The Regulation of Financial Markets and Institution

Introduction
The financial markets play an important role in many economies and governments around the
world have long deemed it necessary to regulate certain aspects of these markets. Because of
differences in culture and history, different countries regulate financial markets and financial
institutions in varying ways, emphasizing some forms of regulation more than others. Differences
also exist in the system of regulation and different countries adopt different systems of regulation
and to regulate financial markets. This chapter, therefore, discusses the role of governments in
their regulatory capacity, the rationale for regulation, forms of regulation and systems of
regulation.

Objectives:
After completing this chapter, you will be able to:
 Understand the justification for regulation.
 Explain the need for governmental regulation of market
 Understand the role of self-regulatory organizations
 Describe the different forms of regulation

Section 1: The Role of Government

Overview
In their regulatory capacities, governments have greatly influenced the development and
evolution of financial markets and institutions. In this section, we will discuss the role of
government in regulation of financial markets and intuitions.

Objectives:
After completing this section, you will be able to:
 Understand the justification for governmental regulation of markets.

Governments' Role in Regulation

Governments in most developed economies have created elaborate systems of regulation for
financial markets, in part because the markets themselves are complex and in part because
financial markets are important to the general economies in which they operate. It is important
to realize that governments, markets, and institutions tend to behave interactively and to affect
one another's actions in certain ways. Thus, it is not surprising to find that a market's reactions to
regulations often prompt a new response by the government, which can cause the institutions
participating in a market to change their behavior further, and so on

The standard explanation or justification for governmental regulation of a market is that the
market, left to it self, will not produce its particular goods or services in an efficient manner and
at the lowest possible cost. Of course, efficiency and low-cost production are hall marks of a
perfectly competitive market. Thus, a market unable to produce efficiently must be one that is not
competitive at the time, and that will not gain that status by itself in the foreseeable future. Of
course, it is also possible that governments may regulate markets that are viewed as competitive
currently but unable to sustain competition, and thus low-cost production, over the long run. A
version of this justification for regulation is that the government controls a feature of the
economy that the market mechanisms of competition and pricing could not manage without help.
Section 2: Purposes and Forms of Regulation
Overview
There are various justifications regarding the need for market regulation and this section
provides us a detailed explanation of why regulation of financial markets and insinuations is
needed. In addition, this section also discusses the different forms of regulation.

Objectives:
After completing this section, you will be able to:
 Understand why regulation of financial markets and institutions is needed.
 Understand the different forms of regulation.

2.1 Justification for Regulation

The three core justifications for regulation are:
 The protection of investors;
 Ensuring that markets are fair, efficient and transparent; and
 The reduction of systemic risk
The three justifications for regulation are closely related and, in some respects, overlap; many of
the requirements that help to ensure fair, efficient and transparent markets also provide investor
protection and help to reduce systemic risk. Similarly, many of the measures that reduce systemic
risk provide protection for investors. The aforementioned objectives of regulation are further
descried below.

1. The Protection of Investors

Investors should be protected from misleading, insider trading, and the misuse of client assets.
Full disclosure of information material to investors' decisions is the most important means for
ensuring investor protection. Investors are thereby better able to assess the potential risks and
rewards of their investments. Disclosure requirements, accounting and auditing standards should
be in place and they should be of a high and internationally acceptable quality. Unless investors
are accorded sufficient protections they will not have faith in the system. This lack of faith will be
detrimental to build a vibrant and robust capital market.

If business is meant to thrive and participants to prosper, building up confidence amongst the
populace is highly important. That is why major regulatory concerns were mainly focused on
investors. In effect, regulation in this respect will not only be beneficial to investors but also to
companies or corporations who would be able to expand and make profits in viable stock.

To sum up regulation helps to:

1) Solve moral hazard problem-taking up unexpected activities by corporate (borrowers) after
mobilizing funds from the public affecting investors interests. Disclosure requirements are good
in this regard.
2) Avoid market failures due to asymmetric information. This is because lack of proper
information for investors with regard to direction of the market may give disincentives to stay in
the market and they might move out of the market.
3) Limit opportunities for agents to act against the interests of their shareholders. Agents
/managers having special information may use for their own advantage at the expense of
shareholders affecting corporate governance. Thus, regulations such as laws against insider
trading could reduce the magnitude of the problem.
4) Regulate investment bankers because, if they are left free, to get more business they may join
hands with the corporate to defraud investor public. Regulations such as code of conduct for
investment bankers are helpful to this end.

2. Ensuring that Markets are Fair, Efficient and Transparent

The fairness of the markets is closely linked to investor protection and, in particular, to the
prevention of improper trading practices. Market structures should not unduly favor some
market users over others. Regulation should detect, deter and penalize market manipulation and
other unfair trading practices.

In an efficient market, the dissemination of relevant information is timely and widespread and is
reflected in the price of securities. The process of regulation should promote market efficiency.

Transparency may be defined as the degree to which information about trading (both for pre-trade
and post-trade information) is made publicly available on a real-time basis. Pre-trade information
concerns the posting of firm bids and offers as a means to enable investors to know, with some
degree of certainty, whether and at what prices they can deal.
Post-trade information is related to the prices and the volume of all individual transactions
actually concluded. Regulation should ensure the highest levels of transparency.

3. The Reduction of Systematic Risk

Although regulators cannot be expected to prevent the financial failure of market intermediaries,
regulation should aim to reduce the risk of failure (including through capital and internal control
requirements). Where financial failure nonetheless does occur, regulation should seek to reduce
the impact of that failure. Market intermediaries should, therefore, be subject to adequate and
ongoing capital and other prudential requirements. If necessary, an intermediary should be able to
wind down its business without loss to its customers and counterparts or systemic damage.

Risk taking is essential to an active market and regulation should not unnecessarily stifle
legitimate risk taking. Rather, regulators should promote and allow for the effective management
of risk and ensure that capital and other prudential requirements are sufficient to address
appropriate risk taking, allow the absorption of some losses, and check excessive risk taking.

Instability may result from events in ones own jurisdiction or in another jurisdiction or occur
across several jurisdictions. So regulators should try to facilitate stability domestically and
globally through cooperation and information sharing. As part of this, one objective of regulation
is to restrict the activities of foreign concerns in domestic market and institution which play an
important role in facilitating stability of the financial system.

2.2 Forms of Regulation

Corresponding to each rationale for regulation is an important form of regulation.

Disclosure Regulation
This is the form of regulation that requires issuers of securities to make public a large amount of
financial information to actual and potential investors. The standard justification for disclosure
rules is that the managers of the issuing firm have more information about the financial health
and future of the firm than investors who own or are considering the purchase of the firm's
securities. The cause of market failure here, if indeed it occurs, is commonly described as
asymmetric information, which means investors and managers have uneven access to or uneven
possession of information. This is referred to as the agency problem, in the sense that the firm's
managers who act as agents for investors, may act in their own interests to the disadvantage of the
investors. The advocates of disclosure rules say that, in the absence of the rules, the investors'
comparatively limited knowledge about the firm would allow the agents to engage in such
practices.

It is interesting to note that several prominent economists deny the need and justification for
disclosure rules. They argue that the securities market would, without governmental assistance,
get all the information necessary for a fair pricing of new as well as existing securities. One way
to look at this argument is to ask what investors would do if a firm trying to sell new shares did
not provide all the data investors would want. In that case, investors either would refuse to buy
that firm's securities, giving them a zero value, or would discount or underprice the securities.
Thus, a firm concealing information would pay a penalty in the form of reduced proceeds from
sale of the new securities. The prospect of this penalty is potentially as much incentive to disclose
as the rules of a governmental agency.

Financial Activity Regulation

It consists of rules about traders of securities and trading on financial markets. A prime example
of this form of regulation is the set of rules against trading by insiders who are corporate officers
and others in positions to know more about a firm's prospects than the general investing public.
Insider trading is another problem posed by asymmetric information, which is of course
inconsistent with a competitive market. A second example of this type of regulation would be
rules regarding the structure and operations of exchanges where securities are traded. The
argument supporting these rules rests on the possibility that members of exchanges may be able,
under certain circumstances, to collude and defraud the general investing public.

Regulation of Financial Institutions

This is the form of governmental monitoring that restricts these institutions' activities in the vital
areas of lending, borrowing, and funding. The justification for this form of government regulation
is that these financial firms have a special role to play in a modern economy. Financial
institutions help households and firms to save; they also facilitate the complex payments among
many elements of the economy; and in the case of commercial banks they serve as conduits for
the government's monetary policy. Thus, it is often argued that the failure of these financial
institutions would disturb the economy in a severe way.

Regulation of Foreign Participants

This is that form of governmental activity that limits the roles foreign firms can have in domestic
markets and their ownership or control of financial institutions.

Regulation of Economic Activity

Authorities use banking and monetary regulation to try to control changes in a country's money
supply, which is thought to control the level of economic activity.

Section 3: Systems of Regulation

Overview
Financial institutions, markets and their products are regulated through three major systems of
regulation. This section will discuss each of these systems of regulation separately.

Objectives:
After completing this section, you will be able to:
 Describe the three systems of regulation
1. Federal/Central Regulation
This type of regulation involves the control of the market at the national level through legislation
or through the creation of government agencies to administer and oversee the legislations.
Naturally, the sensitivity of securities market failures and the special role of depository
institutions in monetary policy place them under federal control. Depository institutions in many
countries including Ethiopia are regulated by respective central banks.
Securities markets are on the other hand regulated by the securities and exchange agency of the
respective country such as the Securities and Exchange Commission (SEC) of the US.

2. Self Regulatory Organizations (SRO)

Self regulation amounts to a situation where members involved in a financial activity come
together and set a code of rules and regulations to abide by in the conduct of their activities.
SROs are said to be cost effective and stable from political interference. Since SROs follow their
own rules and procedure, they are insulated from government pressure, which makes the system
more stable and long lasting. In contrast to the government bureaucracy, the SROs show more
concern and prudent care for the proper implementation of the standards of fair practice, for their
fate is entwined with the proper functioning of the market. As far as self-regulation is concerned,
stock exchanges take the first step through their listing requirements. Stock exchanges employ
quantitative or qualitative listing requirements to screen out participants in the market.

Establishing government regulatory agencies involves a heavy burden and expense in terms of
money, time and manpower. It also exerts considerable pressure on taxpayers, because running
such government agencies requires raising funds from the public. Hence, SROs can generally be
considered as cost effective and stable which makes them an ideal mechanism for regulation.

3. Market Regulation
This approach is also referred to as market action and is in line with the laissez faire approach,
which tells us that the market will take care of itself. In fact, what is meant by market action is
that a market should be able to regulate itself. This is especially with regard to disclosure
regulation. As we noted before, proponents of this approach contend that there is no justification
for disclosure regulation by government because the market would without government
assistance get all the information necessary for a fair pricing of new as well as existing securities
through its power to underprice the securities of firms that do not provide all necessary data.

Market action tells us that economically efficient disclosure will be made in response to
sophisticated investors. The assumptions of efficient disclosure and sophisticated investors may
hold true given the background of the American System where intuitional investors are rampant.
However, even there, the market left alone was supposedly proved to be a failure leading to a
change in the policy of regulatory mechanisms. Then, it needs no critical analysis to affirm the
impracticability of this theory in a developing economy like Ethiopia where the market is at its
embryonic stage thus making the need for issuing government regulations or self-regulation for
stock exchange obvious.
 Summary
Regulations of the financial system and its various component sectors occur in almost all
countries. The rationales for regulation are: (1) investor protection; (2) ensuring that markets are
fair, efficient and transparent; and (3) reduction of systemic risk.

A useful way to organize the many instances of regulation is to see it as having five general
forms: (1) enforcing the disclosure of relevant information; (2) regulating the financial activity
through rules about traders of securities and trading on financial markets; (3) restricting the
activities of financial institutions and their management of assets and liabilities; (4) constraining
the freedom of foreign investors and securities firms in domestic markets; and (5) regulating the
level of economic activity through control of the money supply.

Different countries adopt different systems of regulation. These systems of regulations include:
(1) federal regulation; (2) self-regulation; and (3) market action.