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 The principal aims of regulation are:

  to correct market inefficiencies and to promote efficient and orderly markets 

  to protect consumers of financial products 

  to maintain confidence in the financial system 

  to help reduce financial crime


The market for financial services may be inefficient in the sense that

consumers of financial services make inefficient, ie incorrect, choices. In practice, the main cause of this is likely to be a lack of information and expertise on behalf of consumers with regard to the often complex financial services traded. This is because an individual who doesn’t understand the different financial services between which they are choosing may well make the wrong choice. 
There may be separate regulations applying to different sectors within the market for financial services, in addition to separate regulatory bodies enforcing the different sets of regulations. A particular distinction might be made between the regulations applying in the wholesale market, ie to institutional investment, and the market for personal investment, the retail market.


How might these aims typically be met in practice?



the optimal level of regulation should be such that

the marginal benefits of regulation are equal to the marginal costs. The benefits of regulation arise from meeting the aims outlined above. The costs are of two main types – direct costs and indirect costs.


Direct costs arise

in administering the regulation.
The regulator will incur costs operating the regulatory framework, eg collecting and examining the information provided by market participants and otherwise monitoring their activities. Likewise the regulated firms will incur costs in complying with the regulation, eg in maintaining appropriate records, collating the requisite information and supplying it to the regulator and/or the investor.
In practice, most of these direct costs are borne ultimately by the investor in the form of either higher taxation to fund the regulator and/or higher charges and fees for the financial services that are purchased.


Indirect costs arise

from changes in behaviour, both of consumers and regulated firms, to react to the regulations.
Firms may take less care with their choice of financial service/financial service provider, as they feel that the protection afforded by regulation typically reduces the adverse consequences of not doing so.


Other indirect costs include:

  a sense of diminished professional responsibility in intermediaries and advisors 

  a reduction in consumer protection mechanisms developed by the market itself 

  reduced product innovation 

  reduced competition. 
A regulatory regime designed by existing market participants could even be set up in such a way as to act as a barrier to entry to deter new competition.


need for regulation of financial markets is seen to be greater than the need for regulation of most other markets primarily because of the

The importance of confidence in the financial system and the damage that would be done by a systemic financial collapse.
An example here could be the collapse of a clearing bank. This could lead to a loss of faith in the banking system as a whole and consequently a “run” on banks in which investors attempt to withdraw all of their money.
Similar problems could arise from the failure of an insurance company or pension scheme, leading to a loss of faith in the sector as a whole. More generally, a widespread attempt to withdraw funds from financial institutions that are solvent is likely to lead to problems, as the assets held to back liabilities may not be sufficiently liquid.


Why would a run on the banking system as outlined above cause particular difficulties?



Within each type of regime, the regulation itself can take a variety of forms.

Regulation can be prescriptive, with 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, but often with greater costs, both direct and indirect, than the other possible approaches.
Freedom of action
Alternatively, it 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 (or any other interested parties) to check that it is being properly managed. This is essentially the “freedom with publicity” approach adopted with regard to insurance companies in the UK. UK insurance companies have a great deal of freedom with regard to their financial management, provided that they publish sufficient information to demonstrate to both the regulator and any other interested parties that they are in a sound financial position.
Finally, the regime can allow freedom of action but prescribe the outcomes that will be tolerated.
In contrast with a prescriptive regime, which says what can, cannot and/or must be done, an outcome-based regime is concerned with the end result – eg has the investor made a well-informed decision appropriate to her individual circumstances?


Give three examples of possible prescriptive rules that might be enforced.



Unregulated markets 

It has been argued that the costs of regulation in some markets, especially those where only professionals operate, outweigh the benefits. Consequently, for wholesale markets, in which the parties involved are sufficiently well-informed, the best option may involve no specific regulations. Even here though, the participants will normally still be subject to the general trading and other laws applicable in the particular legal jurisdiction in which they operate.


.Voluntary codes of conduct 

These operate effectively in many circumstances but 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.


2.4 Self-regulation

A self-regulatory system is organised and operated by the participants in a particular market without government intervention. The incentive to do so is the fact that regulation is an economic good that consumers of financial services are willing to pay for and which will benefit all participants. An alternative incentive is the threat by government to impose statutory regulation if a satisfactory self- regulatory system isn’t implemented.


What are the main advantages of a voluntary code compared to statutory regulation? What is the main disadvantage?




2.5  Statutory regulation 
In statutory regulation the government sets out the rules and polices them.


Adv and Disadv of statutory reg

This has the advantage that it should be less open to abuse than the alternatives and may command a higher degree of public confidence. Although even here, there may be concerns that the regulatory body takes greater heed of the views of those it is regulating, than those of the general public. This may reflect the greater political influence of the former. 
Also, economies of scale can be achieved, eg with separate departments monitoring different aspects of financial services provision, such as capital adequacy, product sales and security trading, across all financial markets within the jurisdiction. 
Statutory regulation can be more costly and slower to respond to changing market circumstances. Some say that the market participants themselves are in the best position to devise and run the regulatory system. Outsiders may impose rules that are unnecessarily costly and may not achieve the desired aim. 


Mixed regimes

In practice many regulatory regimes are a mixture of all of the systems described above, with codes of practice, self-regulation, and statutory regulation all operating in parallel. Even a regime that is self-regulatory in name is likely to have statutory aspects. Regulations are often developed by market-driven private institutions (such as stock exchanges) as well as by governments. 
For example, in the UK, the Financial Reporting Council is an independent regulator responsible for promoting high quality corporate governance and reporting to foster investment. 


Outline in one sentence the basic difference between statutory regulation and self- regulation.



List the advantages and disadvantages of self-regulation.



aims might be met by:

  the provision of information, eg quotation systems (to ensure that the market operates in an efficient and orderly way) and product literature (to ensure that customers understand what they are buying) 

  authorisation of financial service providers 

  subsequent supervision of the authorised firms, eg checking solvency, enforcing 
strict accounting information requirements 

  ensuring sufficient liquidity in the marketplace, eg in the money market 

  the provision of settlement systems – again to ensure that trades are carried out in an efficient and orderly way 

  schemes to compensate investors for breaches of the regulations.


Examples of restrictions might include:

  the types of investment or contract that are offered by the institution 

  the types of service provided 

  the levels of charges that may be levied for a particular investment, contract or service 

  the types of investment that may be included within a collective investment vehicle or a pooled investment vehicle, such as a life contract 

  required levels of capital adequacy 

  the types of investment in which a financial institution may itself invest 

  who may control the institution – ie fit and proper person rules.


Self regs adv and disadvantages :

The main advantages are likely to be the reduced cost of regulation and the fact that the rules are set by those with 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.


Advantages of self-regulation

  The regulatory system is implemented by the people with the greatest knowledge of the market, who are therefore able to max the benefits and minimise the costs. In addition they also have the greatest incentive to achieve a soundly financial services industry. 

  Self-regulation should 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 closeness of the regulator to the industry it is regulating, which lead the regulator to side with the industry 

  Consumers may lack of confidence in the regulator. 

  Self-regulatory organisations may inhibit new entrants to a market.