UNIT 5: THE REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

5.1. What is Regulation?

Regulation is a rule or order or directive or act or law or ordinance or pronouncement or
proclamation made by the government. It can be defined as “A rule of order having the
force of law, prescribed by a superior or competent authority, relating to the actions of
those under the authority’s control.
What is Financial Regulation?
Financial regulation is a form of regulation or supervision, which subjects financial
markets and institutions to certain requirements, restrictions and guidelines, aiming to
maintain the integrity of the financial system. This may be handled by either a
government or non-government organization or a body established by a government for
this purpose.
5.2. Purpose of Financial Regulation:
The main objectives of financial regulations are:
 To maintain market confidence – to maintain confidence in the financial system
 To promote financial stability – contributing to the protection and enhancement of
stability of the financial system
 To protect the interests of investors or consumers – securing the appropriate degree of
protection for consumers.
 To reduce financial crime – reducing the extent to which it is possible for a regulated
business to be used for a purpose connected with financial crime.
 Regulating foreign participation in the financial markets
1. Market Confidence: Financial regulations’ main aim is to maintain market
confidence. This objective can be achieved by promoting competition and fairness
(transparency) in the trading of financial securities. This means that there should be no
barriers to entry and exit from markets and financial systems. The market should be open
to a wide range of participants who meet specified eligibility criteria. In addition, the
markets should provide an effective mechanism for the circulation of securities, the right
conditions for investment and promote economic development. The markets are not
possible without investors, individuals and entities that have spare cash and want to
invest in securities.

1
2. Promote Financial Stability: A key objective for financial regulation is to increase
the effective functioning of the financial system in order to enhance the ability to absorb
or overcome financial instability. There are four main factors that can initiate financial
instability: a) increase in interest rates b) increase in uncertainty c) negative shocks to
firms’ balance sheets d) a deterioration in financial intermediaries’ balance sheets.
Examples of financial instability a) Asian crisis of second half of 1990 b) U.S. market
crisis of 2007 c) European markets crisis of 2010. With effective financial regulations,
these crisis could have been avoided.
3. Consumer Protection: It is the ultimate objective of all of the above of regulations to
protect consumers in one or the other way. Some companies may conceal relevant
information or give wrong financial picture to attract investments from people and
investors. Financial regulations prevent issuers of securities from defrauding investors.
Consumer protection also refers to arrangements to protect depositors (or like
arrangements for other classes of investors) in the event of the failure of a financial
institution to pay their deposits back.
4. Reduction of Financial Crime: Financial regulations also require reducing financial
crime of market participants. Various companies and other financial institutions engage
in inflating their financial information to attract investments. Companies often engage in
illegal insider trading and violation of laws.
a) Insider trading: Insider trading is defined as a malpractice wherein trade of a
company’s securities is undertaken by people who by virtue of their work has access to
the otherwise non-public information which can be crucial for making investment
decisions. When insiders, e.g. key employees or executives who have access to the
strategic information about the company, use the same for trading in the company’s
stocks or securities, it is called insider trading and it is highly discouraged by the
securities exchange commission. Insider trading is an unfair practice, wherein the other
stock holders are at great disadvantage due to lack of important insider non-public
information.
5. Regulating Foreign Participation: Especially for under developed countries,
regulating foreign participation in the domestic markets may be necessary to protect the
financial interests of the country and its economy. In such cases, some countries may
restrict activities of foreign concerns in the domestic markets and institutions. Otherwise,

2
these countries may limit the roles of foreign firms on domestic markets and their
ownership control of financial institutions.
5.3. Who are the Financial Regulators?
The financial regulation agencies are also called as financial regulators. Generally every
country has its own financial system and thus has/have financial regulators. Financial
regulation agencies or bodies or regulators differ from country to country. In some
countries, governments directly engage in financial regulation activity whereas in
other countries, governments may appoint one or more such regulation bodies. These
financial bodies or regulators are responsible to frame Regulatory Framework for the
working of financial markets and institutions in that country. Whenever need arises to re-
assess the regulatory framework, financial regulators re-assess and bring new regulations
to protect the interests of financial markets and institutions and investors.
Generally, financial regulators include:
a) Ministry of Finance of the central government
b) Federal Reserve Bank or central bank of the country
c) Securities Exchange Commission
d) Insurance Regulatory Authority
e) Banking Regulation Authority etc.

5.4. Forms of Financial Regulations (Types of Regulations):

1. Disclosure regulations: Disclosure regulations require all the market participants i.e.,
all financial institutions and companies which participate in the financial markets, to
disclose or furnish true and fair financial statements every year. These regulations
protect innocent investors, who lack knowledge about the true financial status about the
market participants, from fraudulent activities of the companies and financial institutions.
2. Regulation of financial institutions: Regulations of financial institutions include
restricting activities of financial institutions in the area of lending, borrowing and
funding.
3. Regulation of foreign participation: These regulations specify the role of foreign
firms in the domestic financial markets. These regulations may allow foreign firms to
participate in the domestic markets or may limit to a certain percentage of investment
only or may completely abandon the foreign participation.

3
4. Financial activity regulations: These regulations are concerned with the type of
financial activities that should take place in the financial markets. For example rules of
trading by the companies, types of financial assets that should be traded on the markets,
not allowing insider trading etc.
Arguments over Regulations:
These are comments or opinions expressed on financial regulations by the financial
analysts, industry experts and economists etc.
A) Arguments in favor of Regulations:
1. Ensures safety of the public funds: Elaborate government rules controlling what
financial institutions can and cannot do arise from multiple causes. One is a concern
about the safety of the public funds, especially the safety of the savings owned by
millions of individuals and families. The reckless management and ultimate loss of
personal savings can have devastating consequences for a family’s future economic well-
being and lifestyle, particularly at retirement. While savers have a responsibility to
carefully evaluate the quality and stability of a financial institution before committing
their savings to it, governments have long expressed a special concern for small savers
who may lack the financial expertise and access to quality information necessary to be
able to judge the true condition of a financial institution correctly. Moreover, many of the
reasons that cause financial institutions to fail – such as fraud, embezzlement,
deteriorating loans, or manipulation of the books by insiders – are often concealed from
the public.
Related to the desire for safety is a government’s goal of promoting public confidence in
the financial system. Unless the public is confident enough in the safety and security of
their funds placed under the management of financial institutions, they will withdraw
their savings and thereby reduce the volume of funds available for productive investment
to construct new buildings, purchase new equipment, set up new businesses, and create
new jobs. The economy’s growth will slow and, over time, the public’s standard of living
will fall.
2. Help in the development of disadvantaged sectors: Regulations are often justified as
the most direct way to aid so called “disadvantaged sectors” in the economy. Examples
include farmers, small traders, new home buyers, and low-income families. Governments
often place high social value and give importance for up-lifting these groups by

4
guaranteeing loans made if possible with lower interest rates. If regulations are not there,
this may not be possible for the governments. Governments also check the regional
imbalance with regulations.
3. Help to check inflation: Financial institutions have the ability of creating money in
the form credit cards, checkable deposits, and other accounts that can be used to make
payments for the purchase of goods and services. History has shown that the creation of
money is closely associated with inflation. Thus, the regulation of money creation has
become a key objective of government activity in the financial sector.
4. Help in supporting Governments for funds and services: Finally, the enforcement
of regulations for financial institutions has arisen because of governments depend upon
financial institutions for funds and important services. Governments borrow money and
depend upon financial institutions to buy a substantial proportion of government IOUs
(acronym of the words “I Owe You” – or it is simply a document that acknowledges the
existence of debt). Financial institutions also aid governments in the collection of tax
revenue. Thus, governments frequently regulate financial institutions simply to ensure
that these important benefits will continue to be provided to them.
Arguments against Regulations:
1. Creates moral hazard: Regulations cause depositors as well as financial institutions
especially banks to behave less cautiously on the belief that the central bank is there to
protect them in case of financial deterioration.
2. Agency capture: Regulators are ex-practitioners who share the same value as
practitioners, and hence may be biased towards banks and insurance companies rather
than money savers.
3. Increases cost of financial services: Adherence to regulations increase the costs to
financial institutions and these costs may be passed on to clients in the form of financial
services costs.
4. Gives room for monopolies to emerge: Regulations may restrain the entry of new
companies and financial institutions. If the entry of new firms is restrained, true
competition may not prevail in the markets. This situation gives room for monopolies to
emerge. Because of monopolistic situation in the markets, consumers may not get quality
services in spite of high cost of service they are paying.

5
5. Leads to market inefficiency: Regulations sometimes not only restrain competition
but also prevents mergers and acquisitions. This allows inefficient firms to stay in the
markets.