CHAPTER FIVE

THE REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

5.1. The Nature of Financial System Regulation
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.
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 by using different procedures and regulations
 Regulation is a guideline, rule, restriction limitation made by any authority in order to
control the way of something.
 Is a form of supervision which subjects finanicial institutions to certain requirements
aiming at maintaining integrity of finanicial system.
The flow of funds from surplus unit to deficit unit, the way how finanicial institutions either
depository or non-depository act as an intermediary to facilitate the flow of fund and to
create additional capital including several related activities, the amount of interest that is paid
as means of reward, the market which can be conducted internally or externally to raise
capital and any activities are not out of regulation regardless of the degree of regulation.
Objectives of regulation
The three major objectives of regulation are:
 To maintain market confidence in the finanicial system.
 To assure finanicial stability
 To sustain customer interest
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.
Most people agree that disclosure provides the information needed to make rational
decisions. But regulation today goes far beyond disclosure requirements, because a growing
number of stakeholders are presumed to be unskilled and incapable of making informed
decisions.

The other basis for financial regulation is concern about risk. A risk can be either systematic
or unsystematic.
 Systematic risk→ is a risk that can be caused as a result of investment and is beyond
the control of investors and companies which causes fluctuation in earning / return. It is
also called as unavoidable risk , market risk ,inherent risk un diversifiable risk ,
A systematic risk can be minimized through diversification.
 Unsystematic risk→ unlike systematic risk, unsystematic risk is raised as a result of
maladministration/mismanagement or any dispute with in the management. It is with in
the control of the organization and it can be avoided by any means so is called as an
avoidable risk.
Regulation is said to be required because individual institutions do not adequately take
account of the external costs they impose on the financial system when they fail. 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
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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.
Financial system is regulated to increase the information available to investors, to
ensure the soundness of the financial system and improve control of monetary policy.

One of the main reasons for having strong financial regulation is increasing information
available to investors. 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. .
Government regulation can reduce adverse selection and moral hazard problems in
financial markets and increase their efficiency by increasing the amount of information
available to investors.
In similar ways, ensuring the soundness of financial system is the 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.
 Types of Financial Regulations
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.
A. Restrictions on Entry
Governments endorse very tight regulations regarding unfair entry of new competitors that
can negatively affect existing competitors. This might put several requirements while joining
to the market like getting license and permission from the authorized body. 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. Example copy
right and patent protects the right of an existing business and an existing artisian from
informal entry of new competitors.

B. Disclosure
A finanicial statement of any organization prepared by an accountant might not provide full
and relevant information regarding finanicial position and performance of that organization.
So there should be adequate notes or declarations given for the finanicial statement in
addition to the quantitative expression .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. The information that is to be disclosed to the public should follow several guidelines
to make sure whether the information is relevant and reliable.

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 C. 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.

Insurance companies are allowed to hold common stock, but their

holdings cannot exceed a certain fraction of their total assets.

D. Deposit Insurance
Deposit accepted from customers is liability for depository finanicial institutions that is to be
paid including interest rate. The government can ensure 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.

E. 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. A competition can be either through price, quantity, quality, or
quantity. Competitors might charge higher price for their product they produce or they
acquire, they might produce large quantity regardless of its quality (poor quality) or they can
produce small quantity of products which cannot satisfy customer needs to maximize their
individual profit. So there should be an adequate regulation to secure the life of the public.

F. 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. An interest rate that can be paid as a means of
motivation or reward is not free from restriction and is not totally up on the consent of the
payers. The more the interest rate that is to be paid for savers is lower, the more it would
cause higher money supply in the market and this might lead to inflation.

5.2 The Principles of Regulation

 Regulation requires that a careful balance be struck between effectiveness and efficiency.
The term effectiveness is regarding achievement of objective regardless of the amount of
resources used. But, to be an efficient there should be minimum use of scarce resource
beyond achieving the stated objective. Regulation has 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.

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  Some of the principles of the regulation of the financial markets and
institutions include: Competitive Neutrality; Cost Effectiveness; Accountability;
Flexibility; and Transparency.

A. 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:

i. Minimal barriers to entry and exit from markets and products;

ii. No undue restrictions on institutions or the products they offer; and
iii. Markets open to the widest possible range of participants.
B. 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 require:

 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.
C. Accountability
The regulatory structure must be accountable to its shareholders 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. There might be in
applicability of means of regulations and for that reason a responsible party should be
carefully identified to make someone responsible for the default.
D. Flexibility
The regulatory framework must have the flexibility to cope up with changing institutional
and product structures without losing its effectiveness. There must be flexibility depending
on circumstances and a regulation should not be rigid.
E. 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.

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5.3 Arguments for and against Financial System Regulations
Finanicial regulations mainly exist due to the existence of economic effect /social effect
of various social phenomena related to the economy. These incidents include;
 Instability in the finance
 Desire to maintain efficient market
 Maintaining fair competition
 Attempting to protect consumer against bad market practice
In the absence of regulation there might be only a possibility of generating short term profit
and problems like adverse selection and moral hazard. Regulations of finanicial practice are
therefore great in ensuring efficiency in the operations of business organizations.
However, in trying to regulate the finanicial related issues there is a likelihood of developing
problems like conflicts of interest and great costs associated with the research.
A regulation might be sympathetic or favor some finanicial market while it is destructive to
others especially for small firms. On the other hand the use of regulation may create
instability. Example; if the supply of certain commodity is regulated, the demand may not be
in a position to equal the supply and a regulation to individual firms with in industry might
lead to unnecessary costs.
Critics of government regulation usually argue that they are too costly relative to the benefit,
on the other hand regulatory polices typically claim that the regulation themselves carry great
benefits but that the rules may be poorly implemented.
However, the defenders of regulation rarely confront deeper arguments about the actual costs
of the polices they propose and the critics of government regulation rarely make sound
economic arguments against them. Either out of ignorance, or for fear of ruffling the feathers
of powerful interest groups of offending the sensibilities of the topical voter.
So what are some of the economic arguments against government regulation? Why
deregulation so often cause more harm than good, and why might deregulation actually be a
good idea?
1. Government regulations are a hidden tax on the market
Regulatory compliance costs, learning about and copying with other complex rules along
with whatever direct cost, each specific regulation imposes on the targeted firms in the
regulated market, merely act as a tax on the affected industry. A tax derives a wedge
between supply and demand, leading to higher prices for consumers and lower net
revenue to producers in most markets. The only difference between tax and regulatory
costs are;
 A tax at least generates some revenue for the government and
 A tax is more typically more transparent and easier to measure relative to
regulatory cost burdens which tend to be hidden.

2. Government regulations dull competitive market forces by erecting

barriers to entry and forcing marginal firms out of the market.
Regulations often act as suppression on competition creating monopolistic or quasi
monopolistic out comes in the affected industries. To the extent that regulations
impose costs that lead some firms to exit the market or discourage entry in to the
market. Regulations lead to a less competitive market place and conditions like
greater efficiency, lower price. Improved quality and higher levels of innovations
cannot exist in the market.

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3. Government regulations are a form of special interest protection and
a rent seeking by the business community.
The common perception is that businesses hate regulation but this a true simple
conclusion and untrue. This means they can run to the government seeking protection
from protection(either domestic or foreign) by advocating regulations that create
barriers to entry , making it more difficult for new rivals to compute on a level
playing field .Example tariff schedules , import restriction occupational licensing
laws.
4. Government regulations are redundant, since the free market is self-
regulating.
The free market, unfettered by the distortion of government regulation and ensconced
with in the frame work of the rule of law and protection for property rights, is a
wondrous mechanism of self-regulating and consumer protection. Accountability,
efficiency remains in play in a market without regulatory barriers to entry.
As long as markets remain competitive and open to the threat of entrepreneurial entry,
consumers are protected by the combination of market forces and rule of law upheld
by the court.
5. Government regulations threaten the rule of law and violate
property right , often subverting market forces to the arbitrary
whims of bureaucratic decision makers
Initially new government regulation are proposed and crafted in a broad scope by
political representatives, but they are then turned over the federal or state government
bureaucracies for implementation and enforcement. The products and services that do
come to be offered in a regulated market place are often tailored more towards
satisfying political / bureaucratic interests than in serving the ultimate interest of the
public. Firms are obliged to add any further design or quality towards their product
they produce.
6. Government regulations are rarely subject to through cost benefit
analysis( CBA)
From a strictly economic point of view, there is no good regulation or bad regulation.
There are only these regulations where benefits exceed costs. However, actually
measuring and assessing the costs and benefits of regulations is exceptionally
challenging as many of the costs of regulation are hidden and/or occur in a long
period of time.