CHAPTER 5: THE REGULATION OF FINANCIAL MARKETS AND

INSTITUTIONS

Objectives At the end of this unit, you will be able to: Explain why financial institutions are
regulated; elucidate the rules and regulations of financial institutions; and discern the nature
application of financial system policies. 6.1The 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
this 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 are 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. Sys 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. 2The financial system is regulated to increase the information
available to investors, to ensure the soundness of the financial system and improve control of
monetary policy.
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.