Ch 3: Regulation

Question 1

List the principle aims of financial services regulation

Answer 1

GRIP

Give confidence in the system
Reduce financial crime
Inefficiencies in the market corrected
Protect consumers

Question 2

Direct costs of regulation

Answer 2

• Administering the regulation
  (e.g. costs for collection/examination of info from market participants & monitoring their activities)
• The costs incurred by regulated firms to comply with regulation
  (e.g.maintaining appropriate records, collating the required info and supplying it to the regulator and/or the investor

Question 3

Indirect costs of regulation

Answer 3

PUMA

• Product innovation reduced and competition reduced
• Undermining of sense of professional responsibility amongs intermediaries and advisors
• Market reduces its own consumer protection mechanisms
• Alteration of consumer behavior, due to false sense of security and a reduced sense of responsibility

Question 4

Why is the need for regulation of the financial markets typically greater than for most other markets?

Answer 4

Firstly, the importance of confidence in the financial system. There is the risk that if one company collapses, it can cause a systemic financial collapse.

Secondly, the asymmetry of information, expertise and negotiating strength that exists between the product provider and end customer.

These issues are exacerbated by the fact that:

1. financial transactions are often long term in nature and can have a significant impact on the future economic welfare of individuals
2. in general, most of the population is not well educated on financial matters and find the range of products offered both complex and confusing

Question 5

List the main functions of the regulator

Answer 5

SERVICE

Setting sanctions
Enforcing regulations
Reviewing and influencing government policy
Vetting and registering firms and individuals
Investigating breaches
Checking management and conduct of providers
Educating consumers and the public

Question 6

What actions can the regulator take to help ensure confidence in the financial system

Answer 6

1. Regularly monitoring that institutions hold sufficient capital to meet their liabilities
2. Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper”
3. Establishing industry compensation schemes
4. Ensuring that the market is transparent, orderly, and provides proper protection to investors
5. Ensuring that listed companies fulfill certain criteria regarding financial stability and disclosure of information

Question 7

Information asymmetry

Answer 7

The situation where at least one party to a transaction has relevant information which the other party or parties do not have.

Question 8

Anti-selection

Answer 8

People will be more likely to take out contracts when they believe their risk is higher than the insurance company has allowed for in its premiums.

Can also arise where existing policyholders have the opportunity of exercising a guarantee or an option. Those who have the most to gain from the guarantee or option will be the most likely to exercise it.

Question 9

Moral hazard

Answer 9

The action of a party who behaves differently from the way they would behave if they were fully exposed to the consequences of that action.

The party behaves inappropriately or less carefully than they would otherwise, leaving the organisation to bear some of the consequences of the action.

Moral hazard is related to information asymmetry, with the party causing the action generally having more information than the organisation that bears the consequences.

This is not the same as anti-selection, which is also taking advantage of particular aspects of an insurance contract, but within the terms offered by the insurer.

Question 10

What are implications of information asymmetries?

Answer 10

Information asymmetries lead to both anti selection and fraud.

An example of anti-selection is where options on contracts are taken up by those with the most to gain.

An example of fraud is where a policyholder does not answer questions on a proposal form fully and truthfully.

The consequences of both anti-selection and fraud are:

1. worse than expected claims experience
2. inequality between policyholders, and between the policyholder and the insurer

Question 11

What actions can the regulator take to reduce asymmetries of information?

Answer 11

SPIDER CC

Selling practices regulated
Price controls imposed
Insider trading prevented
Disclosure of understandable information
Educating consumers
Restricting knowledge to publicly available

Consumer cooling off period
Chinese walls established

Also,
Fairness

Question 12

Describe two ways in which regulation can try to ensure that customers are treated fairly

Answer 12

1. Providers may be directly required by the regulator to demonstrate that they treat customers fairly
2. Actuaries in statutory roles may be required to whistle blow if they believe that a provider is prejudicing the interests of the customer

Question 13

Main influences on policyholders’ reasonable expectations (PRE):

Answer 13

• statements made by the provider, especially those made to the client in marketing literature and other communications
• the past practice of the provider
• the general practices of other providers in the market.

Question 14

Outline the five main types of regulatory regime

Answer 14

(in increasing order of degree of regulation involved)
1. Unregulated markets / lines of business, with no regulation
2. Voluntary codes of conduct, where there is a choice as to whether to adhere
3. Self-regulatory systems, which are organised and operated by the market participants without government intervention
4. Statutory regimes, where the rules are set and policed by the government.
5. Mixed regimes, involving a combination of the above

Question 15

Outline the 3 forms that regimes can adopt

Answer 15

• Prescriptive - detailed rules setting out what may or may not be done
• Freedom of action regulation- Freedom but with rules on publicity
• Outcome-based regulation - Freedom but with prescribed, tolerated outcomes

Question 16

List 2 problems associated with voluntary codes of conduct

Answer 16

1. There may be low public confidence in the approach
2. There may be a few rogue traders who refuse to cooperate

Question 17

What are the advantages and disadvantages of self-regulation

Answer 17

Advantages:
* The system implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost-benefit ratio and incentive to be SEEN to be providing within sound managed environment in which consumers can have confidence.
* Should be able to respond rapidly to changes in market needs.
* May be easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.

Disadvantages:
* May inhibit new entrants to a market (existing participants frame rules that are a barrier to entry)
* The closeness of the regulator to the industry it is regulating, may lead to lack of confidence in the regulator. (danger that the regulator accepts the industry’s POV and is less in tune with views of 3rd parties (mainly consumers)).
* Can lead to a weaker regime than is acceptable to consumers & public

Question 18

What are the advantages and disadvantages of statutory regulation?

Answer 18

Advantages:

1. Less open to abuse
2. Instills more public confidence due to government involvement
3. Should be more efficient if economies of scale can be achieved

Disadvantages:

1. Costs and inflexibility (vs say self-reg)
2. Outsiders may impose rules that are unnecessarily costly, inefficient and which may not achieve the desired aim
3. Government may be inexperienced in regulation

Question 19

List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers

Answer 19

To meet government targets, the central bank can:

1. Control the money supply
2. Determine or influence interest rates
3. Determine or influence inflation rates
4. Determine or influence exchange rates
5. Ensure stability of the financial system
6. Lender of last resort to commercial banks
7. Target macro-economic features such as growth and unemployement

Question 20

The aims of climate change related financial regulations

Answer 20

For financial institutions to…
* * consider climate risks in business decision making and strategic planning
* effectively disclose and report on climate-related risks and opportunities
* adopt a consistent and reliable means of assessing, pricing, and managing climate-related risks
* incorporate environmental, social and governance (ESG) factors into investment management decisions
* incorporate financial risks from climate change into existing risk management processes
* use scenario analysis to inform risk identification and to estimate the impact of financial risks arising from climate change
* consider the impact of climate risks on the ability to meet obligations to policyholders and other key stakeholders