Financial regulation is a way of regulation or administration that subjects financial establishments to requisites, precincts and procedures aimed at maintaining the reliability of the financial structure. Financial regulation involves laws and policies, which regulate what financial institutions, for instance banks, brokers and investment organisations can do. These laws are normally propagated by government supervisors or international bodies to shield investors, maintain organized market and uphold financial steadiness (Simpson 1996, 9). The scope of financial regulation activities may include establishing minimum principles for investment and ways, making day-to-day supervisions, and examining and impeaching wrongdoing.
Importance of financial regulations
Financial regulation is required to achieve certain outcomes, and thus it is important to put up the institutional structure in place that will best secure those outcomes. This may involve ensuring that the structure is in such order that it does not favour some outcomes at the expense of others. If that structure involves more than one regulator, then the structure has to be such that rivalries or disputes between regulatory agencies can be resolved. The regulatory system established also needs to be cost-effective – ensuring that costs to industry or government are not excessive in relation to the benefits being delivered. Equally, the structure of regulation needs to be such that it has, or gains, the confidence of the public, as well as the financial services industry itself (Sottini 2009, 18; Pike and Neale 2006, 27).
Financial regulations on banks
Many countries are considering the institutional structure of regulatory and supervisory agencies in the financial sector on the grounds that the existing structures, which were often established in a markedly different market and institutional environment that exists today, may have become inappropriate. Regulation may be considered a necessary evil, a positive influence or a positive hindrance to the effectiveness of the financial services industry. In most countries, governments have been reviewing their institutional structure of financial regulation, and in some countries major changes have been made.
Institutional structure refers to the number and structure of agencies responsible for the regulation and supervision of financial institutions and markets, which includes the role of the central bank (Llewellyn 1999, 30). While it is universally agreed that the central bank has a major responsibility for maintain the systematic stability. The case for preserving an institutional regulatory structure was strengthened by concerns about legal impediments to integration in many emerging market economies. Whereas the developed economies had a well developed legal system and are committed to the rule of law not as the case in emerging-market countries (Heath 1998, 20).
This was experienced in some countries that established a regulatory agency independent from the central bank which encountered constitutional difficulties. However, the resulting agencies lacked the legal powers and authority to regulate effectively and the same constraints were also faced within the central bank in consolidating non-bank regulatory functions (Llewellyn 1995, 44; Maguire 2007, 102).
Role of regulatory bodies
The chief role of the regulatory agencies is to control the behaviour of financial firms on behalf of customers. In effect, consumers allot over the task of monitoring to a regulatory agency. Not only does the regulatory agency have the expertise to carry out monitoring activities effectively, but there are also savings in costs to individuals by this ‘wouldelegation’ of the monitoring function. It therefore makes sense to secure the benefits of economies of scale, and often of scope, by having a regulator monitor and supervise financial institutions (Gleeson 1999, 87).
The regulatory system is dictated by the nature of financial services institutions. However, the underlying assumption of the institutional regulation is that one can distinguish between different financial services organisations – banks, insurance companies, friendly societies and so on. The implication is therefore that there should be one regulator for all banks, a separate one for insurance companies, and other regulators to the extent that there is a significant number of a type of specific and identifiable financial services organisation.
However, this could grossly inefficient use of regulatory resources if institutional regulator will have to develop and apply regulatory requirements appropriate to all functions that the institution may carry out. For example, the position of a bank regulator supervising a banking institution that also sells insurance products. It could also be difficult to ensure a position of competitive neutrality, where each regulator applies identical requirements to the same or similar business situations where banks and insurers both sell life assurance products, but are subject to different rules under their separate regulators (McMenamin 1999, 45; Shim and Siegel 2008, 55).
Implications of financial regulations on financial stability
Financial stability usually refers to the risks to the financial system as a whole and the integrity of the payments systems. The central bank is universally accepted to have oversight of the stability of the system as a whole (Blair et al. 2001, 67). Yet the central bank is not necessarily the supervisory agency for individual banks or other financial institutions and markets.
When regulation of financial services is demanded, it means regulation should be over and above the regulatory infrastructure that exits for the business in general, for instance all consumers, no matter what they are buying, are entitled to protection under legislation relating to the sale of goods and services and when people call for more regulation of the financial services industry, they are looking for the creation of requirements and remedies above and beyond the general law (Chandra 2008, 51).
Government intrusion in the market conditions is acceptable by its impact in terms of eradication of market failures and externalities (Georgosouli, 2009). The financial market development is alleged as the intensity of market growth, profitability, market values and risk. However, the failures of unregulated markets and externalities may have an effect on the parties into market contracts, but may as well generate utility reductions for third parties through the implications for flow of information or the accessibility and transferability of resources.
The public policy reasons why Government should be interested in financial services sector should include; the functions of banks, life assurers and the other organizations which perform, ultimately, closely connected to individuals’ well-being. Government introducing regulation may make things worse (Jackman, 2004). However, a stable and efficient financial system has a potential power influence on a country’s economic development. This is because it may have an impact on the level of capital formation, efficiency in the allocation of capital between competing claims a, and the confidence of end users in the integrity of the financial system (Frisdon and Fernando 2002, 124).
Risks facing financial institutions
One of the objectives of government regulations is to sustain systematic stability. The strengths and efficiency of the system have equal supply side and demand side impacts on the financial system. This could happen when the risk that the failure of a single financial institution could lead to the destruction of the financial system, undermining confidence in other financial institutions as a whole and threatening failure of other institutions and could even lead to a widespread crisis (Brigham and Ehrhardt 2008, 28). For example, if one institution fails there may be a possibility of a fall on other institutions.
This is mostly an issue faced by banks that at any time do not hold sufficient liquid assets to meet an immediate demand for payment from all their depositors. Since the central bank is always the lender of last resort and if it were also the distinct unified regulatory and supervisory might be alleged as extending the lender of last option role to the full range of financial institution. Then the financial institutions or their customers will be compensated in the event of loss due to insolvency (Edwards and Wolfe 2005, 49; Shim and Siegel 2008, 145).
Systemic risk is most often associated with banks, and in a number of countries it is regarded as the role of the central bank to oversee the financial sector as a whole to prevent the possibility of systemic risk (Vance 2002, 99).
Aligned with this function, central banks will act as ‘lenders of last resort’ for other banks in the banking system, and may be involved in the prudential regulation of banks in the system, ensuring they have sufficient capital at hand to meet immediate demands for payment in the normal course of business. It is argued that the public, or social, costs of this happening are much greater than the private, firm, costs arising from the event. As these public costs are not taken into account by individual firms, regulation should be used to safeguard the position.
The need for financial institutions’ regulation
Some countries imposed bank regulations to ensure effective competition and also to prevent monopolies from developing. For example, in the UK, the Financial Services Authority (FSA) has recently revised the requirements relating to the kinds of information that financial firms should provide to their retail customers. The aim of these regulations was to ensure that customers are better able to understand and compare products thus exerting competitive pressure on the providers of financial products. The implication of this approach is that consumers must be protected against the very competitive market forces that many would argue are the most likely means of delivering what consumers need (Bragg 2006, 122).
The development of bank regulations evolved that if consumers were to have the confidence to invest in financial markets, then they need to be satisfied that these markets are being run properly and are open and transparent. From these development the social costs of having stock markets collapsed due to lack of confidence or poor governance are greater than the private costs to individual market participants themselves, hence it led to the need to ensure good governance and continued confidence in markets so that if individual investors were to entrust their money to financial institutions, then they would need to be satisfied that these institutions were safe and secure (Brigham and Houston 2008, 55).
Regulations for systemic reasons are needed when the societal costs of failure of financial institutions, especially banks, exceed individual costs and as such potential societal costs are not taken into consideration by the organisation’s decision makers. Banks are the source to the payments system, and the most significant source of lending for firms and individuals, and need to secure itself and its customers too (Gill and Chatton 2000, 88). When a bank is about to fall, it could have a serious effect on the system as a whole, and thus leading to the need government developing bank regulations to ensure these institutions are financially sound (Goodhart 1998).
Financial institutions may for this reason be tempted to engaging in more riskier behaviours than they would have if the total risks were summed up in their price model. Dealing with systemic risk is seen as a key issue in the functioning of banks, given their central part in the financial system. Then if one bank was to fall, the rest would not fall since it’s the consumer’s behavior that’s concerned.
Due the seriousness of the fall of banks, the central bank ensures that most regulatory systems would have regulatory intervention to provide for deposit insurance. This would ensure protection of the investors’ money in the event that bank collapses and is unable to meet any of its liabilities. With this in place, there would be no need for investors of banks to withdraw their deposits should another bank fail. However, this assumes the insurance in place covers all institutions and losses, is administratively efficient, and holds the complete confidence of the population; and it is argued that all of these conditions are unlikely to exist.
This because the existence of such deposit insurance creates amoral hazard’, in that banks are likely to take greater risks, and hold less capital, than they would do in the absence of deposit insurance (Fisher and Waters 2003, 79, msn money, 2011).
Equally, investors may take more risks on the basis that they will get compensation if things go wrong. As a result, there are strong reasons for prudential regulation (may be justified on the basis of systemic issues or be justified on the basis of the special nature and importance of the contract between consumers and their bank, which is different from other firms) to ensure that all banks hold the minimum amount of capital necessary to cope with potential losses or shocks, even where deposit insurance does exist this then turns to how much capital banks should hold.
Development of financial service regulation
The development of bank regulations continues to change due to the market imperfections and failures are explained through the economic theory that when markets are working efficiently, free competition is a sufficient mechanism to provide buyers and sellers with all of the information necessary to ensure they make the right decisions (Sharpe, Alexander and Jeffery 2008, 63). The markets were rarely perfectly competitive, and therefore the regulations are needed to mitigate the imperfections.
These financial services market could not work perfectly, often due to the information asymmetries between consumers and providers and as a result regulatory action is taken to overcome these asymmetries and to prevent firms taking advantage of consumers’ lack of knowledge. This regulation increased the confidence of consumers in the financial services industry and encourages grater investment (IBM (NYSE: IBM), 2009).
The regulations were developed to provide consumers’ protection because of the nature of the product and yet there were issues identified that could justify regulatory intervention in order to put right potential problems or ensure structural problems do not arise at any given time. These include systemic issues relating to the financial services industry as a whole. Given that the key nature of financial services to an economy, any crisis in the system could be a disaster for a sophisticated modern economy, and so it was important to ensure that such things do not happen in the first place (Bazley and Haynes 2007).
The central bank ensures that when a crisis could start with a financial problem in one particular organization, then it was also important that there was prudential regulation in place to ensure that individual firms were financially sound. Thus, it would be important to the financial system as a whole, as well as for individual consumers investing with that firm.
Past global financial crisis experiences, which are largely blamed on regulatory deficit in global financial institutions, show how financial regulation is necessary for an economy and the globalised market as a whole. However financial liberalization is necessary for an economy; there is need for a stronger prudential financial regulation and supervision. International cooperation is needed in financial regulation so as to counter cyclical economy. In addition, global finance regulation must be comprehensive to address all financial activities, tools and the participants, and not leave any regulatory gaps, which eventually leads to turmoil in the global economy.
Recent developments in the theory of regulation suggest that the regulatory regime in force in any market at any given time represents equilibrium in competition in the political market-place between opposing forces representing interest groups of various kinds, including the interests of politicians and of the regulators themselves. (Simpson 1998). However, that does not on itself justify regulation, and indeed by some that regulation can simply make the position worse.
Many countries have seen the development of financial institutions that have diversified and conducted business in a number of different sectors. Thus, in some cases, banking, investment management, securities trading and the selling of insurance/assurance products are being undertaken under the umbrella of a single conglomerate (Brigham and Gerhardt 2010). Economies of scope can be developed by using distribution channels to distribute a range of different financial products, while at the same time offering consumers the opportunity to meet all of their financial needs in one place.
The development of bank regulations evolved so that if consumers would have the confidence to invest in financial markets, then they needed to be satisfied that these markets are being run properly and are open and transparent. From these developments, the social costs of having stock markets collapse due to lack of confidence or poor governance are greater than the private costs to individual market participants themselves, hence it led to the need to ensure good governance and continued confidence in markets so that if individual investors were to entrust their money to financial institutions, they would need to be satisfied that these institutions were safe and secure.
Thus, financial regulation is necessary for any given economy. However, the regulations need to attain some standards, which include; have clear objectives, independence and accountability, adequate resources, effective enforcement powers, comprehensive, cost-efficient and consider the market dynamics and the industry structure.
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