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2

Choice of Regulatory Model

Learning outcomes
After studying this unit you should be able to:
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Discuss the different approaches to the regulatory and supervisory model Analyse the need for external regulation Discuss the effectiveness of self regulation Explain enforced self regulation Discuss the differences between sectoral/functional and unified supervision Analyse the growth of ³twin peaks´ approach to regulation

Recommended Reading
Goodhart, C, Hartmann, P, Llewellyn, D, Rojas-Sugrez, L (1998) Financial Regulation: why, how and where now? (Routledge, London ) ch. 1 Baldwin, R & Cave M (1999) Understanding Regulation: Theory Strategy and Practice, Oxford University Press, Oxford) chs 3 & 4 Herring R J & Carmassi J, (2008), The Structure of Cross-Sector Financial Supervision, Financial Markets Institutions & Instruments, Vol. 17 no. 1, February, Blackwell Publishing

Introduction
Traditionally the sectoral or functional approach to regulation and supervision had dominated the financial sector and in many cases the boundaries between the different sectors of activities was also regulated. In other words the organisations themselves were clearly defined as operating in the different markets and therefore subject to the supervision of different regulators. There are three main functions of the supervision which are:
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Macro prudential ( supervision of the financial system) Micro prudential ( supervision of the individual firms) Conduct of Business (protection of consumers)

Prior to the 1990s banks were predominantly supervised by the Central Bank in their country who looked after both the macro and micro sectors but the conduct of business tended to be left to other consumer protection agencies, suc h as consumer fraud agencies, industry associations or law enforcement agencies. Other areas of the financial sector such as securities firms and insurance firms were not considered to be a risk to the financial system because of the nature of their busine ss so did not come under any macro prudential supervision. These firms were either under the supervision of a securities regulator or self regulatory organisation for the securities industry or an insurance commission or self regulatory organisation in tha t sector. The boundaries between the sectors as mentioned above were also closely regulated and firms were not able to operate within the different areas of the financial sector and the large financial conglomerates that we know today did not exist. However over the past 20 years there has been a move towards unified supervisory bodies with the UK arguably being the first major financial sector changing to a unified regulator in 1997, when 9 self regulatory organisations were brought together to form the Financial Services Authority (FSA). However, they were not the first with the Monetary Authority of Singapore (MAS) being formed in 1984, and this regulatory body is unusual in that it is also the main monetary authority for the country. In most countries the monetary authority is kept independent of the regulatory authority and we shall discuss this later in the unit. Singapore was followed by the Scandinavian countries, (Norway 1986; Denmark 1988; and Sweden 1991) and after the UK, South Korea, Japan and Ta iwan formed Unified regulators. A third approach to regulation has been developed more recently and is known as the ³twin peaks´ approach and this has been adopted by Australia and Netherlands in particular with Ireland adopting a hybrid approach to ³twin peaks´. The so called ³twin peaks´ approach allocates the responsibility for prudential regulation and conduct of business to two separate agencies. This is an example of regulation by objectives whereby prudential regulation is designed to promote the safety and soundness of the individual institutions, while conduct of business is directed at consumer protection. However this approach has taken on a new prominence following the 2008 US Treasury ³Blueprint for a Modernised Financial Regulatory Structure´ which presents a long-term optimal regulatory structure based on a separation between prudential and conduct of business regulation. This approach also appears to be favoured by the G30 report on the structure of Financial Regulation, which is significant a s it was issued under the name of Paul Volcker who is a financial advisor to president Obama. France and Spain have been reported to be considering adoption of this model.

Supervision and regulation of financial firms

As previously discussed this is a ma tter of balance. Supervision and regulation should not be overly burdensome to financial firms so that responsibility, innovation and competition are restricted. Equally supervision and regulation should not be so lax as to be ineffective in curbing the e xcesses of profit seeking self interest. Other issues to consider in relation to supervision and regulation is that it can weaken the incentive for the firms to monitor themselves and this is the basis of the examination of the different forms of regulat ion and to consider external, self regulation and enforced self regulation. A second aspect is that regulation can also weaken the responsibility of clients to complete their own due diligence and this balance has to be considered in the construction of ef fective regulation.
External Regulation

We have to examine some of the points that should be reviewed with regard to external regulation or the aspects of what is sometimes referred to as Command and Control approach to regulation. The main advantage of this form of regulation is that is often supported by the force of law which has fixed minimum standards and defined acceptable levels of behaviour. This can also involve the screening of entry to the market, which requires firms to adhere to the standards and levels of behaviour set. External regulation is often seen by the public as highly and the use of penalties within the regulation can also provide a signal of the intent of the forcefulness by which the authorities back up the regulation. However there a number of weaknesses with this form of regulatory strategy which we have to consider:
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Intervenes in the management of the organisation and industry Is prone to capture Complex rules tend to multiply Inflexible High levels of information required Expensive to administer & enforce Compliance costs within the firms are high Incentive only to meet standards rather than exceed them Inhibits desirable behaviour

The excessive prescription often brings the regulator into dispute with the industry. This can cover a number of issues firstly within financial services the risks involved in the delivery of the products and services within the sector are too complex for simple rules. The imposition of prescribed regulation can blur the competitive advantage of

firms based on standards and level of service. The development of a detailed rulebook leads to the lowest way of meeting regulation and can become focused on the process rather than the outcome of regulation. This leads to what many consider to be a tick box culture. In that the letter of the rules are adhered to in order to demonstrate compliance with the regulations rather than examining the outcome of the actions and whether the spirit of the regulation is being achieved. Where areas of concern are identified then additional regulations and rules are added rather than re -examine the existing rules. This leads to the problems on internal compliance of a large number of rules based on a large and complicated rule book. A final issue with regard to the adoption of rules is that is there is no rule applicable then it is deemed that the resultant behaviour and standards is acceptable. This leads to an issue of moral hazard where unacceptable behaviour is deemed appropriate because it is not actually regulated. Accord ingly we have a form of creative compliance where firms will conducts business and accept practices that may not be totally appropriate but comply with the regulations In some areas of regulation the rules are based on Balance Sheet position which is snapshot and is often historical.
Self Regulation

Pure self regulation is where there is no specific regulation or supervision of the sector and the enforcement of the standards and acceptable behaviour is reinforced by existing legal recourse such as common law; commercial law and contract law, without the requirement of specific regulation.
Enforced Self Regulation

This is the more common alternative to external regulation whereby the industry regulates itself and sets out its own rules to ensure that standa rds and acceptable behaviour are followed throughout the industry. It is argued that this form of regulation provides a high level commitment to the industry¶s ³own rules´ and that the rules themselves will be well informed through the industry experience. In this way there is a close fit between the regulator and the standards acceptable to the industry. The rules are more comprehensive and have the potential to change quickly to adjust for changes in the sector as experience is collected. In addition it i s considered that complaints against firms can be dealt with more effectively as agreed procedures accepted by the industry can be applied to the complaints. Also there is greater effectiveness in the detection of violations and obtaining conviction and the application of sanctions against offenders. Lastly from the Government¶s point of view this is a low cost solution as all the costs of the supervision and regulation is borne by the industry itself.

However enforced self regulation is not a panacea for a ll the problems of effective regulation in the financial sector. Firms themselves complain of high costs involved in maintaining the supervisory and regulatory framework and a consequence is that the cost of the regulatory framework is passed on to the cus tomer. Consumers themselves have several issues with self regulation of financial services by the financial services firms. There are concerns that the rules are designed to serve the interest of the firms themselves rather than the consumer and therefore they are not well served by the regulatory framework. It is also perceived that there is weak enforcement as firms are unwilling to invoke heavily penal sanctions on other firms as there may be retaliation if they themselves were to subsequently transgress the regulations and be sanctioned. As a result, consumers consider that it is not a transparent system and have a lack of trust and faith in the framework and therefore will not engage with it and use it effectively. Lastly, the general public, demands Go vernment intervention in the supervision of the sector in order that they have confidence and trust in the regulatory framework.
The rationale for a single financial services regulator

Goodhart (1998) identifies three approaches to the structure of regulation:
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Institutional ± this is directed at the institution rather than the type of business undertaken, the rationale being that it is institutions which become insolvent Functional ± this is concerned with the type of business undertaken irrespective of the institution Objective ± this approach adapts regulation to the objectives, which are trying to be achieved.

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When institutions are diversified, the distinction between functional and institutional regulation becomes important. If a functional approach is taken, then solvency is ignored; if a solely institutional approach is taken different regulators could cause inconsistency. The deregulated financial services sector has seen the blurring o f demarcation lines between businesses and the growth of financial conglomerates. This means that it becomes impossible to regulate on a purely functional basis, while the boundaries between regulators no longer fully reflect the structure of the market. The logical solution to these problems is the creation of a single financial services regulator. Data for the UK in early 1998 showed that a large number of firms had multiple authorisations under the old regime in the UK which had 9 different regulators. It was argued that with the growth of multi -function or diversified firms the need for co-operation and communication between different regulators becomes

more important and the most efficient way to improve the communication is through the creation of a single regulator. However the move towards single regulator throughout the main financial markets in the world is not consistent. As an example within the European Union there are 14 of the 27 member states that have a single or unified regulator and of th ese 4 is the Central Bank. There are 6 sectoral regulators and 3 further countries (Bulgaria, Finland and Luxembourg) that have integrated sectoral which has responsibility for only micro prudential or conduct of business supervision both not both. 3 have combined regulation by sector with objectives and finally Netherlands chose the twin peaks approach with the Central bank responsible for macro and micro supervision Accordingly, there are three main regulatory regimes in existence within the financial sectors. These are:
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Sectoral Single Regulator (or Unified) Twin peaks

Sectoral/Functional Hong Kong and the United States have maintained this form of regulation where different types of institutions or business are regulated by different regulatory bodies. The main argument particularly prior to the 1990s and the deregulation of the financial sectors was that the different financial sectors such as banking, insurance, investment banking, and stock broking offered distinctive products with the boundaries between the activities clearly defined and regulated. These differences were often reinforced by the different delivery channels, accounting procedures, business practices and risk profiles. The United States in particular has separate regulators across banks, investment banks and insurance companies but all three regulators undertake micro prude ntial supervision and consumer protection. However, the most prominent difference is with the regulation of the banks where macro prudential supervision and the possibility of systemic risk. This is where the legal status of the businesses influences which regulator and regulations that the firms will be legislated under. In this sphere of operation the regulation is separated out under the functions such as banks; brokers; insurance companies etc. The arguments for this arrangement is that it is clear who the regulator is and whose responsibility it is for the regulation of the firm. This system works well where there is clear demarcation between the activities that the financial firms are allowed to operate within. However the regulation of the sector beco mes more problematic with the presence of diversified firms that operate in a number of different areas within the

financial sector. The particular problems that can exist with functional regulation of the financial services sector are that of underlap and overlap. Underlap is where the activities of the firm will fall between the remit of different regulators. A common occurrence is where each of the regulators expects the other to pick up the regulation of the issue and often this can result in the firm ¶s activities going unregulated, especially where communication between the regulators is poor. Another issue affecting underlap is regulators operating on tight budgets are not keen to take on extra duties or work which they do not believe to be within th eir statutory remit. Overlap on the other hand is where there can be a duplication of effort as more than one regulatory body is involved which can lead to a duplication of effort to regulate firms in particular areas. In addition there can be conflict bet ween the regulators as their implementation or interpretation of the regulations may differ. This can lead to confusion for the firm and the consumer as there is no clear guidance to the appropriate course of action. Unified The use of a Unified regulator has been adopted in the UK since 1997, whereby there is a single regulator responsible for the activity of all the firms in the sector and is responsible for both prudential (safety & soundness) and conduct of business regulation (consumer protection). The arguments in favour of this form of regulation is that as there is an increasing number of large diversified firms operating in the financial sector then it makes sense for these firms to be regulated by a single regulatory body. It is argued that the sin gle regulator will reduce the problems that can occur with overlap and underlap in the regulatory framework. A second argument in support of the Unified regulator is to create a level playing field in terms of regulation. To achieve a consistency in rule making and supervision on order to remove the opportunities for regulatory arbitrage across the different sectors and to eliminate the possibility of firms in one sector gaining a competitive advantage at the expense of firms in another sector. The third rationale is the efficiency in supervision and compliance that can be summarised with a number of benefits that are perceived to be available to a unified regulator. Benefits of a single regulator include:
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economies of scale and scope ± a single regulator needs only one set of support services simpler structure may be more readily understood by the consumer single regulator is best placed to deal with financial conglomerates

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single regulator should avoid situations of regulatory overlap or underlap accountability might be more easily achieved compliance costs should be reduced to the extent that firms have to deal with only one agency.

Goodhart summarises the arguments against a single regulator as:
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There is sufficient differentiation between banks; insurance companies and securities firms in the way business is conducted to merit separate prudential regulation for each. A single regulator may not differentiate between firms and institutions. A single regulator could become too powerful. A single regulator could become excessively bureaucratic. Essentially it would be a monopolist and could internalise inefficiencies.

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We have looked at the rationale for a single financial services regulator, but why is the structure of a regime important? Goodhart puts forward several reasons:
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Structure affects the organisational culture which in turn affects future effectiveness. If there is more than one regulatory agency, rivalry may exist. If a conflict of objectives arises this could be difficult to resolve if more than one regulator exists. Institutional structure will impact on cost. Multiple agencies allow for the potential of regulatory arbitrage. The implications of this are that an inappropriate regulatory structure can increase costs both monetary and non-monetary in the longer term.

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Goodhart defines the problem clearly: µthe overall objective must be to create an institutional structure that reflects the objectives of regulation and that promotes those objectives most effectively¶.

The trend towards the widespread adoption of the single supervisor has raised some concerns recently. The basic question is whether integrated supervision is feasible and the arguments put forward by Goodhart are considered, for example is it possible to treat the top 50 lar gest firms in the same way regardless of the sector in which each firm conducts its primary business. Depending on the main lines of business there can be differences in accounting practices for the different operations and the consolidation of the busines ses may neither be meaningful nor practical.

A second issue and a particularly topical one given the recent issues and admission by the regulator themselves is whether a single regulator can provide an appropriate balance between conduct of business supervision and micro prudential and even macro prudential supervision. It is argued that typically conduct of business supervision is more publically visible and politically expedient than the necessarily confidential micro prudential problems affecting individ ual financial services firms. Therefore is there a tendency for conduct of business objectives to dominate the other objectives of the regulator over a period of time. This is a current debate in the UK where it is considered by some that the FSA was more concerned with conduct of business regulation and failed to spot the problems both at Northern Rock Bank and at the HalifaxBankofScotland (HBOS) which resulted in the collapse of both banks in 2007 and 2008. The FSA admitted that it devoted too much attent ion to consumer protection ahead of the Northern Rock crisis and announced that in future it intends to place more emphasis on prudential regulation. A third concern can be a conflict between the culture within the regulator itself as conduct of business regulation tends to be dominated by lawyers whereas economists tend to be more involved in the macro prudential issues. Goodhart also pointed out that a single regulator could become too powerful and with monopoly power there may be a tendency to over regul ate. The argument is that with multiple regulators there exists the possibility of consumers of financial services to move to suppliers under a different regulator and indeed for the financial firms to shift regulators themselves which would in theory prev ents over burdensome or arbitrary regulation. Also there may be a tendency that a single regulator with monopoly power can become less flexible and more bureaucratic over time. Twin Peaks Twin peaks refers to the regulatory regimes which split the regulation into two distinct areas which are prudential regulation and code of business. The responsibility for each type of regulation is given to separate agency. This is an example of objectives based supervision with prudential regulation being designe d to promote the safety and soundness of the institutions and therefore it could be argued of the financial system itself, and the conduct of business regulation directed at consumer protection. This form of regulation has been adopted in both Australia an d the Netherlands. Ireland has adopted a slightly different view on this while having two agencies these are operated from within the one organisation. Under this regime the two main areas are seen as separate. The main argument being that whereas under a unified structure it is considered that there is a considerable overlap between the two types of regulation as it is argued that prudential regulators have a strong interest in the way business is done as any wrong doing could damage the confidence in the

institution and lead to its downfall. Others argue that the two types of regulation are in conflict in terms of both regulatory objectives and supervisory style and culture. The prudential regulator is seen more as a remedial ³doctor´ whereas the conduct o f business regulator is portrayed as an enforcement ±led ³policeman´ approach. Therefore if these two supervisory functions are combined in to a single regulator then this can lead to internal conflicts and the possible mis -allocation of resources. While mentioned earlier in the unit that this choice of regulatory structure has been given consideration by both the US and the G30 as a means of taking the supervisory structures forward it is not without its own shortcomings. In particular the responsibilities of the two agencies need to be carefully designated to avoid overlap and duplication. The separation of the two areas does not eliminate the possibility of conflict between them. For example it is possible that the conduct of business regulator may wish to take action against a firm for mis-selling but the sanctions in the opinion of the prudential regulator may threaten the very existence of the firm itself and the latter may prefer for alternative sanctions to be levied that would not impact so severely on the financial viability of the firm. It would be hoped that the two bodies through communicating with each other would be able to resolve any potential problems but consideration would have to be made if there was no agreement as to where the situation would be resolved. As mentioned above the collapse of a firm for wrongdoing could have an adverse impact on the system as a whole.

End of Unit Summary
In this unit we have:
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Examined the arguments for and against enforced and self regulation Examined the different regulatory models sectoral; unified and twin peaks Discussed the trends within the supervisory frameworks and examined the advantages and disadvantages for each.