CH3: Regulation Flashcards
List the principal aims of regulation.
Give confidence in the system
Reduce financial crime
Inefficiencies in the market corrected (and efficient and orderly markets promoted)
Protect consumers
Outline two direct and five indirect costs associated with regulation.
The two direct costs are:
- a cost to the regulator in administering the regulation
- a cost to the regulated firms in complying with it.
The five indirect costs are:
- an alteration in the behaviour of consumers, who may be given a false sense of security or a reduced sense of responsibility for their own actions
- an undermining of the sense of professional responsibility amongst intermediaries and advisors
- a reduction in the market’s own consumer protection mechanisms 4. reduced product innovation
- reduced competition
Why is the need for regulation of financial markets typically greater than the need for regulation of most other markets?
Firstly, the importance of confidence in the financial system. There is a risk that if one company collapses, it can cause a systemic financial collapse of the system.
Secondly, the asymmetry of information, expertise and negotiating strength that exists between the product provider and the end customer.
These issues are exacerbated by the fact that:
- financial transactions are often long term in nature and can have a significant impact on the future economic welfare of individuals
- in general, most of the population is not well educated on financial matters and finds the range of products offered both complex and confusing.
What actions can the regulator take to help ensure confidence in the financial system?
A regulator can help ensure confidence in the financial system by:
- regularly monitoring that institutions hold sufficient capital to meet their liabilities
- ensuring that financial practitioners and managers are competent, act with integrity and are ‘fit and proper’
- establishing industry compensation schemes
- ensuring that the market is transparent, orderly and provides proper protection to investors
- ensuring that listed companies fulfil certain criteria regarding financial stability and disclosure of information.
What actions can a regulator take to help reduce asymmetries of information?
A regulator can help reduce asymmetries of information by:
- requiring full disclosure of information in an understandable form - - educating consumers imposing price controls regulating selling practices
- giving consumers a cooling off period
- restricting knowledge for everyone to that which is publicly available - enforcing insider-trading regulations
- requiring the establishment of ‘Chinese walls’
- having legislation on treating customers fairly and ensuring no unfair contract terms.
Define the following terms:
- anti-selection
- moral hazard.
Anti-selection
People will be more likely to take out contracts (or exercise a guarantee or option) when they believe their risk is higher than the insurance company has allowed for in its premiums (or pricing of guarantees and options).
Moral hazard
The action of a party who behaves differently from the way they would behave if they were fully exposed to the consequences of that action. The party behaves inappropriately or less carefully than otherwise. Moral hazard is related to information asymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.
This is not the same as anti-selection, which is also taking advantage of particular aspects of an insurance contract but within the terms offered by the insurer.
Outline the following forms of regulation:
- prescriptive
- freedom of action
- outcome-based.
Prescriptive - detailed rules on what can and can’t be done
Freedom of action - freedom (principles-based) but with rules on publicity
Outcome-based - freedom but with prescribed tolerated outcome
List the main functions of a regulator.
Setting sanctions
Enforcing regulations
Reviewing and influencing government policy
Vetting and registering firms and individuals
Investigating breaches
Checking prudential management and conduct of providers Educating consumers and the public
Outline the five main types of regulatory regime
- Self-regulatory systems, which are organised and operated by market participants without government intervention
- Statutory regimes, where the rules are set and policed by the government
- Voluntary codes of conduct, where there is choice as to whether to adhere
- Unregulated markets / lines of business, with no regulation
- Mixed regimes, involving a combination of the above
What are the advantages and disadvantages of a self-regulatory regime?
+ Implemented by the people with the greatest knowledge of the market who have the greatest incentive to optimise the cost-benefit ratio
+ Should respond rapidly to changes in market needs
+ Should be easier to persuade firms and individuals to co-operate than under statutory regulation
– The closeness of the regulator to the industry, leading to low public confidence
– May inhibit new entrants to a market
What are the advantages and disadvantages of statutory regulation?
+ Less open to abuse
+ Instils more public confidence due to government involvement
+ Should be more efficient if economies of scale can be achieved, eg grouping by function
– Costs and inflexibility – Outsiders may impose rules that are unnecessarily costly, inefficient and which may not achieve the desired aim
– Government may be inexperienced in regulation (eg if regulation is being established for the first time or in new areas)
List two problems associated with voluntary codes of conduct
- There may be low public confidence in this approach.
- There may be a few ‘rogue’ operators who refuse to co-operate.
List three influences on policyholder expectations.
- Statements made by the provider, especially those made to the client in marketing literature and other communications
- The past practice of the provider
- The general practices of other providers in the market
Describe two ways in which regulation can try to ensure that customers are treated fairly.
- Providers may be directly required by the regulator to demonstrate that they treat customers fairly.
- Actuaries in statutory roles may be required to whistle blow if they believe that a provider is prejudicing the interests of the customer.
