Rationale of financial regulation: Facts vs. myths

logoThursday, 4 May 2017
The financial tsunami that occurred during 2008-2009 washed away gigantic financial institutions mercilessly from the shores of financial systems. In fact the meltdown proved the fact that financial crises have more severe impact on output and employment than business downturn.

Consequent to the global financial turmoil there have been dramatic changes to the regulatory frameworks for financial institutions all over the world. These regulatory developments have taken place both at global and domestic levels. Adopting Basel III capital requirements, introducing special resolution regimes for financial institutions, changing regulatory architectures, improving derivative markets, reforming deposit insurance schemes, strengthening accounting standards and developing macro prudential frameworks are examples of such regulatory responses.Untitled-1

Along with tightening financial regulatory regimes, debates on the volume of such regulations as well as their proportionality and effectiveness have also come to the forefront. Overall, the regulatory perspective towards missteps by financial institutions have become less forgiving due to the adverse impact of such violations on financial systems across the globe.

The broader regulatory compliance and risk management requirements associated with the responses to the crisis is further reflected in the trend of imposing huge penalties by the law enforcement authorities. Ranging from the mis-selling of subprime mortgages to the manipulation of global foreign exchange markets, regulatory fines have led to enhanced legal risk for financial institutions. It has been reported that the regulatory fees paid by the US and the EU Universal banks during the period 2009-2014 has significantly increased relative to banks’ earnings and credit losses.

Considering the trend of mounting regulatory risk for financial institutions, it is topical to shed light on the rationale for financial regulation with the emphasis on separating perceptions from realities. In fact, today’s highly competitive and complex financial markets, with blurred boundaries would definitely require comprehensive regulatory framework to rectify the market imperfections. This article will accordingly discuss the key elements of the rationale of financial regulation along with myths and truths pertaining to modern financial regulation.

Why are financial institutions not set free from regulation?

Despite the financial regulatory landscape having been subject to significant changes after every financial crisis, there are still arguments on the need for such regulation for financial services. Kevin Dowd (1997), a scholar who argued in favour of free banking is of the view that unregulated banking does not cause inflation of the money supply or of prices, and unregulated competition among banks does not destabilise the banking system.

Despite free bankers arguing that best governance is self-governance, financial turmoil of recent years proved that self-governance would not always be effective. In fact the global financial crisis seriously undermined the credibility of “efficient market hypothesis”.

Every financial crisis situation has proved that lack of integrity in financial institutions has been a root cause for such distressed situations. The absence of integrity and a compliance culture in financial systems have attracted more stringent regulatory frameworks. According to the definition developed by Financial Conduct Authority of the UK, compliance requirements are aimed at creating a culture where everyone has ownership and responsibility for doing the right thing. Accordingly, when the alleged first best solution i.e. freely functioning markets fails, the second best alternative of appropriate regulation becomes inevitable.

Need to safeguard the rights and interests of the customers

Customers of financial institutions are vulnerable to being misled. While financial institutions are focused upon the profit maximisation goal there is room for actions detrimental to the rights and interests of the customers. Since they have become the main source of funds for banks and other financial institutions, protecting their rights is of paramount importance. Inserting unfair terms and conditions in the contracts and failure to provide accurate disclosures on transactions are widely discussed misbehaviours.

Charles Goodhart (2009), states that protecting the customer against monopolistic exploitation is a key objective of financial regulation. Another opinion states that business activity should be regulated as companies are licensed by the government. Financial innovations that have been designed to circumvent applicable laws also justify the need for financial regulation.

It can be argued that caveat emptor rule i.e. “buyer beware” concept cannot be applied in simple terms to the financial services. The awareness of the customers about the financial products, particularly complex instruments would depend on the amount of information available to customers. Therefore, in the context of today’s financial markets there should be regulations in place to address information asymmetry in order to enable the customers to take informed decisions on their investments.
Need to regulate the conduct of business

Subsequent to the global financial crisis greater emphasis has been placed on the conduct of business by financial institutions. Such regulations focus on how and why transactions are undertaken and their impact on customers and wider financial markets. This element of regulation has also been identified as shifting towards monitoring and challenging corporate culture. Corporate governance, organisational systems, fitness and propriety requirements and controlling abusive related party transactions have been given prominence under the modern conduct of business regulation. Confining such regulation only to technical rules would not be successful in the milieu of today’s complex financial markets.

Widespread mis-selling of retail mortgages reported in the USA is an example of triggering instability in the financial system due to non-compliances with conduct of business regulations. Hence, the manner in which the financial transaction are executed needs to be subject to prudent norms and principles, as the outcome may have an impact on resilience of the particular financial firm and its customers. Regulatory intervention into business decisions would nevertheless require a balanced approach.

Along with this focus on the conduct of business, capital regulation of financial firms also assumes importance. If no regulatory capital requirement is available, such entities would run without having capital which is built up during good times to face the gloomier times associated with downturns in the economy. Robert Jenkins (2015), former Bank of England policymaker explains the myth related to capital regulation as follows: “Capital is there not just for the risks we think we understand – it is there for the ones we don’t.”

It was evident during the financial crisis that under-capitalised banks could not absorb losses and had to be bailed out with tax payers’ money. Hence the argument that regulatory capital requirements compel firms to set aside sufficient capital, appears to be a myth. One of the lessons from the global financial crisis is that such requirements need to be complemented by stress tests to ensure that there is a sufficient capital buffer to support lending in a downturn.

There is no “one size fits all” type regulatory model

In considering the rationale for regulation, the nature of the financial regulatory landscape should also be taken into account. Splitting the single regulator of the UK into two in respect of conduct of the business and prudential regulation was the most recent change of financial regulatory architecture.

The Financial Conduct Authority (FCA) has been charged with the responsibility of ensuring the well-functioning of the financial markets, consumer protection, market integrity and competition. It has been revealed that there is no “one size fits all” kind of regulatory architecture. The effectiveness of a particular regulatory landscape cannot be fully assessed until there has been another financial crisis.

The single regulator model has been successful for some jurisdictions whereas the twin peak model has been an efficacious structure for some other countries. Therefore, trying to plant a regulatory model disregarding country specific circumstances would create a dysfunctional outcome. In designing a regulatory architecture for a particular financial system it is imperative to ensure that there are no overlaps between requirements imposed by various regulatory bodies.

Regulatory cost for the financial institutions can be reduced by ensuring cohesiveness of regulatory requirements and establishing efficient coordination between entities in a fragmented regulatory framework. Financial institutions also can explore mechanisms to meet requirements of all the regulators, including domestic and international authorities, by devising appropriate reporting methods.

Ensuring financial

system resilience

It is considered that financial firms need to be regulated due to their interconnectedness, which results in contagion that causes systemic damage. The global financial crisis provided virtual evidence that turbulence in the financial sector can have rippling effects on the real sector of the economy, with a collapse in output and employment in advanced economies.

Unlike in other industries where failure of one firm creates an opportunity for the competitors, externalities caused by a collapse of a financial firm to the entire system is much more severe. Imposing systemic surcharges and levies under capital regulation are examples of regulatory responses for addressing systemic risk.

Free marketers argue that when a crisis hits good banks have a strong incentive to distance themselves from bad banks and therefore the contagion effect does not materialise. Today’s multifaceted and interconnected financial sector has, however, proved that exposures of individual institutions to other firms would be a cause to aggravate systemic risk.

Despite most of the regulatory reforms being focused on “too big to fail” institutions, it can be argued that depending on the system specific circumstances, even a tiny financial institution could trigger systemic instability. Financial regulation would, therefore, be a prerequisite to prevent or mitigate such systemic issues through greater scrutiny.

Regulated entities can contribute towards the effectiveness of micro prudential regulation by ensuring the compliance. This will contribute to the success of macroprudential regulation which is focused on the systemic picture. Moreover, if there is no specific mechanism to ensure the orderly exit of an ailing institution from the system, it will exacerbate the consequences of the failure.

According to Maserano (2011), financial stability should be considered as a public good. Making financial institutions subject to a stringent regulatory framework can, therefore, be taken as a supply of this public good. According to Anat Admathi (2014) “better regulation would produce a more stable financial system where banks would be more likely to make the kind of loans and investments that build and expand economic opportunity for society as a whole”.

Need to prevent misappropriation of public funds

There have been domestically and globally reported incidents where financial institutions misuse public funds through fraudulent transactions, financial malpractices, mismanagement and various financial crimes.

According to Ricardo (1873), the distinctive feature of the banker begins when he uses the money of others; as long as he uses his own money he is only a capitalist. Therefore, the regulatory framework needs to be in place specifically to ensure that handling of public funds by financial firms is subject to proper systems and controls. Gorton (2010), states that “privately created bank money is subject to runs in the absence of government regulation”.

Restrictions on related party transactions, single borrower limits, business transactions with directors and directions related to investments by financial institutions can be considered as regulatory requirements imposed on the premise of the above mentioned monetary rationale. Therefore in modern financial regulation, attention of the authorities has been paid to preventing wrongful gains from financial misdemeanours and causing undue losses to financial institutions by various parties.
Special role played by financial institutions in the economy 

The crucial financial intermediary function carried out by banks and other financial institutions, such as finance companies, emphasise their importance in the system. In fact solvent financial institutions are important for the solvency of the economy. The special role played by the banks is reiterated in the historic speech made by the late President of the USA, Roosevelt, in 1933 explaining his plans to stop a run on the banks. He went on to state:

“…let me state the simple fact that when you deposit money in a bank the bank does not put the money into a safe deposit vault. It invests your money in many different forms of credit—in bonds, in commercial paper, in mortgages, and in many other kinds of loans. In other words, the bank puts your money to work to keep the wheels of industry and of agriculture turning round.”

The above statement of President Roosevelt endorses another aspect of financial regulation i.e. fractional reserve banking. Since banks and finance companies keep only a fraction of all deposits, they are exposed to liquidity risk. This is an inherent risk of finance business. Apart from their role as the monetary policy transmitter, financial institutions also act as the heart of the payments and settlements system of the financial sector. The very special role of the banks may convert them to risk amplifiers in the event of a crisis. Therefore, the need for a special regulatory framework to address the problems in financial institutions is justifiable.

Free marketers, however, present the critique that financial regulation impedes innovation. But the global financial turmoil demonstrated that “financial innovation” and “financial engineering” led to unhealthy explosive growth of financial markets and amplified the risks. Over the Counter Derivatives, which were at the heart of the damage caused by the global financial crisis, were an example of the repercussions of unregulated financial innovation.

Requirement to ensure social justice

Financial institutions are vital for the purposes of financial inclusion in a country. They can reduce the percentage of the unbanked population and thereby discourage informal financial transactions. Financial inclusion requires careful planning due to the risks associated with rapid deepening. However, instead of attaching priority to the mere expansion of financial outreach, institutions should also focus on enhancing the quality of their services, effectiveness and efficiency. That argument warrants regulating financial institutions to achieve the social objectives, such as alleviation of poverty and enhancing access to finance, while maintaining financial system stability.

According to Thorton (1965) “…in a society in which law and sense of moral duty are weak and property is consequently insecure, there will be little confidence or credit and there will also be little commerce”. Therefore, a regulatory framework is required to ensure that the formal financial system delivers affordable financial services to the excluded population with greater efficiency without compromising on safety and soundness.
Availability of public safety nets

This is another justification for the regulation of financial institutions. Lastra (2012), states, “If the regulator helps financial institutions on rainy days, it should be possible to monitor them on sunny days”. Since the regulators make available assistance to financial institutions by being the lender of last resort and through various other bail out schemes, there should be a regulatory framework to prevent moral hazard. The Deposit Insurance Scheme can be taken as an example of such a safety net.

The perception of the general public that regulator should bail out them completely in the event of a collapse of a finance company is a myth related to financial regulation. Financial regulation should be defined as a task which would ensure that financial entities conduct their business subject to prudent norms and regulations. More regulatory assistance during turbulent times warrants more regulatory interventions into the conduct of business and corporate affairs of financial institutions.

On the other hand free bankers argue that deposit insurance schemes discourage customers from monitoring the activities of financial institutions and that public safety nets would decrease market discipline. However, the task of safety net undermines the public good concept of regulation, particularly where there has been regulatory forbearance.

Way forward in financial regulation

It is said that financial institutions are global and therefore financial regulation also needs to be global. Hence a carefully devised regulatory framework will be required to address the issues in rapidly evolving globalised financial markets which have digitalised all major areas of financial services. Proportionality of regulation is a vital element as too much risk avoidance may be counterproductive, as it constraints financial intermediation which in turn suppress growth and employment. However disciplined competition through the greater intervention of an effective regulatory framework would support economic activities and enhance consumer welfare. Harmonised regulatory standards through corporation among national and international regulators is necessary in the context of globalised institutions and markets.

Establishing a regulatory system that would accommodate innovations in financial services, while safeguarding customers and ensuring systemic stability would in fact be a challenge, in the absence of collaboration of regulated entities. Instead of mere technical compliance, a holistic approach towards corporate governance structures needs to be ensured by financial institutions to reap benefits of such regulations. All the stakeholders of financial sector need to facilitate to realign the regulatory parameters and principles so as to mitigate the impact of financial crises. Efficiency of law enforcement authorities also need to be coupled with financial regulation in delivering desired outcomes. However no amount of regulation would be effective unless efficient compliance functions of financial institutions prevail in order to prevent corruption and white collar crime.

[The writer, LLM (London), LLB (Hons) Colombo, MICA, is an Attorney-at-Law. The views and opinions expressed in this article are those of the writer and do not necessarily reflect the official policy or position of any institution.]

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