CH9: Regulation in the Financial Services Sector

What are financial services?

Financial services are broadly defined as services related to the management of money.

What are deposit-taking services?

Deposit-taking services include current accounts, instant or term savings accounts, and business deposits.

What are credit services?

Credit services include mortgages, corporate loans, consumer loans, overdrafts, and credit cards.

What are investment services?

Investment services include equity and bond issuance, trading services, hedge funds, asset management, and financial advice.

What are payment services?

Payment services include bank transfers, payment cards, online payments, and foreign exchange.

What are insurance services?

Insurance services include life insurance, general insurance, reinsurance, and brokerage services.

What are the main institutional models of financial intermediation?

Different institutional models:

• Bank lending (Traditional) means an investor deposits money in a bank, and the bank uses it to fund loans and hold reserves.

• A non-bank lending corporation means an investor buys the corporation’s equity or bonds to gain exposure to its lending activity.

• Mutual fund or asset management means an investor buys fund units, and the fund lends to firms by buying corporate bonds, equity, or direct loans.

• Peer-to-peer lending means an investor lends directly to the borrower through a P2P platform.

What trend is affecting financial intermediation?

An important trend is the increasing diversification of financial intermediation outside traditional banking systems.

What are the key characteristics of financial services?

Financial services possess several unique characteristics that make regulation particularly important:

• intangible nature,

• inseparability of production and consumption,

• heterogeneity,

• perishability,

• credence goods.

What is the intangible nature of financial services?

Financial products are not physical goods and are often highly complex.

Consumers may struggle to fully understand risks, pricing structures, and expected returns.

What is inseparability of production and consumption in financial services?

Inseparability of production and consumption means that production and consumption occur together.

Example: withdrawing money from an ATM is both the production and consumption of the service.

What is heterogeneity in financial services?

Heterogeneity means that financial services vary significantly between customers.

Example: insurance premiums depend on the risk profile of the insured individual.

What is perishability in financial services?

Perishability means that financial services are time-sensitive and must often be delivered immediately.

Example: payment transactions.

What are credence goods in financial services?

Credence goods are services where consumers often cannot easily judge quality even after purchasing them.

Financial services are often judged by reputation.

Why regulate financial services?

Businesses rely on financial services to obtain financing, manage risk, and make payments.

Consumers rely on financial services to save, invest, insure themselves, and conduct transactions.

Without regulation, financial services are prone to market failure, and when important markets fail, costs to society are typically very high.

What are the main market failures in financial services?

The lecture identifies two major sources of market failure: information asymmetry and externalities.

Other relevant failures include:

• asymmetric information relating to providers

• behavioural biases

• market power

• coordination and restrictive agreements

• positive externalities

• negative externalities.

What is information asymmetry in financial services?

Information asymmetry means consumers often lack or do not use the information necessary.

Consumers also face difficulty in comparing products and their value because of complexity.

What is asymmetric information relating to providers?

Asymmetric information relating to providers includes unrecognised conflicts of interest between firms and their clients, and difficulty assessing the quality or reliability of providers.

What are behavioural biases in financial services?

Behavioural biases mean consumers may fail to switch providers and may underestimate long-term risks.

What is market power in financial services?

Market power means large financial institutions may face weak competitive constraints, and barriers to entry and expansion may arise from market structure or strategic conduct.

What are coordination and restrictive agreements in financial services?

Coordination and restrictive agreements occur when firms coordinate behaviour in anti-competitive ways or create restrictive arrangements within supply chains.

What are positive externalities in financial services?

Positive externalities mean that benefits to others may cause services to be underprovided in an unregulated market.

What are negative externalities in financial services?

Negative externalities occur when market participants act without considering side effects on competitors, markets, and society. They may also include unintended consequences of regulatory interventions, such as perverse incentives.

What are symptoms of market failure in financial services?

• consumers paying significantly above efficient costs,

• widespread unsuitable product sales

• confidence and participation being threatened by market abuse or unreliable performance

• lack of valuable financial products

• risks to the broader economy.

Who regulates financial services?

Financial regulation involves several different actors operating simultaneously.

These include sector regulators, governments or the European Commission, and competition authorities.

What are sector regulators in financial services?

Sector regulators include national regulators, ESMA, EBA, and EIOPA. Their responsibilities include consumer protection, market integrity, and investigations.

What are governments and the European Commission responsible for in financial regulation?

Governments, finance ministries, and the European Commission are responsible for legislation and Commission directives.

What are competition authorities responsible for in financial services?

Competition authorities, such as the CMA, are responsible for merger control, market investigations, and antitrust enforcement.

Why can authorities have conflicting objectives in financial regulation?

Authorities may have conflicting objectives.

Example: if Commerzbank is not doing well and could be bought by Unibank, the European Commission and EU competition authorities might support it, but the German state might oppose it for national pride reasons.

What is the Financial Conduct Authority, or FCA?

The Financial Conduct Authority focuses primarily on market functioning.

Objectives: consumer protection, market integrity, and promoting effective competition.

The FCA therefore concentrates mainly on conduct regulation.

What is the Prudential Regulation Authority, or PRA?

The Prudential Regulation Authority focuses:

• on safety and soundness of firms

• protection for insurance policyholders

• facilitating effective competition between firms.

What are the main EU financial regulation frameworks?

The main EU financial regulation frameworks are:

• MiFID / MiFID II

• the Mortgage Credit Directive

• the Capital Requirements Directives,

• the Solvency Directives.

What is MiFID / MiFID II?

MiFID / MiFID II concerns conduct in wholesale and retail investment markets.

What is the Mortgage Credit Directive?

The Mortgage Credit Directive concerns consumer protection in their biggest purchase, the home.

What are the Capital Requirements Directives?

The Capital Requirements Directives ensure that banks maintain sufficient capital and liquidity.

What are the Solvency Directives?

The Solvency Directives ensure that insurers remain capable of paying claims and returning investments.

What are the main objectives of EU financial regulation frameworks?

These frameworks mainly attempt to reduce information asymmetry and maintain confidence, while avoiding the cost of firm failure.

What is the direction of modern consumer protection regulation?

Recent regulation increasingly focuses on proactive governance and product oversight.

Firms are expected to define target markets, test products through scenario analysis of possible consumer outcomes, ensure products meet consumer needs, and set up internal governance structures.

Is there a trade-off between competition and consumer protection?

Competition is not viewed as an objective in itself.

Objective: well-functioning markets and better outcomes for consumers.

Regulators therefore attempt to guide firms toward competing on the right dimensions rather than through misleading or excessively risky practices.

Why can excessive competition be problematic in financial services?

Excessive competition, with too many small players, can come from new challengers that take risks they should not take to get customers from incumbents.

Failures of financial institutions may destabilise the market, meaning excessive competition can have negative effects.

What is a well-functioning financial market?

Has both strong supply-side competition and effective consumer participation

What are the demand-side conditions for a well-functioning financial market?

On the demand side, consumers must be able to access information, assess products, and act on information.

What are the supply-side conditions for a well-functioning financial market?

On the supply side, markets require enough competing firms, low barriers to entry, and vigorous rivalry.

What is the FCA perspective on market functioning?

The FCA analyses markets through several assessment lenses:

• consumer journeys,

• barriers to entry,

• firm incentives,

• conflicts of interest,

• market power, and

• supplier coordination.

The framework combines competition analysis with behavioural and consumer-protection analysis.

Is financial regulation succeeding?

Mixed evaluation:

• Insurance markets appear relatively stable because insurer failures are rare and claims are generally paid reliably.

• Banking failures continue to occur, with Silicon Valley Bank presented as a recent example.

• The lecture suggests that effective resolution mechanisms may matter more than preventing every individual failure.

What ongoing challenges remain despite extensive financial regulation?

Several concerns remain despite extensive regulation.

Examples:

• include conflicts of interest in financial advice in Germany,

• hybrid financial products in Spain

• interest rate swaps sold to regional governments in France,