Regulation of financial
industry
Dr.sc. Matej Živković
What is regulation?
• Regulation in the broadest sense is the employment of legal
instruments for the implementation of social-economic policy
objectives.
• Economic regulation consists of two types of regulations: structural
regulation. ‘Structural regulation’ is used for regulating market
structure. Examples are restrictions on entry and exit and rules
against individuals supplying professional services in the absence of
recognized qualifications. ‘Conduct regulation’ is used for regulating
behavior in the market. Examples are price control, rules against
advertising and minimum quality standards. Economic regulation is
mainly exercised on natural monopolies and market structures with
limited or excessive competition.
• Social regulation comprises regulation in the area of the
environment, labor conditions (occupational health and safety),
consumer protection and labor (equal opportunities and so on)
Why do we regulate
• The theoretical underpinning for public
intervention in economic matters is traditionally
based on the need to correct market
imperfections and unfair distribution of the
resources.
• Three more general objectives of public
intervention derive thereby:
1. the pursuit of stability,
2. equity in the distribution of resources and
3. the efficient use of those resources.
Theories of regulation
• Positive theories are directed to the economic
explanation of regulation and deriving the
consequences of regulation. What is?
• Normative theories investigate which type of
regulation is the most efficient. The latter variant
is called normative because there is usually an
implicit assumption that efficient regulation
would also be desirable. What should be?
Theories of regulation
• Public interest theories of regulation: According to public interest
theory, government regulation is the instrument for overcoming the
disadvantages of imperfect competition, unbalanced market
operation, missing markets and undesirable market results.
• Private Interest Theories of Regulation: This theory assumes that
in the course of time, regulation will come to serve the interests of
the branch of industry involved.
• Economic theory of regulation (Chicago theory of government)George Stigler: central proposition was that ‘as a rule, regulation is
acquired by the industry and is designed and operated primarily for
its benefit’.
• Virginia School of Public Choice: In their theories, the term coined
by Ann Krueger (1974), rent seeking, is a central feature. Rent
seeking means the political activity of individuals and groups to
devote scarce resources to the pursuit of monopoly rights granted
by governments.
When shoul regulation be applied
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In case of market failures- abberation of markets from perfect market
conditions:
1. Externalities occur when one party’s actions impose uncompensated
costs or benefits on another party (violating the “private decisions”
condition).
2. Public goods are those for which the cost of providing an additional unit is
negligible and excluding users is costly (violating the “private goods”
condition).
3. The presence of monopoly power in a market allows a firm to control
prices, violating the perfect market condition that all participants are “price
takers.” “Natural monopolies” exist when long-run declining costs make
economies of scale so great that a market can be served at lowest cost only
if production is limited to a single producer. Because the supplier doesn’t
face competition, however, without some form of intervention, prices would
be higher and quantity produced lower than in a competitive market.
4. Finally, when market participants have asymmetric information, markets
may not allocate resources efficiently.
Special consideration of the need for
regulation in finance industry
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Adverse selection
Moral hazard
Insider trading
Information asymetry
Fiduciary duty
Conflict of interest
Regulatory arbitrage
Systemic risk
Herd behavior
Global financial crises
• Started with another american dream:
everybody should own a home
Introduction
Trigger to financial crises
• Bailout of Bear Sterns
• Failure of Lehman
• No response by regulator- Efficient Market
Hypothesis- Markets will take care of everything
• Worldwide contagion
The role of regulation in GFC
• The financial crisis was
not a failure of regulation,
but a failure of
supervision
• Pressures to deregulate
• The philosophy of Allan
Greenspan and removal
of Brooksley Burns
• Derivatives as “Weapons
for mass destruction”
The role of credit rating agencies
• Double role: rating securities and advising about
trading
Regulation of securities markets
• Sucurities are contractual agreements providing
owner with certain rights. These agreements
existed before there was a regulatory body or
any kind of specific regulation.
• The core to exercise these agreements were
exchanges.
• Functions of regulation can be divided to those
of exchanges and those of regulators
The functions of exchanges
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(a) Limited access to trading facility
(b) Standardized trading rules
(c) Clearing procedures
(d) Exclusive roles for members
(e) Dispute resolution
(f) Exclusive rights in information
(g) Listing Requirements
Functions and goals of regulators
• Investors protection
• Efficiency- The argument was that securities regulation required the
production of more public information by firms than they would
provide in an unregulated market
• Complete the organization of the market ‘firm’- Another perspective
is to view the public and private aspects of securities regulation as a
combined effort to create competitive market institutions which will
attract securities business.
• Capture wealth- The public choice analysis views the securities laws
as the product of political competition among groups whose wealth
is affected by the provisions of the laws.
• Protect the Industry from Competition- The view that securities
regulation is a device for organizing the industry into a cartel has
had considerable influence in the area of securities regulation
Selfregulation- an oxymoron?
• Amsterdam was the city
that was the home of the
world’s first stock
exchange, kicked off in
1602 by the issuance of
shares in the Dutch East
India Company (the
Vereenigde OostIndische Compagnie, or
VOC)
• The company that could
have joined was rather
exclusive
Types of regulatory structures
• The regulation of financial intermediaries over the world
has traditionally been on institutional lines whereby
regulation is directed at financial institutions, irrespective
of the mix of business undertaken.
• As financial institutions normally specialised in a
particular business activity, the distinction between
institutional and functional regulation was not considered
of much significance so that regulating an entity was the
same thing as regulating its core business.
• For instance, regulating banks meant regulating the
business of banking and regulating the insurance
company meant the same thing as regulating the
business of insurance.
Cont.
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Institutional supervision- In the more traditional "institutional approach" (also known
as "sectional" or "by subjects" or "by markets"), supervision is performed over each
single category of financial operator (or over each single segment of the financial
market) and is assigned to a distinct agency for the entire complex of activities.
Supervision by objectives- The supervisory model by objectives (or by finalities)
postulates that all intermediaries and markets be subjected to the control of more
than one authority, each single authority being responsible for one objective of
regulation regardless of both the legal form of the intermediaries and of the functions
or activities they perform.
Functional Supervision- The third regulatory model is the so-called "functional
supervision”, or supervision “by activity". It considers as "given" the economic
functions performed in the financial system; unlike other lines of thought regarding
supervisory activities, this approach does not postulate that existing institutions,
whether operative or regulatory, must necessarily continue to exist as such, in terms
of both their structure and role. The "functions" or activities undertaken are
considered to be more stable than the institutions that perform them.
"Single-regulator supervision”- The single-regulator supervisory model is based on
just one control authority, separated from the central bank, and with responsibility
over all markets and intermediaries regardless of whether in the banking, financial or
insurance sector.
Institutional approach
• The present institutional approach to regulation is being
objected mainly on three grounds.
1. The first is the competitive neutrality issue, i.e., different
institution based regulators might adopt different functional
regulation for the same activity with associated costs of
achieving compliance as well as supervisory arbitrage
2. Secondly, there could be a wasteful duplication of scarce
supervisory resources, with each regulator applying
business rules appropriate for every function, which would
be hugely inefficient in terms of regulatory resources
3. Finally, there is the issue of the solvency of the institution,
which could be addressed only on a group-wide basis
Possible approaches to regulatory
structure change:
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function-specific regulation, in which the regulatory domain is
defined by 'functions' performed by financial institutions rather than
‘institutions’.
objective-based regulation, such as systemic protection and
consumer protection objectives such as in the twin-peak model
super-regulator or unified regulation, with the responsibility for
prudential supervision of all financial institutions besides being
responsible forproduct regulation and competition policy in the
financial sector, and
lead /umbrella regulator, in which one of the regulators is
responsible for coordinating the regulation of the overall corporate
group, with the individual operating entities within the group
continuing to be regulated by the specialist regulators.
Mega regulatory models could be broadly
categorised into three categories,
• the Singaporean Model, in which the central
bank is also the super regulator,
• the Scandinavian Model, in which unified
regulation lies outside the central
bank, and
• the Australian Model, in which there are two
regulators with an overarching council above
them.
Arguments in favor of unified
regulation
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Fragmented supervision may raise concerns about the ability of the financial
sector supervisors to form an overall risk assessment of the institution,
operating domestically and often internationally, on a consolidated basis,
As the lines of demarcation between products and institutions have blur,
different regulators could set different regulations for the same activity for
different players. Unified supervision could thus help achieve competitive
neutrality.
The unified approach allows for the development of regulatory
arrangements that are more flexible. Whereas the effectiveness of a system
of separate agencies can be impeded by ‘turf wars’
Unified supervision could generate economies of scale as a larger
organization permits finer specialization of labour and a more intensive
utilization of inputs and unification may permit cost savings on the basis of
shared infrastructure, administration, and support systems
A final argument in favour of unification is that it improves the accountability
of regulation
Arguments against unified
regulation
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Given the diversity of objectives – ranging from guarding against systemic
risk to protecting the individual consumer from fraud – it is possible that a
single regulator might not have a clear focus on the objectives and rationale
of regulation and might not be able to adequately differentiate between
different types of institutions.
A single unified regulator may also suffer from some diseconomies of scale.
Some critics argue that the synergy gains from unification will not be very
large, i.e., economies of scope are likely to be much less significant than
economies of scale. The cultures, focus, and skills of the various
supervisors vary markedly
The public could tend to assume that all creditors of institutions supervised
by a given supervisor will receive equal protection generating ‘moral
hazard’.
Another serious disadvantage of a decision to create a unified supervisory
agency can be the unpredictability of the change process itself.
The change of regulatory paradigma
• From TBTF to their
disintegration
• From microprudential
to macroprudential
regulation
• From pro-cyclical to
counter-cyclical
regulation
Few words on regulatory model in
B&H
• Separated financial markets on institutional
boundaries
• Two entities, two exychanges, three regulators,
very clouded role of CB
Recommendation for the future
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Gretaer transparency
Supervision of substence not details
Treatment of credit rating agencies
Better definition of regultory authority
Separation of retail from wholesale
TBTF
Principle based supervision and regulation