Chapter 3: Regulation Flashcards
(25 cards)
List the principle aims of regulation
GRIP
Give confidence in the system
Reduce financial crime
Inefficiencies in the market corrected
Protect consumers
Direct costs of regulation
- Administering the regulation (e.g. costs for collection / examination of information from market participants & monitoring their activities)
- The cost incurred by regulated firms to comply with regulation (compliance of the regulated firms)
Indirect costs of regulation
PUMA
- Product innovation reduced
- Undermining of intermediaries and advisors professionalism (sense of professional responsibility)
- Market reduces its own consumer protection mechanisms
- Alteration of consumer behaviour, false sense of security and a reduced sense of responsibility
Why is the need to regulation of the financial markets typically greater than for most other markets?
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 of the system.
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.
List the main functions of the regulator
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
Prescriptive regulation
Detailed rules on what can and can’t be done
Information asymmetry
The situation where at least one party to a transaction has relevant information which the other party or parties do not have
Anti-selection
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.
Moral hazard
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 less carefully, 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.)
What are the implications of information asymmetries?
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.
What actions can the regulator take to reduce asymmetries of information?
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
What are the 6 key outcomes that should be achieved as a result of TCF?
- Consumers can be confident that they are dealing with firms where the fair treatment of customers is central to the corporate culture.
- Products and services marketed and sold in the retail market are designed to meet the needs of identified consumer groups and are targeted accordingly.
- Consumers are provided with clear information and are kept appropriately informed before, during and after the point of sale
- Where consumers receive advice, the advice is suitable and takes account of their circumstances
- Consumers are provided with products that perform as firms have led them to expect, and the associated service is of an acceptable standard and as they have been led to expect.
- Consumers do not face unreasonable post-sale barriers imposed by firms to change product, switch provider, submit a claim or make a complaint.
What are the main influences on policyholder expectations?
- 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.
What actions can the regulator take to help ensure confidence in the financial system?
- 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 fulfill certain criteria regarding financial stability and disclosure of information
Define Prescriptive regulation
Prescriptive regulation has detailed rules setting out what may or may not be done.
In general, a prescriptive regime is likely to control tightly the activities of the parties affected, thereby reducing the likelihood that things go wrong. However, it often has greater cost.
Describe freedom of action regulation
Regulation can involve freedom of action but with rules on publicity so that third parties are fully informed about the providers of financial services.
In other words, the firm can do pretty much what it wants provided that it publishes sufficient information for the regulator to check that it is being properly managed.
Outcome-based regulation
This regime follows freedom of action, but prescribes the outcomes that will be tolerated.
Outline the 5 main types of regulatory regime
- Self-regulatory systems, which are organised and operated by the market participants without government intervention
- Statutory regimes, 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.
Discuss the main advantages and disadvantages of a voluntary code compared to statutory regulation
The main advantages are likely to be the reduced cost of regulation and the fact that the rules are set by those with the greatest knowledge of the industry.
The main disadvantage is likely to be the greater incentive to breach the voluntary code, which will have no legal backing and in all likelihood less severe penalties, if any, than with statutory regulation.
Even though these regulatory regimes operate effectively in many circumstances, they are vulnerable to a lack of public confidence or to a few “rogue” operators refusing to co-operate, leading to a breakdown of the system.
Advantages of self-regulation
- The system is implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost-benefit ratio.
- Self-regulation should, in theory, be able to respond rapidly to changes in market needs
- It may be easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.
Disadvantages of self-regulation
- The main problem with self-regulation is the closeness of the regulator to the industry it is regulating. There is a danger that the regulator accepts the industry’s point of view and is less in tune with the views of third parties.
- This can lead to a weaker regime than is acceptable to consumers and other members of the public.
- Even if the regulatory regime is operating efficiently and effectively, it can suffer from low public confidence in the system.
- Self-regulatory organisations may also inhibit new entrants to a market.
What are the advantages of statutory regulation?
- It should be less open to abuse than the alternatives and may command greater public confidence.
- The regulatory body may be able to run efficiently if, for example, economies of scale can be achieved through grouping its activities by function rather than type of business.
What are the disadvantages of statutory regulation?
- It can be more costly and inflexible than self-regulation.
- Outsiders may impose rules that are unnecessarily costly and may not achieve the desired aim.
- It is claimed that attempts by government to improve market efficiency usually fail and that financial services regulation is an economic good that is best developed by the market.
List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers
- Central banks are often responsible for the supervision of banks in their jurisdiction.
The function of the central bank in various territories can also be any of the following in order to meet government targets:
* control the money supply
* determine or influence interest rates
* determine or influence inflation rates
* determine or influence exchange rates
* target macroeconomic features such as growth and unemployment
* ensure stability of the financial system
* be the lender of last resort to commercial banks.
