iMinds - Financial Regulation

Money

Financial Regulation

2010 by iMinds Pty Ltd.

All Rights Reserved.

Financial regulation, simply put, is the supervision and control of the financial system and entities within it by a government body. It is deemed necessary to prevent abuses or failures within financial systems that affect the public or the stability of the system itself. Regulation is carried out differently in countries around the world. For example, in America there are a number of regulatory bodies for different parts of the financial market, while in the UK there is only one. The US regulatory system is also very rules-based, while the UK system is based more on principals.

Adam Smith, an eighteenth century Scottish philosopher, described an invisible hand that directs free markets. It became a lasting image in economic theory. By pursuing their own self-interests, individual market participants engage in the production and exchange of goods and services to the benefit of the whole. This is the invisible hand that guides individuals. It leads the market to operate efficiently and in service of the public good. While Smiths image suggests that a perfect market would function without any oversight, realities of the market require government regulation to ensure economic welfare.

Financial regulation at its most basic level has several goals. These are to guard against systemic failure, protect consumers from misconduct by financial institutions and to encourage efficiency in the financial system. Regulatory bodies may carry out these goals by proscribing some activities and supervising others. Generally speaking, regulated activities are those which may lead to market failure. Market failure is where the market fails to be efficient and beneficial to public economic welfare. Market failure may be caused by anti-competitive practices, market misconduct, asymmetry of information or by market instability.

Regulation of securities markets is carried out by bodies such as Americas Securities and Exchange Commission. The SEC regulates American securities markets by proscribing misconduct by market entities such as brokers and mutual funds, promoting market efficiency and protecting investors. The SEC ensures that sufficient information is provided to investors about securities being issued. Examples of misconduct may be those of insider trading or companies deliberately misinforming investors. Ensuring competition is also a major task for market regulation. Monopolies and cartels result in market inefficiencies that operate usually to the detriment of public economic welfare. The prosecution of anti-competitive behaviours falls under Competition law or, in the United States, Antitrust law.

Regulation of the banking industry is largely concerned with maintaining the stability of banks. In America, the Federal Reserve was founded due to the instability of private banking at the beginning of the 20th century. The lack of public confidence in banks at this time led to bank runs, or large scale withdrawals by panicking depositors. This caused significant disruptions to the American economy and caused major financial collapses. The Federal Reserve was established to manage monetary policy and regulate the banking industry so as to create economic stability.

There are a range of regulations that have been imposed on banks at different times around the world. They are often concerned with the protection of depositors and the reduction of risk exposure. To prevent potential bank runs, some governments provide deposit insurance in the event of bank failure. Banks must also provide information about their activities and financial statements for the benefit of depositors. A bank may be restricted in the amount and type of risk that it can assume through financial assets. A minimum capital requirement can acts as a buffer against the risk of these assets.. As banks may hold the bonds or debt instruments of other banks or financial institutions, if issuer of these assets fails, the holders of the assets may also fail. Hence, banks are prone to systemic risk.

Systemic risk is considered to be a major problem in financial markets. Financial markets and their institutions are often interconnected through investments, services, debts and leveraged collateral. This has become even more apparent with the influence of globalisation and with the increasing range of financial instruments that institutions utilise. By becoming sufficiently large enough and interconnected in a market, a company may be considered too big to fail. Because of its economic presence, it is believed that the government would intervene through bail outs or similar methods if it failed. This leads to moral hazard. This is where a company is able to pursue higher risk activities because protection from failure is assured. However, by providing bailouts, or a by being a lender of last resort, the government further increases moral hazard. Regulations attempt to managing systemic risk before such collapses occur, though they are limited in effect.

There are a number of arguments against financial regulation. Many are concerned with regulation being inefficient and reducing benefits for the public. It increases costs through means such as licensing and registration requirements and reduces liquidity. It also reduces innovation in financial services. Therefore, regulation is counterproductive in achieving its goals of protecting the free market. Other arguments against regulation are similar to the idea of Smiths invisible hand. An unregulated market will be policed by its own participants and will become more productive and efficient through its own workings. Some of these arguments have led to the deregulation, or the partial removal of regulations, from the 1970s onwards. This was to encourage freer, more competitive markets. In times of financial crisis, governments often respond with stricter regulations to prevent similar crises re-occurring. Such has been the case during the first decade of the new millennium.

Partially due to their freedom from regulation, hedge funds have grown in popularity as investment since the late 20th century. While these investments funds are named for hedging against investment risks, many have since used highly leveraged positions to make high risk market transactions. A leveraged position is one where a small amount of capital is used as collateral to borrow larger amounts of money. Because of the lack of regulation, hedge funds have enjoyed high liquidity. Their popularity, however, had led to an increased presence in the market that led to greater systemic risk. In the fallout of the Global Financial Crisis, this has led to financial regulators in the US and other nations to increase their supervision on control of these investment funds. This raises concerns by the funds that their advantages in liquidity will be lost.

While contrary to the spirit of the free market, financial regulation is to some degree necessary for economic systems. While moves towards deregulation encouraged better market performance, it also increases risks for more fragile sectors such as banking. With the spread of global markets, the systemic risk of some financial institutions can have catastrophic results, as was evidenced in the recent Global Financial Crisis. While there may be expectations that regulators will step in to prevent the spread of an economic crash, this only encourages bigger risks. Financial regulation policy then faces the challenge of managing systemic risk and market interactions both domestically and globally. This must be balanced against room for financial innovation and the desire for the invisible hand to direct the market.