Chapter Five

Regulation of Financial Markets and

Institutions and Financial Innovation
 Introduction
• Financial markets play a prominent role in
many economies, and governments around the
world have long deemed it necessary to
regulate certain aspects of these markets.
• In their regulatory capacities, governments
have greatly influenced the development and
evolution of financial markets and institutions.
 Justification for Regulation
• The standard explanation for governmental regulation
of a market is that the market, left to it, will not
produce its particular goods or services, in an
efficient manner and at the lowest possible cost.
• Efficiency and low cost of production are hallmarks
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.
 Cont’d
• 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.
•A short hand expression used by the economists to describe
the reasons for regulation is “market failure”.
•A market is said to fail if it cannot, by itself, maintain all the
requirements for a competitive situation.
 Cont’d
 In short, regulation is needed for the following
reasons:
A. information (efficiency concern)
B. bankruptcy (stability concern)
C. control of monetary policy (optimality
concern)
 Types of Regulation

 Government regulation of financial markets

takes one of four forms.
1.Disclosure regulation
2.Financial activity regulation
3.Regulation of Financial Institutions
4.Regulation of Foreign participants
 Disclosure Regulation
 Disclosure regulation 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.
 Cont’d
 In addition, the problem is said to be one of “agency”,
in the sense that the firm’s managers, who act as
agents for investors, may act in their own interests to
the disadvantage of those 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.
 Financial Activity Regulation
Financial activity regulation 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 a positions to know more about a
firm’s prospectus than the general investing public.
Insider trading is another problem posed by
asymmetric information.
 Cont’d
 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

 Regulation of financial institution is that 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.
 Cont’d
Financial institutions help households and firms to
save, as depository institutions, they also facilitate the
complex payments among many elements of the
economy and 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

 Regulation of foreign participants is that form of

governmental activity that limits the roles foreign
firms can have in domestic markets and their
ownership and control of financial institutions.
 Financial Innovation
 Financial innovation can be defined as the act of
creating and then popularizing new financial instruments
as well as new financial technologies, institutions and
markets. It includes institutional, product and process
innovation.
 Competition among financial institutions has brought
forth and fostered the development of new products and
markets.
 The global pattern of financial wealth has transformed
financial markets from local markets into globally
internationalized financial markets.
 Cont’d
 Through technological advances and the
reduction in trade and capital barriers, surplus
funds in one country can be shifted more easily
to those who need funds in another country.
 As a result, there has arisen a need for financial
products and trading strategies to protect more
efficiently against the adverse movements of
foreign currencies.
Categorizations of Financial Innovation

Since 1960s, there has been a surge in significant

financial innovations.
Observers of financial markets have categorized these
innovations in different ways.
The Economic Council of Canada classifies financial
innovations into the following three broad categories
 Cont’d
1. Market broadening instruments, which increase the liquidity
of markets and the availability of funds by attracting new
investors and offering new opportunities for borrowers:
2. Risk management instruments, which reallocate financial risks
to those who are less averse to them or who have offsetting
exposure, and who are presumably better able to shoulder
them.
3. Arbitraging instruments and processes, which enable
investors and borrowers to take advantage of differences in
costs and returns between markets, and which reflect
differences in the perception of risks, as well as in
information, taxation, and regulations.
 Cont’d
 Another classification system of financial innovations
based on more specific functions has been suggested
by the Bank for International Settlements as follows:
1. price-risk-transferring innovations
2. credit-risk-transferring instruments
3. liquidity generating innovations
4. credit-generating instruments, and
5. equity-generating instruments
 Motivation for Financial Innovation

 There are two extreme views of financial innovation.

 At one extreme are those who believe that the major
impetus for innovation has been the endeavor to
circumvent (or “arbitrage”) regulations and find
loopholes in tax rules.
 At the other extreme are those who hold that the
essence of innovation is the introduction of financial
instruments that are more efficient for redistributing
risks among market participants
 Cont’d
 The following are the most important causes of financial
innovation.
1. Increased volatility of interest rates, inflation, equity prices, and
exchange rates.
2. Advances in computer and telecommunication technologies
3. Greater sophistication and educational training among professional
market participants
4. Financial intermediary competition
5. Incentives to get around existing regulation and tax laws.
6. Changing global patterns of financial wealth.
 Assignment III (15%)
How financial institutions are regulated in
Ethiopia?
End of chapter Five!