Chapter 3: Regulation Flashcards
What are the aims of regulation?
GRIP
> Give confidence in the financial system
> Reduce financial crime
> Inefficiencies in the market corrected and efficient and orderly markets promoted
> Protect consumers
Who borne the cost of regulation?
> investors;
in the form of increased charges and perhaps reduced competition and reduced access to different types of investment
What are direct costs of regulation? (2)
1.> Administering the regulation (e.g. collecting information, monitoring activities)
2> Compliance of the regulated firms (maintaining appropriate records)
What are indirect costs of regulation? (7)
1> Alteration in consumer behavior
2> Undermining of the sense of professional responsibility among intermediaries and advisors
3> Reduction in self regulation by the market
4> Reduced product innovation (rigid and less flexible business environment)
5> Reduced competition (create barriers of entry for new business)
6> Reduced productivity
7> Opportunity costs
Why is the need for regulation in financial markets greater than the need for regulation of
most other markets? (5)
o Maintain confidence in the financial system.
o Risk if one company collapses=> systemic financial collapse of the system
o Asymmetric information, expertise and negotiating strength that exist between the
product provider and the end customer.
o Financial transactions are long term in nature=> significant effect on the future
economic welfare of individuals
o In general majority of the population is not well educated on financial matters and
find the range of products offered both complex and confusing
What are the main functions of a regulator? (7)
SERVICE
o Supervising the prudential management of financial organizations
o Enforcing regulation
o Reviewing and influencing government policy
o Vetting and registering firms and individuals
o Investigating breaches and imposing sanctions
o Checking/supervising the conduct of financial businesses, and taking enforcement action where appropriate
o Educating consumers and the public
What are regulated institutions? (5)
1> Deposit-taking institutions (e.g. retail bank)
2> Financial institutions (e.g. insurance companies, pension funds)
3> Securities markets (i.e. money market instruments, bonds, derivatives)
4> Professional advisors (i.e. actuaries, investment bankers)
5> Non-financial companies offering securities to the public (i.e. offer new shares or debt)
What is information asymetry?
Asymmetries occur when one party has relevant information or expertise or negotiating strength not shared by another party.
Leads to: Anti-selection, moral hazard
What is anti-selection? (4 points)
o People will be more likely to take out contracts
o Or exercise a guarantee or option
o When they believe their risk is higher than the insurance company has allowed for
in its premium setting
o Or pricing of guarantees or options
What is moral hazard?
o The action of a party
o Who behaves differently from the way they would behave
o If they were fully exposed to the consequences of their action.
o Party behaves inappropriately or less carefully otherwise.
o Moral hazard=> information=> party causing the action having more info than the
party who bears the consequences
o Not the same as anti selection
o Who takes advantage of particular aspects of an insurance contract
o But within the terms of the contract
What is an example of information asymmetry?
1> Options on contracts are taken by those with the most to gain
2> Option to renew a contract without further underwriting
> Taken up by an individual with less than average health
> Fraud=> individual lying on a proposal form
Worse than expected claims experience
Inequity between policyholders and between policyholders and insurer.
What steps can a regulator take to help reduce information asymmetries? (10)
> Requiring full disclosure of information in an understandable way
> Educating consumers
> Imposing price controls
> Regulating selling practices
> Giving consumers a cooling of period
> Restricting knowledge to everyone to that which is publicly available
> Enforcing insider trading regulations
Requiring establishment of Chinese walls
Having legislation on treating customers fairly and ensuring no unfair terms
> ‘whistle-blowing’ by actuaries of they believe client is being treated unfairly
What actions can the regulator take to help ensure confidence in the financial system?(5)
1>Regularly monitoring=> institution holds sufficient capital to meet 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 listed companies fulfill certain criteria regarding financial stability and
disclosure information.
Explain the main types of regulatory regimes?
1> unregulated markets - where no financial services specific regulations apply; market participants are subject to normal legislation (cost>benefit)
2> voluntary codes of conduct - drawn up by the financial service industry itself ( vulnerable to lack of public confindence)
3> self regulation - organised and operated by the participants in a particular market without government intervention
4> Statutory regulation - in which government sets out the rules and policies them
5> mixed - a combination of the above (professional bodies)
What are advantages and disadvantages of self-regulation? (4+3)
Advantages:
- knowledge of the market
- optimal cost-benefit ratio
- respond rapidly to changes
- easier persuasion/compliance
Disadvantages:
- Closeness
- low public confidence
- inhibit new entrants
Implemented by the people with the greatest knowledge of the market and
greatest incentive to maximise cost-benefit ratio
o +Should respond rapidly to changes in market needs
o +Easier to persuade firms and individuals to cooperate than under a statutory
regime
o -Low public confidence => regulator close to the market
o High barriers to entry
What are advantages and disadvantages of statutory regulation?
Advantages
- less open to abuse
- greater public confidence
- efficiency
- economies of scale
- split by function
Disadvantages
- costly
- inflexible
- unnecessary rules
-Government may be inexperienced in regulation
What is prescriptive regulation?
Detailed rules on what can and cannot be done
What is freedom of action?
Freedom but with rules on publicity of information
What is outcome based regime?
Freedom but with prescribed tolerated outcomes
What are the functions of the central bank ? (5)
o Control the money supply
o Determine or influence interest rates
o Determine or influence inflation rates
o Determine or influence exchange rates
o Target macro-economic features such as growth and unemployment
o Ensure stability of the financial system
o Lender of last resort to commercial banks
How can regulation try to ensure that customers are treated fairly?
> Providers may be directly required by legislation to demonstrate that they are
treating customers fairly
> Actuaries in statutory positions may be required to whistle blow=> if they believe
that a provider is prejudicing the interests of a customer
What are influencers on policy holder expectations? (3)
> Statements made by the provider=> especially those made to clients in marketing
literature and other communications
> Past practise of the provider
> General practises of other providers in the market
Aims of climate change related financial regulations – for institution to: (6)
1> Consider climate risks in business decision making and strategic planning
2> Effectively disclose and report on climate-related risks and opportunities.
3> Adopt a consistent and reliable means of assessing, pricing and managing climate-related risks.
4> Incorporate environmental, social and governance (ESG) factors into investment management decisions.
5> Incorporate financial risks from climate change into existing risk management processes.
6> Use scenario analysis to inform risk identification and to estimate the impact of financial risks arising from climate change.
