Chapter 3: Regulation Flashcards
List the principle aims of regulation
GRIP
Give confidence in the system
Reduce financial crime
Inefficiencies in the market corrected
Protect consumers
Direct costs of regulation
- administering the regulation (e.g. costs of collection and examination of information provided by market participants & monitoring their activities)
- The cost incurred by regulated firms to comply with regulation (compliance of the regulated firms)
Indirect costs of regulation
PUMA
* Product innovation reduced
* Undermining of intermediaries and advisors professionalism
* Market reduces its own consumer protection mechanisms
* Alteration of consumer behaviour, false sense of security and reduced sense of responsibility
Why is the need to regulation of the financial markets typically greater than for other markets?
- Confidence:
There is a risk that if one company collapses it can cause a systematic financial collapse of the system. - Information Asymmetries, expertise and negotation strength that exists between the product provider and customer.
These issues are exacerbated by the fact:
* Financial transactions are often long term in nature and can have a significant impact on the future economic wellfare of individuals
* In general, most of the population is not well educated on financial matters and find the range of products offered both complex and confusing
List the main functions of the regulator
SERVICE
Setting sanctions
Enforcing regulation
Reviewing and influencing government policy
Vetting and registering firms and individuals
Investigate bridges
Checking management and conduct of providers
Educating consumers and the public
Information asymmetry
The situation where at least one party to a transaction has relevant information which the other party or parties do not have
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 also arise where existing policyholders have the opportunity of exercising a guarantee or an option. Those who have the most to gain from the guarentee 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.
- The party behaves less carefully, leaving the organisation to bear some of the consequences of the action.
- Moral hazard is related to information asymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.
What are the implications of information asymmetries?
Information asymmetries lead to both anti-selection and fraud.
An example of anti-selection is where options on contracts are taken up by those with the most to gain.
An example of fraud is where a policyholder does not answer questions on a proposal form fully and truthfully.
The consequences of both anti-selection and fraud are:
* worse than expected claim experience
* inequality between policyholders and between the policyholder and insurer
What actions can the regulator take to reduce asymmetries of information?
SPIDER CC
* Selling practices regulated
* Price controls imposed (e.g. setting maximim commissions scales / premium rates)
* Insider trading prevented
* Disclosure of understandable information
* Educating consumers
* Restricting knowledge to publicly avialable
- Consumer cooling-off period (cancel contract without penalty)
- Chinese walls
- Faireness (In SA the Financial Sector Conduct Authority FSCA has implemented TCF principles)
Main influences on policyholder expectations
- statements made by the provider, especially those made to the client in marketing literature and other communications
- the past practice of the product provider
- the general practices of other providers in the market
What actions can the regulator take to help ensure confidence in the financial system?
- Captital adequacy: Regularly monitoring that institutions hold sufficient capital to meet their liabilities
- Competence and integrety: Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper” for their work
- Compensation schemes: Funded by industry / government which recompense to investors who have suffered losses (due to fraud, bad advice)
- Protection for investors: Making sure the market is transparent, orderly
- Stock exchange requirements: Ensuring that listed companies fulfill certain criteria regarding disclosure of information and financial stability
Outline the five main types of regulatory regimes
- Self-regulatory systems, which are oranised and operated by the market participants without government intervention
- Statutory regimes, where the rules are set and policed by the government
- Voluntary codes of conduct, where there is a choice as to whether to adhere
- Unregulated markets, with no regulation
- Mixed regimes, involving a combination of the above
Prescriptive
It can be prescriptive, with detailed rules setting out what may or may not be done (e.g. statutary regulation)
Freedom of action regulation
Freedom but with rules on publicity (e.g. unregulated markets, voluntary codes of conduct)
Outcome-based regulation
Freedom but with prescribed, tolerated outcomes (e.g. self-regulation)
Advantages of self-regulation
- The system implemented by people with the greatest knowledge of market, who also have the greatest incentive to achieve 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
Disadvanteges of self-regulation
- The closeness of the regulator to the industry it is regulating. The danger that the regulator accepts the industy’s POV and is less tune with 3rd parties.
- Can lead to weaker regime than is acceptable.
May inhibit new entrants to a market (existing participants frame rules to act as barrier).
Advantages & Disadvantages of statutory regulation
Advantages:
* Less open to abuse
* Instills more public confidence due to government involvement
* Should be more efficient if economies of scale can be achieved (grouping activities by function)
Disadvantages
* Costs and inflexibility
* Outsiders may impose rules that are unnecessarily costly, inefficient and which may not achieve the desired aim.
* Government may be inexperienced in regulation
List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers
To meet government targets, the central bank can:
* Control money supply
* Determine or influence interest rates
* Determine or influence inflation rates
* Determine or influence exchange rates
* Ensure stability of the financial system
* Lender of last resort to commercial banks
* Target macro-economic features such as growth and unemployment
Advantages and Disadvantages of voluntary codes of conduct
Advantages
* Reduced cost of regulation
* Rules set by those with greates knowledge of the industry
Disadvantages
* Low public confidence
* Few rogue traders who refuse to cooperate
* Greater incentive to breach the voluntary code, which will have no legal backing
Describe two ways in which regulation can try to ensure that costumers are treated fairly
- Providers may be directly required by the regulator to demonstrate that they treat costumers fairly
- Actuaries in statutory roles may be required to whistle blow if they believe that a provider is prejudicing the interests of the consumer
The aims of climate change related financial regulations
- 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 risk 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
