Fall 2008 VersionFall 2008 Version

Professor Dan C. Jones

FINA 4355

Handout, Takaful

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

8. Regulation of Private-Sector 8. Regulation of Private-Sector Financial ServicesFinancial Services

Professor Dan C. Jones

FINA 4355

Handout, Takaful

3

Study PointsStudy Points

Private-sector financial services

Government’s role in regulating private-sector financial services

Overview of financial services regulation

Structure of regulatory authorities

Governmental actions affecting financial services regulation

Private-sector Financial Services

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Scope and Role of Financial ServicesScope and Role of Financial Services

Financial intermediariesFirms 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 conglomeratesProduct integration or advisory integration

Financial conglomerates and financial services

integration in Chapter 25.

Government’s 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 risksRisk of cascading failure

Simultaneous withdrawal by depositors (caused by a loss of confidence 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 theoriesPeltzman (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 failuresDifficulty 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)

Overview of Financial Services Regulation

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Regulatory InterventionsRegulatory Interventions

Prudential regulationConcerned with the financial condition of the financial intermediaryEvolved primarily because of information problems and negative externalities (especially for banking)

Market conduct regulationGovernment prescribed rules establishing inappropriate marketing practicesEvolved primarily because of information problems

Competition policy (antitrust) regulationConcerned with actions of the intermediary that substantially lessen competitionremains 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 nation’s 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 supervisionSupervision should be adequate

The Basel Capital AccordA banking credit risk management framework with a minimum capital standard of 8%

Basel II (newer)Minimum capital requirementsSupervisory review of an institution’s internal assessment process and capital adequacyEffective use of disclosureInsight 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 insolvenciesAimed 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 and taxation is discussed in

Chapter 24.

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Financial Conglomerate RegulationFinancial Conglomerate Regulation

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

Permissible activities (Table 8.1)The majority of countries allow joint banking and securities activitiesMost permitting banks to undertake securities activities within the bank itselfFew, 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 IAISExamines the common interests of the three financial services and develops 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 1990sFinancial 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 regulationNew 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

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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Discussion Question 2Discussion Question 2

Debate the following proposition: “government regulation of insurance premium rates is justified.”

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Discussion Question 3Discussion Question 3

What are the essential differences between government supervision of banks and of insurers? Why do these differences exist?

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Discussion Question 4Discussion Question 4

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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Discussion Question 5Discussion Question 5

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?”