Chapter 3 - Regulation

Question 1

What are the main aims of regulation? (4)

Answer 1

Correct perceived market inefficiencies and to promote efficient and orderly markets
Protect consumers
Maintain confidence in the financial system
Reduce financial crime

Question 2

What are the main costs of regulation? How much regulation is necessary in a given market?

Answer 2

Direct costs:

• Administering the regulation (cost for regulators)
• Adhering to regulation (cost for companies governed by regulation, such as reporting costs)
• These costs are ultimately met by the investor in the form of higher taxation or higher charges.

Indirect costs:
- Moral hazard in the form of:
False sense of security for consumers leading to a change in behaviour
Loss of sense of professional responsibility of providers
Reduced consumer protection mechanisms bought forward by the market participants

• Reduced product innovation
• Reduced competition

Question 3

Discuss the two main reasons why the need for regulation in financial markets is arguably stronger than that of other markets.

Answer 3

Confidence

• Loss of confidence in a financial system can lead to its collapse, especially in the global, technological economy
• Necessary to prevent a domino effect so that entire markets do not collapse

Asymmetric information
- Protect consumers from exploitative financial products and providers

Question 4

What are the main functions of a regulator?

Answer 4

Influencing and reviewing government policy
Vetting and registration of business
Supervising the prudence of financial organisations
Enforcing regulations and investigating suspected breaches
Providing information and education to consumers and the public

Question 5

Define information asymmetry, anti-selection, moral hazard and fraud.

Answer 5

One party to a transaction has relevant information which the others do not have.

When consumers choose financial products or exercise options from which they stand to gain the most.

A change in behaviour to if the party was fully exposed to the consequences of an action.

When a policyholder deliberately avoid disclosing information to a product provider in order to get a better price. This is illegal, unlike anti-selection.

Question 6

What are the main sources of information asymmetry which result in regulation in financial markets? Discuss how information asymmetries can be dealt with through regulation.

Answer 6

The cost or difficulty of obtaining relevant information.
The majority of the population will probably not be well educated in financial matters.

Disclosure and education

• Providers should disclose all information and make sure that consumers understand the products
• The regulator could try to educate the population by creating awareness.

Insider trading regulations and Chinese walls
- Attempt to minimise the effects of a conflict of interest.

Negotiation

• Consumers typically do not have much leverage in negotiating terms and prices of products
• Can implement price controls
• Regulate selling practices
• Right to terminate the sales process
• Provide a cooling-off period during which a consumer can cancel a contract without penalty

Consumer protection legislation against unfair terms in insurance contracts

• Use plain language
• Contract terms
• Discontinuance benefits

Treating the customer fairly (TCF)

• Ensure providers of financial products consider the interests of their customers
• Whistle-blowing requirement for professionals (such as actuaries)
• Benefits and charges can often be varied at the discretion of the product providers and so should be influenced by reasonable policyholder expectations:
  1) Statements made by the product provider
  2) Past practice
  3) General practice of the product providers in the market.

Question 7

Discuss how regulation can maintain confidence in a financial system.

Answer 7

Capital adequacy

• Ensure institutions hold sufficient financial resources to cover expected (and unexpected) liabilities in the short and long term
• Set capital requirements

Competence and integrity

• Of financial practitioners and managers
• Prove competence by obtaining qualifications and earning experience
• Must also be judged as a “fit and proper” person

Compensation schemes

• Funded by industry or government
• Recompense investors who have suffered losses due to fraud, poor advice or failure of the service provider (not market related losses)
• May be a limited compensation to avoid moral hazard

Ensure markets are transparent, orderly and provide proper protection

Stock exchange requirements

• Listed companies must fulfil certain criteria regarding financial stability and disclose certain financial information
• Regulators will monitor prices and reporting of deals to identify/deter insider trading and prevent substantial private acquisitions of shares which would affect other shareholders
• Regulation of new share issues and take-over bids
  1) Protection of interests of existing shareholders, managers and the public
  2) Should not lead to market-dominating companies
  3) Preventing a bidder from retracting a significant offer
  4) Disclosure of certain information

Question 8

What are the main forms of regulation? (3)

Answer 8

Prescriptive
- Detailed rules

Freedom of action
- May include rules to inform public of actions and provide information

Outcome-based
- Specify what outcomes will be tolerated

Question 9

What are the main types of regulatory regimes? List the advantages and disadvantages of each.

Answer 9

Unregulated markets
- In some markets the costs of regulation may outweigh the benefits, such as markets where only professionals practice

Voluntary codes of conduct

• Effective in many circumstances
• May be a lack of public confidence
• May be a few who refuse to cooperate, which leads to a breakdown in the system

Self-regulation

• Organised and operated by participants in the market without government intervention
• Incentive is that regulation is an economic good which consumers are willing to pay for, as well as the desire to keep government out of the market and avoid statutory regulations

Advantages

• Implemented by people who know the market best and its needs
• Respond rapidly to changes in market needs
• Easier to persuade firms and individuals to co-operate

Disadvantages

• Closeness of the regulator to the industry means it may be out of tune with the needs of third parties
• Weaker regime than is acceptable to consumers and the public
• May prevent new entrants into the market

Statutory regulation
- Government sets out rules and policies

Advantages

• Less open to abuse and may command greater public confidence (depending on the government)
• Economies of scale can be achieved by the regulatory body through grouping its activities by function, rather than type of business

Disadvantages

• May implement unnecessary and costly policies
• Less flexible than self-regulation

Mixed regimes
- In reality, regimes will probably be a mix of all of the above