Financial Institutions and Markets

CHAPTER 4: REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

Unit Introduction
This unit will discuss about what a financial system regulationis, its need and usefulness in an
economy. It will elaborate on the types of actors that appear in the financial system as
regulators. In subsequent sections, we will look more closely at general regulations of financial
markets and institutions and will see whether it has improved the functioning of financial
system.

Unit Objectives
Upon completion of this unit, you will be able to;
 Describe the purpose, the need and objectives of financial system regulations
 Explain the role of financial system regulators
 Explain the need for governmental regulation of market
 Describe the different forms of regulation
 Describe the processes of financial regulation and arguments regarding financial system
regulation

4.1 The Nature of Financial System Regulation

Financial regulation is a form of regulation or supervision, which subjects financial markets
and institutions to certain requirements, restrictions and guidelines aiming to maintain the
integrity of financial system.

A good financial system with a well-functioning competitive market as well as a well-

supporting financial institution is an essential ingredient for sustainable economic growth.
The objective of financial regulation is to create market confidence, financial stability, consumer
protection, and reduction of financial crime. Developing sound Financial Markets requires the
establishment of public confidence in the institutions that constitute the Finance Sector.

Confidence can only be maintained if these institutions deliver services as promised. Thus
one of the duties of Governmental Authorities is to preserve the long term stability of the
financial system and reliability of its components. Governments could do these by using
different procedures and regulations. Regulation of financial markets rests on the government
that it serves the interest of the public by protecting investors and guarding against systemic
risk. With regard to investor protection, regulations maintain that their oversight is justified
on the grounds that investors are uninformed and unskilled.

Financial regulation has also influenced the structure of banking sectors, by decreasing
borrowing costs and increasing the variety of financial products available. The banking sector

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has witnessed tremendous competition not only from the domestic banks but from foreign
banks alike. In fact, competition in the banking sector has emerged due to disintermediation
and deregulation. The liberalized economic scenario of countries has opened various new
avenues for increasing revenues of banks. In order to grab this opportunity, commercial banks
of many countries have launched several new and innovated products, introduced facilities like
ATMs, Credit Cards, Mobile banking, Internet banking etc.

Banking regulation, for instance, has often been put in place with several – and sometimes
conflicting-objectives in mind, such as promoting strong national financial institutions, offering
consumer protection, assisting industrial and/or regional development and preserving financial
stability, in particular the safeguarding of the payment and settlement system. This has led in
the past to tight and widespread regulation, ranging from interest rate ceilings and branching
restrictions to capital requirements and deposit insurance. The most important duty and
responsibility of central banks of the respective countries has become overseeing bank
activities and trying to protect banks falling into risk of going out of business.

There are also agencies that regulate the operations of the financial system in free market
economies without direct government intervention. The usual form of intervention by the
government is through the enactment of relevant laws. Such Acts of Parliament are laws meant
to provide equal opportunity or platform for all players, smooth operations, and safeguarding
the national interest of the country. Financial institutions are regulated and monitored through
central banks. Therefore, all the participants in the financial system are under obligations to
adhere to. The relevant regulators of financial systems in free market economies as well as
mixed economies include institutions like, in the US for example, the Central bank, Securities
and Exchange Commission (SEC) and The Stock Exchange (like NYSE-New York Stock
Exchange), among other regulatory agencies that may evolved out of necessity. There are
contemporary issues such as corporate governance and accounting standards that prompt the
formation of agencies to mount surveillance on the practices in various economies.

Government's role in Financial Markets

The government can play one or more of the following roles in financial markets:
 Provide a level playing field for financial markets by promoting their development.
 Participate in the financial markets by running state-owned financial institutions
 Provide a regulatory framework that ensures safety and soundness of the financial system.

Types of regulations
 Disclosure regulations-problem of asymmetric information and agency problem
 Financial activity regulation-about traders of securities and trading on financial
assets. Examples. Rules on trading by corporate insiders- insider trading.

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 Regulation of financial institutions- restricting activities of financial institutions in

the area of lending, borrowing and funding
 Regulation of foreign participants-limit the roles of foreign firms on domestic
markets and their ownership control of financial institutions

4.2 The need for regulation

The initial focus, and still the central element, of regulatory system is to solve the problem of
the uninformed investor through company disclosure and transparency of trading markets.
The following can be considered as core objectives of financial system supervision.
 Public confidence in the financial sector
 Protecting depositors who have placed funds on financial sector
 To promote competition and thus improved efficiency
Most people agree that disclosure provides the information needed to make rational decisions.
But regulations today goes far beyond disclosure requirements, because a growing number of
stakeholders are presumed to be unskilled and incapable of making informed decisions. For
example because of asymmetric information in financial markets, that means investors may
be subject to adverse selection and moral hazard problems that may hinder the efficient
operation of financial markets.

Asymmetric information: A situation where one party to a financial transaction has better
information than the other about factors relevant to the transaction. One party often does not
know enough about the other party to make accurate decisions. This inequality is called
asymmetric information. For example, a borrower who takes out a loan usually has better
information about the potential returns and risks associated with the investment projects for
which the funds are earmarked than the lender does. Lack of information creates problems in
the financial system on two fronts: Adverse Selection (before the transaction is entered into) and
and Mortal Hazard (after transaction).
 Adverse selection: is the problem created by asymmetric information before the
transaction occurs. Adverse selection in financial markets occurs when the potential
borrowers who are the most likely to produce an undesirable (adverse) outcome—the
bad credit risks-are the ones who most actively seek out a loan and are thus most
likely to be selected. Because adverse selection makes it more likely that loans might
be made to bad credit risks, lenders may decide not to make any loans even though
there are good credit risks in the marketplace.
 Moral hazard: is the problem created by asymmetric information after the transaction
occurs. Moral hazard in financial markets is the risk (hazard) that the borrower might
engage in activities that are undesirable (immoral) from the lender‘s point of view,

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because they make it less likely that the loan will be paid back. Because moral hazard
lowers the probability that the loan will be repaid, lenders may decide that they would
rather not make a loan.

The other basis for financial regulation is concern about systemic risk. Systemic risk arises if
the failure of one financial institution causes a run on other institutions and precipitates
system-wide failure. The so-called ―systemic risk‖ can originate from aggregate adverse shocks
that lead to simultaneous failures of several intermediaries or from contagion, that is from the
propagation of one bank's failure to other banks in a sequential fashion. But almost every
aspect of financial markets, if not daily living itself, involves systemic risk. One of the most
complex issues facing governments is identifying the appropriate level and form of
intervention. Regulatory efficiency is a significant factor in the overall performance of the
economy. Inefficiency ultimately imposes costs on the community through higher taxes and
charges, poor service, uncompetitive pricing or slower economic growth. Clearly there must be
limits on the applicability of this rational for regulation.

In similar ways, ensuring the soundness of financial system is other reason for the necessity
of the rules and procedures. Uncertain and confusing information can also lead to widespread
collapse of financial intermediaries, referred to as a financial panic. Because providers of funds
to financial intermediaries may not be able to assess whether the institutions holding their
funds are sound, if they have doubts about the overall health of financial intermediaries, they
may want to pull their funds out of both sound and unsound institutions.

The possible outcome is a financial panic that produces large losses for the public and causes
serious damage to the economy.

Contagion: The collapse of one financial institution leading to bad debts and/or a loss of confidence
in other financial institutions, possibly causing their collapse- a particular problem for banks.
To protect the public and the economy from financial panics, the governments are
implementing a number of regulations. These regulations are taking the form of;

 Restrictions on Entry
 Disclosure
 Restrictions on Assets and Activities
 Deposit Insurance
 Limits on Competition and
 Restrictions on Interest Rates.

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i. Restrictions on Entry: Governments endorse very tight regulations governing who is

allowed to set up a financial intermediary. Individuals or groups that want to establish a
financial intermediary, such as a bank or an insurance company, must obtain a charter
from the state or the Federal Government.

ii. Disclosure: There are stringent reporting requirements for financial intermediaries. Their
bookkeeping must follow certain strict principles, their books are subject to periodic
inspection, and they must make certain information available to the public.

iii. Restrictions on Assets and Activities: There are restrictions on what financial
intermediaries are allowed to do and what assets they can hold. Before you put your funds
into a bank or some other such institution, you would want to know that your funds are
safe and that the bank or other financial intermediary will be able to meet its obligations
to you. One way of doing this is to restrict the financial intermediary from engaging in
certain risky activities.

For example some counties legislation separates commercial banking from the securities
industry so that banks could not engage in risky ventures associated with this industry.

Another way is to restrict financial intermediaries from holding certain risky assets, or at
least from holding a greater quantity of these risky assets than is prudent. For example,
commercial banks and other depository institutions are not allowed to hold common
stock because stock prices experience substantial fluctuations.

iv. Deposit Insurance: The government can insure people‘s deposits so that they do not
suffer any financial loss if the financial intermediary that holds these deposits fails. All
commercial and mutual savings banks, with a few minor exceptions, are required to enter
deposit insurance, which is used to pay off depositors in the case of a bank‘s failure.

v. Limits on Competition: Politicians have often declared that unbridled competition

among financial intermediaries promotes failures that will harm the public. Although the
evidence that competition does this is extremely weak, it has not stopped the state and
federal governments from imposing many restrictive regulations.

vi. Restrictions on Interest Rates: Competition has also been inhibited by regulations that
impose restrictions on interest rates that can be paid on deposits and loans.

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4.3 The Principles of Regulation

Regulation requires that a careful balance be struck between effectiveness and efficiency. It has
a great potential to impose costs and should be designed to meet its purposes while minimizing
direct costs of regulation and the broader costs arising from rules which restrict economic
activity. The main principle of the regulation of the financial markets and institutions includes:
 Competitive Neutrality;
 Cost Effectiveness;
 Accountability;
 Flexibility and
 Transparency
i. Competitive Neutrality: The regulatory burden applying to a particular financial
commitment or promise should apply equally to all who make such commitments, as per
the competitive neutrality principle. It requires further that there would be:

 Minimal barriers to entry and exit from markets and products;

 No undue restrictions on institutions or the products they offer; and
 Markets open to the widest possible range of participants.
ii. Cost Effectiveness: Regulation can be made totally effective by simply prohibiting all
actions potentially incompatible with the regulatory objective. But, by inhibiting productive
activities along with the anti-social, such an approach is likely to be highly inefficient. Cost
effectiveness is one of the most difficult issues for regulatory cultures to come to terms
with. Any form of regulation involves a natural tension between effectiveness and
efficiency. Yet the underlying legislative framework must be effective, by fostering
compliance through enforcement in cases where participants do not abide by the rules.

In general, a cost-effective regulatory system may requires:

 An allocation of functions among regulatory bodies which minimizes overlaps,
duplication and conflicts;
 An explicit mandate for regulatory bodies to balance efficiency and effectiveness;
 The allocation of regulatory costs to those enjoying the benefits; and
 A presumption in favor of minimal regulation unless a higher level of intervention is
justified.
iii. Accountability: The regulatory structure must be accountable to its stakeholders and
subject to regular reviews of its efficiency and effectiveness. In addition, regulatory
agencies should operate independently of sectional interests and with appropriately
skilled staff.

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iv. Flexibility: The regulatory framework must have the flexibility to cope up with changing
institutional and product structures without losing its effectiveness.

v. Transparency: Transparency of regulation requires that all guarantees be made explicit

and that all purchasers and providers of financial products be fully aware of their rights
and responsibilities. It should be a top priority of an effective financial regulatory
structure that financial promises (both public and private) to be understood. If there is
a general perception that a particular group of financial institutions cannot fail
because they have the authorization of government, there is a great danger that
perception will become a reality.

4.4 Arguments Regarding Financial System Regulations

The financial system is among the most heavily regulated sectors of most economies. The
government regulates financial markets for different reasons. But, there are different views as
to the need and extent of Government intervention in financial markets.

 Some argue that free and competitive markets can produce an efficient allocation
of resources and provide a strong foundation for economic growth and development.

 Others emphasize that Governments could play in maintaining a healthy economic

and social environment in which enterprises and their customers can interact with
confidence.

Since different scholars have contradictory stands for or against the regulations it is better to
examine about some reasons that have led to the present regulatory environment. Some of the
views for or against financial market regulations include:

 Regulation for Financial Safety;

 Systemic Stability;
 Information Asymmetry;
 Regulatory Assurance; and
 Regulation for Social Purposes.
i. Regulation for Financial Safety: One of the vital economic functions of the financial
institutions is to manage, allocate and price risk. However, there are some areas of the
financial activities where government intervention is aimed at eliminating or
reducing risk.

In essence, the task is to decide which financial promises have characteristics that
warrant much higher levels of safety than would otherwise be provided by markets
(even when they are subject to effective conduct, disclosure and competition

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regulation). As a general principle, financial safety regulation will be required where

promises are judged to be very difficult to honor and assess, and produce highly
adverse consequences if breached. Promises which rank highly on these characteristics
are referred to as having a high ‘intensity’.

On the other hand, many regulations in the financial institutions‘ sector spring from the
ability of some financial institutions to create money in the form of credit cards,
checkable deposits, and other accounts that can be used to make payments for purchase
of goods and services. Such creation of money is closely associated with inflation which
should be managed by the government. Financial regulation arises from the risks
attaching to financial promises. While in some other industries safety regulation aims to
eliminate risk almost entirely (example, to eliminate health risks in food preparation), this
is not an appropriate aim for most areas of the financial activities.

ii. Systemic Stability: The more sophisticated the economy, the greater is its dependence
on financial promises and the greater its vulnerability to failure of the financial system.
The first case for regulation to prevent systemic instability arises because of certain
financial promises have an inherent capacity to transmit instability to the real economy,
inducing undesired effects on output, employment and price inflation.

When financial distress in one market or institution is communicated to others and,

eventually, engulfs the entire system, there will be the most potential source of systemic
risk is financial contagion.

iii. Information Asymmetry: Information Asymmetry is a situation where further

disclosure, no matter how high quality or comprehensive, cannot overcome market
failure. The second case for regulation relates to the need to address information
asymmetry. In a market economy, consumers are assumed, for the most part, to be the
best judges of their own interests. In such cases, disclosure requirements play an
important role in assisting consumers to make informed judgments. However, disclosure
is not always sufficient.

For many financial products, consumers lack (and cannot efficiently obtain) the
knowledge, experience or judgment required to make informed decisions. In these cases,
it may be desirable to substitute the opinion of a third party for that of consumers
themselves. In effect, the third party is expected to behave paternalistically, looking out
for the best interests of consumers when they are considered incapable of doing so alone.
To some extent, such third parties can be supplied by markets (such as the role played by
self regulatory associations).

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However, for many years the practice in all countries has been for government prudential
regulators to take on much of this role.

iv. Regulatory Assurance: If regulation is pursued to the point of ensuring that promises
are kept under all circumstances, the burden of honor is effectively shifted from the
promisor to the regulator. All promisors would become equally risky (or risk free) in the
eyes of the investing public. Regulation at this intensity removes the natural spectrum
of risk that is fundamental to financial markets. If it were extended widely, the
community would be collectively underwriting all financial risks through the tax system,
and markets would cease to work efficiently.

A concern about the safety of the public‘s funds, especially the savings owned by
millions of individuals and families, however, does not mean that all financial services
should be subject to financial safety regulation.

Thus, regulation cannot and should not ensure that all financial promises are kept. The
government should not provide an absolute guarantee in any area of the financial system
(just as it does not do so in other areas).

How intensively, then, should financial safety regulation be applied?

Theoretically, however, the intensity of financial safety regulation should be proportional to
the intensity of financial promises. A large amount of intense financial promises are those
which provide payments services.
Such promises are intrinsically difficult to honour. Those who use them rarely have the
time, motivation or resources to assess the risks, and any breach would have potentially
highly adverse consequences for the efficient conduct of commerce in the whole economy.
The most intense safety regulation should therefore apply to the provision of means of
payment, to the point of securing their safety at the highest possible level, short of an
outright Government guarantee. Beyond this, the extent of regulatory assurance is a matter
for judgment.
How much regulatory assurance should it provide in the various areas of the financial system?
At a minimum, this requires that the regulator has unambiguous powers to intervene in
the operations of institutions making such intense promises. Regulation should seek to
ensure that, while risk remains, those making promises ensure that risks are appropriately
managed in accordance with the reasonable expectations of their promises. If regulation stops
short of providing a guarantee against failure, it must provide speedy and efficient
mechanisms for resolving financial distress when it arises, so as to minimize the danger of
loss or contagion.

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v. Regulation for Social Purposes: Obliging financial institutions to subsidies some

activities compromises their efficiency and is unlikely to prove sustainable in a
competitive market. A further case for regulation is sometimes made on the grounds that
financial institutions have ‗community service obligations‘ to provide subsidies to some
customer groups.

For example, financial institutions are urged to deliver certain services free of charge
or at a price below the cost of provision. This is the least persuasive case for
intervention. Financial institutions, like other business corporations, are designed to
produce wealth, not to redistribute it. This is not to say that their creation of wealth
should ignore the claims of social and moral propriety. But it is another thing
entirely to require financial institutions to undertake social responsibilities for which
they are not designed or well suited.

4.5 Systems of Regulation

Financial institutions, markets and their products are regulated through three major systems
of regulation. This section will discuss each of these systems of regulation separately.

1. Federal/Central Regulation
This type of regulation involves the control of the market at the national level through legislation
or through the creation of government agencies to administer and oversee the legislations.
Naturally, the sensitivity of securities market failures and the special role of depository
institutions in monetary policy place them under federal control. Depository institutions in
many countries including Ethiopia are regulated by respective Central Banks.

Securities markets are on the other hand regulated by the securities and exchange agency of
the respective country such as the Securities and Exchange Commission (SEC) of the US.

2. Self Regulatory Organizations (SRO)

Self regulation amounts to a situation where members involved in a financial activity come
together and set a code of rules and regulations to abide by in the conduct of their activities.
SROs are said to be cost effective and stable from political interference. Since SROs follow their
own rules and procedure, they are insulated from government pressure, which makes the
system more stable and long lasting. In contrast to the government bureaucracy, the SROs
show more concern and prudent care for the proper implementation of the standards of fair
practice, for their fate is entwined with the proper functioning of the market. As far as self-
regulation is concerned, stock exchanges take the first step through their listing requirements.
Stock exchanges employ quantitative or qualitative listing requirements to screen out
participants in the market.

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Establishing government regulatory agencies involves a heavy burden and expense in terms of
money, time and manpower. It also exerts considerable pressure on taxpayers, because
running such government agencies requires raising funds from the public. Hence, SROs can
generally be considered as cost effective and stable which makes them an ideal mechanism for
regulation.

3. Market Regulation
This approach is also referred to as market action and is in line with the laissez faire approach,
which tells us that the market will take care of itself. In fact, what is meant by market action is
that a market should be able to regulate itself. This is especially with regard to disclosure
regulation. As we noted before, proponents of this approach contend that there is no
justification for disclosure regulation by government because the market would without
government assistance get all the information necessary for a fair pricing of new as well as
existing securities through its power to underprice the securities of firms that do not provide
all necessary data.

Market action tells us that economically efficient disclosure will be made in response to
sophisticated investors. The assumptions of efficient disclosure and sophisticated investors
may hold true given the background of the American System where intuitional investors are
rampant. However, even there, the market left alone was supposedly proved to be a failure
leading to a change in the policy of regulatory mechanisms. Then, it needs no critical analysis
to affirm the impracticability of this theory in a developing economy like Ethiopia where the
market is at its embryonic stage thus making the need for issuing government regulations or
self-regulation for stock exchange obvious.

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Exercises:
Instruction: Read and analyze the following questions carefully and answer them correctly.

1. Define and discuss on each of the following terms and statements:

A. Financial Regulations
B. Rational for financial regulations
C. Contagion/Bank run
D. Asymmetric Information
E. Adverse Selection
F. Moral Hazard
2. What are regulations of financial markets and institutions? Explain.
3. Discuss on arguments related with financial regulations.
4. List down the principles of financial regulation? Explain
5. How does financial regulation reduce problems related with asymmetric
information?
6. List down types of regulation and explain them in detail.
7. What should be Government's role in Financial Markets?
8. What does restrictions on assets and activities in financial regulations?
9. Explain the role of financial system regulators.
10. Financial institutions, markets and their products are regulated through three
major systems of regulation. Discuss each of these systems of regulation separately.

Habtamu A.
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