Chapter 3: Regulation Flashcards
List the principal aims of regulation
GRIP
* Give confidence in the system
* Reduce financial crime
* Inefficiencies in the market corrected, and promote efficient and orderly markets
* Protect consumers of financial products
Ouline direct costs of regulation
- Administering the regulation
- Compliance for the regulated firms
In practice, most of these direct costs are borne ultimately by the investor in the form of either higher taxation to fund the regulator and / or higher charges and fees for the financial services that are purchased.
Outline indirect costs of regulation
PUMA
* Product innovation reduced
* Undermining of intermediaries and advisors professionalism (sense of professional responsibility)
* Market reduces its own form of consumer protection mechanisms
* Alteration of consumer behaviour, false sense of security and a reduced sense of responsibility.
Why is the need for regulation of financial markets typically greater than for most other markets?
Firstly, 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.
Secondly, is the importance of asymmetry of information between the product provider and the 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
List the main functions of a regulator
SERVICE
* Setting sactions
* Envorcing regulation
* Reviewing and influencing government policy
* Vetting and registering firms and individuals
* Investigating breaches
* Checking management and conduct of providers
* Educating consumers and the public
What is 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.
What is anti-selection?
People will be more likely to take out contracts when they believe their risk is higher than the insurance compnay has allowed for in its premium.
Can also arise where exisitng policyholders have the opportunity of exercising a guarantee or an option. Those who have most to gain from the guarantee or option will be the most likely to exercise it.
What is 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 inappropriately or less carefully than they would otherwise, 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.
(This is not the same as anti-selection, which is also taking advantage of particular aspects of an insurance contract, but within the terms offered by the insurer)
What are the implications of information asymmetries?
Information asymmetries can lead to both anti-selection and fraud.
An example of anti-selection is where options are taken up by those who have 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:
1. worse than expected claims experience
2. inequality between policyholders, and between the policyholder and the insurer.
What actions can regulators take to reduce asymmetries of information?
SPIDER CC
* Selling practices regulated
* Price controls imposed
* Insider trading prevented
* Disclosure of understandable information
* Educating customers
* Restricting knowledge to the publicly available.
- Consumer cooling-off period
- Chinese walls established
Also, fairness
List the 6 key outcomes that should be achieved as a result of TCF
- Consumers can be confident that they are dealing with firms where fair treatment of customers is central to the corporate culture.
- Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly.
- Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale.
- Where consumers receive advice, the advice is suitable and takes account of their circumstances.
- Consumers are provided with products that perform as firms have led them to expect, and the associated services is of an accpetable standard and as they have been led to expect.
- Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.
List the main influences on policyholder expectations
- Statements made by the product provider, especially those made to the customer in marketing literature and other communications
- The past practice of the product provider
- The general practices of other product providers in the market.
What actions can the regulator take to help ensure confidence in the financial system
- Regularly monitoring that institutions hold sufficient capital to meet their liabilities
- Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper”
- Establishing industry compensation schemes
- Ensuring that the market is transparent, orderly, and provides proper protection to investors
- Ensuring that listed companies fulfill certain criteria regarding financial stability and disclosure of information
List the 5 areas addressed by regulation to maintain confidence in the financial system
- Capital adequacy
- Competence and integrity
- Compensation schemes
- Other protection for investors
- Stock exchange requirements
Discuss the 5 areas addressed by regulation to maintain confidence in the financial system
- Capital adequacy:
* Holding sufficient financial resources to cover liabilities is a key aspect to protecting consumers and reducing systematic risk
* Financial service providers must also ensure they have sufficient margins.
* 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. - Competence and integrity:
* Competence means that financial practitioners and managers know the appropriate course of action to take on behalf of the investor.
* Integrity means that they choose to take it.
* Individuals may need to prove their competence by obtaining specified qualifications or the membership of a professional organisation.
* Regulation can also prevent an individual from working in a particular industry. - Compensation schemes:
* Regulators may establish compensation schemes, funded either by the industry or by the government which provide recompensation to investors who have suffered losses.
* These typically cover losses due to fraud, bad advice, or failure of the service provider rather than the market-related losses. - Other protection for investors:
* Security market regulators will seek to ensure that the market is transparent, orderly and provides proper protection to investors.
* Transparency is required to ensure that they are able to see more easily exactly what is happening in the marketplace. - Stock exchange requirements:
* Companies listed on a stock exchange will have to fulfil certain criteria regarding financial stability and will need to fulfill specified obligations for the dislosure of financial and other information.
* There are likely to be regulations governing issues of new shares and takeover bids for companies.
What is prescriptive regulation?
Regulation is prescriptive if it details rules setting out what may or may not be done.
It is likely to control tightly the activities of the parties affected, thereby reducing the likelihood that things go wrong.
However, it has greater costs.
What is freedom of action regulation?
Regulation can involve freedom of action, but with rules on publicity so that third parties are fully informed about the providers of financial services.
In other words, firms can do pretty much what they want, provided that they publish sufficient information for the regulator to check that it is being properly managed.
What is outcome-based regulation
This regime can allow freedom of action, but prescribes the outcomes that will be tolerated.
This regulation is concerned with the end result.
Outline the 5 main types of regulatory regime
- Self-regulatory systems, which are organised 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 / lines of business, with no regulation
- Mixed regimes, involving a combination of the above
Describe the main advantages and the main disadvantages of a voluntary code compared to statutory regulation
The main advantages are likely to be the reduced cost of regulation and the fact that the rules are set by those with the greatest knowledge of the industry
The main disadvantage is likely to be the 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
Discuss the advantages of self-regulation
An advantage of self-regulation is that the system is implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost-benefit ratio.
Self-regulation should, in theory, be able to respond rapidly to changes in market needs.
Also, it may be easier to pursuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.
Discuss the disadvantages of self-regulation
The main problem with self-regulation is the closeness of the regulator to the industry it is regulating.
There is a danger that the regulator accepts the industry’s point of view and is less in tune with the views of third parties
This can lead to a weaker regime than is acceptable to consumers and other members of the public. Even if the regulatory regime is operating efficiently and effectively, it can suffer from low public confidence in the system.
Self-regulatory organisations may also inhibit new entrants to a market.
Discuss the advantages of statutory regulation
This has the advantage that it 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 economies of scale can be achieved through grouping its activities by function rather than type of business.
Discuss the disadvantages of statutory regulation
The disadvantage of statutory regulation are that it can be more costly and inflexible than self-regulation.
It is argued that the 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 market efficiency usually fail and that financial services regulation is an economic good that is best developed by the market.
List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers
- Central banks are often responsible for the supervision of banks in their jurisdiction
- Control the money supply
- Determine or influence interest rates
- Determine or influence inflation rates
- Determine or influence exchange rates
- Target microeconomic features such as growth and unemployment
- Ensure stability of the financial system
- Be the lender of last resort to commercial banks.
List 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 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
- Consider the impact of climate risks on the ability to meet obligations towards policyholders and other key stakeholders.
