Chapter Five

5) Financial Market Regulation

Regulatory Standards
Why regulation?
The fact that market is highly exposed to fraudulent speculation and insider manipulations
calls for institutional framework to ensure stability, smoothen the operation of the markets,
protect shareholders and promote public confidence. FI are responsible for enormous amount of
investors’ money. They run the payment system upon which a modern economy is crucially
dependent. The financial sector is the major employer and can be a significant foreign exchange
earner for the country and charge with the crucial role of allocating financial capital to its most
productive use. The government, as agent of the public has major interest in the operations of
the FIs For these reasons, the government have consistently intervened to regulate and control
the activities of financial institution system.
Market Failure
A market is to fail if it cannot, by itself, maintain all the requirements for a competitive situation
Financial market regulation is justified because the market mechanisms of competition and
pricing could not manage without help. The financial crises of the world are believed to be the
result of market failures. The competitive markets theories are based the premise that there is
perfect flow of information in the market. But in reality there is imperfect flow of information.
For example, investors (buyers of securities) and the management of the firms (sellers) have
unequal opportunity to information about:
 Solvency of the FIs
 Financial and operating performance results
 Management and its philosophy
The rational for government Intervention
Government intervention is rationalized on the grounds of Market failure-that is, left to itself the
market would produce a sub-optimal outcome. The following are some of the frequently cited
failures requiring intervention to correct.
 The externalities problem
 The problem of asymmetric information
 The Principal-agent Problem

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  The moral hazard problem

Externalities Problem
The Financial system provides a payment mechanism for the entire economy and FIs play a
pivotal role of linking both users and lenders of funds. This means that problem in the Financial
sector can potentially have a disastrous effect on the entire economy.
Problem of Asymmetric Information
Asymmetric information means investors and managers are subject to uneven access to or
uneven possession of information.The managers and directors of a company as well as FIs have
more information than the investors (suppliers of fund) on:
 Soundness of the company
 Its likely policies

This could lead to problems such as insider-trading and the concealment of relevant information
from investors For this reason the following regulations are necessary:

 law that prohibits insider trading

 Regulation on disclosure requirements
 Obliging companies to make public a great deal of financial information to potential and
actual investors

The principal-Agent Problem

Managers and directors are agents of shareholders and investors (principals). There is potential
problem that the directors and managers could pursue their own interest at the expense of the
shareholders and investors. For this reason they are obliged to disclose information on the
financial performance of the company and are subject to rules on their own dealings
The moral hazard Problem
By moral hazard we mean that an insurance against an event occurring will make the event more
likely to occur than if the event was not insured against. For example, a deposit insurance
protection scheme will guarantee investors their funds should a deposit taking institution get into
difficulty. However, this may encourage depositors to channel more of their funds into risky FIs
which are more likely to run into problems and thereby lead to a higher loss of deposit than the
case no deposit protection insurance policy exists.

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Objectives of Government Regulation
The government is responsible for the following activities:
 Consumer protection
 Ensuring bank solvency
 Improving macroeconomic stability
 Ensuring Competition
 Stimulating growth
 Improving the allocation of resources

Governments have many objectives when intervening in the financial Markets.

These include:
a. Promoting financial stability
b.To provide protection for investors against fraud or the dissemination of misleading or
inadequate information. Example of Fraud:
 Deliberate manipulation of share prices
 The concealment of crucial information from investors
 The sale of inappropriate policies
 Insider trading
 The misuse of investors’ funds

c. Desire to promote fair and healthy competition to ensure competitive price for consumers
d. To control the activities of FIs in order to exert some degree of control over the level of
economic activities, particularly with respect to monetary policy.
Types of Government Regulations
1. Disclosure Regulation: This regulation requires issuers of securities to make public a
large amount of financial information to actual and potential investors. This reduces, if
not to avoid problem of information asymmetric and agency problems.
2. Insider Financial Activities Regulation: This regulation restricts insider trading by
insiders who are corporate officers and others in positions who know more about a firm’s
prospects than general public insider trading is another problem posed by asymmetric

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 information. This is b/s there may be possibility that members of exchange may be able,
under certain circumstances, to collude and defraud the general investing public
3. Regulation of financial institution system: These regulation restricts FIs’ activities in
the vital areas of lending, borrowing, and funding activities The idea of these restrictions
is to ensure that FIs do not take excess risks with investors’ funds and also limit potential
conflicts of interestFor example in US and UK banks have long been prohibited from
holding significant stakes in companies since this could result in distorted lending to such
companies should they get into financial difficulty.
4. Liquidity requirement: Such regulations aim to ensure that unnecessary problems do
not arise due to insufficient liquidity to meet depositor's demand. For this reason
commercial banks are expected (legally required) to maintain a prudent level of cash
reserve as a ratio of their deposit to meet withdrawal demands known as the reserve ratio.
5. Capital Adequacy requirement (long run solvency): Liquidity requirements are
essentially about maintaining adequate short-term cash to meet demand for deposit
withdrawals. Solvency is, however, a medium to long-term concept concerning the ability
of an institution to meet its liabilities as they fall dueThe need to maintain sufficient
capital to ensure that the FI is regarded as a solvent and remains so even if there are
losses on its assets can therefore serve a useful purpose.
6. Regulation of foreign Participants: Such regulation limits the role foreigner firms can
play in domestic markets and their ownership or control of FIs.
7. Licensing regulations: FI institutions should be licensed. This helps to prevent
undesirable individuals from running FIs and to ensure that FI does not act recklessly
with investors’ funds

Regulation of the Commercial Banking (CBS) sector: Because of the special role that CBs
play in the financial system, banks are regulated and supervised by governments.
The common regulations include:
a. Minimum Capital requirement for CBs
b. Capital Adequacy
c. Liquidity requirement
d. Asset Quality
e. Portfolio diversification

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 f. Ceiling imposed on interest rate payable on deposits
g. Geographical restriction on branch banks
a. Minimum Capital requirement for CBs: FI wanting to formalize must have a
minimum amount of equity capital to support their activates

Ethiopia: The minimum paid up capital that shall be required to obtain a banking business.
Which shall be fully paid in cash and deposited in a bank in the name and to the account of the
bank under formation. (Directive No. SBB/24/99)
b. Capital Adequacy: Refers to the level of capital in an organization that is available to
cover its risk. All FI institutions are required to have a minimum amount of capital
relative to the value of their assets This means in the event of loss of assets, the
organization would have to sufficient funds of its own (rather than borrowed from
depositors) to cover the loss. Capital adequacy standards refer to the percentage of assets
that is financed by debt or it refers to the maximum level of debt versus equity (degree of
leverage) that the FI can have
c. Liquidity requirement: Liquidity refers to the amount of available cash (or near cash)
relative to FIs demand for cash. The level of liquidity requirement depends on the
stability of the market. In Ethiopia "Current liabilities" shall mean the sum of demand
(current) deposits, savings deposits and time deposits and similar liabilities with less than
one-month maturity period. Any licensed bank shall maintain liquid assets of not less
than 25% (twenty five percent) of its total current liabilities.
d. Asset Quality: Asset quality refers the risk to earnings derived from loans. It measures
the degree of risk that some of the loan portfolio will not be repaid. For this bank
regulations limit the portfolio that may be extended as unsecured loan.
e. Portfolio diversification: This refers to FIs’ need to ensure that they have not
concentrated their portfolio in one geographic sector or one market segment
f. Ceiling imposed on interest rate payable on deposits: Countries impose ceiling on the
maximum interest rate that could be paid by banks on deposits other than demand
(checking) account.
g. Geographical restriction on branch banks: Some federal or local states prevent large
banks from expanding geographically and thereby forcing out or taking over smaller
banking entities, possibly threatening competition.

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