Question

Question 2 Critically discuss the reasons why there is regulations imposed on, and more monitoring of Financial Institution compared to companies in other industries.

Answer 1

Supervision has a number of important functions. In addition to the consistent implementation of regulation, supervision can complement regulation in dealing with the financial sector's continuous innovation and adaptation, thereby reducing the need for frequent rule changes and promoting regulatory stability. Moreover, supervision can go beyond the quantitative requirements to address qualitative matters such as corporate governance, influencing banks to change their risk culture for the better. Consistent implementation of the rules is one of the important roles of supervision, possibly the most important. It is a way to ensure sound balance sheets and a resilient financial system.  In a highly dynamic, changing and complex world, regulations are permanently playing catch-up with t The financial system undergoes constant evolution. Any given regulatory framework - be it simple or complex - would thus inevitably face limitations in constraining the risks in this system.he continuously adapting financial sector. Supervision can complement regulation in dealing with this challenge. In order to remain effective, a regulatory system needs to address these limitations and challenges. Cases of large losses at banks and other firms due to weaknesses in governance and culture are all too common. At the heart of these cases, there is an inevitable link between poor risk culture, on the one hand, and failures in controls and governance, on the other. Such weaknesses therefore have safety and soundness implications and represent a major risk factor with tangible consequences for banks' profitability, reputation and competitiveness.

• Financial regulations protect consumers’ investments.
• Regulations prevent financial fraud and limit the risks financial institutions can take with their investors’ money.
• Financial regulators oversee three main financial sectors: banking, financial markets, and consumers.

The economic rationale for regulation The analysis to follow focuses upon seven components of the economic rationale for regulation and supervision in banking and financial services:

1. Potential systemic problems associated with externalities (a particular form of market failure).

2. The correction of other market imperfections and failures.

3. The need for monitoring of financial firms and the economies of scale that exist in this activity.

4. The need for consumer confidence which also has a positive externality.

5. The potential for Grid Lock, with associated adverse selection and moral hazard problems

6. Moral hazard associated with the revealed preference of governments to create safety net arrangements: lender of last resort, deposit insurance, and compensation schemes.

7. Consumer demand for regulation in order to gain a degree of assurance and lower transactions costs.

Two generic types of regulation and supervision are identified:

(i) prudential regulation, which focuses on the solvency and safety and soundness of financial institutions

(ii) conduct of business regulation which focuses on how financial firms conduct business with their customers.

The financial sector provides liquidity. If the financial system is working well, individuals, businesses, and governments are able to convert their assets into cash at short notice, without undue loss of value.

The provision of liquidity is useful to individuals for meeting unexpected obligations. It is also critical to society at large. Access to liquidity allows businesses to deploy their capital in ways that increase the productive capacity of the economy. Without it, households and businesses would be forced to hold larger sums of cash to protect against unforeseen events. The result would be fewer resources for investment and the provision of fewer goods and services to consume.

The financial sector is, however, a critical link in the functioning of the economy: every economic interaction has a financial component, such as a payment. The spillovers to the real economy from dysfunction or operational failure in the financial and payments systems can be severe. Moreover, these spillovers can add to ‘moral hazard’, whereby financial institutions take risks under the assumption that the resulting costs would be, at least partly, borne by others (for example, their creditors or society at large). The potential for undue risk-taking is exacerbated by the problem of asymmetric information, where the party ultimately bearing the risk is not fully aware of it.

In addition, the core functions of financial intermediaries make them vulnerable to a change in customer and investor confidence, more so than for most firms. In particular:

• Because they undertake maturity transformation, financial intermediaries hold long-term assets while being subject to short-term obligations. This exposes them to the possibility of runs.
• In intermediating between savers and borrowers, financial institutions tend to be highly leveraged relative to other companies. As a consequence, depositors and other creditors have a relatively small capital buffer against unexpected losses, which can provide a strong incentive to withdraw their funds during periods of stress.
• The interlinkages between financial firms are greater than in most industries. This can be useful for allocating resources and risks. But it also means that shocks to one institution can be propagated across institutions and borders, often rapidly, as was demonstrated during the financial crisis.

The critical role of the financial sector and its inherent vulnerabilities suggest that it should be subject to more regulation than most other industries. (Although market discipline has a role to play, past experience has shown its limitations.) Even so, it is important to recognise the limits of what regulation can achieve. The financial sector is an information-intensive industry, so the financial system can change rapidly in response to technological change. As a result, regulations may be circumvented or become outdated very quickly, and will often produce unintended consequences. This does not remove the need for a good deal of regulation. But it does point to the importance of effective supervision – especially during the boom times – rather than reliance on inflexible rules.