CHP 4

Question 1

1. The aims of regulation

Answer 1

1. Correct perceived market inefficiencies and
2. Promote efficient and orderly markets
3. Protect consumers of financial markets
4. Maintain confidence in financial systems
5. Help reduce financial crime

Question 2

2. Cost of regulation

Answer 2

Regulation has a cost – regulators must aim to develop a system that achieves the objectives and where the benefits outweigh the cost. (optimal level = marginal benefit = marginal cost of regulation)

Question 3

Regulation Direct costs

Answer 3

• Administering the regulation – cost for the regulator

* Compliance for the regulated firms – cost for the participant

Question 4

Regulation Indirect costs

Answer 4

• An alteration in the behavior of consumers – may be given a false sense of security and a reduced sense of responsibility for their own actions
• An undermining of the sense of professional responsibility amongst intermediaries and advisers
• A reduction in consumer protection mechanisms developed by the market itself
• Reduced product innovation
• Reduced compition

Question 5

3. The need for regulation

Answer 5

The need is greater in financial services than other markets because of:
• Confidence
• Asymmetric information

Question 6

3. The need for regulation

• Confidence

Answer 6

Danger is that problems in one area spread to other parts of the system and the damage done by a systemic financial collapse.
To prevent systemic collapse or loss of confidence it is only required that the collapse of one participant does not threaten the whole system.

Question 7

4. The functions of a regulator

Answer 7

1. Influencing and reviewing government policy
2. Vetting and registration of firms and individuals authorized to conduct certain types of business.
3. Supervising the prudential management of financial institutions and the way in which they do their business
4. Enforcing regulations, investigating suspected breaches and imposing sanctions
5. Providing info to consumers and the public

Question 8

Regulation may be segregated by type of financial business (e.g. insurance or investment).
It will be necessary to regulate:

Answer 8

1. Deposit-taking institutions
2. Financial intermediaries
3. Securities markets
4. Professional advisers
5. Non-financial companies offering securities to the public

Question 9

5. Areas addressed by regulation – information asymmetry

Answer 9

Info asymmetry – a party in a transaction has relevant info the others don’t.
• Def: Anti-selection: People will take out contracts when they believe their risk is higher than what is allowed for in the premiums.
• Def: Moral hazard: Risk that an insured may attempt to take unfair advantage of the insurer. (e.g. false claim)
• Information asymmetry can lead to anti-selection. E.g. options available will more likely be exercised by someone who will find it more beneficial.
• Information asymmetry can cause prospective policy holders to avoid disclosing everything (e.g. health problem)
• The area of info asymmetry of most concern: info asymmetry between provider and end user of products. There is a difference in negotiating power and expertise.

Question 10

• The area of info asymmetry of most concern: info asymmetry between provider and end user of products. There is a difference in negotiating power and expertise.

Answer 10

o This is accentuated by the fact that fin transactions (IV, insurance and pension) have large impact on the future economic welfare of individuals.
o Many people are not financially very sophisticated and find fin solutions complex and confusing

Question 11

5.2. Dealing with information asymmetry

Answer 11

• Disclosure and education
• Conflicts of interest – knowledge about 3rd parties can be restricted to public info by insider trading regulation. (Chinese walls or separation of functions between organisations)
• Negotiation – individual rights protected by price controls and regulation of selling practices. E.g. cooling off
• Unfair features of insurance contracts – consumer protection act
• TCF – needed because of the long duration and complexity of fin products and the impact of unfair treatment. COI is increased by clauses allowing providers to change benefits and charges. It is generally accepted that discretionary benefits and charges should not be too dissimilar from those customers were led to believe at outset.

Question 12

There is no precise method of defining what customers were lead to believe (PRE – Policyholder Reasonable Expectations), main influences on policy holder expectations are:

Answer 12

o Statements by the provider – e.g. especially marketing material and other comms
o Past practice
o General practice of other providers

Question 13

6. Areas addressed by regulation – Maintaining confidence

6. 1. Capital adequacy

Answer 13

Institutions must hold sufficient capital to cover their liabilities.
• Could be assets must be at least a specified proportion of liabilities (according to a prescribed basis)
• Sufficient assets held to ensure probability of insolvency over a specified period is below a certain level.
Ensuring this requires accurate models to monitor risk levels and that they are used with competency.

Question 14

6. Areas addressed by regulation – Maintaining confidence

6. 2. Competence and integrity

Answer 14

Ensuring competence and integrity of fin practitioners and managers is a crucial role for a fin regulator.
Individuals may need to prove competence by qualification or membership to professional body.
Regulators may prevent an individual from working in a particular industry or at a senior level of they are not deemed fit and proper.

Question 15

6. Areas addressed by regulation – Maintaining confidence

6. 3. Compensation schemes

Answer 15

Regulators may establish compensation schemes, funded by industry or government to compensate investors who suffered losses. E.g. losses due to fraud, bad advice or failure of service provider rather than market-related losses.

Question 16

6. Areas addressed by regulation – Maintaining confidence

6. 4. Other protection for investors

Answer 16

Security market regulators want the market to be transparent, orderly and to provide proper protection to investors.

Question 17

6. Areas addressed by regulation – Maintaining confidence

6. 5. Stock exchange requirements

Answer 17

Companies listed will have to fulfill certain requirements regarding financial stability and fulfill specified obligations for disclosure of financial and other info.
Regulators will monitor things like prices at which business is done and the reporting of deals.
Regulations governing the issue of new shares and take-over bids for companies.

Question 18

6. Areas addressed by regulation – Maintaining confidence

Answer 18

6. 1. Capital adequacy
7. 2. Competence and integrity
8. 3. Compensation schemes
9. 4. Other protection for investors
10. 5. Stock exchange requirements

Question 19

7. Regulatory regimes

Forms of regulation

Answer 19

• Prescriptive
Setting out detailed rules of what is allowed and not allowed.
• Freedom of action
Freedom of action but with rules on publicity so third parties are fully informed about the providers of financial services.
• Outcome-based
Freedom of action but prescribe the outcomes that will be tolerated.

Question 20

7.1. Unregulated markets

Answer 20

In some markets the cost of regulation outweighs the benefits – especially markets where professionals operate. E.g. where commodity products with guaranteed benefits are sold only on price, such as term assurance.

Question 21

7.2. Voluntary codes of conduct

Answer 21

Operate effectively in many circumstances but are vulnerable to lack of public confidence and rogue operators.

Question 22

7.3. Self-regulation

Answer 22

Organized and operated by participants in the market without government intervention.
The incentive is that regulation is an economic good and consumers of fin services are willing to pay a premium for this.
Another incentive is the threat of statutory regulation being imposed if self-regulation is not implemented.

Question 23

7.3. Self-regulation

Advantages

Answer 23

• Implemented by the people with the greatest knowledge.
• People that have the greatest incentive to achieve optimal cost benefit ratio.
• Could respond quicker to changes in environment
• It may be easier to persuade firms to co-operate to this rather than a government bureaucracy.

Question 24

7.3. Self-regulation

Disadvantages

Answer 24

• Regulator is very close to the industry, may lose sight of the 3rd party point of view.
• Can lead to weaker regime that is acceptable for consumers. Even if it is operating efficiently and effectively it can suffer from lack of public confidence.
• Self-regulatory regimes may inhibit new entrants into the market.
• Largest players has the most say and could force the regulatory framework in their favour.

Question 25

7.4. Statutory regulation

Answer 25

Government sets out the rules and polices them.

Question 26

7.4. Statutory regulation | Advantages

Answer 26

* Should be less open to abuse and command a higher degree of public confidence. * Could generate economies of scale by grouping activities by function rather than type of business.

Question 27

7.4. Statutory regulation | Disadvantages

Answer 27

* Could be more costly and inflexible * Could argue that market participants are in the best position to devise and run the regulatory system. Outsiders may impose unnecessary and costly rules and may not achieve the desired aim. * It is said that aims by government to improve market efficiency usually fail and is best developed by the market.

Question 28

Regulatory regimes | Professionalism and professional bodies

Answer 28

Regulators aim at the professional responsibility of market practitioners and intermediaries as a source of benefits. Professional bodies ensure their members are appropriately qualified for the work they undertake and conform to professional standards.