CHP 4 Flashcards
- The aims of regulation
- Correct perceived market inefficiencies and
- Promote efficient and orderly markets
- Protect consumers of financial markets
- Maintain confidence in financial systems
- Help reduce financial crime
- Cost of regulation
Regulation has a cost – regulators must aim to develop a system that achieves the objectives and where the benefits outweigh the cost. (optimal level = marginal benefit = marginal cost of regulation)
Regulation Direct costs
- Administering the regulation – cost for the regulator
* Compliance for the regulated firms – cost for the participant
Regulation Indirect costs
- An alteration in the behavior of consumers – may be given a false sense of security and a reduced sense of responsibility for their own actions
- An undermining of the sense of professional responsibility amongst intermediaries and advisers
- A reduction in consumer protection mechanisms developed by the market itself
- Reduced product innovation
- Reduced compition
- The need for regulation
The need is greater in financial services than other markets because of:
• Confidence
• Asymmetric information
- The need for regulation
• Confidence
Danger is that problems in one area spread to other parts of the system and the damage done by a systemic financial collapse.
To prevent systemic collapse or loss of confidence it is only required that the collapse of one participant does not threaten the whole system.
- The functions of a regulator
- Influencing and reviewing government policy
- Vetting and registration of firms and individuals authorized to conduct certain types of business.
- Supervising the prudential management of financial institutions and the way in which they do their business
- Enforcing regulations, investigating suspected breaches and imposing sanctions
- Providing info to consumers and the public
Regulation may be segregated by type of financial business (e.g. insurance or investment).
It will be necessary to regulate:
- Deposit-taking institutions
- Financial intermediaries
- Securities markets
- Professional advisers
- Non-financial companies offering securities to the public
- Areas addressed by regulation – information asymmetry
Info asymmetry – a party in a transaction has relevant info the others don’t.
• Def: Anti-selection: People will take out contracts when they believe their risk is higher than what is allowed for in the premiums.
• Def: Moral hazard: Risk that an insured may attempt to take unfair advantage of the insurer. (e.g. false claim)
• Information asymmetry can lead to anti-selection. E.g. options available will more likely be exercised by someone who will find it more beneficial.
• Information asymmetry can cause prospective policy holders to avoid disclosing everything (e.g. health problem)
• The area of info asymmetry of most concern: info asymmetry between provider and end user of products. There is a difference in negotiating power and expertise.
• The area of info asymmetry of most concern: info asymmetry between provider and end user of products. There is a difference in negotiating power and expertise.
o This is accentuated by the fact that fin transactions (IV, insurance and pension) have large impact on the future economic welfare of individuals.
o Many people are not financially very sophisticated and find fin solutions complex and confusing
5.2. Dealing with information asymmetry
- Disclosure and education
- Conflicts of interest – knowledge about 3rd parties can be restricted to public info by insider trading regulation. (Chinese walls or separation of functions between organisations)
- Negotiation – individual rights protected by price controls and regulation of selling practices. E.g. cooling off
- Unfair features of insurance contracts – consumer protection act
- TCF – needed because of the long duration and complexity of fin products and the impact of unfair treatment. COI is increased by clauses allowing providers to change benefits and charges. It is generally accepted that discretionary benefits and charges should not be too dissimilar from those customers were led to believe at outset.
There is no precise method of defining what customers were lead to believe (PRE – Policyholder Reasonable Expectations), main influences on policy holder expectations are:
o Statements by the provider – e.g. especially marketing material and other comms
o Past practice
o General practice of other providers
- Areas addressed by regulation – Maintaining confidence
6. 1. Capital adequacy
Institutions must hold sufficient capital to cover their liabilities.
• Could be assets must be at least a specified proportion of liabilities (according to a prescribed basis)
• Sufficient assets held to ensure probability of insolvency over a specified period is below a certain level.
Ensuring this requires accurate models to monitor risk levels and that they are used with competency.
- Areas addressed by regulation – Maintaining confidence
6. 2. Competence and integrity
Ensuring competence and integrity of fin practitioners and managers is a crucial role for a fin regulator.
Individuals may need to prove competence by qualification or membership to professional body.
Regulators may prevent an individual from working in a particular industry or at a senior level of they are not deemed fit and proper.
- Areas addressed by regulation – Maintaining confidence
6. 3. Compensation schemes
Regulators may establish compensation schemes, funded by industry or government to compensate investors who suffered losses. E.g. losses due to fraud, bad advice or failure of service provider rather than market-related losses.
