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W. Jean Kwon, Ph.D., CPCU
School of Risk Management, St. John’s University
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Risk Management and Insurance: Perspectives in a Global Economy
8. Regulation of Private-Sector Financial
Services
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Study Points
 Private-sector financial services
 Government’s role in regulating private-sector financial
services
 Overview of financial services regulation
 Structure of regulatory authorities
 Governmental actions affecting financial services regulation
3
Private-sector Financial Services
4
Financial intermediaries
 Definition
• Firms/entities that bring together providers and users of funds
 Functions
• Market financial services products offered through the financial
intermediation process
• Not actually manufacture (underwrite) all of the products they sell
• Match savers with investors, thus obviating the need for savers to locate
investors directly and vice versa
 Notes
• All financial intermediaries issue their own claims.
• Financial intermediaries would not exist in a perfect market.
5
Types of Financial Intermediaries
 Depository institutions
 Security firms (investment banks)
 Insurance companies
 Mutual funds
Financial conglomerates and financial
services integration in Chapter 25!
 Pension funds
 Financial conglomerates
• Financial conglomerates
• Product integration or advisory integration
6
Government’s Role in Regulating Private-sector
Financial Services
7
Why Regulate Financial Services?
 Market imperfection
 Information asymmetry – the “lemons” problem
 Market power
 Negative externalities – possibility of systematic risks
• Risk of cascading failure
• Simultaneous withdrawal by depositors (caused by a loss of
confidence in the financial institutions)
8
Public Interest Theory of Regulation
 Regulation is:
• To serve the public interest by protecting consumers from abuse.
• To maximize economic efficiency, including preventing or making
right significant societal or consumer harm that results from market
imperfections
9
Private Interest Theories of Regulation
 Theories
• Peltzman (1976) – Self-interested regulators engage in regulatory
activities consistent with maximizing their political support.
• Meier (1988) – Regulation is shaped by bargaining between private
interest groups within the existing political and administrative structure.
• Stigler (1971) – Regulation is “captured” by and operated for the benefit
of the regulated industry.
 Regulation unduly influenced by special interests could result in:
• Restrictions on entry of new domestic and foreign entrants
• Suppression of price and product competition
• Control of inter-industry competition from those selling similar or
complementary products
10
When is Regulatory Intervention Justified?
 Only if the three conditions are met:
• Actual or potential market imperfections exist.
• The market imperfections do or could lead to meaningful economic
inefficiency or inequity.
• Government action can ameliorate the inefficiency or inequity.
11
Government Failures
 Difficulty in identification and formulation of goals
 Principal-agent problems where government employees are
agents for the public
 Rent-seeking behavior engaged by the regulated
 The problem of capture (related to the rent-seeking
behavior)
12
Financial Services Regulation
13
Regulatory Interventions
 Prudential regulation
• Concerned with the financial condition of the financial intermediary
• Evolved primarily because of information problems and negative
externalities (especially for banking)
 Market conduct regulation
• Government prescribed rules establishing inappropriate marketing
practices
• Evolved primarily because of information problems
 Competition policy (antitrust) regulation
• Concerned with actions of the intermediary that substantially lessen
competition
• Remains the most critical element in government oversight
14
Commercial Banking Regulation
 Commercial banks are subject to oversight in every national
market.
 Every major market provides for some type of deposit
insurance on the savings of customers.
 Banks are subject to oversight by the nation’s central bank
and/or a banking regulator.
15
The Basel Committee on Banking Supervision (BCBS)
 Two principles
1. No foreign banking establishment should escape supervision
2. Supervision should be adequate
 The Basel Capital Accord
• A banking credit risk management framework with a minimum capital
standard of 8%
 Basel II (newer)
• Minimum capital requirements
• Supervisory review of an institution’s internal assessment process
and capital adequacy
• Effective use of disclosure
• Insight 8.1
16
Securities Regulation
 Focuses on both the new and secondary issues markets,
mandating certain disclosures to prospective purchasers
about the securities
 To rectify buyers’ information asymmetry problems
 The Sarbanes-Oxley (SOX) Act
17
International Organization of Securities Commissions
(IOSCO)
 Objectives and Principles of Securities Regulation (IOSCO
Principles)
 ISOCO Assessment Methodologies
18
Insurance Regulation
 Focused chiefly on monitoring and preventing insolvencies
• Aimed more at protecting policyholders from losses occasioned by
insurer insolvency
 International Association of Insurance Supervisors (IAIS)
• Promotes cooperation among insurance supervisors
• Sets international standards for insurance regulation and supervision
• Issues principles, standards and guidance papers on issues related
to insurance supervision
Insurance regulation and taxation is
discussed in Chapter 24.
19
Financial Conglomerate Regulation
 Details of financial institution regulation vary not only from
country to country but from financial sector to financial
sector.
 Permissible activities (Table 8.1)
• The majority of countries allow joint banking and securities activities
• Most permitting banks to undertake securities activities within the
bank itself
• Few, if any, countries permit insurance underwriting within a bank
 The Joint Forum on Financial Conglomerates (Joint Forum)
• Consists of the Basel Committee, IOSCO and the IAIS
• Examines the common interests of the three financial services and
develops principles and identifying international best practices
20
Structure of Regulatory Authorities
21
Structure of Regulatory Authorities
22
Governmental Actions
 After the Asian and other financial crises of the late 1990s
• Financial services regulation has become less diverse
• The major intergovernmental organizations involved in financial
services regulation playing more active and constructive roles
 The trend toward allowing mutual insurers and banks to
convert to shareholder-owned firms
 Privatization of banks and insurance firms in several
countries
 Significant combinations of banks and insurance firms
23
Governmental Actions (2007 Credit Risk Crisis)
 Contagion of credit risk around the world
• Coordination at the government and inter-government organization
level
 Movement back to stringent regulation
• Governments loss of confidence in self regulation
• More emphasis on risk-capital (solvency) and market conduct
regulation
 Increase in government takeover (control) of financial
institutions
 Search for newer sources of capital by financial institutions
• Sovereign funds
24
Future Prospects
 Risk-based prudential regulation
• New disclosure-based financial regulatory model evolving
internationally
• Integrated international approaches to accounting standards,
securities regulation and financial institution regulation
 Interest in common international financial regulation in areas
for which such would be feasible
25
Discussion Questions
26
Discussion Question 1
 Explain carefully why government regulation of privatesector financial service firms is considered necessary.
27
Discussion Question 2
 Debate the following proposition: “government regulation of
insurance premium rates is justified.”
28
Discussion Question 3
 What are the essential differences between government
supervision of banks and of insurers? Why do these
differences exist?
29
Discussion Question 4
 Examine the structure of financial regulation in your home
country and compare it with the structure in another
economy. Do you find any significant differences in the
structures or in the accompanying regulatory objectives?
Elaborate your findings.
30
Discussion Question 5
 Offer your answers to the questions posed in Note 2 of this
chapter.
• “Could there be a “chicken and egg” problem here? Could regulation
that shields consumers from the consequences of their mistakes or
from failing to become better informed about the quality of financial
intermediaries result in their expecting government protection? Is it
possible that the market might devise its own means of minimizing
the effects of mistakes and providing consumers with adequate
information were government intervention at a lesser level?”
31