Chapter 3 Regulation

Question 1

Why do financial services need stricter regulation? (3)

Answer 1

• Lack of info mainly causes financial failure.
• Especially info concerning risk and the product being taken on.
• Financial services need stricter regulation due to the complexity of their products and the long-term nature and large financial impact their products might have

Question 2

Aims of financial regulation

GRIPL

Answer 2

• Correct perceived market inefficiencies and promote an efficient and orderly market
• Protect consumers of financial products
• Give confidence in the financial system
• Reduce financial crime
• Limit the likelihood and intensity of potential failures in the financial system and the need to step in as a lender of last resort

Acronym:
G = Give confidence
R = Reduce financial crime
I = Inefficiencies in market corrected
P = Protect consumer
L = Lender of last resort

Question 3

What is a lender of last resort?

Answer 3

Government is usually the lender of last resort because financial collapse influences the economy badly

They usually lend money through the central bank

Question 4

Types of cost of regulation (2)

Answer 4

1. Direct cost

2. Indirect cost

Question 5

Examples of direct regulatory cost (2)

Answer 5

• Administering regulation (cost to regulator)
• Collect and examine the information from the market
• Monitor market participants
• Compliance of regulated firms (cost to firms complying with the regulation)
• Maintain appropriate records
• collating information and supplying it to the regulator

Question 6

Examples of indirect regulatory cost (5)

Answer 6

• Consumers are less cautious
• Undermining the sense of responsibility among intermediaries and advisers
• Reduction in consumer protection mechanisms developed by the market
• Reduce product innovation
• Reduce competition

Question 7

What are the main issues regulators are concerned with (2)

Answer 7

To provide confidence in the market and reduce information asymmetry

Question 8

Why is confidence in regulation an issue (6)

Answer 8

• Problems in one area can spread to another and lead to systemic financial collapse
• Happens when one institution’s financial position is closely linked to another
• For example the collapse of one bank can lead to a run on withdrawals
• Banks usually only keep a certain portion of funds to meet day to day withdrawals
• This will lead to banks calling on loans and overdrafts to fund the run on withdrawals
• Leading to ultimate financial collapse

Question 9

Why is information asymmetry in regulation an issue

Answer 9

The better informed (usually the financial service provider) is better informed and can take their additional knowledge as an advantage to the detriment of the participant

Question 10

Functions of regulation

SERVICE

Answer 10

Acronym
S = Setting sanctions
E = Enforcing regulation
R = Reviewing and enforcing government policy
V = Vetting and registering  individuals
I = Investigte breaches
C = Check management and conduct of providers
E = Educate consumers and the public

Question 11

How is regulation segregated (5)

Answer 11

• Deposit-taking institutions
• Financial institutions
• Security Market
• Professional advisors
• Non-financial companies offering securities to the public - e.g. Ensuring sufficient info is provided in prospectus and consumers are well informed.

Question 12

What is anti-selection

Answer 12

People will take out more risk if they believe they pose more risk than what is allowed in the premium, e.g.taking out life insurance without underwriting

Question 13

What is a moral hazard

Answer 13

When people behave differently than normal due to them not being fully exposed to consequences of the risk, e.g. not parking a car inside a garage

Question 14

How does the regulator protect consumers from information asymmetry? (7)

Answer 14

• Disclosure of information pertaining to the product in simple language
• Educating consumers
• Reducing possible conflicts of interest (e.g. chinese walls)
• Negotiation weakness of consumer by allowing cooling-off periods at no penalty
• Regulate sales practice, e.g., including cooling off periods
• Price controls
• Treating customers fairly

Question 15

How do regulators maintain confidence in the financial markets? (4)

Answer 15

• Capital adequacy - Hold a certain amount of capital for unforeseen liabilities and meet short term liabilities if there is a shortage in capital.
• Ensuring competency and integrity - Know what to do (through qualification) and actually do the right thing
• Compensation schemes - Schemes funded by industry/government to provide assistance. This has a moral hazard attach (can only provide % or max)
• Stock exchange requirements - Meet strict criteria (stricter than IFRS) and also ensure monopolies doesn’t occur.

Question 16

Forms of regulation (3)

Answer 16

• Prescriptive = Rules on what is and is not allowed. Usually with high direct and indirect costs.
• Freedom of Action = Freedom but rules on publicity
• Outcome-based = Freedom of action but prescribed tolerated outcome

Question 17

Types of regulation

Answer 17

• Self-regulatory = which are organised and operated by market participants without government intervention
• Statutory = where the rules are set and policed by the government
• Voluntary codes of conduct = where there is a choice as to whether to adhere

Unregulated markets/lines of business = with no regulation

Mixed regimes, involving a combination of the above

Question 18

Advantages (3) and Disadvantages (2) of a self-regulatory regime

Answer 18

+ Implemented by the people with the greatest knowledge of the market, who have the greatest incentive to optimise the cost-benefit ratio

+ Should respond quickly to changes in market needs

+ Should be easier to persuade firms and individuals to co-operate than under statutory regulation

– The closeness of the regulator to the industry, leading to low public confidence

– May inhibit new entrants to a market

Question 19

Advantages (4) and disadvantages (3) of statutory regulation

Answer 19

+ Less open to abuse

+ Instils more public confidence due to government involvement

+ Should be more efficient if economies of scale can be achieved, eg grouping by function

+ Independent from industry

– Costs and inflexibility

– Outsiders may impose rules that are unnecessarily costly, inefficient and which may not achieve the desired aim

– Government may be inexperienced in regulation (eg if regulation is being established for the first time or in new areas)

Question 20

South African FSRA (Fin Service Reg Act) (2)

Answer 20

Comprises of the prudential authority (driven by SARB)

and the Financial Service Conduct Authority (ensuring consumers are informed and treated fairly)

Question 21

Role central bank in regulation

Answer 21

In SA through PA to ensure financial soundness

Question 22

Role of SARB (7)

Answer 22

• Control money supply
• Determine and influence interest. inflation and exchange rates
• Target macroeconomic features (especially unemployment and growth)
• Ensure stability in the financial sector
• Lender of last resort to banks

Question 23

How state intervention enforces regulation

Answer 23

• Can only be sold through state owed monopoly

* Adding costs and tariffs to certain classes of business

Question 24

How is policyholder reasonable expectations built up

Answer 24

• Past practice
• Product literature + what was communicated
• What competitors ar doing

Question 25

How to deal with conflict on interest

Answer 25

• Decline
• Disclose
• Setting up chinese walls
• Keep detailed record of workings being done

Question 26

7 actions regulators can put in place to mitigate damages caused by climate risk

Answer 26

1. Require to consider climate risk as part of business decision-making and strategic planning
2. Disclose information on climate related risks and opportunities
3. Have consistent and reliable methods for assessing, pricing, and managing climate risk
4. Include ESG (environmental, social, and governance) factors in decision management
5. Include financial risks arising from climate risk in all risk management processes
6. Use scenario analysis to help identify climate risk and their financial impact
7. Consider climate risk influence on the ability to meet obligations

Question 27

List areas of an insurance company a regulator might regulate

Answer 27

1. Range of products authorised to sell – eg only life or only general
2. Product features – eg ensure ethical / in the public interest
3. Product pricing – eg so that the premium is neither inadequate for the risk nor excessive
4. Sales literature – eg so that not misleading
5. Sales process – eg advice given, disclosures, commission levels, cooling-off periods
6. Policy documents – eg fair terms and conditions
7. Underwriting process – eg gender neutral pricing, restriction on the use of genetics
8. Claims underwriting process – eg ensure applied fairly
9. Customer service standards – eg how complaints are dealt with
10. Treating customers fairly – eg in relation to bonuses and reviewable charges / premiums
11. Investments held – eg avoid excessive concentration
12. Use of reinsurance – eg require a certain level of transfer of risk
13. Provisions and capital requirements – eg ensure adequate relative to the risks
14. Capital held – eg quality, type
15. Models – eg ensure capital calculations meet a minimum standard
16. Data – eg confidentiality, security
17. Systems and processes – eg manage conflicts of interest through using Chinese walls
18. Senior management – eg assess conduct and competence.