Chapter 3 Flashcards
What are the aims of regulation?
Financial markets of all developed economies are regulated to some extent
Developed countries – government acts as lender of last resort as consequence of complete financial market failure would be severe for country, economy and society
One aim is to limit likelihood and potential cost of failures of financial services companies,
and to limit the need to step in as lender of last resort
Principle aims of regulation:
- Correct perceived market inefficiencies and promote efficient and orderly markets
- Protect consumers of financial products
- Maintain confidence in the financial system
- Help reduce financial crime
Market may be inefficient in sense that consumers of financial services make inefficient (incorrect) choices – lack of information and expertise of private investors with regard to complex services traded
What are the costs of regulation?
- The cost of regulation
Regulators must develop system that achieves aims specified above at MINIMUM cost and hope benefits outweigh costs
Optimal level of regulation is when marginal benefits of regulation = marginal costs
2.1. Direct costs
Administering the regulation – collection and examination of information provided by market participants and monitoring their activities
Compliance for the regulated firms – maintain records, collating the requisite information and supplying it to regulator / investor
In practice, most direct costs are borne by the investor – higher taxation to fund the regulator and/or higher charges and fees for financial services
2.2. Indirect costs
Alteration in behaviour of consumers who may be given false sense of security and reduced sense of responsibility for their own actions – moral hazard
Undermining the sense of professional responsibility among intermediaries and advisors – moral hazard
Reduction in consumer protection mechanisms developed by the market – moral hazard
Reduced product innovation
Reduced competition
As financial markets become globalised regulators have to co-ordinate their activities on an international basis
Why is the need for regulation of financial markets greater than that of other markets?
Claimed that need for regulation of financial markets is greater than that of other markets, because:
Confidence Asymmetric information
Major contribution to collapse of African Bank was lack of regulation when it came to the bank’s lending – lent out millions of unsecured loans to individuals who were unable to at any point afford the repayment
3.1. Confidence
Dangers of problems in one area spreading to other parts of the system and damage that would be done by a systemic financial collapse
Systemic risk – risk of failure of one financial institution leading to the failure of another, which in turn causes difficulties for a third institution and so on
This risk arises when financial positions of different institutions are very closely interlinked and can result in overall failure of financial system
Collapse of large bank could lead to loss of faith in banking system
To prevent systemic collapse or loss of confidence:
Not necessary to guarantee the solvency of every financial institution
BUT, to ensure that the failure of one participant does not threaten the whole system
3.2. Asymmetric information
The better-informed party could use information for own benefit and to detriment of the other party.
What are the functions of the regulator?
The functions of a regulator
Influencing and reviewing government policy
Vetting and registration of firms and individuals authorised to conducts certain types of business
Supervising the prudential management of financial organisations and the way in which they conduct business
Enforcing regulations, investigation suspected breaches and imposing sanctions
Providing information to consumers and the public
Regulation may be segregated by type of financial business – insurance and investment
It will be necessary to regulate:
Deposit-taking institutions Financial institutions Securities markets Professional advisers Non-financial companies offering securities to the public
What is information asymmetry and how does it lead to anti-selection and moral hazard?
Information asymmetry – situation where at least one party to a transaction has relevant information which the other party or parties do not have
Prospective policyholder tries to avoid disclosing information
Area of most concern is the asymmetry of information between the product provider and the end customer – difference in expertise and negotiating strength that often exists in financial transactions
Information concerning financial services may be widely available obtaining the required info will normally involve a cost
Anti-selection
People will be more likely to take out contracts when they believe their risk is higher than the insurance company has allowed for in its premiums.
Can arise where existing policyholders have the opportunity of exercising a guarantee or an option.
Those who have the most to gain from the guarantee or option will be most likely to exercise it.
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.
Party behaves inappropriately or less carefully than they would otherwise, leaving the organisation to bear some of the consequences of the action
How is information asymmetry dealt with - Disclosure and education - Conflicts of interest - Negotiation
Disclosure and education
Reduced or mitigated by requirements for a service provider to disclose full information about its products or itself in an understandable form and by perhaps by consumer education by the regulator
Conflicts of interest
Knowledge held by service provider about third parties can be restricted to that which is publicly available by insider-trading regulations
AND, by techniques such as Chinese walls or separation of functions between different organisations
Negotiation
Weakness of an individual in negotiating a deal with a large institution may be addressed by price controls or the regulation of selling practices
Strengthen customer’s position by giving them right to terminate the sales process at any time
OR, providing a cooling off period during which a consumer can cancel a contract with no penalty
Price controls could involve:
Setting of max commission scale Requirement for a fee basis (customer pays fixed fee for advice) rather than commission basis (fee depends on product sold, provider and size of premium paid) – to ensure that advice given is in best interest of consumer Max premium rates and/or levels of management charges
How is information asymmetry dealt with - Unfair features of insurance companies - Treating the customer fairly
Unfair feature of insurance contracts:
Product provider writes legal contract document
Have great expertise in designing contracts and legal teams that ensure the contract wording is in their favour.
Retail customer has none of these advantages
Thus, there is consumer protection legislation that provide unfair terms in insurance contracts to be set aside
Examples:
Literature – plain, easy to understand language Contract terms – company not able to change the contract terms significantly without a valid reason and without allowing the consumer to have sufficient notice and opportunity to immediately dissolve the contract Discontinuance benefits – size and payment of surrender values
Treating the customer fairly
Countries have legislations and regulations to ensure providers consider interests of customers
In many jurisdictions there is general regulatory requirement on regulated bodies to treat customers fairly.
The interpretation of what treating customers fairly means can vary significantly by jurisdiction
Key outcomes that should be achieved as a result of TCF:
Consumers can be confident that they are dealing with firms where fair treatment of customers is central to corporate culture Products and services marketed and sold in market are designed to meet needs of identified consumer groups and are targeted accordingly Consumers provided with clear info and kept informed before, during and after point of sale Advice given is suitable and takes account of consumers’ circumstances Products perform as firms have led them to expect and associated services is of acceptable standard Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit claim or make complaint
Actuary with statutory responsibilities - frequently include the requirement to notify the regulatory authorities if actuary believe product provider is acting in way that is prejudice in interests of its customers
Whistle-blowing
This imposes a conflict of interest on the actuary
Discretionary benefits and charges should not be too dissimilar from those that customers were led to believe they would receive when they entered into contract
Main influences on policyholder expectations are:
Statements made by provider – especially those made to customer in marketing literature and other communications Past practice of the product provider General practices of other product providers in the market
How is confidence in the financial market maintained - Capital adequacy
Capital adequacy
Must hold sufficient financial resources to cover liabilities – to protect consumers and reduce systematic risk
Cash, capital, liquid securities and credit lines
Financial services providers must show that their assets are enough to cover liabilities at present, AND
Also, must show that they have sufficient margins to ensure that they are likely to be able to do so in future in face of adverse experience – capital requirements and required capital
Must also be able to meet short-term expected and unexpected liability outgo
Statutory requirements relating to coverage of liabilities could take form of:
Assets = to specified proportion of liabilities with both assets and liabilities being valued according to a prescribed basis Sufficient assets must be held to ensure probability of insolvency over a particular time period is lower than a specified level taking into account company’s risk
Ensuring all of this requires accurate models of business – to monitor risk levels and must be used with competence and integrity
How is confidence in the financial market maintained - Competence and integrity
Competence and integrity
Ensuring this is a crucial role for a financial regulator
Competency – know the appropriate course of action to take on behalf of investor
Integrity – they choose to take it
Prove competence – obtaining specified qualifications or membership of professional organisation
NB role of regulator is to determine which professional organisations and qualifications to recognise
May also be able to prevent an individual from working in particular industry or at senior level if they are not judged to be fit and proper
How is confidence in the financial market maintained - Compensation schemes
Compensation schemes
Regulators may establish compensation schemes, funded by industry or by government
Provide recompense to investors who have suffered losses
Cover losses due to fraud, bad advice or failure of service provider rather than market-related losses
Investors not compensated if value of shares held goes down because market as a whole does or company involved performs badly.
To reduce impact of moral hazard – amount of compensation might be limited to max percentage of any loss or to max absolute amount
Ensures that investor retains some incentive to consider financial integrity of provider
How is confidence in the financial market maintained - Other protection for investors
Other protection for investors
Security market regulators will seek to ensure market is transparent, orderly and provides proper protection to investors
Important to protect private investors who might be less informed than institutions
Transparency required to ensure that they are able to see more easily what exactly in happening in marketplace
Orderliness necessary because often not able to trade immediately in response to new info or events that impact upon market prices
How is confidence in the financial market maintained - Stock exchange requirements
Stock exchange requirements
Companies listed on the stock exchange will have to fulfil certain criteria regarding financial stability
AND, will have to fulfil specified obligations for the disclosure of financial and other info
May be more onerous than general accounting requirements that apply to all companies
Aim is to ensure investor can make well-informed investment decisions
Regulators will monitor aspects such as prices at which business is done and reporting of deals
Trading volumes may be recorded to:
Deter or identify occurrence of insider trading, based upon non-public information Prevent substantial acquisitions of shares occurring quickly and privately – to protect position of shareholders
Regulations governing issues of new share and takeover bids for companies
Aimed at protection of those at an
information disadvantage
Principles that might be required to be observed in takeover;
Protection of interests of existing shareholders & managers & wider public interest That it does not lead to market-dominating companies restricting competition Prevention of a bidder retracting an offer – other than in expectational circumstances Disclosure of specified info
What are the different regulation regimes?
1.Forms of regulation
Different types
Most important are self-regulation and statutory regulation
Prescriptive
Detailed rules setting out what may or may not be done
Prescriptive regime likely to control tightly the activities of parties affected – reducing likelihood of thing going wrong
Often has greater costs than other approaches
Freedom of action
Regulation can involve freedom of action but with rules on publicity so that third parties are fully informed about the providers
Firm can do what they want as long as it publishes sufficient information for the regulator to check that it is being properly managed
Outcome-based
Regime can allow freedom of action but prescribe the outcomes that will be tolerated
Concerned with end result – has investor made well-informed decision
- Unregulated markets and unregulated lines of business
Has been argued that cost of regulation in some markets outweigh the benefits
Markets where only professionals operate or commodity products with guaranteed benefits that are sold only on price (assurances)
So here best option is no specific regulations – participants will still be subject to general trading and other laws
- Voluntary codes of contract
Are vulnerable to a lack of public confidence or to a few rogue operators refusing to co-operate – leading to break down of system
Advantages: (compared to statutory)
Reduced cost of regulation
Rules set by those with greatest knowledge of industry
Disadvantage
Greater incentive to breach the voluntary code – which will have no legal backing and less severed penalties
- Self-regulation
Organised and operated by the participants in a particular market without government intervention
Incentive is that regulation is an economic good that consumers of financial services are willing to pay for and which will benefit all participants
Other incentive, threat by government to impose statutory regulation if a satisfactory self-regulation system isn’t implemented
- Statutory regulation
The government sets out the rules and polices them
- Mixed regimes
In practice many regulatory regimes are a mixture of all the systems
What is are the advantages and disadvantages of self-regulation?
Advantages of self-regulation
Implemented by the people with the most knowledge of the market
And who also have greatest incentive to achieve the optimal cost-benefit ratio
Should be able to respond rapidly to changes in market needs
Easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy
Disadvantages of self-regulation
The closeness of the regulator to the industry it is regulating
Danger than the regulator accepts the industry’s point of view and is less in tune with the views of third parties (consumers of financial services)
This can lead to weaker regime than is acceptable to consumers and other members of the public
Even if the regime is operating efficiently and effectively, it can suffer from low public confidence
Regulator must be fair and objective, but it must be clearly seen to be so in the eyes of the investing public
It may also inhibit new entrants to a market
What is are the advantages and disadvantages of statutory regulation?
Advantages of statutory regulation
Should be less open to abuse than alternatives
May command greater public confidence
May be concerns that regulatory body takes more heed of views of those it is regulating than those of the consumers
Regulatory body may be able to be run efficiently if economies of scale can be achieved through grouping its activities by function rather than type of business
Example of split function – have separate regulators responsible for monitoring market conduct and regulatory solvency
Disadvantages of statutory regulation
More costly and inflexible then self-regulation
Argued that market participants are in best position to devise and run the regulatory system
Outsiders might impose rules that are unnecessarily costly and may not achieve desired aim
