Fall 2008 Version

1. Fall 2008 Version Professor Dan C. Jones FINA 4355 Handout, Takaful

2. Risk Management and Insurance: Perspectives in a Global Economy8. Regulation of Private-Sector Financial Services Professor Dan C. Jones FINA 4355 Handout, Takaful

3. Study 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

4. Private-sector Financial Services

5. Scope and Role of Financial Services • Financial intermediaries • Firms 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.

6. Types of Financial Intermediaries • Depository institutions • Security firms (investment banks) • Insurance companies • Mutual funds • Pension funds • Financial conglomerates • Financial conglomerates • Product integration or advisory integration Financial conglomerates and financial services integration in Chapter 25.

7. Government’s Role in Regulating Private-sector Financial Services

8. Why Regulate Financial Services? • Market imperfection • Information asymmetry – the “lemons” problem • Market power • Negative externalities – possibility of systematic risks • Risk of cascading failure • Simultaneous withdrawal by depositors (caused by a loss of confidence in the financial institutions) Also discussed in Chapter 2

9. Theories 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

10. Theories of Regulation • Private interest theories • Peltzman (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

11. 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

12. Government Imperfections! • Government failures • Difficulty 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)

13. Overview of Financial Services Regulation

14. Regulatory Interventions • Prudential regulation • Concerned with the financial condition of the financial intermediary • Evolved primarily because of information problems and negative externalities (especially for banking) • Market conduct regulation • Government prescribed rules establishing inappropriate marketing practices • Evolved primarily because of information problems • Competition policy (antitrust) regulation • Concerned with actions of the intermediary that substantially lessen competition • remains the most critical element in government oversight

15. Commercial 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.

16. Commercial Banking Regulation • The Basel Committee on Banking Supervision (BCBS) • Two principles • No foreign banking establishment should escape supervision • Supervision should be adequate • The Basel Capital Accord • A banking credit risk management framework with a minimum capital standard of 8% • Basel II (newer) • Minimum capital requirements • Supervisory review of an institution’s internal assessment process and capital adequacy • Effective use of disclosure • Insight 8.1

17. Securities 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

18. Insurance Regulation • Focused chiefly on monitoring and preventing insolvencies • Aimed 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.

19. Financial 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 activities • Most permitting banks to undertake securities activities within the bank itself • Few, 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 IAIS • Examines the common interests of the three financial services and develops principles and identifying international best practices

20. Other Intergovernmental Organizations • The International Network of Pensions Regulators and Supervisors • The Financial Stability Forum • The Islamic Financial Services Board • The Financial-Sector Assessment Program

21. Structure of Regulatory Authorities

22. Structure of Regulatory Authorities

23. Governmental Actions • After the Asian and other financial crises of the late 1990s • Financial 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

24. Future Prospects • Risk-based prudential regulation • New 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

25. Discussion Questions

26. Discussion Question 1 • Explain carefully why government regulation of private-sector financial service firms is considered necessary.

27. Discussion Question 2 • Debate the following proposition: “government regulation of insurance premium rates is justified.”

28. Discussion Question 3 • What are the essential differences between government supervision of banks and of insurers? Why do these differences exist?

29. Discussion 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.

30. Discussion 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?”