Chapter 3 - Regulation Flashcards
Principle aims of Regulation
- Correct perceived market inefficiencies and promote efficient and orderly markets
- Protect consumers of financial products
- Reduce financial crime
- Maintain confidence in the financial system
Costs of regulation
Regulation has a cost and regulators try to develop a system where they can achieve their aims at minimum cost and hope that the benefits outweigh the costs:
Direct costs of regulation include :
1. Administering the regulation
2. Ensuring Compliance for regulated firms
Indirect costs of regulation include :
1. Moral Hazard
- Alteration of consumer behavior who may be given a false sense of security and a reduced sense of responsibility for their actions
- Undermining sense of professional responsibility among intermediaries and advisors
- Reduction in consumer protection mechanisms developed by the market itself
- Reduced product innovation
- Reduced competition
Why is regulation needed ?
Financial markets need regulation for 2 main reasons :
- Confidence
- Dangers of one problem spreading to other parts of the system , and the damage that would be done by a systemic ( 1 company fails which results in another failing and so on … ) financial collapse
- It is not necessary to guarantee the solvency of every financial institution but merely to ensure that the failure of one does not threaten the entire system - Information Asymmetry
- Situation where at least one party to a transaction has relevant information which the other party/parties do not
Functions of a regulator
- Influencing and reviewing government policy
- vetting and registration of firms authorized to conduct particular types of business
- provide information to public and consumers
- enforcing regulation , investigating suspected breaches and imposing sanctions
- supervising prudential management of financial organizations
- supervising conduct of financial businesses , and taking enforcement action where appropriate
Dealing with information asymmetry
- Disclosure and education
- full disclosure with simple , understandable info presented to client
- education on products by regulator - Negotiation
- negotiation strength usually weak by consumers
- Can be dealt with by price controls and selling practice regulations such as max commission scale , fee instead of comm , cooling off period , early termination possible , etc - Conflicts of interest
- Mitigated with insider trading regulations
- separation of functions within and between organizations
- Chinese walls - Unfair features of insurance contracts
- providers writes legal contract document
- providers have great expertise in product design and legal teams ensure policy wording in favour of providers
- consumer has none of these advantages so regulation in place to protect against unfair terms - Treating Customers Fairly
- FSCA implemented TCF with 6 key outcomes
- whistle blowing by actuaries especially those in statutory positions
How do regulators maintain Confidence ?
- Capital Adequacy
- ensure holding of sufficient financial resources to cover liabilities
- financial resources include capital , cash , liquid securities and credit lines - Competence and Integrity
- Proof of integrity and competence by obtaining specified qualifications or membership to professional organisations ( eg. ASSA , SAICA , LSSA , etc ) - Compensation Schemes
- funded by industry/government to recompense investors who suffer financial losses due to fraud , bad advice , service provider failure , etc rather than market related losses - Stock Exchange requirements
- disclosure of financial and other information by listed companies
Regulatory Regimes and forms within regimes
Regulatory Regimes:
1. Unregulated markets and unregulated lines of business
- Voluntary Codes of conduct
- Following regulation is voluntary here
- Can breakdown due to lack of public confidence , few companies refusing to cooperate - Self regulation
- Operated and organised by participants in a particular market without government intervention
- may inhibit new entrants - Statutory regulation
- government sets the rules and policies them
- less open to abuse
- greater public confidence
more costly and inflexible vs self regulation - Mixed regimes
- most common in practice
Forms of regulation :
1. Prescriptive
- detailed rules on what and what not can be done
- Outcome based
- allows freedom of action but prescribes tolerable outcomes - Freedom of action
- rules on publicity only so that 3rd parties are fully informed about providers of financial services
Who is involved in policy developments with respect to climate risks and sustainability ?
Paris Agreement which most countries signed in 2015 to strengthen global response to climate change, and committed to implement policies such as :
- keeping a global temperature rise of less than 2 degrees above pre-industrial levels
- to pursue efforts to limit the temperature increase to 1.5 degrees Celsius.
All UN member states also all adopt Sustainable development goals (SDGs) which focus on developments that balance social, economic and environmental sustainability.
What are the aims of these policy developments with respect to climate risks and sustainability ?
In order to limit the impact of climate change on the financial system, regulators are working on regulations whose aims include ensuring that financial institutions:
- consider climate risks in business decision making and strategic planning
- effectively disclose and report on climate-related risks and opportunities
- adopt a consistent and reliable means of assessing, pricing, and managing climate-related risks
- incorporate environmental, social and governance (ESG) factors into investment management decisions
- incorporate financial risks from climate change into existing risk management processes
- use scenario analysis to inform risk identification and to estimate the impact of financial risks arising from climate change
