RFS Week 1: The Rationale for the Regulation of Financial Services
Regulation: Creation and Scope
Primary Legislation
In the context of finance, primary legislation refers to laws created by Acts of Parliament. These Acts begin as bills that have been approved by both Houses of Parliament and subsequently received Royal Assent, becoming Statute Law in the UK. This type of legislation forms the foundational legal framework for regulating financial services.
Secondary Legislation: This includes regulations and rules made under the authority of primary legislation, allowing for more specific and detailed provisions to be established in response to evolving market conditions. These regulations are often detailed in statutory instruments and can cover a wide range of aspects, including compliance requirements, conduct of business rules, and prudential standards to ensure the stability of the financial system.
Enables government departments and administrative agencies to set out how primary legislation will be applied.
Codification and notice
Laws are codified and published so that parties are on notice regarding what is and is not legal.
Regulation as an Activity
A regulator’s activity can be thought of as an ongoing set of actions: the regulator
Makes and agrees certain rules or principles of behaviour.
Monitors whether those rules are obeyed.
Enforces rules where necessary.
Example of activity: supervision of industry and general monitoring to ensure nothing untoward happens.
What is Regulation?
Regulation in the broadest sense
Regulation is the employment of legal instruments for implementing social-economic policy objectives.
From a broad lens, economic regulation encompasses all forms of state intervention in the economy.
A more specific, common definition
Economic regulation presumes significant state intervention in industries with market power or that produce essential goods or services, with the aim of increasing social welfare.
Public vs Private Interest Theories Justifying Regulation
Theories help explain why regulation exists and how it should work in practice.
The public interest theory was the standard economic thinking on regulation from the late nineteenth century until the late 1960s.
•This theory is based on two basic assumptions.
• Firstly, markets are extremely fragile and likely to work inefficiently if we let them operate autonomously.
• Secondly, government regulation can correct these shortcomings, i.e., it can compensate for social welfare losses associated with market failures
Are Markets Efficient?
Regulation helps markets function better than they would without regulation.
The assumption is that markets do not operate as efficiently as desired.
The classical view of efficiency: perfectly competitive markets with many well-informed producers and consumers, independent decisions, and prices that reflect all relevant information. The "invisible hand" of self-interest is supposed to deliver efficient outcomes.
The Free Market Narrative (Contract-based View)
Markets are regulated only by contracts agreed between parties.
Law intervenes to enforce contracts upon request according to the parties’ intention, not to impose fairness.
Source for this view excerpted in the transcript: Rawlings, Georgosouli, and Russo (2014).
Critical question: Is this an accurate picture of financial markets?
Public intervention requires identifying market anomalies and implementing corrective policies.
Economic regulation, from this view, promotes productive efficiency, adequate resource allocation, and consumer protection.
Private Interest Theory (overview)
Public Interest Theory, which was the standard economic thinking on regulation from the late 19th century to the late 1960s, is based on two core assumptions:
Markets are fragile and likely to underperform if left to operate autonomously.
Government regulation can correct these shortcomings and compensate for social welfare losses associated with market failures.
From this perspective, public interventions in finance aim to improve financial stability, ensure financial markets operate "fairly," protect consumers, prevent fraud, and enhance competition by removing market manipulation or monopolies.
Multiple versions exist; core premise: regulation does not automatically meet its objectives.
Regulation may benefit private interests of certain groups rather than the public.
Regulators may pursue their own interests as well.
Regulatory Capture
Occurs when groups with a vested interest influence regulatory policy decisions to achieve preferred outcomes.
Linked to success in influencing legislators or regulatory agencies so that policies favored by regulated firms are implemented.
Regulation as a Market (economic good)
Regulation can be seen as a product whose optimal allocation depends on demand and supply interactions.
Organizations and groups use power to persuade lawmakers to adopt their view on regulation.
May result in legal protection against competition or other biases that favor certain actors.
Interest Group Theory
Multiple competing interests; no single group captures regulators completely.
Regulators must determine an efficient level of regulation that balances various interests while maximizing political support.
Regulation and Corruption (toll theories)
Regulators may gain from monopoly positions by creating inefficient laws and extracting revenues via bribes or campaign contributions.
“Tolls” are payments by firms to secure favorable regulation.
Corruption is viewed as a way to overcome inefficiencies in regulation from a certain theoretical lens.
The Economic Rationale for Financial Regulation (Intro & Context)
Key reference: Llewellyn, D. (1999) – The Economic Rationale for Financial Regulation.
Central idea: regulation exists to address market failures and to promote welfare in financial markets.
Why Might Market Failure Exist? – The Nature of Product
Financial products are often:
Intangible and technically sophisticated; comparisons can be difficult.
Subject to rapid change and innovation, increasing complexity.
Long-term in nature; long time horizons before value or faults become clear to consumers.
Often involve fiduciary relationships; long time before consumer awareness of value/faults.
Purchasing decisions for financial products are high-stakes, potentially affecting well-being.
Information asymmetry: advice and product quality are not easily verifiable at the point of sale.
Consumer vulnerability: advice not always aligned with customer needs.
Risk of misrepresentation or concealment of important information at the time of purchase.
Regulatory insight is often used to address these issues and improve outcomes for consumers.
Regulation to Address Market Failures and Promote Welfare
Regulation aims to help markets work more efficiently and safeguard welfare.
Ex ante vs ex post regulation:
Ex ante: measures to prevent harmful conduct from arising.
Ex post: measures to halt or reduce harm after it occurs, including systemic harms.
Regulating can prevent market failures or promote goals that markets alone cannot achieve.
Source: Rawlings et al. (2014) – emphasis on preventative regulation and systemic safeguards.
Common Market Failures
Asymmetric information: unequal information/knowledge between parties; relates to products and the financial standing of sellers; can be exploited; can create moral hazard.
Product issues: complexity and lack of transparency hinder quality assessment at purchase; consumers often ill-equipped to assess product value.
Free-rider problem: under-investment in information; assumes others have investigated suitability; lack of public goods leads to under-procurement of information.
Moral Hazard
Definition: taking on risk because someone else bears the cost (e.g., insurance).
When safety nets (ex post protections) exist for consumers (e.g., bank deposit protection), firms may take more risks.
Consequences include:
Reduced incentives to exercise caution.
Lower capital protection to meet liabilities.
Risk is subsidised; higher returns can encourage risk-taking rather than safe behavior.
Regulation can mitigate moral hazard by imposing safeguards (e.g., minimum capital requirements).
Other Potential Causes of Market Failures
Negative externalities and systemic risk are highlighted as central concerns in financial regulation.
Systemic Risk and the Global Financial Network
Systemic risk: risk to the financial system as a whole from the failure of a single institution.
Domino/contagion effects: a problem in one firm can propagate to others and threaten the entire system.
Banks are especially central due to their role in financial intermediation.
The network example (page shows a sample of international banks) illustrates interconnectedness across the global financial system.
Public Confidence and the Grid Lock Problem
Grid lock problem: if some firms misbehave and others do not, competing incentives may discourage good behavior unless there is regulation.
If regulation is absent, firms that act properly may lose business to those that take advantage of weaker rules.
Regulation helps set minimum standards that good firms know will be applied to all, breaking grid lock and maintaining market confidence.
Consumer confidence is linked to stronger regulatory oversight; regulated markets tend to display higher trust.
Behavioral and Individual Considerations
Individual behavioral biases play a role in financial decisions.
Example: Hyperbolic discounting
People prefer smaller-sooner rewards over larger-later rewards, more so as the delay increases.
Question: “Do you want £10 now or £20 in 4 years?” demonstrates non-constant discount rates.
Implications for saving and pensions:
Difficulty in persuading individuals to delay consumption and save for the future.
Supports mechanisms like automatic enrolment in UK pensions to improve long-term saving.
What Should Regulation Aim to Achieve? – Goals/Objectives
Protect investors
Address agency problems: increase transparency of information in markets/exchanges.
Require licensing/approval for actors; rules of conduct and behaviour.
Rise of conduct regulation; includes deposit and policy protections.
Retail consumer issues: asymmetric information, complex products, behavioural biases.
Introduction of consumer protection regimes (e.g., UK Consumer Duty).
Financial stability
Focus on stability of individual firms and the financial system as a whole.
Post-financial crisis emphasis on macro-prudential regulation in addition to micro-prudential.
Micro-prudential: position of individual firms.
Macro-prudential: systemic risk and the impact of firm failures on the system; consider how broader economic shifts (e.g., interest rate changes) affect risk-taking.
Other regulatory goals
Competitive markets and maintenance of healthy competition; guard against monopolies and cartels.
Prevention of financial crime: money laundering, terrorist financing, bribery/corruption; preventing tax evasion; mitigating system misuse.
Costs and Costs of Regulation
What are the costs of regulation?
Administration costs: running regulatory agencies and government costs.
Compliance costs: what the regulated industry must pay to comply with regulations; can be substantial.
In some cases, compliance costs can exceed administration costs (historical estimate around up to 9\% of industry turnover in the retail investment sector in 1994).
Excess costs can create inefficiencies in the market (e.g., excessive paperwork; deters small-premium products targeted at lower-income groups).
Budgets of major regulators (example figures for 2024/25):
Prudential Regulation Authority (PRA): budget ≈ £331.3\text{ million}, up 7\% from 2023/24.
Financial Conduct Authority (FCA): budget ≈ £755.0\text{ million}, up 10.7\%.
How regulator costs are funded
FCA collects three types of fees: application fee, permissions fee, and annual fee.
FCA also funds several other bodies (e.g., Payment Systems Regulator, PRA, Financial Ombudsman Service, Financial Services Compensation Scheme, Money and Pensions Service).
Global/regulatory cost impact
Estimated that regulatory differences across the world cost businesses about 780\text{ billion} per year (Financial Times, 2018).
EU research (2017): ongoing and one-off regulatory costs typically constitute about 2\%-4\% of total operating costs for financial services firms.
Costs in Practice: Self- Regulation
Is self-regulation an alternative?
Potential advantages
Driven by those being regulated; embeds compliance responsibility.
Flexible; potentially lower cost.
Potential disadvantages
Conflicts of interest; lack of confidence in the process; weak sanctions; lack of transparency.
Why consider self-regulation?
To keep costs down; minimize government interference; increase flexibility; bolster corporate responsibility; respond to rogue operators without heavy-handed regulation.
When might self-regulation be most appropriate?
When required standards of behavior are well understood.
When there is less risk of serious or widespread harm.
When the industry is cohesive and mature, making self-regulatory organizations (SROs) and enforcement more feasible.
In a competitive market context.
Summary of Key Implications for Financial Services Regulation
Regulation is designed to address market failures and promote welfare by:
Reducing information asymmetries and moral hazard.
Preventing systemic risk and protecting the financial system’s integrity.
Maintaining consumer confidence and fair dealing in financial markets.
Encouraging competitive markets and preventing financial crime.
The debate between public and private interest theories informs how regulation should be designed and implemented; concerns about regulatory capture and the potential benefits of self-regulation must be weighed.
Costs of regulation are material and multi-faceted, including administrative, compliance, and wider market efficiency effects, but are justified by aims of stability, protection, and welfare.
Behavioral insights (e.g., hyperbolic discounting) help explain why regulation and mechanisms like automatic enrolment in pensions are necessary to guide individual behavior toward long-term welfare.
Quick Reference: Key Terms and Concepts
Primary Legislation: Acts of Parliament; statute law.
Secondary Legislation: Delegated legislation; application of primary law by government departments.
Public Interest Theory: Regulation corrects market failures; aims to protect consumers; ensure stability and fair competition.
Private Interest Theories: Regulation may reflect or be captured by private interests; includes regulatory capture, regulation as an economic good, and toll-based corruption.
Market Failures: Asymmetric information; moral hazard; product complexity; externalities; systemic risk; free-rider problem.
Micro-prudential Regulation: Focus on the financial position of individual firms.
Macro-prudential Regulation: Focus on systemic risk and the entire financial system.
Ex ante vs ex post Regulation: Preventing harm vs mitigating harm after it occurs.
Grid Lock: Coordination problem where lack of universal standards can deter good practices; regulation can set minimum standards to align behavior.
Self-regulation (SROs): Industry-led regulation with potential benefits and risks; appropriate under certain conditions.
Hyperbolic Discounting: A behavioral bias affecting long-term saving decisions; basis for automatic enrolment policies.
Systemic Risk/Contagion: The risk that problems in one institution propagate and destabilize the financial system as a whole.
Compliance and Administration Costs: The two main cost categories of regulation; often substantial and influence industry behavior.
Note: The notes above reflect the content and structure of the provided transcript (Page 1–43) and are organized to serve as a comprehensive study aid for the topic: The Rationale for the Regulation of Financial Services.