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«Introduction According to Llewellyn, regulation is the establishment of detailed rules of conduct. He is of the opinion that regulation differs from ...»

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Journal of European Studies

Why Regulate Financial Markets? The Underlying

Rationale for Financial Regulation in the Wake of

the Current Crisis

Samra Chaudary

Daisy Salvador-Adebayo

Introduction

According to Llewellyn, regulation is the establishment of detailed

rules of conduct. He is of the opinion that regulation differs from

monitoring and supervision.1 The complexity of the financial

services business, the introduction of new products (e.g.

derivatives) coupled with the infinite list of existing ones, the diverse needs of individuals which creates an opportunity to confuse and cheat customers, makes it a difficult task to prepare rules which would effectively outlaw the unacceptable behaviour.2 There are various reasons why the market needs to be regulated which could range from externalities, monopoly/ oligopoly/ monopsony, principal-agent problems, and barriers to entry/ exit, information failures, public good and market integrity which would comprehensively outlaw the unethical behaviour.3 Barriers to entry (exit) The competitors in the markets would require a new entrant to be fit, to have a license and to meet proper requirements.4 It is desirable to facilitate competition between those who are exposed to any type of regulation.

D. T. Llewellyn, “The New Economics of Banking” (Manchester Statistical Society, 1998).

Howard Davies, “Ethics in Regulation”, Business Ethics: A European Review 10, no.4 (October 2001):280-287.

Ibid.

Financial Services and Markets Act; FSMA 2000 chapter 8, part 1, visit at www.uk-financial-services-and-markets-act-2000.couk/s-23.

Journal of European Studies Externalities (positive or negative) Management should prevent negative externalities to impact on the environment and try to generate positive externalities through prudential regulations to avoid the systemic risk. There is need to identify the type and extent of the systemic risk i.e. is it a negative externality or information problem or a disclosure problem?

Asymmetric information Information failures arise due to lack of sufficient and effective disclosures or if information is difficult to understand and verify, for example making it difficult to understand the real value of goods; low quality goods can be highly priced and vice versa. It can lead to adverse selection and create a “market for lemons”.

However, there is a remedy for correction of information asymmetries through mandatory disclosures. Disclosure means that the information is accessible, relevant, verifiable, comprehendible and can be used to form the basis of right decisions. If some information is available to the insider and not to the outsider, he can probably exploit the information to make abnormal/illegal profits.5 In a well-functioning market, the share should reflect all relevant and available information (semi-strong form). This will not only protect the investor but also help him to take an informed decision.

Principal-Agent problem To monitor the free rider problem in a firm the Conduct of Business (COB) Regulations and various other strategies could be adopted. This would help to solve conflicts, since it is very difficult for shareholders to monitor the activities of the board.

COB rules on trading, regulation of information flows within firms

–  –  –

and compensation and redress are some of the remedies that will minimise principal-agent problems.6 Public good and market integrity Consumer protection should be promoted in order to promote market integrity/rationale. The main rationale for „market integrity‟ is that there should be equality of access to everyone. Moreover market should be fair i.e. there should be no information asymmetries. Besides there should be trust building and promotion of confidence among participants of the market alongside confidentiality. This idea was also supported by Benston who came up with six regulatory goals for consumer protection: (1) to maintain consumer confidence in the financial system, (2) to ensure that a supplier on whom consumers rely does not fail, (3) to make certain that consumers receive sufficient information to make “good” decisions and are dealt with fairly, (4) to ensure fair pricing of financial services, (5) to protect consumers from fraud and misrepresentation and (6) to prevent invidious discrimination against individuals.7 To avoid any uncertainty about market integrity there should be a strict implementation of regulations against market abuse. This would protect against insider trading, market manipulations and release of misleading information.

“The FSA is part of a tripartite model (The Treasury, the Bank of England and the FSA) of regulation in the UK and is effectively a state regulatory”.8 The Financial Services Authority (FSA) is responsible for the regulation of insurance companies, banks, stockbrokers etc. It derives its power for regulation from the Financial Services and Markets Act (FSMA). According to FSMA (2000), chapter 8, part 1, the regulatory objectives are;

Financial Services Authority; FSA handbook, visit at www.fsa.gov.uk.

G. J. Benston, “Consumer Protection as Justification for Regulating FinancialServices Firms and Products”, Journal of Financial Services Research 17, no.3 (2000): 277-301.

K. McPhail, Ethics and the Individual Professional Accountant: A Literature Review (Institute of Chartered Accounts of Scotland, 2006).





Journal of European Studies  Market confidence;

 Public awareness;

 The protection of consumers, and  The reduction of financial crime.9 According to Davies the FSMA‟s aims are: the promotion of confidence in the UK‟s markets; the protection of consumers (bearing in mind their responsibility for their own decisions); the promotion of public understanding of the financial system (a new aim for financial regulation), and the reduction of financial crime.10 The purpose of this essay is to explore why financial markets are being regulated and also why there is need for financial regulation in the wake of the current global economic crisis. The paper also discusses the role of the European financial markets.

Why regulate financial markets?

It is believed that there is communal interference in economic matters because of the need to correct inequitable distribution of resources and market imperfections. According to Di Giorgio, Di Noia and L. Piatti there are three objectives of the regulation of financial markets; (1) promotion of macroeconomics and microeconomic stability (2) achievement of precision in the market, intermediaries and investor safety and (3) protection and encouragement of competition in the financial intermediation division.11 Benston points out that financial services and firms are subjected to more regulations than other products/services because it provides benefits in the form of taxes to government. The FSMA (2000) H. Davies, “Ethics in Regulation”.

DiGiorgio, et al, “Financial Market Regulation”.

Journal of European Studies regulations assure protection to consumers from fraud, misrepresentation, discrimination and information asymmetry.

Issues relating to negative externalities is another reason for regulating financial markets, which is justifiable for financial firms with government-insured deposits; insurance firms that provide government-mandated non-contracting third party insurance and organizations which underwrite long-term life insurance and annuities.12 Regulating financial markets ensures against information asymmetry, reduces fraudulent activities in the market, lessens exploitation and protects against the breakdown of management, allowing investors to operate with confidence in the financial institutions, without fear of a negative spiral effect and the eventual failure of the market. Individuals cannot solve these challenges on their own by trying to work things out in the market, rather the government needs to make financial markets secure and monitor their working.13 Regulation of financial markets leads to transparency by ensuring that organizations fully disclose all information (whether favourable or not) concerning the participants.14 In an unregulated market investors will have inadequate information as companies would not feel obliged to disclose information. Investors on the other hand need full information as it is unsafe to transact business based on market gossip or hearsay. Regulations also enable market participants to trust the market and have confidence in market activities, since it promotes and ensures transparency in dealings.

American financial markets became top-notch only after prudential George. J. Benston, Regulating Financial Markets (Washington D.C: AEI Press, 1999), 39.

See Dodd-Frank Act (2003) at www.dodd-frank-act.us/Dadd_Front_Act_ Text-Section_1088.html.

DiGiorgio, et al, “Financial Market Regulation”.

Journal of European Studies policies were implemented to make them open. Now they suffer from lack of trust – not over regulation.15 Regulation is also necessary to ensure economic stability, for it curtails the harmful effect of risky decisions taken by organizations. Risky decisions taken by a company do not affect that organization alone but other institutions as well and eventually the market at large. The spill-over effect of the failure of an organization envelops not just the directors, managers, employees, customers, suppliers and creditors of that company it also engulfs the organizations that its creditors, suppliers and employees have borrowed from. The spill-over effect of their risky decisions however does not deter firms hence the government needs to step in with regulations and policies to curtail the potential effect on others. The government is required to protect investors by improving the prevalent regulations and ensuring the implementation of policies that guarantee adequate collateralization of financial transactions. It should also make sure that clearing houses are properly monitoring the completion of trades.

Rationale for financial regulation in the wake of the current crisis Blackaby observed that “Existing financial problems were caused by the overthrow of the Glass-Steagal act and other previous reasonable guidelines established to restrain economy wide damage caused by some big financial corporations”.16 Scholars of Finance are of the view that the current crisis was not owing to “over regulation” but a lack of application of existing regulations.

Another reason was the laid back attitude of board members of big

–  –  –

financial institutions towards risk management, for they preferred running after more profits regardless of the risk exposure.17 Systemic risk arises because banks are subject to runs which have contagion effects. Bank runs and asset-liability maturity mismatch creates inherent instability that can lead to a severe crisis in the economy. Depositors often cannot distinguish sound from unsound banks. When a feeling prevails that a bank is unsound, it can result in mass withdrawals which can create severe liquidity problems in turn leading quickly to solvency problems. Such a crisis can spread like a virus in the whole banking sector, as all banks are interlinked and constantly deal with one another.

Systemic risk is a function of size and interconnectedness. The downfall of small but interconnected firms like Lehman Brothers had an immensely negative impact on the international financial market. On the other hand large but not interconnected firms like Barclays and BCCI did not create a great worldwide mess. The opposite was the case for Northern Rock owing to lack of market confidence. These examples show how the failure of one firm can lead to the failure of many markets. Nonetheless there are

regulatory tools for remedying systemic risks. These include:

prudential regulation & capital adequacy requirements (Basel I, II and III), increased focus on liquidity risk, deposit of reserves with the central bank, set off and netting rules to limit inter-counterparty exposure and Lender of the Last resort (LOLR) to inject liquidity into the system. The tool kit can also be expanded by adding quantitative easing, resolution schemes for banks, bail outs, nationalizations and forced sales.

Many for and against arguments exist for the regulation of systemic risk, e.g. deposit insurance is sufficient to protect deposit holders but does not cover total deposit. Similarly it is rational to Jon Danielsson, “The Myth of the Riskometer”, (January 2009), available from www.voxeu.org/article/financial-regulation-built-sand-myth-riskometer.

Journal of European Studies withdraw deposits with low opportunity cost and high uncertainty.

On the other hand, it is not rational for depositors to withdraw from a solvent bank. LOLR eases the liquidity problem but also creates moral problems so banks should not over-rely on LOLR.

Banking crises do not necessarily lead to bank runs. It is a low probability but high impact event. However a standard prescription is prudential regulation of individual institutions via capital requirements, LOLR facility as a backstop and deposit insurance as a minimal safety net.

The current crisis was triggered by destructive activities such as fraud and market manipulation promoted by directors, board members and even the regulators who were appointed to apply the regulations. Even rating agencies failed to carry out due diligence before rating firms, and good ratings were given to firms which were seen as big. Market players embarked on a „winner takes all‟ attitude turning a blind eye to the danger that their risky decisions would affect the market at large due to the interconnectivity of the financial market.

The introduction of complex financial instruments such as derivatives also contributed to the crisis.18 As these instruments were understood by very few people, there were no appropriate regulations to protect investors. It was noted in an extract of the Treasury Select Committee report by Jon Moulton that a number of these products are considered by most people to be difficult to analyze due to their complex nature and lack of information.19 Turner in his speech noted that the FSA was upbraided for not forecasting the risks big finance houses were taking, so it has now taken important initiatives to develop its supervisory measures. In the wake of the financial crisis several regulatory policies have been proposed in a bid to curtail the effects of the crisis (which are Ibid.



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