8 Regulation Private Financial Services

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Fall 2008 VersionFall 2008 Version

Professor Dan C. Jones

FINA 4355Handout, Takaful


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Risk Management and Insurance: Perspectives in a Global EconomyRisk Management and Insurance: Perspectives in a Global Economy

8. Regulation of Private8. Regulation of Private--SectorSector

Financial ServicesFinancial Services

Professor Dan C. Jones

FINA 4355

Handout, Takaful


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Study PointsStudy Points

Private-sector financial services

Governments role in regulating private-sector financial

services

Overview of financial services regulation

Structure of regulatory authorities

Governmental actions affecting financial services regulation


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Private-sector Financial Services


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Scope and Role of Financial ServicesScope and Role of Financial Services

Financial intermediaries

Firms or other entities that bring together providers and users of funds

Market financial services products offered through the financial

intermediation process

Not actually manufacture (underwrite) all of the products they sell

Match savers with investors, thus obviating the need for savers to

locate investors directly and vice versa

All financial intermediaries issue their own claims.

Financial intermediaries would not exist in a perfect market.


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Types of Financial IntermediariesTypes of Financial Intermediaries

Depository institutions

Security firms (investment banks)

Insurance companies

Mutual funds

Pension funds

Financial conglomeratesFinancial conglomerates

Product integration or advisory integration

Financial

conglomerates and

financial services

integration in Chapter

25.


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Governments Role in Regulating Private-sector

Financial Services


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Why Regulate Financial Services?Why Regulate Financial Services?

Market imperfection

Information asymmetry the lemons problem

Market power

Negative externalities possibility of systematic risks

Risk of cascading failure

Simultaneous withdrawal by depositors (caused by a loss ofconfidence in the financial institutions)

Also discussed

in Chapter 2


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Theories of RegulationTheories of Regulation

Public interest theory

Regulation exists to serve the public interest by protecting consumers

from abuse.

To maximize economic efficiency, including preventing or making

right significant societal or consumer harm that results from market

imperfections


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Theories of RegulationTheories of Regulation

Private interest theories

Peltzman (1976) Self-interested regulators engage in regulatory

activities consistent with maximizing their political support.

Meier (1988) Regulation will be shaped by a type of bargaining that

occurs between private interest groups within the existing political and

administrative structure.

Stigler (1971) Regulation is captured by and operated for the

benefit of the regulated industry.

Regulation unduly influenced by special interests could result in:Restrictions on entry of new domestic and foreign entrants

Suppression of price and product competition

Control of inter-industry competition from those selling similar or

complementary products


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Government Imperfections!Government Imperfections!

If financial markets were perfectly competitive, regulation

would be unnecessary.

When is intervention justified only if the three conditions

are met:Actual or potential market imperfections exist.

The market imperfections do or could lead to meaningful economic

inefficiency or inequity.

Government action can ameliorate the inefficiency or inequity


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Government Imperfections!Government Imperfections!

Government failures

Difficulty in identification and formulation of goals

Principal-agent problems where government employees are agents

for the public

Rent-seeking behavior engaged by the regulated

The problem of capture (related to the rent-seeking behavior)


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Overview of Financial Services Regulation


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Regulatory InterventionsRegulatory Interventions

Prudential regulationConcerned with the financial condition of the financial intermediary

Evolved primarily because of information problems and negativeexternalities (especially for banking)

Market conduct regulationGovernment prescribed rules establishing inappropriate marketingpractices

Evolved primarily because of information problems

Competition policy (antitrust) regulationConcerned with actions of the intermediary that substantially lessencompetition

remains the most critical element in government oversight


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Commercial Banking RegulationCommercial Banking Regulation

Commercial banks are subject to oversight in every national

market.

Every major market provides for some type of deposit

insurance on the savings of customers.

Banks are subject to oversight by the nations central bank

and usually a banking regulator.


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Commercial Banking RegulationCommercial Banking Regulation

The Basel Committee on Banking Supervision (BCBS)Two principles

No foreign banking establishment should escape supervision

Supervision should be adequate

The Basel Capital Accord

A banking credit risk management framework with a minimumcapital standard of8%

Basel II (newer)

Minimum capital requirementsSupervisory review of an institutions internal assessment processand capital adequacy

Effective use of disclosure

Insight 8.1


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Securities RegulationSecurities Regulation

Focuses on both the new and secondary issues markets,

mandating certain disclosures to prospective purchasers

about the securities

To rectify buyers information asymmetry problems

The Sarbanes-Oxley (SOX) Act

International Organization of Securities Commissions(IOSCO)

Objectives and Principles of Securities Regulation (IOSCO Principles)

ISOCO Assessment Methodologies


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Insurance RegulationInsurance Regulation

Focused chiefly on monitoring and preventing insolvencies

Aimed more at protecting policyholders from losses occasioned by

insurer insolvency

International Association of Insurance Supervisors (IAIS)Promotes cooperation among insurance supervisors

Sets international standards for insurance regulation and supervision

Issues principles, standards and guidance papers on issues related to

insurance supervision

Insurance regulation an

taxation is iscusse in

a ter 4.


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Financial Conglomerate RegulationFinancial Conglomerate Regulation

Details of financial institution regulation vary not only fromcountry to country but from financial sector to financialsector.

Permissible activities (Table 8.1)The majority of countries allow joint banking and securities activities

Most permitting banks to undertake securities activities within thebank itself

Few, if any, countries permit insurance underwriting within a bank

The Joint Forum on Financial Conglomerates (Joint Forum)Consists of the Basel Committee, IOSCO and the IAIS

Examines the common interests of the three financial services anddevelops principles and identifying international best practices


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Other Intergovernmental OrganizationsOther Intergovernmental Organizations

The International Network of Pensions Regulators and

Supervisors

The Financial Stability Forum

The Islamic Financial Services Board

The Financial-Sector Assessment Program


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Structure of Regulatory AuthoritiesStructure of Regulatory Authorities


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Structure of Regulatory AuthoritiesStructure of Regulatory Authorities


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Governmental ActionsGovernmental Actions

After the Asian and other financial crises of the late 1990s

Financial services regulation has become less diverse

The major intergovernmental organizations involved in financial

services regulation playing more active and constructive roles

The trend toward allowing mutual insurers and banks to

convert to shareholder-owned firms

Privatization of banks and insurance firms in several

countries

Significant combinations of banks and insurance firms


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Future ProspectsFuture Prospects

Risk-based prudential regulation

New disclosure-based financial regulatory model evolving

internationally

Integrated international approaches to accounting standards,

securities regulation and financial institution regulation

Interest in common international financial regulation in areas

for which such would be feasible


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Discussion Questions


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Discussion Question 1Discussion Question 1

Explain carefully why government regulation of private-sector

financial service firms is considered necessary.


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Debate the following proposition: government regulation of

insurance premium rates is justified.


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What are the essential differences between government

supervision of banks and of insurers? Why do these

differences exist?


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Discussion QuestionDiscussion Question

Examine the structure of financial regulation in your home

country and compare it with the structure in another

economy. Do you find any significant differences in the

structures or in the accompanying regulatory objectives?

Elaborate your findings.


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Offer your answers to the questions posed in Note 2 of this

chapter.

Could there be a chicken and egg problem here? Could regulation

that shields consumers from the consequences of their mistakes or

from failing to become better informed about the quality of financial

intermediaries result in their expecting government protection? Is it

possible that the market might devise its own means of minimizing the

effects of mistakes and providing consumers with adequate

information were government intervention at a lesser level?

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8 Regulation Private Financial Services