Lecture Economics for investment decision makers: Chapter 12 - CFA In stitute

Chapter 12 - Economics of regulation. This chapter sescribe classifications of regulations and regulators, describe uses of self-regulation in financial markets, describe the economic rationale for regulatory intervention, describe regulatory interdependencies and their effects, describe tools of regulatory intervention in markets,...

Chapter 12

Economics of Regulation

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1 Introduction

• Regulation is important because of its impact on individuals, businesses, and the economy

• Regulation may be proactive or reactive

• A challenge with financial regulation is managing systemic risk

- Systemic risk is the risk of the failure of the financial system

• Uncertainty regarding regulation is a risk that affects business decisions

2 Overview of regulation

• Regulations may be enacted by

- statutes (that is, laws);

- established by government

agencies or other regulators,

which are administrative laws

and regulations; or

- interpretations of courts (that

is, case law)

• Independent regulators get

their authority from government

bodies or agencies

• Outside bodies may be referred

to by regulatory authorities

Self-regulation in financial markets

• A self-regulating organization (SRO) is a nongovernmental entity that

represents and regulates its members

- Some independent regulators are SROs, which may have authority from a government body or from its members

- SROs are similar to statutory bodies in some countries

- The use of self-regulatory bodies varies among countries

• SROs are not considered regulators unless they are given authority by a government body or agency

Classifying regulations and laws

• We can classify regulations by objectives:

• We can classify regulations by function:

- Substantive law focuses on the rights and responsibilities of entities and the

relationships among entities

- Procedural law focuses on the methods of administering substantive law

and the process for determining the rights of parties

Safety Commerce and trade Privacy Consumers’ rights Protection Investor protection Environmental Antitrust

Labor and employment Financial system

Economic rationale for regulation

• Regulation may be necessary if market solutions are not sufficient

- Although the market solution is the most efficient allocation of resources, the market may not be frictionless, with constant returns to scale and without

externalities

• Regulation is needed when there are informational frictions and externalities

- Informational frictions include asymmetrical information and agency

problems

• Regulations are needed to supply a public good (e.g., defense) that has shared benefits but which may not be funded without regulations

Regulatory interdependence

• The regulated firms and industry may benefit (regulatory capture) from being regulated

- Example: regulations may restrict competition

• When there are differences in regulations across jurisdictions, there may be regulatory competition and regulatory arbitrage

- Regulations can be designed to attract entities (e.g., incorporation laws)

- Entities can shop for regulatory environments in which they may be able to exploit differences in regulations

• The interdependency of countries’ regulators, each with different objectives, is important because without coordination, countries may be at a competitive

disadvantage

• Overlapping jurisdictions can result in conflicts, such as bank stress test results (generally not available to the public) and securities regulations’ disclosure

requirements

Tools of regulatory intervention

• Tools available:

- Taxing (to encourage or discourage certain decisions)

- Restricting activities (such as insider trading)

- Mandating activities (such as minimum capital standards)

- Imposing of sanctions and penalties (such as punitive fines for insider-trading violations)

• Choosing the appropriate tool is difficult, and more than one tool may be

applied for a given situation or problem

- Consistency in the application of tools is desirable

• It is difficult to judge whether specific actions by regulators are effective

because financial systems are dynamic and complex

3 Regulation of commerce

Commerce is regulated by the government for many reasons, including

• dealing with externalities (e.g., pollution) and public goods,

• promoting commerce,

• protecting labor (e.g working conditions),

• protecting consumers (e.g., product safety),

• protecting intellectual property,

• ensuring privacy of customers,

• ensuring an appropriate legal environment (e.g., contracts, permits),

• supporting and protecting domestic business interests (e.g., fair competition), and

• promoting competition in the domestic market (e.g., antitrust laws)

Appropriate legal framework

(IOSCO’s framework)

(1) Company Law

1.1 company formation

1.2 duties of directors and officers

1.3 regulation of takeover bids and other

transactions intended to effect a change in

control

1.4 laws governing the issue and offer for sale of

securities

1.5 disclosure of information to security holders to

enable informed voting decisions

1.6 disclosure of material shareholdings

(2) Commercial Code/Contract Law

2.1 private right of contract

2.2 facilitation of securities lending and

hypothecation

2.3 property rights, including rights attaching to

securities, and the rules governing the

transfer of those rights

(3) Taxation Laws

3.1 clarity and consistency, including, but not limited to, the treatment of investments and investment products

(4) Bankruptcy and Insolvency Laws

4.1 rights of security holders on winding up 4.2 rights of clients on insolvency of intermediary 4.3 netting

(5) Competition Law

5.1 prevention of anti-competitive practices 5.2 prevention of unfair barriers to entry 5.3 prevention of abuse of a market dominant position

(6) Banking Law

(7) Dispute Resolution System

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Antitrust laws

• Antitrust regulations are intended to prohibit abusive and anticompetitive

behavior, including exclusive dealings and refusals to deal, pricing

discriminations, and predatory pricing

- Example of antitrust concerns: software bundling by Microsoft

- Example of use of antitrust for competitive advantage: Microsoft EU claims against Google

• A challenge is that antitrust issues may involve many different regulators

- In the United States: Department of Justice, Federal Trade Commission, etc

4 Regulation of financial markets

• Goals of securities regulation:

- Protect investors

- Create confidence in markets

- Enhance capital formation

• Goals of regulating financial institutions:

- Protect consumers and investors

- Ensure safety and soundness of institutions

- Smooth payment system

- Provide access to credit

• Regulation of financial markets is necessary because the consequences of

The regulation of financial markets

• Regulation of markets

- maintains integrity of markets,

- acts as a referee for fairness,

- maintains financial stability, and

- ensures appropriate and fair disclosures

- Disclosures include financial statements, accounting standards, periodic disclosures, and price transparency disclosures

• Securities market regulation focuses on

- reducing agency problems (e.g., governance, fee disclosure, proxy voting, and soft-dollar expenses) and

- protecting retail investors (but not necessarily large investors)

Prudential supervision

• Prudential supervision is the regulation and monitoring of the safety and

soundness of financial institutions

- Promote financial stability

- Reduce system-wide risks (systemic risk)

- Protect customers of financial institutions

• Prudential supervision also relates to confidence in the financial system

- Diversifying assets

- Managing and monitoring risk taking

- Ensuring adequate capitalization

5 Cost – benefit analysis of regulation

• Regulatory burden is the cost of regulation to the regulated entity.

• Net regulatory burden is the private cost of regulation minus the private

benefits of regulation

• Benefits include a more competitive environment, reduced risk to the financial system, and enhanced market liquidity

• Costs of regulation may be direct (e.g., compliance attorneys, pollution control equipment) or indirect (e.g., lost sales, lower returns)

• Costs and benefits are difficult to estimate, despite there being mandated cost– benefit analyses by the government

- A sunset provision would require a cost–benefit analysis as part of the

renewal of a regulation

6 Analysis of regulation

• Regulations may focus on a sector, an industry, a company, or a security

depending on the purpose of the regulation

• Examples of sector regulation: the regulation of the financial sector

post-financial crisis (e.g., capital standards, risk management)

- Trade-off: increase stability of industry versus reduce growth opportunities and returns

• Example of industry regulation: discount window borrowing by banks

- Issue: whether this information should be disclosed to investors

• Example of security regulation: collateralized mortgage-backed securities

- The Dodd–Frank Act prohibits references to ratings in regulations of

securities as a result of the financial crisis problems

Conclusions and summary

• Legislative bodies, regulatory bodies, and courts typically enact regulation

• Regulatory bodies include government agencies and independent regulators granted authority by a government or governmental agency Some independent regulators may be self-regulating organizations

• Typically, legislative bodies enact broad laws or statutes; regulatory bodies issue administrative regulations, often implementing statutes; and courts interpret

statutes and administrative regulations, which may result in judicial law

• Regulators have responsibility for both substantive and procedural laws The former focuses on rights and responsibilities of entities and relationships among entities The latter focuses on the protection and enforcement of the former

• The existence of informational frictions and externalities creates a need for

regulation Regulation is expected to have societal benefits and should be

assessed using a cost–benefit analysis

• Regulation that arises to enhance the interests of regulated entities reflects

Conclusions and summary

• Regulatory competition is competition among different regulatory bodies to use regulation to attract certain entities

- Regulatory arbitrage is the use of regulation by an entity to exploit differences

in economic substance and regulatory interpretation or in regulatory regimes

to the entity’s benefit

• Interdependence in the actions and potentially conflicting objectives of

regulators are important considerations for regulators, those regulated, and

those assessing the effects of regulation

• There are many regulatory tools available to regulators, including price

mechanisms (such as taxes and subsidies), regulatory mandates and

restrictions on behaviors, provision of public goods, and public financing of

private projects

• The choice of regulatory tool should be consistent with maintaining a stable

Conclusions and summary

• The breadth of regulation of commerce necessitates the use of a framework that identifies potential areas of regulation This framework can be referenced

to identify specific areas of regulation, existing and anticipated, that may affect the entity of interest

• The regulation of securities markets and financial institutions is extensive and complex because of the consequences of failures in the financial system

These consequences include financial losses, loss of confidence, and the

disruption of commerce

• The focus of regulators in financial markets includes prudential supervision, financial stability, market integrity, and economic growth among others

• Regulators should conduct ongoing cost–benefit analyses of regulations,

develop techniques to enhance their measurement, and use economic

principles to guide them