Chapter Five: Regulation of Financial Markets and Institutions

Why is the financial system so important? The purpose of the global financial system is simple, to
enable the lifeblood of capitalism to do its job, to enable capital to go where it can get the greatest
return for its owner. The system does that through a plethora of ever more complex arrangements
and devices, financial and technological, though its fundamental character remains the same. The
financial system has evolved to enable the safe movement of funds across boundaries, organizational
or national and, paraphrasing Shubik, money is a substitute for trust, in the world of trade. The
present global financial crisis has shown how much our welfare, economic and social, depends on a
sound global financial system. 
system. 

Aims Financial Regulators

The specific aims of financial regulators are usually:

 To enforce applicable laws

 To prosecute cases of market misconduct
 To license providers of financial services
 To protect clients, and investigate complaints
 To maintain confidence in the financial system

Financial System Regulation

As noted in the introduction, regulation may be applied to facilitate the general operation of markets,
to enhance safety or to pursue social objectives. This section provides a basic framework for
considering whether and, if so, where and how each of these purposes of regulation should be
applied in the financial system.

General Market Regulation

All markets, financial and non-

non-financial, face potential problems associated with the conduct of
market participants, anti-
anti-competitive behaviour and incomplete information. These common forms
of market failure have justified at least a minimum level of regulatory intervention in markets on an
economy wide basis. Such intervention generally takes the form of:

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  conduct regulation 
regulation  such as criminal sanctions for fraud and prohibitions on
anti-
anti-competitive behaviour; and

 disclosure regulation 
regulation  such as general prohibitions on false and misleading statements
contained in fair trading laws.

There are some markets where this minimum level of economy wide regulation is considered to be
inadequate. These markets, or their products, have characteristics which warrant more specific
disclosure and conduct rules than apply in other industries. In many cases, it is also considered
necessary to establish a separate regulatory agency to conduct such specialised regulation.
A key question for the Inquiry was to decide where conduct and disclosure regulation of financial
markets is best left to general economy wide arrangements and where more specialised regulation is
required. As 
As a general principle, greater regulatory consistency and efficiency will result from
economy wide regulation. Consequently, this should always be preferred unless a clear case for
sector specific arrangements can be demonstrated.

The Inquiry examines the case for specialized regulation in:

 financial market integrity

 retail consumer protection and

 competition policy

Financial Market Integrity

Market integrity regulation aims to promote confidence in the efficiency and fairness of markets. It
seeks to ensure that markets are sound, orderly and transparent. Financial market prices can be
sensitive to information, and this raises the potential for misuse of information. For this reason,
regulators around the world impose specific disclosure requirements (such as prospectus rules) and
conduct rules (such as prohibitions on insider trading) on financial market participants. The
complexity of financial products and markets, their intrinsic risks  including those due to limited
information 
information  and the detailed knowledge required to deliver efficient regulation in this area argue
strongly for continued specialised regulatory arrangements.

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Consumer Protection

Consumer protection refers to the forms of regulation aimed at ensuring that retail consumers have
adequate information, are treated fairly and have adequate avenues for redress. There are close links
and no clear dividing line between consumer protection and market integrity regulation in retail
markets since both use the same regulatory tools, namely disclosure and conduct rules. For example,
prospectus requirements can promote both consumer protection and confidence in the efficiency and
fairness of retail financial markets.

Specialist consumer protection in the financial system is justified on two grounds.

First, the complexity of financial products increases the probability that financially unsophisticated
consumers can misunderstand or be misled about the nature of financial promises, particularly their
obligations and risks. This, combined with the potential consequences of dishonour, has led most
countries to establish a disclosure regime for financial products that is considerably more intense
than disclosure rules for most non-
non-financial products.

Secondly, financial complexity also increases the incidence of misunderstanding and dispute. Given
this, and the high cost of litigation, a number of countries have imposed specific regulation of
financial sales and advice and established low-
low-cost industry complaints schemes or tribunals for
resolving disputes.

Competition Regulation

Competition regulation refers to laws which ensure that all markets are competitive. Two main areas
of concern are market concentration and collusion which can lead to overpricing of financial
products and underprovision of services essential to economic growth and welfare.
While financial products are complex and any assessment of competition requires detailed analysis
of markets, the key features relevant to competition assessment in this sector are not unique. The
application of economy wide competition regulation to the financial system ensures regulatory
consistency. Anti-
Anti-competitive behaviour is not unique to financial markets, and it is preferable to
establish both the bounds of acceptable competitive behaviour and rules for mergers and acquisitions
which are common to all industries. Accordingly, the case for specialised arrangements in this area
is relatively weak.

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Principles of Regulation

Competitive Neutrality

Competitive neutrality requires that the regulatory burden applying to a particular financial
commitment or promise apply equally to all who make such commitments. It requires further that
there be:

 minimal barriers to entry and exit from markets and products;

 no undue restrictions on institutions or the products they offer; and

 markets open to the widest possible range of participants.

Cost Effectiveness

Cost effectiveness is one of the most difficult issues for regulatory cultures to come to terms with.
Any form of regulation involves a natural tension between effectiveness and efficiency. Regulation
can be made totally effective by simply prohibiting all actions potentially incompatible with the
regulatory objective. But, by inhibiting productive activities along with the anti-
anti-social, such an
approach is likely to be highly inefficient.

The underlying legislative framework must be effective, including by fostering compliance through
enforcement in cases where participants do not abide by the rules. However, a cost -effective
regulatory system also requires:

 a presumption in favour of minimal regulation unless a higher level of intervention is

justified;

 an allocation of functions among regulatory bodies which minimises overlaps, duplication

and conflicts;

 an explicit mandate for regulatory bodies to balance efficiency and effectiveness;

 a clear distinction between the objectives of financial regulation and broader social
objectives; and

 the allocation of regulatory costs to those enjoying the benefits.

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Transparency

If there is a general perception that a particular group of financial institutions cannot fail because
they have the imprimatur of government, there is a great danger that perception will become reality.
Transparency of regulation requires that all guarantees be made explicit and that all purchasers and
providers of financial products be fully aware of their rights and responsibilities. It should be a top
priority of an effective financial regulatory structure that financial promises (both public and private)
be understood.

Flexibility

One of the most pervasive influences over the continuing evolution of the financial system will be
technology. While it is not possible to forecast with any certainty the precise impact that technology
will have on the shape of financial services and service delivery, it is certain that the impact will be
considerable. These developments make flexibility critical. The regulatory framework must have the
flexibility to cope with changing institutional and product structures without losing its effectiveness.

Accountability

Regulatory agencies should operate independently of sectional interests and with appropriately
skilled staff. In addition, the regulatory structure must be accountable to its stakeholders and subject
to regular reviews of its efficiency and effectiveness.

The fundamental costs brought about by regulations which are of major concern to financial
institutions as they alone are responsible for them. These are;
1. - Administrative costs of the SRO’s and the SIB.
2. - Administrative costs of the compliance of the regulated firms.
3. - The cost of dedicated capital to comply with requirements.
4. - Contributions of funds needed to compensate failure.
5. - Loss of competition
6. - Instability due to lack of diversification
7. - Loss of comparative advantage over foreign competitors
8. - A moral hazard

Financial Market Crash

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Financial markets across the globe have crashed repeatedly throughout history and a market crash is
a nightmare for any potential investor. There are certain causes that lead to a market crash,
including a high rise in stock prices over a considerable span of time. Economic optimism is the
prime reason, as a consistent rise in stock prices lead towards crash. A sudden crash can be the cause
of agony, anxiety and frustration. All through stock market history, financial analysts and investment
advisory service providers have failed to provide effective speculation regarding market crashes.

Financial market crash may be due to certain specific economic reasons. According to
investorwords.com, a crash is defined as “a precipitous drop in market prices or economic
conditions." This definition clarifies the sudden drop of a market crash and explains why many
investors have been turned away from stock trading.

An abrupt fall in share prices can create panic among the investors, and confused investors tend to
sell almost all of their shares. Shareholder's psychology changes and this leads towards confusion
and chaos. Stocks, securities and bonds are sold at random rates. To avoid the catastrophic effects of
financial market crash, it is wise to keep an eye on the financial market trends.

The major causes of stock market crash are as follows:

 A drastic shift in price  An alteration in earnings

 earning ratio  Changes in dividend
Thus, a persistent boom in the financial market can collapse and result in a sudden crash. In addition
to depending upon the advice of financial specialists, it is a good idea to keep an eye on the
prevailing market trends.
trends.

Some of the well known Financial Market Crashes can be classified as follows :
• Wall Street Crash of 1929 : The Wall Street crash occurred on Oct 29, 1929 and followed
the period of the “roaring twenties” when the stock markets had been experiencing robust growth.
Companies responsible for the stock market boom were the Radio Corporation of America (RCA),
General Motors and investment trusts such as Goldman Sachs trading Corporation. From August 24,
1921 to September 3, 1929, the Dow Jones Industrial Average (DJIA) experienced a six fold rise
from 63.9 to nearing 381.2 points. However, it became clear after a certain point of time that it was a
mere bubble and Oct 24, 1929 (Black Thursday) felt one of the first shocking market drops. This was
followed by Black Monday and Black Tuesdays on Oct 28 and Oct 29 which followed suit. While
Black Monday experienced a fall of 12.8% on the DJIA, Black Tuesday experienced a day of chaos

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where the shares of the RCA and Goldman Sachs fell dramatically. Across the two days, the DJIA
fell by about 23%.
• Dow Jones Crash of 1987 : The crash on Oct 19, 1987 also known as Black Monday was
preceded by strong economic optimism when the DJIA increased from 776 to 2722 from August
1982 till its peak in August 1987. The crash of Oct 19 started from Oct 14, Friday and continued for
five days consecutively following its initial fall of 3.81% and 4.60% followed by Black Monday
when the DJIA plummeted 508 points losing 22.6% in one day of intra-day trading. The S&P 500
dropped by 20.4% and the NASDAQ composite lost only about 11.3% largely due to the reason that
NASDAQ market system failed. The crash is recorded as the greatest single-day loss that Wall Street
ever suffered in the event of continuous trading. Between the start of trading on Oct 14 to the close
on Oct 19, the DJIA had lost 760 points or a decline by over 31%. The 1987 crash had a worldwide
phenomenon as the FTSE 100 Index lost by about 10.8% on Monday followed a decline of around
12.2% on the following day as all the world markets declined substantially. The collapse had mainly
been blamed on program trading, portfolio insurance and derivatives and the prior information of an
impending worsening of economic indicators.
• Asian Economic Crisis or East Asian Financial Crisis of 1997 : It was a period of
economic unrest that started in July 1997 in Thailand and South Korea with the collapse of Kia and
gradually translated into falling stock markets and other asset prices in the economies of the Four
Asian Tigers (namely Hong Kong, Singapore, Taiwan and South Korea). The economies of
Indonesia, Thailand and South Korea were the most affected by the crisis with their currencies
falling dramatically relative to the US dollar with the South Korean economy being hit the hardest.
Trouble started brewing long before in the months of May and June when the Asian Tigers grew at
an average of 8%-12% and attracted huge inflows foreign capital. The Thai Baht which was pegged
at 25 to the dollar from 1985 to July 2, 1997 fell to its nadir at 56 to the US dollar at January 1998.
The Thai Stock Market fell by about 75% in 1997. In the case of Philippines, the PSE Composite
Index fell by about 2000 points in 1997. The Peso fell from about 26 pesos to the dollar at the start
of the crisis to about 40 pesos at the end of the crisis. In the case of Korea, the Korean Won plunged
from less than 1000 per US dollar to less than 1700 per dollar. By the end of 1997, the Kuala
Lampur Stock Exchange (KLSE) lost more than 50% 1200 under 600 and the Malaysian Ringgit fell
from 2.50 to under 3.80 to the dollar. In case of Indonesia, after the financial crisis of 1997, it had a
severe impact on the Rupiah with continuing periods of devaluation which took the rate to 18000
Rupiah for 1 US dollar from the level 2000 Rupiah for 1 US dollar before the crisis.

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 Summary of financial markets crashes

Year & Date Name

2006 Great Arabian Crash

2005-(till date) Iranian stock market crisis

October 2002 Stock market downturn of 2002

September 2001 post-9/11 crash

March 2000 Dot-com bubble crash

1998 Russian financial crisis

1997 1997 mini-crash

1992 Asian financial crisis of 1997

October 13, 1989 Black Wednesday

October 19, 1987 Friday the 13th mini-crash

October 29, 1929 Black Tuesday

October 28, 1929 Black Monday

October 24, 1929 Black Thursday

1929 Stock Market Crash of 1929

May 9, 1873 Der Krach

September 24, 1869 Black Friday

May 10, 1837 Panic of 1837

1819 Panic of 1819

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