Rationale for Regulation
Regulation applies in most countries. It has been harmonized on an EU wide basis. The level of financial services regulation varies in its specifications from state to state. An aim of regulation is to protect the integrity of markets. This underpins fair dealing and proper operation of pricing mechanisms.
Traditionally financial regulation regulated institutions. The modern trend is towards regulation of institutions, intermediaries, and participants in accordance with their function. In consequence, a single financial institution may be regulated in different ways in respect of different aspects of its activities.
Financial services include commercial banking, securities, investment services and, insurance. These functions have been traditionally regulated given their importance to the functioning of the economy and for consumer protection.
A financial services business carries the risk of insolvency. Insolvency risk is said to be made up of a number of elements including
- credit risk (risk of non-payment by customers and counterparties),
- market risk being the risk in investments and markets,
- systematic risk being a risk by reason of a ripple effect on the economy.
Banks become owners of their deposits and issue loans in their own names. Banks fund themselves from deposits, interbank loans, bond issues or central bank lending.. Financial institutions and in particular banks run the risk that their insolvency may destabilize the entire economy by undermining the payment and banking system.
Regulation in relation to the securities industry is based on consumer protection and the public interest in stability. The securities industry covers the issuing of securities, underwriting, brokerage, and advice. This is commonly undertaken by so-called investment banks. The regulation seeks to protect investors, provide for transparency and ensure fair dealings.
Financial regulation is important in connection with money supply and monetary policy. Most states control their monetary supply, interest rates and seek to control inflations, though their central bank.
Regulatory Objectives
Financial regulation seeks to achieve a number of objectives. The primary objective is the protection of clients including investors and depositors and insurance policyholders. The protection is against insolvency, bad advice, bad practices, and inappropriate products.
Regulation will seek to minimize contagious systematic risk. The collapse of one financial institution may rapidly lead to the collapse of others and ultimately the entire system. The collapse of one institution may endanger liquidity and undermine the payment system.
Regulation seeks to promote the integrity and smooth operation of financial markets. The provision of adequate information on issuers through prospectuses and transparent on-going listing obligations, measured against the market abuse and manipulation including insider dealing are vital to regulating the market.
Proper regulation generates market confidence and assists liquidity.
Regulatory Institutions
In most countries, banks are regulated by the Central Bank. In the United States, the securities industry is regulated by the Securities and Exchange Commission. The Financial Conduct Authority and the Prudential Regulation Authority are the regulators in the UK. The Central Bank has now resumed functions as regulator in Ireland.
In the first decade of the century, principles-based regulation predominated. This was a pragmatic response to the difficulty of detailed regulation and the rapid movement and specification of products and services. It emphasised less prescriptive rules.
It was seen in terms of a movement away from “tick the box” exercises to a principled approach based on management systems and control. The principles of due care and skill, adequate resources, proper market conduct, treating customers fairly, and managerial promotions, avoidance of conflict, suitable advice, protection of client assets, interaction with regulators.
Modern regulation tends to provide a simplified system of enforcement. There may be a compulsory arbitrational Ombudsman Scheme which is simpler and less costly than court proceedings.
Regulatory Methods
The regulation will focus on the conduct of business. There may be regulations in relation to types of products, which may require approval. Regulation for retail and consumer investors will be more intense. For such nonprofessional investors and consumers, there may be fiduciary-like obligations and a duty of care. It is no longer the case that the financial service provider and the consumer are treated as persons dealing at arm’s length.
Regulation will involve some element of supervision. There may be a framework within which the business must be conducted. In the case of service providers, there will usually be authorisation and prudential supervision. The authorisation will require sufficient capital, reputation, infrastructure and systems, business plan, competence.
Prudential supervision will require adequate capital and management to mitigate against the risk of insolvency. The regulation will usually involve intervention and sanctions as required.
There is generally a deposit guarantee scheme for depositors and investors. There will be a cap based on absolute terms or a percentage of the deposit/investment or both.
Regulation also focuses on the issuers of securities; principally public companies. Investment banks and others providing services such as underwriters and placement agents will be regulated from a prudential perspective. Other service providers will be regulated as advisers to the issuer in providing the documentation including, in particular, the prospectus.
In the securities industry, regulation focuses on institutions and intermediaries. Their activities may range from market-making, investments advice, information, clearing and settlement, custodial functions and underwriting.
The regime usually provides a framework for the sale and transfer of financial products. This will seek to deal with clearing settlement and custodian services. The requisite certainty will minimise legal risk.
Conglomerate Institutions I
Universal banking has been prominent on the European continent for many years. Commercial banks commonly engaged in other activities including capital markets activities such as underwriting, investment and trading, brokerage and fund management. Some banks also undertake insurance businesses and have established financial conglomerates.
Conglomerate banking with linked investment banking and commercial banking services have been shown to exacerbate systematic risk. The Central Bank may be obliged by necessity to lend to them to maintain the stability of the financial system.
The EU allows home country authorisation for the supervision of cross-border financial activity including branches. However, subsidiaries are regulated in the host state. This regulation provides for the harmonization of financial services rules throughout Europe. This includes basic rules in relation to authorization and licensing, prudential supervision and capital adequacy.
There are exceptions to the home country rule in relation to the monetary and liquidity policy of the banks. These remain subject to the host state in view of its vital role as a potential lever of policy in the host state economy.
Conglomerate Institutions II
Cross-border services outside the EU may be regulated by the home state and the host state. This may lead to double regulation. The Basle Concordat of The Bank of International Settlement sought to provide consolidated supervision of commercial banks to the extent that they were involved in cross-border banking activities through foreign branches.
The Concordat provided for home country regulation if it was adequate. However foreign branches are subject to approval in both home and host regulator. Host regulators may impose restrictive standards on the bank if basic standards are not maintained by the home regulator or enforced by it in foreign branches. The Basel Concordat is not legally binding but is authoritative.
The Bank of International Settlements promotes conglomerate supervision. The EU followed the BIS Concordat with its first and second consolidated banking directive. They are now incorporated in the credit institution directives and consolidated banking directives in 2006.
There is an EU directive on prudential supervision of financial conglomerates. It aims to provide capital measures, overall solvency rules, risk exposure rules, and intergroup transaction rules.
The Bank of International Settlements is the bank of Central Banks. The International Organization of Security Commissioners is based in Montréal, the former BIS in Basel. The BIS principles for international effective banking supervision are an important worldwide standard.
The IOSCO is a looser organization and does not have the same reputation as BIS. They mainly operate through studies and seek to promote industry standards.
Capital Markets
Capital markets deploy excess savings and seek to match it with those who need capital. The investment may be in loans or equity. There is a primary market when issuers issue loans or equity. The secondary market involves the sale and purchase of issued securities and provides liquidity. The capital markets may operate through a regular stock exchange, over-the-counter or informal markets.
Investment banks must segregate their assets for each client. The assets in the hands of the investment banks are property and are held on behalf of the client. This is fundamentally different from the case of a commercial bank which is the owner of the deposits.
The capital market participators include intermediaries who may advise issuers, brokers or other investment advisors. Some provide services in clearing and settlement. The functions may be undertaken by securities houses, investment firms, and investment banks on a fee-basis. The securities which they hold do not become their assets in the same way as a commercial bank so that they do not share the risk in the same manner.
Capital Markets Securities
The capital markets were traditionally comprised in stock exchanges which were either regulated or self-regulated. However, with the development of information technology, over-the-counter and informal markets developed. Over-the-counter electronic communication networks have facilitated this phenomenon.
Traditionally stock exchanges were self-regulated. External regulation by government departments was minimal. Stock exchanges were formerly the sole regulators of security investment services through listing and other arrangements.
A feature of modern securities regulation has been to remove regulation from stock exchanges and place it with an independent supervisor. Regulation focuses not only on the exchange but also service providers and intermediaries in the market in accordance with their functions. This may range from underwriting, market makers, clearing and settlement, custodian, brokerage, investors, investment advisors.
Capital Markets Intermediaries
Such intermediaries may, however, take positions as underwriters in issuing and as market makers in the primary or secondary markets. They may not, however, deal with client’s monies as their own. This contrast with commercial banks. This key difference is important. Commercial banks deal on their own account, becomes owners of the deposits etc. and lend. Investment banks deal on behalf of clients.
The EU has played an important role in the regulation of capital markets. The liberalisation of capital commenced in the late 1980s and became fully effective on 1st January 1993. The basic principle was established by which the home state regulator regulates prudential and solvency matters and the host state regulates conducts of business matters. The provision was made for the cross-border provision of the financial services and the establishment of branches and subsidiaries in the host state.
In relation to the securities industry, the focus of regulation is on proper custody and segregation of client’s money and on the quality of advice. In the commercial banking sector, the focus is on systemic risk and the protection of depositor’s money in relation to clearing and settlement. It focuses on ensuring that trades are properly executed and that there is sufficient backup in the underlying entitlements, entries, and records.
US Regulation
US Legislation long placed significant limitations on interstate banking. The legislation was not repealed until the 1990s.
US legislation in 1991 made the establishment of foreign bank branches, agency and representatives subject to federal level approval. The host state’s regulator has to be satisfied that the home country regulator is capable of consolidated supervision.
Securities regulation is largely a federal matter in the United States. The states may also regulate financial services.
Under the 1933 Securities Act, all securities distributed in the United States the way of public offering must be registered with the SEC. It will consider within five days whether to review the issue. Most first-time issues will be reviewed in a 4 to 6 week period following which securities may be offered but not sold.
The preliminary prospectus may be issued. The focus of the regulation is on the prospectus. If the filed prospectus is satisfactory, securities may be sold in two-year-period according to the terms and conditions.
There are limited exceptions in the requirement for registration. Some purely private placements may qualify.