Unit 5

The Regulation of Financial Markets and Institutions

2.1 The Nature of Financial System Regulation
A good financial system with a well-functioning competitive market as well as a well-
supporting financial institution is an essential ingredient for sustainable economic growth.
Developing sound Financial Markets requires the establishment of public confidence in
the institutions that constitute the Finance Sector.
Confidence can only be maintained if these institutions deliver services as promised. Thus
one of the duties of Governmental Authorities is to preserve the long term stability of the
financial system and reliability of its components. Governments could do by using
different procedures and regulations. Regulation of financial markets rests on the tenet
that it serves the interest of the public by protecting investors and guarding against
systemic risk. With regard to investor protection, regulations maintain that their
oversight is justified on the grounds that investors are uninformed and unskilled.
The initial focus, and still the central element, of regulatory system is to solve the problem
of the uninformed investor through company disclosure and transparency of trading
markets. Most people agree that disclosure provides the information needed to make
rational decisions. But regulation today goes far beyond disclosure requirements, because
a growing number of stakeholders are presumed to be unskilled and incapable of making
informed decisions.
The other basis for financial regulation is concern about systemic risk. Systemic risk
arises if the failure of one financial institution causes a run on other institutions and
precipitates system-wide failure. Regulation is said to be required because individual
institutions do not adequately take account of the external costs they impose on the
financial system when they fail. But almost every aspect of financial markets, if not daily
living itself, involves systemic risk. One of the most complex issues facing governments is
identifying the appropriate level and form of intervention.
Regulatory efficiency is a significant factor in the overall performance of the economy.
Inefficiency ultimately imposes costs on the community through higher taxes and charges,
poor service, uncompetitive pricing or slower economic growth. Clearly there must be
limits on the applicability of this rational for regulation.

One of the other main reasons for having strong financial regulation is increasing
information available to investors. For example because of asymmetric information in
financial markets, that means investors may be subject to adverse selection and moral
hazard problems that may hinder the efficient operation of financial markets. Risky firms
or outright crooks may be the most eager to sell securities to unwary investors, and the
resulting adverse selection problem may keep investors out of financial markets.
Furthermore, once an investor has bought a security, thereby lending money to a firm, the
borrower may have incentives to engage in risky activities or to commit outright fraud.
The presence of this moral hazard problem may also keep investors away from financial
markets. Government regulation can reduce adverse selection and moral hazard problems
in financial markets and increase their efficiency by increasing the amount of information
available to investors.
In similar ways, ensuring the soundness of financial system is the other reason for the
necessity of the rules and procedures. Uncertain and confusing information can also lead
to widespread collapse of financial intermediaries, referred to as a financial panic.
Because providers of funds to financial intermediaries may not be able to assess whether
the institutions holding their funds are sound, if they have doubts about the overall health
of financial intermediaries, they may want to pull their funds out of both sound and
unsound institutions.
The possible outcome is a financial panic that produces large losses for the public and
causes serious damage to the economy. To protect the public and the economy from
financial panics, the governments are implementing a number of regulations. These
regulations are taking the form of Restrictions on Entry; Disclosure; Restrictions on
Assets and Activities; Deposit Insurance; Limits on Competition; and Restrictions on
Interest Rates.
i. Restrictions on Entry
Governments endorse very tight regulations governing who is allowed to set up a financial
intermediary. Individuals or groups that want to establish a financial intermediary, such
as a bank or an insurance company, must obtain a charter from the state or the Federal
Government.
ii. Disclosure
There are stringent reporting requirements for financial intermediaries. Their
bookkeeping must follow certain strict principles, their books are subject to periodic
inspection, and they must make certain information available to the public.
iii. Restrictions on Assets and Activities
There are restrictions on what financial intermediaries are allowed to do and what assets
they can hold. Before you put your funds into a bank or some other such institution, you
would want to know that your funds are safe and that the bank or other financial
intermediary will be able to meet its obligations to you. One way of doing this is to restrict
the financial intermediary from engaging in certain risky activities.
 For example some counties legislation separates commercial banking from the
securities industry so that banks could not engage in risky ventures associated with this
industry.
Another way is to restrict financial intermediaries from holding certain risky assets, or at
least from holding a greater quantity of these risky assets than is prudent. For example,
commercial banks and other depository institutions are not allowed to hold common stock
because stock prices experience substantial fluctuations.
iv. Deposit Insurance
The government can insure people’s deposits so that they do not suffer any financial loss if
the financial intermediary that holds these deposits fails. All commercial and mutual
savings banks, with a few minor exceptions, are required to enter deposit insurance, which
is used to pay off depositors in the case of a bank’s failure.
v. Limits on Competition;
Politicians have often declared that unbridled competition among financial intermediaries
promotes failures that will harm the public. Although the evidence that competition does
this is extremely weak, it has not stopped the state and federal governments from
imposing many restrictive regulations.
vi. Restrictions on Interest Rates;
Competition has also been inhibited by regulations that impose restrictions on interest
rates that can be paid on deposits and loans.
 In subsequent sub sections, we will look more closely at general regulations of financial
markets and institutions and will see whether it has improved the functioning of
financial system.
2.2 The Principles of Regulation
 Regulation requires that a careful balance be struck between effectiveness and

efficiency. It has a great potential to impose costs and should be designed to meet its
purposes while minimizing direct costs of regulation and the broader costs arising
from rules which restrict economic activity.
 The main principle of the regulation of the financial markets and institutions

includes: Competitive Neutrality; Cost Effectiveness; Accountability; Flexibility;

and Transparency
i. Competitive Neutrality
The regulatory burden applying to a particular financial commitment or promise should
apply equally to all who make such commitments, as per the competitive neutrality
principle. It requires further that there would 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.
ii. Cost Effectiveness
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-social, such an approach is likely to be highly inefficient. 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. Yet the
underlying legislative framework must be effective, by fostering compliance through
enforcement in cases where participants do not abide by the rules.
 In general, a cost-effective regulatory system may requires:
 an allocation of functions among regulatory bodies which minimizes overlaps,
duplication and conflicts;
 an explicit mandate for regulatory bodies to balance efficiency and effectiveness;
 the allocation of regulatory costs to those enjoying the benefits; and
 a presumption in favor of minimal regulation unless a higher level of
intervention is justified.
iii. Accountability
The regulatory structure must be accountable to its stakeholders and subject to regular
reviews of its efficiency and effectiveness. In addition, regulatory agencies should operate
independently of sectional interests and with appropriately skilled staff.
iv. Flexibility
The regulatory framework must have the flexibility to cope up with changing institutional
and product structures without losing its effectiveness.
v. Transparency
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) to be understood. If there is a general
perception that a particular group of financial institutions cannot fail because they have
the authorization of government, there is a great danger that perception will become a
reality.
2.3 Arguments for and against Financial System Regulations
The financial system is among the most heavily regulated sectors of most economies. The
government regulates financial markets for different reasons. But, there are different
views as to the need and extent of Government intervention in financial markets. Some
argue that free and competitive markets can produce an efficient allocation of resources
and provide a strong foundation for economic growth and development. Others emphasize
that Governments could play in maintaining a healthy economic and social environment
in which enterprises and their customers can interact with confidence.
 Since deferent scholars have contradictory stands for or against the regulations it is
better to examine about some reasons that have led to the present regulatory
environment. Some of the views for or against financial market regulations include:
Regulation for Financial Safety; Systemic Stability; Information Asymmetry;
Regulatory Assurance; and Regulation for Social Purposes.

i. Regulation for Financial Safety

One of the vital economic functions of the financial institutions is to manage, allocate and
price risk. However, there are some areas of the financial activities where government
intervention is aimed at eliminating or reducing risk.
In essence, the task is to decide which financial promises have characteristics that warrant
much higher levels of safety than would otherwise be provided by markets (even when
they are subject to effective conduct, disclosure and competition regulation). As a general
principle, financial safety regulation will be required where promises are judged to be
very difficult to honor and assess, and produce highly adverse consequences if breached.
Promises which rank highly on these characteristics are referred to as having a high
‘intensity’.

On the other hand, many regulations in the financial institutions’ sector spring from the
ability of some financial institutions to create money in the form of credit cards, checkable
deposits, and other accounts that can be used to make payments for purchase of goods and
services. Such creation of money is closely associated with inflation which should be
managed by the government. Financial regulation arises from the risks attaching to
financial promises. While in some other industries safety regulation aims to eliminate risk
almost entirely (for example, to eliminate health risks in food preparation), this is not an
appropriate aim for most areas of the financial activities.

ii. Systemic Stability

The more sophisticated the economy, the greater is its dependence on financial promises
and the greater its vulnerability to failure of the financial system.
The first case for regulation to prevent systemic instability arises because of certain
financial promises have an inherent capacity to transmit instability to the real economy,
inducing undesired effects on output, employment and price inflation.
When financial distress in one market or institution is communicated to others and,
eventually, engulfs the entire system, there will be the most potent source of systemic risk
is financial contagion.
iii. Information Asymmetry
Information Asymmetry is a situation where further disclosure, no matter how high
quality or comprehensive, cannot overcome market failure. The second case for regulation
relates to the need to address information asymmetry. In a market economy, consumers
are assumed, for the most part, to be the best judges of their own interests. In such cases,
disclosure requirements play an important role in assisting consumers to make informed
judgments. However, disclosure is not always sufficient.
For many financial products, consumers lack (and cannot efficiently obtain) the
knowledge, experience or judgment required to make informed decisions. In these cases, it
may be desirable to substitute the opinion of a third party for that of consumers
themselves. In effect, the third party is expected to behave paternalistically, looking out
for the best interests of consumers when they are considered incapable of doing so alone.
To some extent, such third parties can be supplied by markets (such as the role played by
self regulatory associations). However, for many years the practice in all countries has
been for government prudential regulators to take on much of this role.
iv. Regulatory Assurance
If regulation is pursued to the point of ensuring that promises are kept under all
circumstances, the burden of honour is effectively shifted from the promisor to the
regulator. All promisors would become equally risky (or risk free) in the eyes of the
investing public. Regulation at this intensity removes the natural spectrum of risk that is
fundamental to financial markets. If it were extended widely, the community would be
collectively underwriting all financial risks through the tax system, and markets would
cease to work efficiently.
A concern about the safety of the public’s funds, especially the savings owned by millions
of individuals and families, however, does not mean that all financial services should be
subject to financial safety regulation. Thus, regulation cannot and should not ensure that
all financial promises are kept. The government should not provide an absolute guarantee
in any area of the financial system (just as it does not do so in other areas).
How intensively, then, should financial safety regulation be applied?

Theoretically, however, the intensity of financial safety regulation should be proportional

to the intensity of financial promises. A large amount of intense financial promises are
those which provide payments services. Such promises are intrinsically difficult to honour.
Those who use them rarely have the time, motivation or resources to assess the risks, and
any breach would have potentially highly adverse consequences for the efficient conduct
of commerce in the whole economy.
The most intense safety regulation should therefore apply to the provision of means of
payment, to the point of securing their safety at the highest possible level, short of an
outright Government guarantee. Beyond this, the extent of regulatory assurance is a
matter for judgment.

How much regulatory assurance should it provide in the various areas of the financial
system?
At a minimum, this requires that the regulator has unambiguous powers to intervene in
the operations of institutions making such intense promises. Regulation should seek to
ensure that, while risk remains, those making promises ensure that risks are
appropriately managed in accordance with the reasonable expectations of their promises.
If regulation stops short of providing a guarantee against failure, it must provide speedy
and efficient mechanisms for resolving financial distress when it arises, so as to minimize
the danger of loss or contagion.
v. Regulation for Social Purposes
Obliging financial institutions to subsidies some activities compromises their efficiency
and is unlikely to prove sustainable in a competitive market. A further case for regulation
is sometimes made on the grounds that financial institutions have ‘community service
obligations’ to provide subsidies to some customer groups.
For example, financial institutions are urged to deliver certain services free of charge or at
a price below the cost of provision. This is the least persuasive case for intervention.
Financial institutions, like other business corporations, are designed to produce wealth,
not to redistribute it. This is not to say that their creation of wealth should ignore the
claims of social and moral propriety. But it is another thing entirely to require financial
institutions to undertake social responsibilities for which they are not designed or well
suited.