Chapter 3-Regulation Flashcards
- In a developed economy, why would the government act as a lender of last resort?
In most developed economies, the government acts ultimately as lender of last resort because the consequences of complete financial market failure would be so severe for country, economy and society.
- What are the four main aims of regulation?
The principal aims of regulation are:
• 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.
- In developing a regulatory regime, what factors should the regulators try and strike a balance between?
Regulation has a cost. Regulators must attempt to develop a system that can achieve the aims specified above at minimum cost and hope that the benefits, which are difficult to measure, outweigh the costs.
- Outline the direct and indirect costs of financial market regulation.
Direct costs arise in administering the regulation and in compliance for the regulated firms.
Other, economic, costs of regulation have been claimed to arise from:
• an alteration in the behaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions
• an undermining of the sense of professional responsibility
amongst intermediaries and advisors
• a reduction in consumer protection mechanisms developed by the market itself
• reduced product innovation
• reduced competition.
- How and why are regulators having to co-ordinate their activities?
As financial markets become increasingly globalised, regulators are having to co-ordinate their activities on an international basis.
- Explain two reasons why regulation is more important in financial markets than in other industries.
It is often claimed that the need for regulation of financial markets is greater than the need for regulation of most other markets for two reasons.
The first is the importance of confidence in the financial system, the dangers of problems in one area spreading to other parts of the system, and the damage that would be done by a systemic financial collapse. To prevent systemic collapse or loss of confidence it is not necessary to guarantee the solvency of every financial institution, but merely to ensure that the failure of one participant does not threaten the whole system.
The second reason for the importance of regulating financial markets is the asymmetry of information between the product provider and the end customer. This is discussed later in the booklet.
- State the five main functions of a regulator.
- 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 and the way in which they conduct their business
- enforcing regulations, investigating suspected breaches and imposing sanctions
- providing information to consumers and the public.
- Give five examples of financial institutions that is necessary to regulate.
- deposit-taking institutions
- financial intermediaries
- securities markets
- professional advisers
- non-financial companies offering securities to the public.
- Define information asymmetry.
Information asymmetry is the situation where at least one party to a transaction has relevant information which the other party or parties do not have.
- Explain how information asymmetry can lead to anti-selection and give two examples of this.
Information asymmetry can lead to anti selection. If a contract has an option that can be exercised by the policyholder or benefit scheme member, it is more likely that the option will be exercised by an individual who would find it most beneficial. For example:
• lnsurability options, where an individual can increase the level of life cover without supplying medical evidence, are more likely to be exercised by lives in poor health. Lives in good health may find it cheaper just to buy a new policy, subject to full underwriting.
• Individuals in normal health are more likely to exercise guaranteed annuity rate options that are attached to their pension fund at the point of retirement. Even if the guaranteed rates are in the money for lives in normal health, lives with health impairments may be able to purchase an impaired life annuity at a better rate.
- Describe the information asymmetry where a prospective policyholder tries to avoid divulging information to a product provider.
Another source of information asymmetry is where a prospective policyholder tries to avoid divulging information to a product provider.
For example, an individual who believes that special terms for a contract might be imposed were a medical examination required might propose for a sum assured just below the limit that would t rigger an automatic medical examination, and not answer questions on a proposal truthfully. This is an example of fraud.
- Why is the asymmetry of information between the product provider and the end customer of concern to regulators?
The area of information asymmetry that is of most concern to regulators is the asymmetry of information between the product provider and the end customer. There is a difference in expertise and negotiating strength that often exists in financial transactions, particularly in retail markets. This is made more significant by the fact that financial transactions related to investment, insurance and pensions have a significant impact on the future economic welfare of individuals. Furthermore in most countries the majority of the population is not well educated in financial matters, and find the range of solutions offered to their needs complex and confusing.
- Describe ways in which information asymmetries can be reduced or mitigated?
Information asymmetry can be reduced or mitigated by requirements for a service provider to disclose full information about its products or itself in an understandable form and perhaps by consumer education by the regulator.
Knowledge held by a service provider about thi rd parties can be rest ricted to that which is publicly available by insider-trading regulations and by techniques such as ‘Chinese walls’ or separation of functions between different organisations.
The weakness of an individual in negotiating a deal with a large institution may be addressed by price controls or the regulation of selling practices. The customer’s position can 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 a consumer can cancel a contract with no penalty.
In all retail financial products, the product provider writes the legal contract document. Financial product providers have great expertise in designing contracts and legal teams that ensure the contract wording is in their favour. The retail customer has none of these advantages. Hence in many countries there is consumer protection legislation that provides for unfair terms in insurance contracts to be set aside.
- Describe the regulatory requirements to treat customers fairly.
In some countries there is legislation or regulation to ensure that providers of financial products consider the interests of their customers. In many jurisdictions there is a general regulatory requirement on regulated bodies to treat their customers fairly. However, the interpretation of what treating customers fairly means can vary significantly by jurisdiction.
Where an actuary has statutory responsibilities, these frequently include the requirement to notify the regulatory authorities if the actuary believes that a product provider is acting in a way that would prejudice the interests of its customers. This requirement imposes a clear conflict of interest on the actuary. It is generally accepted that this type of requirement is necessary because of the complexity of financial products, their long duration, and the financial impact that unfair treatment could have on customers.
These conflicts are exacerbated by the fact that in many cases financial products and schemes have benefits or charges that can be varied at the discretion of the product provider. It is generally accepted that discretionary benefits and charges should not be too dissimilar from those customers were led to believe that they would receive when they entered into the contract or transaction.
There is no precise method of defining what customers were led to believe at the inception of a contract, but it is generally accepted that the main influences on policyholder expectations are:
• 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
- How may regulators protect against systematic risk?
A key aspect to protecting consumers and reducing systematic risk is that institutions must hold financial resources to cover their l iabilities. Financial resources include capital, cash, liquid securities and credit lines. Ensuring this requires that accurate models of the business are in place to monitor risk levels and that they are used with competence and integrity.
Indeed, ensuring the competence and integrity of financial practitioners and managers is a crucial role for a financial regulator. Individuals may have to prove their competence by obtaining specified qualifications or membership of a professional organisation. Regulators may also be able to prevent an individual working in a particular industry or at a senior level if they are not judged to be a ‘fit and proper’ person.
Regulators may establish compensation schemes, funded either by the industry or by government which provide recompense to investors who have suffered losses. These typically cover losses due to fraud, bad advice or failure of the service provider rather than market-related losses.
