Chapter 3: Regulation

Question 1

Principle aims of regulation

Answer 1

• to correct perceived market inefficiencies and to promote efficient and orderly markets
• to protect consumers of financial products
• to maintain confidence in the financial system
• to help reduce financial crime

Question 2

Direct costs of regulation

Answer 2

• administering the regulation (eg. costs for collection/examination of information from market participants & monitoring their activities)
• The cost incurred by regulated firms to comply with regulation (compliance of the regulated firms)

Question 3

Indirect costs of regulation

Answer 3

• alteration in the bahaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions
• an undermining in the sense of professional responsibility among intermediaries and advisors
• a reduction in consumer protection mechanics developed by the market itself
• reduced product innovation
• reduced competition

Question 4

Why is the need to regulation of the financial markets typically greater than for most other markets?

Answer 4

Firstly, the importance of confidence in the financial system. There is the 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 end customer.

These issues are exacerbated by the fact that:

1. financial transactions are often long term in nature and can have a significant impact on the future economic welfare of individuals
2. in general, most of the population is not well educated on financial matters and find the range of products offered both complex and confusing

Question 5

List the main functions of the regulator

Answer 5

SERVICE

Setting sanctions

Enforcing regulations

Reviewing and influencing government policy

Vetting and registering firms and individuals authorised to conduct certain types of busines

Investigating breaches

Checking (supervising) management and conduct of providers

Educating consumers and the public

Question 6

Information asymmetry

Answer 6

The situation where at least one party to a transaction has relevant information which the other party or parties do not have

It includes

• anti-selection
• moral hazard

The area of information asymmetry that is of most concern is the asymmetry of information between the product provider and end customer. There is a difference in expertise and negotiating strength that oftern exists in financial transactions, particularly in retail markets

Question 7

Anti-selection

Answer 7

People are more likely to take out contracts when they believe their own risk is higher than the insurance company has allowed for in its premiums

Anti-selection can also arise where existing policyholders have the opportunity to exercise a guarantee or an option. Those who have the most to gain from the option or guarantee will be the most likely to exercise it, for example, a guaranteed insurability option (lives in good health may find it cheaper to take out a new policy)

Question 8

Moral hazard

Answer 8

The action of a party who behaves differently from the way they would have behaved if they were fully exposed to the consequences of that action.

The party behaves inappropriately or less carefully than they would otherwise, leaving the organisation to bear some of the consequences of the action.

Question 9

What actions can the regulator take to reduce asymmetries of information?

Answer 9

SPIDER CC

Selling practices regulated (addresses negotiation weakness of and individual)

Price controls imposed (addresses negotiation weakness of and individual)

Insider trading prevented

Disclosure of full information in an understandable form

Educating consumers

Restricting knowledge to publicly available

Consumer cooling off period (the right to cancel a policy without a penalty)

Chinese walls established (virtual barriers to block the exchange of information between departments of a company - reduces conflicts of interests

Also,
Fairness

Question 10

Describe two ways in which regulation can try to ensure that customers are treated fairly

Answer 10

1. Providers may be directly required by the regulator to demonstrate that they treat customers fairly
2. Actuaries in statutory roles may be required to whistleblow if they believe that a provider is prejudicing the interests of the customer

Question 11

What actions can the regulator take to help ensure confidence in the financial system

Answer 11

1. Regularly monitoring that institutions hold sufficient capital to meet their liabilities
2. Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper”
3. Establishing industry compensation schemes
4. Ensuring that the market is transparent, orderly, and provides proper protection to investors
5. Ensuring that listed companies fulfill certain criteria regarding financial stability and disclosure of information

Question 12

Compensation schemes

Answer 12

• funded either by the industry or by the government
• provide recompense to investors who have suffered losses.

Typically losses are due to fraud, bad advice, or failure of the service provider rather than market-related losses.

Question 13

Regulatory Regimes - Forms of regulation

Answer 13

• Prescriptive
• Freedom of Action
• Outcome-based

Question 14

Prescriptive regulation

Answer 14

Detailed rules on what can and can’t be done

Question 15

Freedom of action regulation

Answer 15

Involves freedom of action but with rules on publicity so that third parties are fully informed about the providers of financial services

Question 16

Outcome-based regulation

Answer 16

Freedom of action but with prescribed, tolerated outcomes

Question 17

Outline the five main types of regulatory regime

Answer 17

1. Self-regulatory systems, which are organised and operated by the market participants without government intervention (for example a stock-excange)
2. Statutory regimes, where the rules are set and policed by the government.
3. Voluntary codes of conduct, where there is a choice as to whether to adhere
4. Unregulated markets / lines of business, with no regulation
5. Mixed regimes, involving a combination of the above, such as professional bodies such as ASSA

Question 18

List 2 problems associated with voluntary codes of conduct, as well as the advantages and disadvantages compared to statutory regulation

Answer 18

Problems;

1. There may be low public confidence in the approach
2. There may be a few rogue traders who refuse to cooperate

Advantage:

1. Likely to reduce the costs of regulation
2. The rules are set by those with the greatest knowledge of the industry

Disadvantage:
1. Greater incentive to breach the voluntary code, which will have no legal backing and in all likelihood less severe penalties, if any, than with statutory regulation

Question 19

Incentives for self-regulation

Answer 19

• Regulation in an economic good that consumers of financial services are willing to pay for and which will benefit all participants
• The threat by government to impose statutory regulation if a satisfactory self-regulatory system isn’t implemented

Question 20

Advantages of self-regulation

Answer 20

• The system implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost-benefit ratio.
• Should be able to respond rapidly to changes in market needs.
• May be easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.

Question 21

Disadvantages of self-regulation

Answer 21

• The closeness of the regulator to the industry it is regulating. The danger that the regulator accepts the industry’s POV and is less in tune with 3rd parties.
• Can lead to a weaker regime than is acceptable to consumers and other members of the public
• May inhibit new entrants to a market (existing participants frame rules)

Question 22

Advantages of statutory regulation

Answer 22

• Should be less open to abuse than the alternatives and may command greater public confidence.
• The regulatory body may be able to run efficiently if, for example, economies of scale can be achieved through grouping its activities by function (such as capital adequacy) rather than by type of business

Question 23

Disadvantages of statutory regulation

Answer 23

• It can be more costly and inflexible than self-regulation
• It is argued that 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. It is claimed that attempts by government to improve efficiency usually fail and that financial services regulation is an economic good that is best developed by the market

Question 24

List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers

Answer 24

1. Control the money supply
2. Determine or influence interest rates
3. Determine or influence inflation rates
4. Determine or influence exchange rates
5. Ensure stability of the financial system
6. Lender of last resort to commercial banks
7. Target macro-economic features such as growth and unemployment

Question 25

Main influences of regulation on policyholder expectations:

Answer 25

• 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.