Regulation of financial industry

1. Regulation of financial industry Dr.sc. Matej Živković

2. What is regulation? • Regulation in the broadest sense is the employment of legal instruments for the implementation ofsocial-economic policy objectives. • Economic regulation consistsof two types of regulations: structural regulation. ‘Structural regulation’ is used for regulating marketstructure. Examples are restrictions on entry and exit and rules againstindividuals supplying professional services in the absence of recognizedqualifications. ‘Conduct regulation’ is used for regulating behavior in themarket. Examples are price control, rules against advertising and minimumquality standards. Economic regulation is mainly exercised on naturalmonopolies and market structures with limited or excessive competition. • Social regulation comprises regulation in the area of the environment, laborconditions (occupational health and safety), consumer protection and labor(equal opportunities and so on)

3. Why do we regulate • The theoretical underpinning for public intervention in economic matters is traditionally basedon the need to correct market imperfections and unfair distribution of the resources. • Three moregeneral objectives of public intervention derive thereby: • the pursuit of stability, • equity in thedistribution of resources and • the efficient use of those resources.

4. Theories of regulation • Positive theoriesare directed to theeconomic explanation of regulation and deriving the consequences ofregulation. What is? • Normative theoriesinvestigate which type of regulation is themost efficient. The latter variant is called normative because there is usually animplicit assumption that efficient regulation would also be desirable. What should be?

5. Theories of regulation • Public interest theories of regulation: Accordingto public interest theory, government regulation is the instrument forovercoming the disadvantages of imperfect competition, unbalanced marketoperation, missing markets and undesirable market results. • Private Interest Theories of Regulation: This theory assumes that in thecourse of time, regulation will come to serve the interests of the branch of industry involved. • Economic theory of regulation (Chicago theory of government)- George Stigler: centralproposition was that ‘as a rule, regulation is acquired by the industry and isdesigned and operated primarily for its benefit’. • Virginia School of Public Choice: In their theories, the term coined by Ann Krueger (1974), rent seeking,is a central feature. Rent seeking means the political activity of individuals andgroups to devote scarce resources to the pursuit of monopoly rights granted bygovernments.

6. When shoul regulation be applied • In case of market failures- abberation of markets from perfect market conditions: • 1. Externalities occur when one party’s actions imposeuncompensated costs or benefits on another party(violating the “private decisions” condition). • 2. Public goods are those for which the cost of providingan additional unit is negligible and excluding usersis costly (violating the “private goods” condition). • 3. The presence of monopoly power in a market allows afirm to control prices, violating the perfect market conditionthat all participants are “price takers.” “Naturalmonopolies” exist when long-run declining costs makeeconomies of scale so great that a market can be servedat lowest cost only if production is limited to a singleproducer. Because the supplier doesn’t face competition,however, without some form of intervention,prices would be higher and quantity produced lowerthan in a competitive market. • 4. Finally, when market participants have asymmetricinformation, markets may not allocate resources efficiently.

7. Special consideration of the need for regulation in finance industry • Adverse selection • Moral hazard • Insider trading • Information asymetry • Fiduciary duty • Conflict of interest • Regulatory arbitrage • Systemic risk • Herd behavior

8. Global financial crises • Started with another american dream: everybody should own a home

9. Introduction

10. Trigger to financial crises • Bailout of Bear Sterns • Failure of Lehman • No response by regulator- Efficient Market Hypothesis- Markets will take care of everything • Worldwide contagion

11. The role of regulation in GFC • The financial crisis was not a failure of regulation, but a failure of supervision • Pressures to deregulate • The philosophy of Allan Greenspan and removal of Brooksley Burns • Derivatives as “Weapons for mass destruction”

12. The role of credit rating agencies • Double role: rating securities and advising about trading

14. Regulation of securities markets • Sucurities are contractual agreements providing owner with certain rights. These agreements existed before there was a regulatory body or any kind of specific regulation. • The core to exercise these agreements were exchanges. • Functions of regulation can be divided to those of exchanges and those of regulators

15. The functions of exchanges • (a) Limited access to trading facility • (b) Standardized trading rules • (c) Clearing procedures • (d) Exclusive roles for members • (e) Dispute resolution • (f) Exclusive rights in information • (g) Listing Requirements

16. Functions and goals of regulators • Investors protection • Efficiency- The argument was that securities regulation required the production of morepublic information by firms than they would provide in an unregulatedmarket • Complete the organization of the market ‘firm’- Another perspective is to view the public and private aspects of securitiesregulation as a combined effort to create competitive market institutionswhich will attract securities business. • Capture wealth- The public choice analysis views the securities laws asthe product of political competition among groups whose wealth is affectedby the provisions of the laws. • Protect the Industry from Competition- The view that securities regulation is a device for organizing the industryinto a cartel has had considerable influence in the area of securitiesregulation

17. Selfregulation- an oxymoron? • Amsterdam was the city that was the home of the world’s first stock exchange, kicked off in 1602 by the issuance of shares in the Dutch East India Company (the Vereenigde Oost-Indische Compagnie, or VOC) • The company that could have joined was rather exclusive

18. Types of regulatory structures • The regulation of financial intermediariesover the world has traditionally beenon institutional lines whereby regulation is directed at financial institutions,irrespective of the mix of business undertaken. • As financial institutions normallyspecialised in a particular business activity, the distinction between institutional andfunctional regulation was not considered of much significance so that regulating anentity was the same thing as regulating its core business. • For instance, regulatingbanks meant regulating the business of banking and regulating the insurance companymeant the same thing as regulating the business of insurance.

19. Cont. • Institutional supervision- In the more traditional "institutional approach" (also known as "sectional" or "by subjects" or"by markets"), supervision is performed over each single category of financial operator (or over eachsingle segment of the financial market) and is assigned to a distinct agency for the entire complex ofactivities. • Supervision by objectives- The supervisory model by objectives (or by finalities) postulates that all intermediaries andmarkets be subjected to the control of more than one authority, each single authority beingresponsible for one objective of regulation regardless of both the legal form of the intermediaries andof the functions or activities they perform. • Functional Supervision- The third regulatory model is the so-called "functional supervision”, or supervision “byactivity". It considers as "given" the economic functions performed in the financial system; unlikeother lines of thought regarding supervisory activities, this approach does not postulate that existinginstitutions, whether operative or regulatory, must necessarily continue to exist as such, in termsof both their structure and role. The "functions" or activities undertaken are considered to be morestable than the institutions that perform them. • "Single-regulator supervision”- The single-regulator supervisory model is based on just one control authority, separated fromthe central bank, and with responsibility over all markets and intermediaries regardless of whether inthe banking, financial or insurance sector.

20. Institutional approach • The present institutional approach to regulation is being objected mainly onthree grounds. • The first is the competitive neutrality issue, i.e., different institutionbasedregulators might adopt different functional regulation for the same activity withassociated costs of achieving compliance as well as supervisory arbitrage • Secondly,there could be a wasteful duplication of scarce supervisory resources, with eachregulator applying business rules appropriate for every function, which would behugely inefficient in terms of regulatory resources • Finally,there is the issue of the solvency of the institution, which could be addressed only ona group-wide basis

21. Possible approaches to regulatory structure change: • function-specific regulation, in which the regulatory domain is defined by'functions' performed by financial institutions rather than ‘institutions’. • objective-based regulation, such as systemic protection and consumerprotection objectives such as in the twin-peak model • super-regulator or unified regulation, with the responsibility for prudentialsupervision of all financial institutions besides being responsible forproduct regulation and competition policy in the financial sector, and • lead /umbrella regulator, in which one of the regulators is responsible forcoordinating the regulation of the overall corporate group, with theindividual operating entities within the group continuing to be regulated bythe specialist regulators.

22. Mega regulatory models could bebroadly categorisedinto threecategories, • the Singaporean Model, in which the central bank is also the super regulator, • the Scandinavian Model, in which unified regulation lies outside the centralbank, and • the Australian Model, in which there are two regulators with an overarchingcouncil above them.

23. Arguments in favor of unified regulation • Fragmented supervision may raise concerns about the ability of the financial sectorsupervisors to form an overall risk assessment of the institution, operatingdomestically and often internationally, on a consolidated basis, • As the lines of demarcation between products and institutions have blur, differentregulators could set different regulations for the same activity for different players.Unified supervision could thus help achieve competitive neutrality. • The unified approach allows for the development of regulatory arrangements thatare more flexible. Whereas the effectiveness of a system of separate agencies canbe impeded by ‘turf wars’ • Unified supervision could generate economies of scale as a larger organizationpermits finer specialization of labour and a more intensive utilization of inputs andunification may permit cost savings on the basis of shared infrastructure,administration, and support systems • A final argument in favour of unification is that it improves the accountability ofregulation

24. Arguments against unified regulation • Given the diversity of objectives – ranging from guarding against systemicrisk to protecting the individual consumer from fraud – it is possible that asingle regulator might not have a clear focus on the objectives and rationaleof regulation and might not be able to adequately differentiate betweendifferent types of institutions. • A single unified regulator may also suffer from some diseconomies of scale. • Some critics argue that the synergy gains from unification will not be verylarge, i.e., economies of scope are likely to be much less significant thaneconomies of scale. The cultures, focus, and skills of the various supervisorsvary markedly • The public could tend to assume that all creditors of institutions supervisedby a given supervisor will receive equal protection generating ‘moral hazard’. • Another serious disadvantage of a decision to create a unified supervisoryagency can be the unpredictability of the change process itself.

25. The change of regulatory paradigma • From TBTF to their disintegration • From microprudential to macroprudential regulation • From pro-cyclical to counter-cyclical regulation

26. Few words on regulatory model in B&H • Separated financial markets on institutional boundaries • Two entities, two exychanges, three regulators, very clouded role of CB

27. Recommendation for the future • Gretaer transparency • Supervision of substence not details • Treatment of credit rating agencies • Better definition of regultory authority • Separation of retail from wholesale • TBTF • Principle based supervision and regulation