Chapter: Regulation Flashcards
Principle aims of regulation
- to correct perceived market inefficiencies and to promote efficient and orderly markets
- to protect consumers of financial products
- to maintain confidence in the financial system
- to help reduce financial crime
Direct costs of regulation
- administering the regulation (eg. costs for collection/examination of information from market participants & monitoring their activities)
- The cost incurred by regulated firms to comply with regulation (compliance of the regulated firms)p
Indirect costs of regulation
- alteration in the bahaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions
- an undermining in the sense of professional responsibility among intermediaries and advisors
- a reduction in consumer protection mechanics developed by the market itself
- reduced product innovation
- reduced competition
Why is the need to regulation of the financial markets typically greater than for most other markets?
Firstly, the importance of confidence in the financial system. There is the risk that if one company collapses, it can cause a systemic financial collapse of the system.
Secondly, the asymmetry of information, expertise and negotiating strength that exists between the product provider and end customer.
These issues are exacerbated by the fact that:
- financial transactions are often long term in nature and can have a significant impact on the future economic welfare 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
w
Information asymmetry
The situation where at least one party to a transaction has relevant information which the other party or parties do not have
It includes
- anti-selection
- moral hazard
The area of information asymmetry that is of most concern is the asymmetry of information between the product provider and end customer. There is a difference in expertise and negotiating strength that oftern exists in financial transactions, particularly in retail markets
Anti-selection
People are more likely to take out contracts when they believe their own risk is higher than the insurance company has allowed for in its premiums
Anti-selection can also arise where existing policyholders have the opportunity to exercise a guarantee or an option. Those who have the most to gain from the option or guarantee will be the most likely to exercise it, for example, a guaranteed insurability option (lives in good health may find it cheaper to take out a new policy)
Moral hazard
The action of a party who behaves differently from the way they would have behaved 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.
What actions can the regulator take to reduce asymmetries of information?
SPIDER CC
Selling practices regulated (addresses negotiation weakness of and individual)
Price controls imposed (addresses negotiation weakness of and individual)
Insider trading prevented
Disclosure of full information in an understandable form
Educating consumers
Restricting knowledge to publicly available
Consumer cooling off period (the right to cancel a policy without a penalty)
Chinese walls established (virtual barriers to block the exchange of information between departments of a company - reduces conflicts of interests
Also,
Fairness
Describe two ways in which regulation can try to ensure that customers are treated fairly
- Providers may be directly required by the regulator to demonstrate that they treat customers fairly
- Actuaries in statutory roles may be required to whistleblow if they believe that a provider is prejudicing the interests of the customer
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
Compensation schemes
- funded either by the industry or by the government
- provide recompense to investors who have suffered losses.
Typically losses are due to fraud, bad advice, or failure of the service provider rather than market-related losses.
Regulatory Regimes - Forms of regulation
- Prescriptive
- Freedom of Action
- Outcome-based
Prescriptive regulation
Detailed rules on what can and can’t be done
Freedom of action regulation
Involves freedom of action but with rules on publicity so that third parties are fully informed about the providers of financial services