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Regulation of the Financial Sector
Financial systems in most countries were highly regulated until the early 1980s. This followed the end of the Bretton Woods system of fixed exchange rates in 1973 and also most capital controls in the 1970s. Regulation of the financial system, often termed prudential policy, was also used to control monetary policy.
Reasons for Deregulation
The reason for deregulation in the 1980s was the rise in competition of offshore banking, such as the Eurocurrency markets, which escaped many of the domestic regulations. During the 1980s, foreign banks were allowed to operate in domestic markets for the first time.
UK Deregulation in 1987
In the UK during 1987, there was deregulation of the services banks could offer, such as allowing stockbroking services.
Financial Crises in the Early 1990s
In the early 1990s, some countries had financial crises, such as Finland, due to too much deregulation.
Reasons for Regulation
There are four main reasons for financial regulation: 1. Asymmetric information 2. The principal-agent problem 3. Moral hazard 4. Externalities.
Asymmetric Information
Managers of financial firms, sellers of market-based financial products, financial advisers, etc., generally have more information about the products they are offering or recommending than the buyers. This is because the products are complex and the purchases are often one-off.
Principal-Agent Problem
Related to asymmetric information, investors employ the management and staff of a financial institution to act as their agents in dealing with that institution or with markets, and need to ensure that agents do their best.
Incentives for Managers
Managers may have numerous incentives to ensure that their firm prospers and may receive performance-related bonuses. Investors need to ensure that their stockbroker or financial adviser is acting in their best interest.
Moral Hazard
A case of regulating against the effects of regulating. Deposit insurance schemes intended to reduce risk for investors may encourage institutions and investors to behave more recklessly than they otherwise would, defeating the original purpose.
Externalities
Externalities in economics are costs or benefits for people other than the transactors. Financial firm failure is generally viewed as more serious than non-financial firm failure due to external benefits from financial activity.
Externalities
Costs or benefits for people other than the transactors in an economic transaction.
Impact of Financial Firm Failure
The failure of financial firms is generally viewed as more serious than nonfinancial firms due to external benefits from financial activity, particularly in banks operating the payments system.
Private Benefits of Financial Activity
Private benefits to depositors, borrowers, and banks are paid for by interest rates, fees, etc. Failure of a bank can lead to loss of means of payment and a contagious rush of deposit withdrawals, potentially collapsing the payment system.
Interbank Market and Confidence
Contagion leads to the spread of problems in the banking system, as one bank's failure undermines confidence, causing depositors to rush to draw cash from even sound banks. Panic demands for cash can be met through overnight loans in the interbank market.
Self-regulation
Regulations and enforcement are in the hands of market practitioners working for a self-regulatory organization (SRO) responsible for a particular area of financial activity. Advantages include flexibility and insider knowledge, but disadvantages include agency capture and regulatory sympathy towards the regulated.
Statutory Regulation
Requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing, but it lacks flexibility and problems may not be identified until they become serious.
Statutory regulation
Requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing. Disadvantages include lack of flexibility and problems not identified until they become serious.
Types of regulation
The relevant types of regulation in financial markets and their participants include: a) Disclosure requirements b) Regulation of exchanges c) Licensing requirements d) Restrictions on activity
Disclosure requirements
Companies wishing to have their shares publicly traded in organized exchanges are required to disclose a wide variety of information about their financial position. Directors are required to make public their own buying or selling of the firm's shares.
Regulation of exchanges
Participants are required to get the best price when trading on behalf of clients. Insider trading is usually illegal.
Licensing requirements
Most types of financial activity require participants to be licensed, primarily to exclude undesirable individuals from managing other people's money and to increase confidence in the system. Licensing also provides a sanction; persistent offenders can lose their license.
Restrictions on activity
The range of activities undertaken by firms may be restricted to prevent conflicts of interest.
Other forms of regulation for banking
These include capital adequacy, deposit protection, liquidity requirements, and exposure to risk limits.
Costs of regulation
In deciding how strict regulation should be and what form it should take, there are four issues to consider: 1) Moral hazard 2) Agency
Reckless Behavior
When individuals feel protected, they may behave more recklessly, leading to less prudent monitoring and decision-making.
Agency Capture
When a regulatory body becomes too aligned with the views of the regulated firms, often due to recruiting individuals from those firms and maintaining close connections with them.
Compliance Costs
The costs associated with adhering to regulations, such as providing additional information about products, setting up compliance departments, and meeting regulatory requirements.
Effect of Regulation on Costs
Regulation adds costs to firms, similar to imposing a tax, leading to a shift in the supply curve (SL to SL0) and a decrease in activity volume (from 0L to 0M) while increasing prices (from P to P0).
Inefficiencies of Regulation
Regulation reduces the efficiency of banks, making them less profitable, impeding economic growth, and creating barriers for new entrants into the banking industry.
Forms of Regulation
Regulation can involve structurally regulating banks' activities, as seen in the Glass-Steagall Act of 1933 which separated commercial banks from securities trading in the United States.
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Basel 3
Basel III is a set of international banking regulations developed by the Basel Committee on Banking Supervision to strengthen the regulation, supervision, and risk management of the banking sector.
Basel 3 Potential Drawbacks
Potential drawbacks of Basel III include a decline in annual growth due to banks passing on the cost of extra capital to borrowers and reduction in borrowing.
Basel 3 Regulation
Basel III includes more explicit regulation of the derivatives market, off-balance sheet items, and increased capital requirements for trading and derivatives.
Counterparty Credit Risks
Basel III addresses exposure to central counterparty risks and aims to increase capital requirements for trading and derivatives.
Dodd Frank Act
The Dodd-Frank Act, introduced by the US Congress in 2010, aims to protect consumers in the finance sector and watch for potential threats to the entire financial system through the creation of the Consumer Financial Protection Bureau and the Financial Stability Oversight Council.
Volcker Rule
The Volcker Rule prohibits insured depository institutions and their affiliates from engaging in proprietary trading, acquiring or retaining equity interests in hedge funds or private equity funds, and sponsoring hedge funds or private equity funds.
Effectiveness of Volcker Rule
The Volcker Rule was not as effective as hoped and was believed to have done more harm to the economy than good. It was difficult to enforce, reduced liquidity in some markets, and led to various amendments in 2019.
MiFID II
Markets in Financial Instruments Directive (MiFID II) is a regulation across the EU aimed at establishing a single market in investment services and activities. It provides passporting rights and aims to enhance investor protection and market transparency.
Mifid
Markets in Financial Instruments Directive Mifid was originally set up in 2007 and aimed at establishing a single market in investment services and activities.
Passporting Rights
The ability of an investment firm authorised in one EEA country to provide investment services or perform investment activities in another EEA country without requiring additional authorisation.
Mifid II
Introduced in early 2018, it aims to strengthen regulation to prevent a further financial crisis in the EU, increase transparency in the investments sector, regulate over-the-counter (OTC) trading, impose regulations on algorithm trading and high frequency trading, require detailed trade reports, and include more financial instruments in the regulatory framework.
Future Regulation
The aim is to have all countries regulated equally, possibly implemented by a body such as the IMF. It aims to control the use of derivatives and securitization, limit the use of off-balance sheet items, and ensure capital buffers are more related to the risk of the loans.
Summary of Financial Regulation
Financial activity is complex and risky, requiring protection and oversight. Regulation can rely on statutory power or self-regulation, and takes various forms such as licensing, information disclosure, and restriction of activity. The UK has transitioned from self-regulation to a more statutorily based approach in recent years.
Financial Regulation
It carries costs that are ultimately passed on to the users of the system.
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Asymmetric information
Managers of financial firms, sellers of market-based financial products, financial advisers, etc. generally have more information about the products they are offering or recommending than the buyers.
Principal-agent problem
Investors employ the management and staff of a financial institution to act as their agents in dealing with that institution or with markets. How can the principals ensure that agents do their best?
Incentives for managers
Managers may have numerous incentives to ensure that their firm prospers, such as performance-related bonuses. Investors need assurance that their stockbroker has made the best trades and that their financial adviser is recommending the best products for them.
Moral hazard
A case of regulating against the effects of regulating. Interventions like deposit insurance may encourage institutions and investors to behave more recklessly, defeating the original purpose.
Externalities
External costs or benefits for people other than the transactors. The failure of financial firms is generally more serious than the failure of non-financial firms due to external benefits from financial activity, particularly in the case of banks operating the payments system.
Contagion
The spread of a problem across financial institutions and markets due to undermined confidence, leading to events like bank runs and the rush for cash in the interbank market.
What happens when there is a rush for cash from depositors?
Confidence in the system generally and depositors rush to draw cash from banks, which are perfectly sound. The interbank market spreads the rush for cash.
What source does a bank facing panic demands for cash turn to?
One source will be overnight loans in the interbank market. When a bank withdraws or refuses to renew an interbank loan, there is the danger that the borrowing bank is then short of cash and cannot meet demands from its own customers.
What is self-regulation?
In a self-regulatory system, regulations and their enforcement are in the hands of market practitioners usually working for a self-regulatory organization (SRO) responsible for a particular area of financial activity. Advantages include flexibility and insiders' knowledge, while disadvantages are mainly linked to agency capture.
What is statutory regulation?
Statutory regulation requires legislation and a publicly appointed and paid body to monitor compliance and bring prosecutions where necessary. Advantages include a strong and unbiased approach to wrongdoing, while disadvantages include lack of flexibility and problems not being identified until they become serious.
What are the types of regulation relevant to financial markets and their participants?
The types of regulation relevant to financial markets and their participants include: a) Disclosure requirements, b) Regulation of exchanges, and c) Licensing requirements.
What are the disclosure requirements for companies wishing to have their shares publicly traded in organized exchanges?
If companies wish to have their shares publicly traded in organized exchanges, they are required to disclose a wide variety of information about their financial position. Directors are required to make public their own buying or selling of the firm's shares.
What are the requirements for participants trading on behalf of clients on exchanges?
Participants are required to get the best price when trading on behalf of clients. Insider trading is usually illegal.
What is the purpose of licensing requirements for financial activity?
Licensing requirements for most types of financial activity are intended primarily to exclude undesirable individuals from managing other people's money and to increase confidence in the system.
Insider trading is usually illegal.
Insider trading is the illegal practice of trading stocks based on non-public, material information about a company.
Licensing requirements
Most types of financial activity require participants to be licensed. This is intended to exclude undesirable individuals from managing other people's money and to increase confidence in the system. Licensing also provides a sanction (persistent offenders can lose their license).
Restrictions on activity
The range of activities undertaken by firms may be restricted to prevent conflicts of interest. For example, in early 2002, the US investment banking world was shocked by the discovery that analysts working for the equities division of Merrill Lynch were publishing favorable reports on companies which were clients of Merrills investment banking arm even though they knew the companies shares were a poor investment.
Costs of regulation
The case for regulating financial activity involves getting the best protection for the least possible cost. In deciding how strict regulation should be and what form it should take, there are four issues to consider: Moral hazard, Agency capture, Compliance costs, and Costs to firms.
Regulation and Compliance
Firms may incur additional costs to set up internal controls and compliance departments to meet regulations. This is similar to adding a tax on the product, which results in a shift of supply from SL to SL0, leading to a decrease in activity volume (from 0L to 0M) and an increase in price (from P to P). Regulation can also reduce bank efficiency, limit new entrants, and have macroeconomic costs.
Inefficiencies of Regulation
Regulation can reduce bank efficiency, making well-regulated banks less profitable and susceptible to takeover by less regulated banks. It can also hinder economic growth and create barriers to new entrants in the banking industry.
Forms of Regulation
There are three main forms of banking regulation: regulating the structure and activities of banks, implementing liquidity regulations, and enforcing capital adequacy regulations.
Liquidity Requirement
To enable regulators to monitor the liquidity of the banking system, banks are required to make frequent, even daily, statistical returns.
Capital Adequacy Regulation
The regulation of capital adequacy ensures that a bank has sufficient capital committed by shareholders and long-term bondholders to absorb negative shocks to assets without threatening the wealth of depositors.
Basel Committee
The Basel Committee is a committee of bank regulators from G10 countries, Switzerland, and Luxembourg, which meets in Basel and uses a secretariat provided by the Bank for International Settlements.
Basel Accord (Basel 1)
In 1988, the Basel Committee established a set of guidelines for implementation from 1993 known as the Basel Accord or Basel 1. It focused on a risk assets ratio (RaR) calculated using tier 1 capital.
