Chapter 3 Flashcards
Regulation (25 cards)
Describe the Principal aims of regulation: (4)
(GRIP)
Give confidence in the financial system.
▪ Checking ongoing solvency (capital adequacy) of authorised providers.
▪ Enforcing strict accounting information requirements.
▪ Ensuring the competence and integrity of financial practitioners.
o Reduce financial crime.
▪ Vetting (investigating and approving) the firms authorised to conduct
certain activities.
▪ Vetting the individual authorised to conduct certain activities.
▪ Enforcing regulations.
▪ Investigating suspected breaches of regulation.
▪ Imposing sanctions if regulations have not been met.
o Inefficiencies in the market corrected.
▪ Ensuring sufficient liquidity in the marketplace, e.g., by having market
makers.
▪ The provision of settlement systems (to ensure that trades are carried in
an efficient
▪ Imposing stock exchange requirements on listed companies.
o Protect consumers.
▪ Disclosure of information and product literature (to ensure that
customers understand what they are buying)
▪ Cooling off-periods.
▪ The initial authorisation of the main players in a particular market.
▪ Schemes to compensate investors for breaches of the regulations.
▪ Legislation preventing the use of unfair contract terms.
▪ Legislation on treating customers fairly.
identify the costs that are incurred due to regulation:
Regulation has a cost since regulators must attempt to develop a system that
can achieve the aims specified above at minimum cost and hope that the
benefits, which are difficult to measure, outweigh the costs.
o The optimal level of regulation should be such that the marginal benefits = marginal costs.
o Direct costs:
▪ Administering the regulation.
-Costs for collection/examination of information from mkt. participants.
-Cost of monitoring their activities.
▪ The cost incurred by regulated firms to comply with regulation
(compliance of the regulated firms)
o Indirect costs: (PUMA C)
▪ Product innovation reduced.
▪ Undermining of the sense of professional responsibility among
intermediaries and advisors.
▪ Market reduces its own consumer protection mechanisms.
▪ An alteration in the behaviour of consumers, who may be given a false sense of security and a reduced sense of responsibility for their own actions.
▪ Competition reduced.
Identify The need for regulation: (2)
o The need for regulation of the financial markets is typically greater than for
most other markets for two reasons:
▪ Confidence:
* Confidence in the financial markets is very important because
there is the risk that if one institution collapses, it can cause a
systemic financial collapse of the system.
▪ Asymmetric information:
* This refers to the asymmetry of information between the
product provider and the end customer.
* Expertise and negotiating strengths that exists between the
provider and end customer.
o These issues are exacerbated by the fact that:
▪ Financial transactions are often long term in nature and can have a
significant impact of the future economic welfare of individuals.
▪ In general, most of the population is not well educated on financial
matters and fine the range of products offered both complex and
confusing.
Identify the functions of a regulator (7)
SERVICE:
o Setting sanctions.
o Enforcing regulations.
o Reviewing and influencing government policy.
o Vetting and registering firms and individuals.
o Investigating breaches.
o Checking management and conduct of providers.
o Educating consumers and the public.
The regulator can help ensure confidence in the financial system by: (5)
▪ Regularly monitoring that institutions hold sufficient capital to meet their liabilities.
▪ Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper”.
▪ Establishing industry compensation schemes.
▪ Ensuring that the market is transparent, orderly, and provides proper protection to investors.
▪ Ensuring that listed companies fulfil certain criteria regarding financial stability and disclosure of information.
How does a regulator maintain confidence in the financial sector?
- Capital adequacy
-reduce systemic risk and protects the customer
-financial service providers are required to demonstrate that there are sufficient assets that cover the liabilities and sufficient margins for adverse experience (capital requirement) - Competence and integrity
-Competence means they know the appropriate course of action to take
on behalf of the investor and integrity means that they choose to take it.
-competence can be proved by obtaining qualifications e.g. actuarial
-regulators may prevent an individual from working in a particular industry if they do not see them as fit - Compensation schemes (refunding investors who suffered losses)
-funded either by the industry or by the government
-losses due to fraud, bad advice, failure of financial service provider rather than market related losses
-to reduce moral hazard, compensation amount = maximum percentage of the loss or a maximum absolute amount - this ensures that the investor has incentive to consider the integrity of the financial service provider - Investor protection
-ensure market is transparent and orderly
-Transparency - reduces information asymmetries
-Orderly - market does not overreact - Stock exchange requirements
-companies listed on the stock exchange must fulfill a certain criteria
-aim is to help investors to make more informed decisions
-monitoring of prices and reports
-regulation governing the issue of new shares and takeover bids for companies
Criteria that makes a person unfit for a particular industry or role: (4)
-association with a financial institution that breached regulations
-convictions for fraud
-has been bankrupt in the past
-no previous experience, expertise or qualification
The following principles might be required to be observed in a
takeover situation: (4)
- Protection of the interests of existing shareholders and
managers, as wider as the wider public interest. - The takeover does not lead to a market-denominating companies restricting competition.
- Prevention of bidder from retracting an offer, other than in exceptional circumstances.
- Disclosure of specified information, e.g., all shareholdings above a certain level.
What are the three forms of regulation: (3)
o Prescriptive:
▪ detailed rules setting out what may or may not be done.
▪ It is likely to control tightly the activities of the parties affected, thereby reducing the likelihood that things go wrong.
▪ It often has greater costs, both direct and indirect, than other forms of regulation.
o Freedom of action:
▪ Involves freedom of action but with rules on publicity so that third
parties are fully informed about the providers of financial services.
o Outcome-based:
▪ This form allow freedom of action but prescribe the outcomes that will
be tolerated.
What are the 5 types of regulatory regimes?
- Unregulated markets and unregulated lines of business
-markets with little or no government oversight
-cost of regulation outweighs the benefit in a market where all parties are sufficiently well informed e.g. Markets where professionals operate, commodity products with guaranteed benefits are sold on price - Voluntary codes of conduct
-self-regulated ethical guidelines adopted by industry groups or firms without legal enforcement - Self-regulation
-Organisations establishing their own standards and codes of conduct - Statutory regulation
-legally binding regulations enforced by government authorities - Mixed regimes e.g. Professional bodies (IFoA, ASSA)
-self regulation is encouraged but statutory ensures compliance
What are the advantages (2) and disadvantages (3) of voluntary codes of conduct?
▪ Advantages:
* Reduced cost of regulation.
* The rules are set by those with greatest knowledge of the
industry.
▪ Disadvantages:
* Greater incentive to breach the voluntary code.
* No legal consequences and in all likelihood less severe penalties.
* Vulnerable to a lack of public confidence.
In a self regulated regulatory regimes, what could stock exchanges regulate? (3)
- Companies listed on it
-must fulfill a certain criteria - transactions that take place within the exchange
-record the time, place and volume to discourage insider trading - traders/brokers dealing on the exchange
-to prevent misconduct and ensure capital adequacy
What are the advantages (4) and disadvantages (4) of self-regulation?
▪ Advantages of self-regulation:
* 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.
* 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.
* There’s usually some government legislation in which the regulation is based upon which is an advantage.
▪ Disadvantages of self-regulation:
* The closeness of the regulator to the industry it is regulating.
* The danger that the regulator accepts the industry’s point of view and is less in tune with 3rd parties.
* Can lead to a weaker regime than is acceptable to consumers and other members of the public.
* May inhibit new entrants to a market since existing participants
frame rules.
What are the advantages (3) and disadvantages (5) of Statutory regulation?
▪ Advantages of statutory-regulation:
* It is less open to abuse than the other regulatory regimes.
* May command greater public confidence.
* The regulatory body may be able to run efficiently.
o Economies of scale can be achieved through grouping
its activities by function rather than type of business.
o An example of a split by function could be to have separate regulators responsible for monitoring market conduct and regulatory solvency.
▪ Disadvantages of statutory-regulation:
* It can be more costly than self-regulation.
* It can be less flexible than self-regulation.
* It is argued that market participants themselves are in the best position to develop and run the regulatory system.
o That outsiders may impose rules that are unnecessarily costly and may not achieve the desired aim.
o I.e., the optimal level of regulation might not be achieved.
* Reduces innovation.
* Government may be inexperienced in regulating a new product or emerging market.
Discuss the role that major financial institutions can play in supporting the regulatory and business environment. (3)
- Central Bank
-supervision of banks - State intervention
-some financial products may only be sold by state monopoly companies
-impose maximum tariff premium rates
-restrict a free market and limits the number of participants in the market (need to meet state requirements)
-reduces innovation and new developments - Large market participants
-help smaller participants find niche markets and to stabilise premium rates
-may distort the market (competitive legislation - regulations reduce the power of large market participants to ensure competition and avoid them colluding in order to set prices and make it difficult for other companies to enter the market)
-may take up all the available resources the regulator has (leaving limited resources for regulators to monitor smaller market participants)
-A Systemically Important Financial Institution (SIFI) is a financial institution whose failure might trigger a financial crisis. (regulators may create rules that apply to SIFI)
What are the possible functions of a bank? (7)
-Control the money supply
-determine/influence interest rates
-determine/influence inflation rates
-determine/influence exchange rates
-ensure stability of the financial system
-lender of last resort to commercial banks
-target macro-economic features such as growth and unemployment
Trading volumes may also be recorded, in order to: (2)
- Deter and/or identify the occurrence of insider trading, based upon non-public information. (spike in trade volumes before an announcement)
- Prevent substantial acquisitions of shares occurring quickly and privately, so as to protect the positions of other shareholders. (the buying of shares without other shareholders knowing)
What are the 2 situations that arise due to information asymmetries?
- Anti-selection
-the customer has more information about the actual risk than the insurer does e.g. smoker, guarantees/ options
Consequences of anti-selection
-worse than expected claims experience
-inequality between policyholders
2. Moral Hazard
-the insurer cannot observe how the client behaves
What is the area of information asymmetry that is of most concern to the regulator?
*The asymmetry of information between the product provider and the end customer:
-differences in expertise and negotiating strength
-is more significant since the financial services have significant impact on the future economic welfare of individuals
How can a regulator reduce information asymmetry? (8)
SPIDER CC:
o Selling practices regulated. (addresses the weakness of an individual negotiating with a large institution)
o Price controls imposed.
o Insider trading prevented.
o Disclosure of understandable information.
-mitigate by disclosing full information in an understandable form
o Educating consumers.
o Restricting knowledge to publicly available. (reduces insider trading)
o Consumer cooling off period.
-strengthens the customer’s position
o Chinese walls established.
Explain how certain features of financial contracts might be identified as unfair.
-financial provider has all the expertise to write up the contract to their favour
-The literature could be hard to understand language
-The contract terms may be allowed to change without any notice to the customer
-the size and payment of discontinuance benefits depends on the financial provider
How can regulators ensure that customers are treated fairly? (2)
-providers may be required to demonstrate
-actuaries may be required to whistleblow
What should be considered as principles of treating customers fairly (TCF)? (6)
F – Fairness must be part of the culture of the business.
A – Advice must be suitable and given by qualified individuals.
I – Information must be clearly disclosed to stakeholders.
R – Right product design to meet consumers’ needs.
S – Service and performance must aim to be the best possible.
C – Clear policies must guide fair treatment and process changes.
What influences policyholder expectations (PRE)? (3)
-The statements released by the provider
-the provider’s competitors in the market
-the past performance of the provider
