Chapter 4: Regulation

Question 1

4 Aims of regulation

Answer 1

• to correct perceived market inefficiencies and promote efficient and orderly markets
• to protect the consumers of financial products
• to maintain confidence in the financial system
• to help reduce financial crime

Question 2

2 Direct costs of regulation

Answer 2

• a cost to the regulator in administering the regulation

- a cost to the regulated firms in complying with it.

Question 3

5 Indirect costs of regulations

Answer 3

• an ALTERATION in the BEHAVIOUR of consumers who may be given a false sense of security or a reduced sense of responsibility for their own actions.
• an UNDERMINING of the sense of professional responsibility amongst intermediaries and advisors.
• a reduction in the market’s own consumer PROTECTION MECHANISMS
• reduced product innovation
• reduced competition

Question 4

Why is the need for regulation of the financial markets greater than the need for regulation of most other markets?

Answer 4

IMPORTANCE OF CONFIDENCE in the financial system
It is not necessary to guarantee the solvency of each financial institution, but merely ensure that the failure of one does not affect the whole system.

ASSYMETRY of information, expertise and negotiating strength that exists between the consumer and the provider.
These issues are exacerbated by the fact that financial transactions are often long term in nature and can have a significant impact on the economic welfare of individuals.

Question 5

How would the regulator help ensure confidence in the financial system?

Answer 5

• by regularly monitoring that institutions hold SUFFICIENT CAPITAL to meet their liabilities.
• by ensuring that financial managers and practitioners are COMPETENT,
• by establishing industry COMPENSATION SCHEMES

Question 6

How can a regulator help reduce asymmetries of information?

Answer 6

• by requiring FULL DISCLOSURE OF INFORMATION, in an understandable form
• by EDUCATING CONSUMERS
• by giving consumers a COOLING OFF PERIOD after purchase of a financial product
• by restricting knowledge for everyone to that which is PUBLICLY AVAILABLE
• by enforcing INSIDER TRADING regulations
• by techniques such as CHINESE WALLS

by the provision of consumer protection legislation that aims to ensure that:

• UNFAIR TERMS in contract design are eliminated
• the INTEREST OF CUSTOMERS are considered

Question 7

What are the main functions of a regulator?

Answer 7

S - setting SANCTIONS
E - ENFORCING regulations
R - REVIEWING and influencing government policy
V - VETTING and registering firms and individuals
I - INVESTIGATING breaches
C - checking CAPITAL ADEQUACY, management and conduct of providers
E - EDUCATING consumers and the public

Question 8

3 Forms of regulation

Answer 8

PRESCRIPTIVE
Detailed rules setting out what may and may not be done.

OUTCOME-BASED
The range of tolerable outcomes is prescribed.

FREEDOM OF ACTION
Freedom of action, but with rules on publicity so that 3rd parties are fully informed about the providers of financial services.

Question 9

5 Main types of regulatory regime

Answer 9

• Self-regulatory systems
• Statutory regimes
• Voluntary codes of conduct
• Unregulated markets
• Mixed regimes

Question 10

Self-regulatory systems

Answer 10

Organised and operated by market participants without government intervention.

Question 11

Statutory regimes

Answer 11

The rules are set and policed by the government

Question 12

Voluntary codes of conduct

Answer 12

Firms have a choice as to whether to adhere

Question 13

Advantages of a self-regulatory regime

Answer 13

• It is implemented by the people with the greatest knowledge of the market, who have the greatest incentive to optimise the cost-benefit ratio.
• It should respond rapidly to changes in market needs
• It should be better able to persuade firms and individual to cooperate, than under statutory regulation.

Question 14

Disadvantages of a self-regulatory regime

Answer 14

• The closeness of the regulator to the industry
• Low public confidence
• May inhibit new entrants to a market

Question 15

Advantages of statutory regulation

Answer 15

• less open to abuse
• instills more public confidence then self regulation
• it should be more efficient if economies of scale can be achieved

Question 16

Disadvantages of statutory regulation

Answer 16

• costs
• inflexibility

The government may impose rules that are unnecessarily costly, inefficient and may not achieve the desired aim.

Question 17

Main problems with voluntary codes of conduct

Answer 17

• low public confidence

- rogue operators who refuse to cooperate

Question 18

In what circumstances might there be a strong case for unregulated markets?

Answer 18

• Markets where the costs of regulation outweigh the benefits, e.g. in markets where any professionals operate
• Commodity products, with guaranteed benefits (such as term assurance which is sold on the basis of price)