Chapter five

The Regulation of Financial Markets and Institutions

In addition to the acquisition of fundamental knowledge about the financial system of the world,
the study of financial institution and financial market can be effective if we give considerable
attention to critical issues with regard to the governing policies and regulations of the area. In
other words, students of business-related streams, who deeply involve themselves in all the fields
of finance, are expected to know the rules and regulations that deal with the formation and
operation of the financial institutions and financial markets. That is the reason why we are trying
to give considerable concentration to the general regulations of the financial system and its
related issues in this unit.

On the other hand, until we understand the rules and regulations behind any system, we will not
be in a position to implement and use it for our purpose. Accordingly, this unit is intended to
cater to your needs in understanding the rules and procedures of the financial institutions and
financial markets, to sharpen you, being capable of knowing and putting into practice those
regulations. The different sub-sections of this unit will be strengthened, updated and customized
through different examples and case in points to improve, clarify and arouse an enthusiastic
interest in the subject of ‘Financial Markets and Institutions’. It is therefore worth clarifying the
regulations of the subject matter under the sub sections of:
The Nature of Financial System Regulation; The Principles of Regulation, and
Arguments for and against Financial System Regulations.
Give due concentration and have the benefit of the content of the unit!

At the end of this unit, you should be able to:

 explain why financial institutions are regulated;
 explain the rules and regulations of financial institutions; and
 Distinguish the nature application of financial system policies.
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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 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 is

 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.
 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. (Systematic risk is a risk that impacts the entire market
or a large sector of the market, not just a single stock or industry. Examples
include natural disasters, weather events, inflation, changes in interest rates, war and even
terrorism).
 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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 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. Clearly there must be limits on the
applicability of this rational for regulation.

 One of the other main reasons for having strong financial regulation is increasing
information available to investors. For example, because of a symmetric 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/willing to sell securities to unwary/careless
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.
 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.

The possible outcome is a financial panic that produces large losses for the public and causes
serious damage to the economy.
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 To protect the public and the economy from financial panics, the governments are
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implementing a number of regulations. These regulations are taking the form of

 Restrictions on Entry; Disclosure; Restrictions on Assets and Activities; Deposit
Insurance; Limits on Competition; and Restrictions on Interest Rates.

i. 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.

ii. Disclosure
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.

iii. Restrictions 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.

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.

[Link] 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
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depositors in the case of a bank’s failure.

 v. Limits on Competition;
Politicians have often declared that 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.

vi. 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.

 In subsequent sub sections, we will look more closely at general regulations of financial
markets and institutions and will see whether it has improved the functioning of financial
system.

5.2 The Principles of Regulation

 Regulation requires that a careful balance be struck between effectiveness and efficiency.
It has a great potential to impose costs and should be designed to meet its purposes while
minimizing direct costs of regulation and the broader costs arising from rules which
restrict economic activity.
 The main principle of the regulation of the financial markets and institutions includes:
Competitive Neutrality; Cost Effectiveness; Accountability; Flexibility; and
Transparency

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
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 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
be a top priority of an effective financial regulatory structure that financial promises (both public
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and private) to be understood. If there is a general perception that a particular group of financial
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 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.

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’.

On the other hand, many regulations in the financial institutions’ sector spring from the ability of
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some financial institutions to create money in the form of credit cards, checkable deposits, and
 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.

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.

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
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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.

[Link] Assurance
If regulation is pursued to the point of ensuring that promises are kept under all circumstances,
the burden of honour is effectively shifted from the promisor to the regulator. All promisors
would become equally risky (or risk free) in the eyes of the investing public. Regulation at this
intensity removes the natural spectrum of risk that is fundamental to financial markets. If it were
extended widely, the community would be collectively underwriting all financial risks through
the tax system, and markets would cease to work efficiently.

A concern about the safety of the public’s funds, especially the savings owned by millions of
individuals and families, however, does not mean that all financial services should be subject to
financial safety regulation. Thus, 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).

How intensively, then, should financial safety regulation be applied?

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 honour. 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.

How much regulatory assurance should it provide in the various areas of the financial system?
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 At a minimum, this requires that the regulator has unambiguous powers to intervene in the
operations of institutions making such intense promises. Regulation should seek to ensure that,
while risk remains, those making promises ensure that risks are appropriately managed in
accordance with the reasonable expectations of their promises. If regulation stops short of
providing a guarantee against failure, it must provide speedy and efficient mechanisms for
resolving financial distress when it arises, so as to minimize the danger of loss or contagion.

v. Regulation for Social Purposes

Obliging financial institutions to subsidies some activities compromises their efficiency and is
unlikely to prove sustainable 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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  Summary

The development of a sound financial industry is partly in the hands of the legislators and
supervisors. They have to establish the framework for the healthy development of these
industries and to deal with the incidences of market failure and imperfections. This should
benefit not only consumers but also the economy as a whole through better protection of the
existing and future wealth of the country, the availability of more funds for investment purposes
and the strengthening of state finances through tax incomes.

The financial system warrants specialized regulation due to the complexity of financial products,
the adverse consequences of breaching financial promises and the need for low-cost means to
resolve disputes. All markets, financial and non-financial, face potential problems associated
with the conduct of market participants, anti-competitive behavior and incomplete information.
These common forms of market failure have justified at least a minimum level of regulatory
intervention in markets on an economy wide basis. There are some markets where this minimum
level of economy wide regulation is considered to be inadequate.

In the financial system, specialized regulation is required to ensure that market participants act
with integrity and that consumers are protected. If a borrower from bank, having a financial
guarantee from an insurance firm, fails to pay the debt as per the agreement, the bank will collect
the amount from the insurance company. The longer the period and the higher the number of
default customers would endanger the operation of insurance companies and banks as many of
the banks have invested on insurance companies.

The regulation which prohibits insurance companies from providing financial guarantee
therefore, would contribute for the minimization of systemic risk in the country’s financial
sector. Regulation imposes costs directly for their implementation and indirectly on the wider
economy as it restricts some economic activities. This highlights the need to balance prudential
and efficiency considerations.
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For market efficiency reasons, regulation must also take account of the risk that some financial
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failures may have onerous/heavy consequences for financial system stability and hence the real
 economy. In different countries introduction of market economy principles and liberalization
fundamentally changed the state involvement in the monitoring of financial operations. The role
of the state has evolved towards establishing market conduct rules, and prudential regulations,
particularly focusing on solvency and consumer protection measures.
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