Financial Institutions and Markets: Regulation of Financial Markets and Institutions

CHAPTER FIVE
REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

5.1 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 (principle) 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. 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.

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.

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Department of Accounting and Finance
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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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.

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.The possible outcome is a financial
panic that produces large losses for the public and causes serious damage to the economy.

The financial system is regulated to increase the information available to investors, toensure the
soundness of the financial system and improve control of monetary policy.

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 regulation, Restrictions of financial institutions, Deposit Insurance,financial activities
regulation, Limits on Competition, and Restrictions on Interest Rates.

a) 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.

b) Disclosure Regulation

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.

c) Regulation of financial institutions

It is also called regulations 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 countries legislation separates commercial banking from the securities industry so
that banks could not engage in risky ventures associated with this industry.

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Department of Accounting and Finance
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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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. However, Insurance companies are allowed to hold
common stock, but their holdings cannot exceed a certain fraction of their total assets.

d) Financial activity regulation

These are rules about traders of securities and trading on financial markets. Probably the best
example of this type of regulation is rules prohibiting the trading of a security by those who,
because of their privileged position in a corporation, know more about the issuer’s economic
prospects than the general investing public. Such individuals are referred to as insiders and
include, yet are not limited to, corporate managers and members of the board of directors.
Trading by insiders (referred to as insider trading) is another problem posed by asymmetric
information.

e) 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.

f) Limits on Competition;

Politicians have often declared that unbridled (uncontrolled) 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.

g) 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.

5.2 The Principles of Regulation

The main principle of the regulation of the financial markets and institutions includes:
Competitive Neutrality; Cost Effectiveness; Accountability; Flexibility; and Transparency

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Department of Accounting and Finance
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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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

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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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.

5.3 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.

One of the most difficult tasks facing those charged with designing financial market regulations
is that of defining the aims and boundaries of regulation for financial safety.

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’.

The higher the intensity of a promise, the stronger will be the case for regulation to reduce the
likelihood of breach.

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

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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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.

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).

Primary responsibility should remain with those who make financial promises. It would be
inequitable for the government to underwrite some financial promises but not other promises
made by participants in the broader economy.

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 honor. 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.

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.

The position of banks as the main providers of payments services adds to the risk that bank
failure might disrupt the integrity of the payments system and precipitate a wider economic crisis

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Financial Institutions and Markets: Regulation of Financial Markets and Institutions

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 Regulation for Social Purposes

Obliging financial institutions to subsidize some activities compromises their efficiency and is
unlikely to prove sustainability 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.

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Department of Accounting and Finance
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