Chapter 5
Financial market regulation
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Chapter contents
government's role in financial markets
theory of regulation
financial regulation in the US and EU
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5.1 Government's role in financial markets
The government can play one or more of the
following roles in financial markets:
provide a level playing field for financial markets by
promoting their development.
participate in the financial markets by running
state-owned financial institutions
provide a regulatory framework that ensures safety
and soundness of the financial system.
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5.2 Theory of regulation
Why regulation?
Market failures
Adam Smith argued that individuals and firms in the
pursuit of self-interest would be led, as if by an
invisible hand, to actions that maximized general
well-being
Greenwald and Stiglitz showed that whenever
information is imperfect or markets incomplete—
there is a presumption that markets are not pareto
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5.2 Theory of regulation
Why regulation?
Market failures
They argue that the invisible hand often seems invisible
because it’s not there.
They concluded that there are no theoretical
grounds for the belief that unregulated markets will,
in general, lead to societal well being.
Market failures produce externalities and restrain
competition.
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5.2 Theory of regulation
Why regulation?
Market Irrationality
The standard competitive equilibrium model
assumed that all individuals were rational.
But individuals may not be rational and may deviate
from rationality in systematic ways. Individuals have to
be saved from themselves.
Markets suffer from irrational exuberance and
irrational pessimism.
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5.2 Theory of regulation
Why regulation?
Distributive justice
Markets may not produce outcomes that are
socially just.
Regulations may be an important instrument for
achieving distributive objectives, especially when
governments face tight budgetary constraints.
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5.2 Theory of regulation
Arguments against regulation
Creates moral hazard-causes depositors as well
as banks to behave less cautiously on the
belief that the central bank is there to protect
them
Agency capture-regulators are ex-practitioners
who share the same value as practitioners, and
hence may be biased towards banks rather than
depositors
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5.2 Theory of regulation
Arguments against regulation…
increases cost of financial services-it has cost
and financial institutions may pass it on to
clients
gives room for monopolies to emerge-cost of
regulation may restrain entry and exit
leads to market inefficiency-prevents mergers
and acquisitions and allows inefficient firms to
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5.2 Theory of regulation
Regulation Vs other forms of intervention
Critics of regulation argue the objectives of
regulation can be achieved better at lower costs by
using “market based” interventions, i.e. taxes and
subsides.
But price interventions have limitations
1. Imperfect information and incomplete contracting-in
the presence of imperfect information and
incomplete contracting, optimal incentive schemes
typically are highly non-linear and may even impose
constraints like rationing and terminations)
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5.2 Theory of regulation
Regulation Vs other forms of intervention
Limitations of price interventions...
2. Prices vs. quantities
quantity interventions (regulations)may lead to a
higher level of expected utility than price
interventions.
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5.2 Theory of regulation
Purpose of regulation?
prevent issuers of securities from
defrauding investors by concealing relevant
information
promote competition and fairness in the
trading of financial securities
promote stability of financial institutions
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5.2 Theory of regulation
Purpose…
restrict activities of foreign concerns in domestic
markets and institutions
control the level of economic activity
To avoid concentration of financial power in hands of
few individuals and organizations
To promote public confidence in the financial system,
so that savings flow smoothly into productive
investment, and payment for goods and services are
made speedily and efficiently.
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5.2 Theory of regulation
Types of regulations
(1) disclosure regulations-problem of asymmetric information and
agency problem
(2) financial activity regulation-about traders of securities and trading on
financial assets.
Examples. Rules on trading by corporate
insiders- insider trading(the illegal practice of trading on the
stock exchange to one's own advantage through having access to
confidential information)
Example For example, an executive of Company XYZ who
purchases shares of the company based on a pending merger
announcement is engaging in illegal insider trading.
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5.2 Theory of regulation
Types of regulations…
(3) regulation of financial institutions- restricting
activities of financial institutions in the area
of lending, borrowing and funding
(4) regulation of foreign participants-limit the
roles of foreign firms on domestic markets
and their ownership control of financial
institutions
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End of Chapter 5
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