a particular time period is lower than a specified level, taking the company’s risks into account

Question 25

What are examples of cases where a regulator would deem an individual as not being ‘fit’ or ‘proper’ for the position that they are undertaking?

Answer 25

• They have past association with management of a financial institution that previously breached regulations
• They have convictions for fraud
• They have been bankrupt in the recent past
• They have no previous experience, expertise or professional qualifications with regard to the management of a financial institution

Question 26

What are compensation schemes?

Answer 26

They are established by regulators to provide a compense to investors that have suffered loss
- They typically cover losses due to fraud, bad advice or failure of the service provider rather than market based losses

Question 27

What other protection is provided for investors?

Answer 27

Security market regulations will seek to ensure that the market is transparent, orderly and provides proper protection to investors

Question 28

Why may trading volumes be recorded on the stock exchange?

Answer 28

• To deter and/or identify the occurrence of insider trading based on specific non-public information
• To prevent substantial acquisitions of shares occurring quickly and privately to protect the position of other shareholders

Question 29

What are the 5 types of regulatory regime

Answer 29

1) Self-Regulation
2) Statutory Regulation
3) Unregulated Markets
4) Voluntary codes of conduct
5) Mixed Regime

Question 30

What is a prescriptive regulatory regime?

Answer 30

It has detailed rules setting out what may or may not be done
- The activities of the parties affected are controlled tightly
- It often has greater direct and indirect costs

Question 31

What is a freedom of action regime?

Answer 31

The regulation involves freedom of action but has rules on publicity so that third parties are fully informed on the providers of financial services

Question 32

What is an outcome based regime?

Answer 32

This allows for freedom of action but outcomes that will be tolerated are prescribed
It is more concerned with the end result

Question 33

What are the advantages and disadvantages of voluntary codes of conduct?

Answer 33

Advantages :
- They have reduced cost of regulation
- The rules are set by those with the most knowledge

Disadvantages :
- There is a greater incentive to breach the code as there is no legal backing, and therefore less sever penalties

Question 34

What are the advantages and disadvantages of the self regulation regime?

Answer 34

Advantages :
- Implemented by those with the greatest knowledge of the market
- Should be able to respond rapidly to changes in market needs (in theory)
- May be easier to persuade firms and individuals to cooperate with a self regulatory organisation as compared to government bureaucracy

Disadvantages
- The closeness of the regulator to the industry being regulated may-> They may accept the point of view of the industry and ignore third parties
- It may lead to a weaker regime than acceptable to consumers and other members of the public
- Self regulatory organisations may inhibit new entrants to the market -> existing participants may have come up with rules that act as a barrier to entry

Question 35

What are the advantages and disadvantages of statutory regulation?

Answer 35

Advantages :
- Less open to abuse and commands public confidence
- The regulatory body may be able to run efficiently if economies of scale are achieved through grouping activities by function rather than by type of business

Disadvantages :
- More costly and inflexible than self regulation
- May be argued that the market participants themselves are in the best position to devise and run the regulatory system -> outsiders may impose rules that are unnecessarily costly and may not achieve the desired aim
- May lead to barriers of entry
- There may still be a lack of public confidence

Question 36

What are the aims of the regulations proposed to limit the impact of climate change on the market?

Answer 36

They aim to ensure that financial institutions:
- Effectively disclose and report on climate related risks and opportunities
- Adopt a consistent and reliable means of assessing, pricing and managing climate based related risks
- Incorporate environmental, social governance factors into their investment decisions
- Incorporate financial risks from climate change in their existing management process
- Use scenario analysis to inform risk identification and estimate the impact of financial risk arising from climate change
- Consider the impact of climate risks on the ability to meet obligations to policyholders and other key stakeholders