13.1 The theory of regulation

bonds, bills and derivatives – the funds at risk were largely those of professional

investors. Now, however, many people have at least an indirect interest in the per-

formance of such markets through unit trusts, investment trusts, pension funds and

endowment mortgages managed for them by professional fund managers. More of

us than ever before have a reason for wishing nancial markets to be sound.

This chapter outlines the theory of regulation and goes on to consider the changes

in the approach to regulation that have occurred in the UK nancial sector since

the mid-1980s. We then look at the regulation of the nancial sector across the

European Union. The chapter also examines the problems caused by the globalisa-

tion of nancial markets and the rapid development of the complex markets in

derivatives and swaps. The nal section deals with the attempts of governments and

central banks to cope with these changes.

13.1The theory of regulation

The theoretical argument for regulation depends on the notion of market failure

– interferences with the market ideal of perfect competition that might arise, for

example, from the presence of elements of monopoly or oligopoly, the presence

of externalities, the lack of information in general or the existence of asymmetric

information. We came across asymmetry of information in section 7.6 in relation to

bank managers and their clients. Here we are more likely to be concerned with the

ignorance of consumers relative to producers in highly technical markets. This lies

at the heart of many consumer protection issues. The possibility of market failure,

together with the political sensitivity of nancial services, provides rm support for

some level and form of the regulation of nancial markets.

There are, however, a number of arguments against regulation. These concentrate

on four failings of regulation:

l

Regulation creates moral hazard. That is, it causes people to behave in a counter-productive way. For example, a belief that the government will ensure the safetyof deposits with all nancial institutions leads savers to deposit their money with-out giving thought to the behaviour of their bank. This allows organisations thatare badly managed or staffed with dishonest people to survive. Equally, if nancialinstitutions believe that they will always be rescued from collapse, they may takegreater risks in their lending policies in search of higher returns.

Moral hazard:The notion that people or organisations that feel protected from risk take

greater risks than they would otherwise do. The protection of individuals and rms thus

makes the system as a whole riskier.

l

Regulation results in agency capture. In other words, producers often dominate the regulatory process since the activities of regulators are much more importantto each of the relatively small number of producers than to each of the muchlarger number of consumers. Further, the next career move of regulators is often

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Chapter 13 • The regulation of nancial markets

into the industry they have been regulating and so they may not wish to offend

producers. Again, regulators may be ex-practitioners who share the judgements

and values of the producers.

l	Regulation creates compliance costs (the costs of adhering to the regulations) for producers. If producers are able to pass on the costs to consumers, the result is higher prices and lower output.

l	The need to comply with regulations increases the costs of entry into and exit from markets. This helps to preserve monopoly positions and make cartels more stable.

Combining the last two arguments produces the proposition that regulation inhibits

competition and thus reduces the efciency with which nancial markets help to

allocate the economy’s scarce resources. However, even if we accept that regulation

restricts competition, it is certainly not the only factor in nancial markets that does

so and there is no guarantee that a reduction in regulation will lead to increased

competition. The deregulation argument may work in two ways.

l	Regulation keeps out new entrants who, if they could enter, would force existing rms in the market to be more efcient and would compete prices down.

l	Regulation prevents mergers and acquisitions and allows small, inefcient rms to remain in business. Thus, deregulation would lead to mergers that would produce economies of scale and scope and the replacement of poor management.

With regard to the rst of these, the benets of lower prices that might arise

from deregulation have to be weighed against costs such as possible reductions in

the stability of the system and increased risk of loss for consumers. Unfortunately

for the second proposition, studies of the considerable merger activity in US bank-

ing in the 1980s and 1990s did not produce convincing evidence of increased

efciency or protability (Rhoades, 1992). On the other hand, if there were signic-

ant economies of scale, and mergers occurred to take advantage of them, it would

become more difcult for new entrants to come into the market, even in the absence

of regulation.

It therefore seems that none of the criticisms of regulation provides sufcient

reason in itself to reject all regulation, though the criticisms point to matters that

must be taken into account in decisions over the amount and form of regulation.

About the form of regulation, we must ask who should carry out the regulation

– the government or a government agency (statutory regulation), or the industry

itself (self-regulation). The argument for self-regulation has two elements. Firstly,

the industry has a commercial incentive to protect its reputation and members are

prepared to pay to achieve this. Secondly, practitioners understand the needs of

the industry and are likely to interfere less with its efcient functioning. This refers

to a common complaint against statutory regulators that, because they are heavily

criticised over the collapse of rms but not praised for actions that lead to lower

prices, they tend to impose excessive safety standards, raising the cost of regulation

to both producers and consumers.

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