Ch 3: Regulation

Question 1

Prescriptive regulation

Answer 1

Detailed rules on what can and can’t be done

Question 2

Freedom of action regulation

Answer 2

Freedom but with rules on publicity

Question 3

Outcome-based regulation

Answer 3

Freedom but with prescribed, tolerated outcomes

Question 4

List possible functions of the central bank, as part of the regulatory or supervisory regime for financial product providers

Answer 4

To meet government targets, the central bank can:

1. Control the money supply
2. Determine or influence interest rates
3. Determine or influence inflation rates
4. Determine or influence exchange rates
5. Ensure stability of the financial system
6. Lender of last resort to commercial banks
7. Target macro-economic features such as growth and unemployement

Question 5

List 2 problems associated with voluntary codes of conduct

Answer 5

1. There may be low public confidence in the approach

2. There may be a few rogue traders who refuse to cooperate

Question 6

Outline the five main types of regulatory regime

Answer 6

1. Self-regulatory systems, which are organised and operated by the market participants without government intervention
2. Statutory regimes, where the rules are set and policed by the government.
3. Voluntary codes of conduct, where there is a choice as to whether to adhere
4. Unregulated markets / lines of business, with no regulation
5. Mixed regimes, involving a combination of the above

Question 7

What actions can the regulator take to help ensure confidence in the financial system

Answer 7

1. Regularly monitoring that institutions hold sufficient capital to meet their liabilities
2. Ensuring that financial practitioners and managers are competent, act with integrity and are “fit and proper”
3. Establishing industry compensation schemes
4. Ensuring that the market is transparent, orderly, and provides proper protection to investors
5. Ensuring that listed companies fulfill certain criteria regarding financial stability and disclosure of information

Question 8

List the main functions of the regulator

Answer 8

SERVICE

Setting sanctions
Enforcing regulations
Reviewing and influencing government policy
Vetting and registering firms and individuals
Investigating breaches
Checking management and conduct of providers
Educating consumers and the public

Question 9

What actions can the regulator take to reduce asymmetries of information?

Answer 9

SPIDER CC

Selling practices regulated
Price controls imposed
Insider trading prevented
Disclosure of understandable information
Educating consumers
Restricting knowledge to publicly available

Consumer cooling off period
Chinese walls established

Also,
Fairness

Question 10

What are the advantages and disadvantages of statutory regulation?

Answer 10

Advantages:

1. Less open to abuse
2. Instills more public confidence due to government involvement
3. Should be more efficient if economies of scale can be achieved

Disadvantages:

1. Costs and inflexibility
2. Outsiders may impose rules that are unnecessarily costly, inefficient and which may not achieve the desired aim
3. Government may be inexperienced in regulation

Question 11

Describe two ways in which regulation can try to ensure that customers are treated fairly

Answer 11

1. Providers may be directly required by the regulator to demonstrate that they treat customers fairly
2. Actuaries in statutory roles may be required to whistle blow if they believe that a provider is prejudicing the interests of the customer

Question 12

Why is the need to regulation of the financial markets typically greater than for most other markets?

Answer 12

Firstly, the importance of confidence in the financial system. There is the risk that if one company collapses, it can cause a systemic financial collapse of the system.

Secondly, the asymmetry of information, expertise and negotiating strength that exists between the product provider and end customer.

These issues are exacerbated by the fact that:

1. financial transactions are often long term in nature and can have a significant impact on the future economic welfare of individuals
2. in general, most of the population is not well educated on financial matters and find the range of products offered both complex and confusing

Question 13

What are implications of information asymmetries?

Answer 13

Information asymmetries lead to both anti selection and fraud.

An example of anti-selection is where options on contracts are taken up by those with the most to gain.

An example of fraud is where a policyholder does not answer questions on a proposal form fully and truthfully.

The consequences of both anti-selection and fraud are:

1. worse than expected claims experience
2. inequality between policyholders, and between the policyholder and the insurer

Question 14

List the principle aims of regulation

Answer 14

GRIP

Give confidence in the system
Reduce financial crime
Inefficiencies in the market corrected
Protect consumers

Question 15

Indirect costs of regulation

Answer 15

PUMA

Product innovation reduced
Undermining of intermediaries and advisors professionalism
Market reduces its own consumer protection mechanisms
Alteration of consumer behavior, false sense of security and a reduced sense of responsibility

Question 16

Direct costs of regulation

Answer 16

• administering the regulation (eg. costs for collection/examination of information from mkt. participants & monitoring their activities)
• The cost incurred by regulated firms to comply with regulation (compliance of the regulated firms)

Question 17

Information asymmetry

Answer 17

The situation where at least one party to a transaction has relevant information which the other party or parties do not have.

Question 18

Anti-selection

Answer 18

People will be more likely to take out contracts when they believe their risk is higher than the insurance company has allowed for in its premiums.

Can also arise where existing policyholders have the opportunity of exercising a guarantee or an option. Those who have the most to gain from the guarantee or option will be the most likely to exercise it.

Question 19

Moral hazard

Answer 19

The action of a party who behaves differently from the way they would behave if they were fully exposed to the consequences of that action.
The party behaves less carefully, leaving the organisation to bear some of the consequences

Question 20

Main influences on policyholder expectations:

Answer 20

• statements made by the provider, especially those made to the client in marketing literature and other communications
• the past practice of the provider
• the general practices of other providers in the market.

Question 21

5 Areas addressed by regulation - maintaining confidence

Answer 21

• Capital adequacy
• Competence and integrity
• Compensation schemes
• Investor protection (regulators seek to ensure that the mkt. is transparent, orderly and protects investors)
• Stock exchange requirements

Question 22

Compensation schemes

Answer 22

• funded either by the industry or by the government
• provide recompense to investors who have suffered losses.
  Typically losses due to fraud, bad advice or failure of the service provider rather than market-related losses.

Question 23

Advantages of self-regulation

Answer 23

• The system implemented by the people with the greatest knowledge of the market, who also have the greatest incentive to achieve the optimal cost-benefit ratio.
• Should be able to respond rapidly to changes in market needs.
• May be easier to persuade firms and individuals to co-operate with a self-regulatory organisation than with a government bureaucracy.

Question 24

Disadvantages of self-regulation

Answer 24

• The closeness of the regulator to the industry it is regulating. The danger that the regulator accepts the industry’s POV and is less in tune with 3rd parties.
• Can lead to a weaker regime than is acceptable.
• May inhibit new entrants to a market (existing participants frame rules)