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Risk Management and Insurance: Perspectives in a Global Economy
8. Regulation of Private-Sector
Financial Services
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Information
Points to Ponder
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
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Private-sector Financial Services
Scope and Role of Financial Services
Financial intermediaries
Firms or other entities that bring together providers and users of
funds.
Their products are financial services offered through the financial
intermediation process.
They may not actually manufacture (underwrite) all of the financial
services they sell
Financial intermediation of all types matches savers with investors,
thus obviating the need for savers to locate investors directly and vice
versa.
All financial intermediaries issue their own claims.
Financial intermediaries would not exist if competition were perfect.
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Types of Financial Intermediaries
Depository institutions
Security firms (investment banks)
Insurance companies
Mutual funds
Pension funds
Financial conglomerates
Financial conglomerates
Product integration or advisory integration
Financial
conglomerates and
financial services
integration in Chapter
25.
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Government’s Role in Regulating Private-sector
Financial Services
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)
Also discussed
in Chapter 2
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Theories of Regulation
Public interest theory
Regulation exists 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
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Theories of Regulation
Private interest theories
Peltzman (1976) – Self-interested regulators engage in regulatory
activities consistent with maximizing their political support.
Meier (1988) – Regulation will be shaped by a type of bargaining that
occurs 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 especially foreign
entrants
Suppression of price and product competition
Control of inter-industry competition from those selling similar or
complementary products
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Government Imperfections!
If financial markets were perfectly competitive, regulation
would be unnecessary.
When is 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
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Government Imperfections!
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)
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Overview of Financial Services Regulation
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
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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 usually a banking regulator.
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Commercial Banking Regulation
The Basel Committee on Banking Supervision (BCBS)
Two principles
No foreign banking establishment should escape supervision
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
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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 Act
International Organization of Securities Commissions
(IOSCO)
Objectives and Principles of Securities Regulation (IOSCO Principles)
ISOCO Assessment Methodologies
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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.
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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
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Other Intergovernmental Organizations
The International Network of Pensions Regulators and
Supervisors
The Financial Stability Forum
The Islamic Financial Services Board
The Financial-Sector Assessment Program
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Structure of Regulatory Authorities
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Structure of Regulatory Authorities
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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
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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
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Discussion Questions
Discussion Question 1
Explain carefully why government regulation of private-sector
financial service firms is considered necessary.
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Discussion Question 2
Debate the following proposition: “government regulation of
insurance premium rates is justified.”
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Discussion Question 3
What are the essential differences between government
supervision of banks and of insurers? Why do these
differences exist?
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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.
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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?”
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