Chapter 8: Regulation of financial services

Question 1

Principal aims of regulation

Answer 1

• promote efficient and orderly markets
• protect consumers of financial products
• maintain confidence in the financial system
• help reduce financial crime

Question 2

Costs of regulation

Answer 2

Direct costs:

• costs arising in administering the regulation - borne ultimately by the investor

Indirect costs:

• arise from changes in behaviour, both of consumers and regulated firms, to react to the regulators.
• sense of diminished professional resposibility in intermediaries and advisors
• reduction in consumer protection mechanisms developed by the market
• reduced product innovation
• reduced competition

Question 3

Need for regulation in financial markets compared to other markets

Answer 3

Greater than for other markets due to:

• importance of confidence in the financial system
• damage that would be done by systemic financial collapse
• professional market participants likely have superior knowledge to general public = protect them from abuse by professionals

Question 4

Forms of regulation

Answer 4

• Prescriptive
• Freedom of action
• Outcome-based

Question 5

Types of regulatory regime

Answer 5

• Unregulated markets
• Voluntary codes of conduct
• Self-regulation
• Statutory regulation
• Mixed regimes

Question 6

Prescriptive regulation

Answer 6

Detailed rules setting out what may and may not be done

Question 7

Freedom of action regulation

Answer 7

Freedom of action but with rules on publicity so that third parties are fully informed about the providers of financial services

Question 8

Outcome-based regulation

Answer 8

Freedom of action but with prescribed outcomes that will be tolerated

Question 9

Unregulated markets

Answer 9

Where cost of regulation often outweigh the benefits.
Still subject to general trading and other laws applicable in particular legal jurisdiction.

Question 10

Voluntary codes of conduct

Answer 10

Operate effectively in many circumastances but vulnerable to lack of public confidence or few rogue operators refusing to cooperate = breakdown of the system.

Question 11

Self-regulation and
advantages & disadvantanges

Answer 11

Organised and operated by participants in a particular market without government intervention.

Advantages:

• Implemented by those with the greatest knowledge of the market & highest incentive to maximise benefits and minimise costs.
• Able to respond rapidly to changes in market’s needs.
• Easier to persuade firms and individuals to cooperate.

Disadvantages:

• Closeness of regulator to industry it’s regulating = side with industry.
• Consumers may lack confidence in the regulator.
• May inhibit new entrants into the market.

Question 12

Incentive of self-regulation

Answer 12

Regulation is an economic good that consumers of financial services are willing to pay for & which benefit all participants.
Threat by government to impose statutory regulation if unsatisfactory system is implemented.

Question 13

Statutory regulation and
advantages and disadvantages

Answer 13

Government sets out rules and polices them.

Advantages:

• less open to abuse
• may command a higher degree of public confidence

Disadvantages:

• may impose unnecessarily costly rules that don’t achieve desired aim

Question 14

Mixed regimes

Answer 14

Mixture of all systems described above.
Regulations often developed by market-driven private institutions (like stock exchanges) as well as governments.