Rationale, objectives & principles of regulation

Introduction

There are four elements to regulation:

• Institution of rules of conduct (or rules for operation).

• Monitoring (observance of whether the rules instituted are obeyed).

• Supervision (observance of the behaviour of participants).

• Enforcement (ensuring that the rules are adhered to).

Regulation has a profound effect on the operation of the financial markets and its development, and it has to be adjusted frequently as developments in the financial sector take place (i.e. it must be efficient). However, to remain in step with innovation in the financial system is no mean task, because the business of the financial sector is innovation, and this applies particularly in banking which is at the very centre of the financial markets. New instruments are created frequently. For this and other reasons the regulatory authorities have to get the regulated "on board", i.e. involved in the regulation process, on the basis that the regulation of this sector is in the interests of the participants. Another important dimension of regulation is that it must be cost-effective. These and other issues pertaining to regulation are covered in this section under the following headings:

• Rationale for regulation.

• Objectives of regulation.

• Principles of regulation.

Rationale for regulation

Introduction

The financial sector plays a pivotal role in the economy in that in its absence or partial failure the economic machine will be severely damaged. Imagine if the payments system failed or the banks are closed for extended periods (such as occurred in Argentina in 2001/2 - where segments of the economy were reduced to barter trade). The financial sector is also a major employer and is a major attractor of foreign exchange if soundly managed. This sector also carries the responsibility of allocating capital to the most productive uses.

The main rationale for government intervention is "market malfunction" which means that the financial system will produce a sub-optimal outcome in the absence of regulation. Thus, government intervention has welfare benefits. The consumer and the participants want regulation and are even prepared to pay for it.

The "rationale" for regulation amounts to "why regulation is necessary" There are a number of reasons:

• Systemic malfunction.

• Market imperfections.

• The moral hazard problem.

• Economies of scale.

• Consumer confidence and consumer demand for regulation.

• Supplier demand for regulation.

Systemic malfunction

As we have mentioned, the financial system plays a vital role in the economy, and failure or malfunction of the system can disrupt economic activity severely. Banks are the only financial intermediaries that intermediate between all sectors of the economy (household, corporate, government and foreign) and all the other financial intermediaries. In addition, the banking system provides the payments and clearing systems for all transactions that take place in the economy. The failure of a major bank not only causes losses for depositors and shareholders, but also disrupts payments and the settlement of previously effected transactions immediately and possibly for some time.

Within the financial sector there are major differences between intermediaries in terms of systemic issues. The banks are the prime focus in this regard because of the reasons: the payments system, the size of banks in relation to other financial intermediaries (the largest repository of financial wealth in the economy), the possibility of bank runs, and the fact that there are few large banks. The failure of one unit trust, for example, will not disrupt the functioning of the economy.

Market imperfections

If the market were perfect in terms of competition, there would be no cause for intervention by the authorities. Perfect competition does not exist, and the consequence is that there are market imperfections. There are many examples of market imperfections that stand in the way of consumer protection:

• Problems of asymmetric information. This means that some persons have information that is denied to other persons or some persons supply information that is ambiguous or incorrect to other persons.

• Inadequate information on the part of the consumer of financial products and services.

• Consumers are not equally equipped to gauge the quality of bank products.

• Consumers are not able to assess the safety and soundness of financial intermediaries and agents in the financial system.

• Principal-agent problems. The directors and managers act as agents for the investors and shareholders of a financial intermediary (i.e. the principals). However, the agents may pursue their own interests at the expense of the principals. The best example is that the managers and directors may have a performance bonus scheme that encourages them to take risks in the financial markets.

The moral hazard problem

The moral hazard problem in banking is associated with government preference for the introduction of safety net arrangements such as lender of last resort facilities and deposit insurance. The most potentially hazardous is the latter. Deposit insurance creates a condition that the event insured against (losing the deposit) is more likely to occur.

Economies of scale

Users of financial products (e.g. deposits) ideally should monitor the behaviour and soundness of financial intermediaries and markets. However, this is a laborious and costly task in terms of time involved. Essentially, the regulatory authorities undertake this task on behalf of the users. Rating agencies also play a role in this regard, but the cost of the reports of the rating agency is expensive for the proverbial man in the street.

Consumer confidence and consumer demand for regulation

The role of regulation is also to set minimum standards for products in order that consumers gain confidence in the system. The mere existence of inferior products may tarnish the good products. Consumer demand for regulation is rational for the following reasons:

• Lower transactions costs.

• Consumers have a lack of information and even if they had information they lack the ability to use the information.

• Consumers require a degree of assurance in their transactions with financial intermediaries.

• They may have had a bad experience with a bank in the past.

• The value of a long-term contract (e.g. a 3-year deposit) may be affected by the behaviour of the intermediary during the period of the deposit.

Supplier demand for regulation

It is in the interests of the suppliers of financial products to demand regulation. The motivation is that ill-behaved intermediaries may affect the business of well-behaved intermediaries. In some countries the ratio of notes in circulation to total money stock is significantly higher than in other countries, despite the existence of well-managed intermediaries. Clearly this means that the consumer keeps his/her wealth in bank notes under the proverbial mattress as opposed to bank deposits (and foregoes a return).