(Routledge, London) Ch. 1
(Routledge, London) Ch. 1
(Routledge, London) Ch. 1
|
After studying this unit you should be able to:
O Discuss the different approaches to the regulatory and supervisory model
O Analyse the need for external regulation
O Discuss the effectiveness of self regulation
O Explain enforced self regulation
O Discuss the differences between sectoral/functional and unified supervision
O Analyse the growth of ³twin peaks´ approach to regulation
%oodhart, C, Hartmann, P, Llewellyn, D, Rojas-Sugrez, L (1998) g
(Routledge, London ) ch. 1
Baldwin, R & Cave M (1999)
Oxford University Press, Oxford) chs 3 & 4
Herring R J & Carmassi J, (2008), The Structure of Cross-Sector Financial
Supervision, g
Vol. 17 no. 1, February,
Blackwell Publishing
Traditionally the sectoral or functional approach to regulation and supervision had
dominated the financial sector and in many cases the boundaries between the
different sectors of activities was also regulated. In other words the organisations
themselves were clearly defined as operating in the different markets and therefore
subject to the supervision of different regulators.
There are three main functions of the supervision which are:
O Macro prudential ( supervision of the financial system)
O Micro prudential ( supervision of the individual firms)
O Conduct of Business (protection of consumers)
Prior to the 1990s banks were predominantly supervised by the Central Bank in their
country who looked after both the macro and micro sectors but the conduct of
business tended to be left to other consumer protection agencies, suc h as consumer
fraud agencies, industry associations or law enforcement agencies. Other areas of
the financial sector such as securities firms and insurance firms were not considered
to be a risk to the financial system because of the nature of their busine ss so did not
come under any macro prudential supervision. These firms were either under the
supervision of a securities regulator or self regulatory organisation for the securities
industry or an insurance commission or self regulatory organisation in tha t sector.
The boundaries between the sectors as mentioned above were also closely
regulated and firms were not able to operate within the different areas of the financial
sector and the large financial conglomerates that we know today did not exist.
However over the past 20 years there has been a move towards unified supervisory
bodies with the UK arguably being the first major financial sector changing to a
unified regulator in 1997, when 9 self regulatory organisations were brought together
to form the Financial Services Authority (FSA). However, they were not the first with
the Monetary Authority of Singapore (MAS) being formed in 1984, and this regulatory
body is unusual in that it is also the main monetary authority for the country. In most
countries the monetary authority is kept independent of the regulatory authority and
we shall discuss this later in the unit. Singapore was followed by the Scandinavian
countries, (Norway 1986; Denmark 1988; and Sweden 1991) and after the UK,
South Korea, Japan and Ta iwan formed Unified regulators. A third approach to
regulation has been developed more recently and is known as the ³twin peaks´
approach and this has been adopted by Australia and Netherlands in particular with
Ireland adopting a hybrid approach to ³twin peaks´.
The so called ³twin peaks´ approach allocates the responsibility for prudential
regulation and conduct of business to two separate agencies. This is an example of
regulation by objectives whereby prudential regulation is designed to promote the
safety and soundness of the individual institutions, while conduct of business is
directed at consumer protection. However this approach has taken on a new
prominence following the 2008 US Treasury ³Blueprint for a Modernised Financial
Regulatory Structure´ which presents a long-term optimal regulatory structure based
on a separation between prudential and conduct of business regulation. This
approach also appears to be favoured by the %30 report on the structure of Financial
Regulation, which is significant a s it was issued under the name of Paul Volcker who
is a financial advisor to president Obama. France and Spain have been reported to
be considering adoption of this model.
¯
As previously discussed this is a ma tter of balance. Supervision and regulation
should not be overly burdensome to financial firms so that responsibility, innovation
and competition are restricted. Equally supervision and regulation should not be so
lax as to be ineffective in curbing the e xcesses of profit seeking self interest.
Other issues to consider in relation to supervision and regulation is that it can
weaken the incentive for the firms to monitor themselves and this is the basis of the
examination of the different forms of regulat ion and to consider external, self
regulation and enforced self regulation. A second aspect is that regulation can also
weaken the responsibility of clients to complete their own due diligence and this
balance has to be considered in the construction of ef fective regulation.
We have to examine some of the points that should be reviewed with regard to
external regulation or the aspects of what is sometimes referred to as Command and
Control approach to regulation. The main advantage of this form of regulation is that
is often supported by the force of law which has fixed minimum standards and
defined acceptable levels of behaviour. This can also involve the screening of entry
to the market, which requires firms to adhere to the standards and levels of
behaviour set. External regulation is often seen by the public as highly and the use of
penalties within the regulation can also provide a signal of the intent of the
forcefulness by which the authorities back up the regulation.
However there a number of weaknesses with this form of regulatory strategy which
we have to consider:
O Intervenes in the management of the organisation and industry
O Is prone to capture
O Complex rules tend to multiply
O Inflexible
O High levels of information required
O Expensive to administer & enforce
O Compliance costs within the firms are high
O Incentive only to meet standards rather than exceed them
O Inhibits desirable behaviour
The excessive prescription often brings the regulator into dispute with the industry.
This can cover a number of issues firstly within financial services the risks involved in
the delivery of the products and services within the sector are too complex for simple
rules. The imposition of prescribed regulation can blur the competitive advantage of
firms based on standards and level of service. The development of a detailed
rulebook leads to the lowest way of meeting regulation and can become focused on
the process rather than the outcome of regulation. This leads to what many consider
to be a tick box culture. In that the letter of the rules are adhered to in order to
demonstrate compliance with the regulations rather than examining the outcome of
the actions and whether the spirit of the regulation is being achieved.
Where areas of concern are identified then additional regulations and rules are
added rather than re -examine the existing rules. This leads to the problems on
internal compliance of a large number of rules based on a large and complicated rule
book. A final issue with regard to the adoption of rules is that is there is no rule
applicable then it is deemed that the resultant behaviour and standards is
acceptable. This leads to an issue of moral hazard where unacceptable behaviour is
deemed appropriate because it is not actually regulated. Accord ingly we have a form
of creative compliance where firms will conducts business and accept practices that
may not be totally appropriate but comply with the regulations
In some areas of regulation the rules are based on Balance Sheet position which is
snapshot and is often historical.
¯
Pure self regulation is where there is no specific regulation or supervision of the
sector and the enforcement of the standards and acceptable behaviour is reinforced
by existing legal recourse such as common law; commercial law and contract law,
without the requirement of specific regulation.
¯
This is the more common alternative to external regulation whereby the industry
regulates itself and sets out its own rules to ensure that standa rds and acceptable
behaviour are followed throughout the industry. It is argued that this form of
regulation provides a high level commitment to the industry¶s ³own rules´ and that the
rules themselves will be well informed through the industry experience. In this way
there is a close fit between the regulator and the standards acceptable to the
industry. The rules are more comprehensive and have the potential to change
quickly to adjust for changes in the sector as experience is collected. In addition it i s
considered that complaints against firms can be dealt with more effectively as
agreed procedures accepted by the industry can be applied to the complaints. Also
there is greater effectiveness in the detection of violations and obtaining conviction
and the application of sanctions against offenders. Lastly from the %overnment¶s
point of view this is a low cost solution as all the costs of the supervision and
regulation is borne by the industry itself.
However enforced self regulation is not a panacea for a ll the problems of effective
regulation in the financial sector. Firms themselves complain of high costs involved
in maintaining the supervisory and regulatory framework and a consequence is that
the cost of the regulatory framework is passed on to the cus tomer.
Consumers themselves have several issues with self regulation of financial services
by the financial services firms. There are concerns that the rules are designed to
serve the interest of the firms themselves rather than the consumer and therefore
they are not well served by the regulatory framework. It is also perceived that there is
weak enforcement as firms are unwilling to invoke heavily penal sanctions on other
firms as there may be retaliation if they themselves were to subsequently transgress
the regulations and be sanctioned. As a result, consumers consider that it is not a
transparent system and have a lack of trust and faith in the framework and therefore
will not engage with it and use it effectively.
Lastly, the general public, demands %o vernment intervention in the supervision of
the sector in order that they have confidence and trust in the regulatory framework.
ñ
%oodhart (1998) identifies three approaches to the structure of regulation:
O
± this is directed at the institution rather than the type of
business undertaken, the rationale being that it is institutions which
become insolvent
O g
± this is concerned with the type of business undertaken
irrespective of the institution
O ± this approach adapts regulation to the objectives, which are
trying to be achieved.
Sectoral/Functional
Hong Kong and the United States have maintained this form of regulation where
different types of institutions or business are regulated by different regulatory bodies.
The main argument particularly prior to the 1990s and the deregulation of the
financial sectors was that the different financial sectors such as banking, insurance,
investment banking, and stock broking offered distinctive products with the
boundaries between the activities clearly defined and regulated. These differences
were often reinforced by the different delivery channels, accounting procedures,
business practices and risk profiles. The United States in particular has separate
regulators across banks, investment banks and insurance companies but all three
regulators undertake micro prude ntial supervision and consumer protection.
However, the most prominent difference is with the regulation of the banks where
macro prudential supervision and the possibility of systemic risk.
This is where the legal status of the businesses influences which regulator and
regulations that the firms will be legislated under. In this sphere of operation the
regulation is separated out under the functions such as banks; brokers; insurance
companies etc.
The arguments for this arrangement is that it is clear who the regulator is and whose
responsibility it is for the regulation of the firm. This system works well where there is
clear demarcation between the activities that the financial firms are allowed to
operate within. However the regulation of the sector beco mes more problematic with
the presence of diversified firms that operate in a number of different areas within the
financial sector. The particular problems that can exist with functional regulation of
the financial services sector are that of underlap and overlap.
Underlap is where the activities of the firm will fall between the remit of different
regulators. A common occurrence is where each of the regulators expects the other
to pick up the regulation of the issue and often this can result in the firm ¶s activities
going unregulated, especially where communication between the regulators is poor.
Another issue affecting underlap is regulators operating on tight budgets are not
keen to take on extra duties or work which they do not believe to be within th eir
statutory remit.
Overlap on the other hand is where there can be a duplication of effort as more than
one regulatory body is involved which can lead to a duplication of effort to regulate
firms in particular areas. In addition there can be conflict bet ween the regulators as
their implementation or interpretation of the regulations may differ. This can lead to
confusion for the firm and the consumer as there is no clear guidance to the
appropriate course of action.
Unified
The use of a Unified regulator has been adopted in the UK since 1997, whereby
there is a single regulator responsible for the activity of all the firms in the sector and
is responsible for both prudential (safety & soundness) and conduct of business
regulation (consumer protection). The arguments in favour of this form of regulation
is that as there is an increasing number of large diversified firms operating in the
financial sector then it makes sense for these firms to be regulated by a single
regulatory body. It is argued that the sin gle regulator will reduce the problems that
can occur with overlap and underlap in the regulatory framework.
A second argument in support of the Unified regulator is to create a level playing
field in terms of regulation. To achieve a consistency in rule making and supervision
on order to remove the opportunities for regulatory arbitrage across the different
sectors and to eliminate the possibility of firms in one sector gaining a competitive
advantage at the expense of firms in another sector.
The third rationale is the efficiency in supervision and compliance that can be
summarised with a number of benefits that are perceived to be available to a unified
regulator.
Benefits of a single regulator include:
O economies of scale and scope ± a single regulator needs only one set of
support services
O simpler structure may be more readily understood by the consumer
O single regulator is best placed to deal with financial conglomerates
O single regulator should avoid situations of regulatory overlap or underlap
O accountability might be more easily achieved
O compliance costs should be reduced to the extent that firms have to deal with
only one agency.
We have looked at the rationale for a single financial services regulator, but why is
the structure of a regime important? %oodhart puts forward several reasons:
O Structure affects the organisational culture which in turn affects future
effectiveness.
O If there is more than one regulatory agency, rivalry may exist.
O If a conflict of objectives arises this could be difficult to resolve if more than one
regulator exists.
O Institutional structure will impact on cost.
O Multiple agencies allow for the potential of regulatory arbitrage.
O The implications of this are that an inappropriate regulatory structure can
increase costs both monetary and non-monetary in the longer term.
%oodhart defines the problem clearly: µthe overall objective must be to create an
institutional structure that reflects the objectives of regulation and that promotes
those objectives most effectively¶.
The trend towards the widespread adoption of the single supervisor has raised some
concerns recently. The basic question is whether integrated supervision is feasible
and the arguments put forward by %oodhart are considered, for example is it
possible to treat the top 50 lar gest firms in the same way regardless of the sector in
which each firm conducts its primary business. Depending on the main lines of
business there can be differences in accounting practices for the different operations
and the consolidation of the busines ses may neither be meaningful nor practical.
A second issue and a particularly topical one given the recent issues and admission
by the regulator themselves is whether a single regulator can provide an appropriate
balance between conduct of business supervision and micro prudential and even
macro prudential supervision. It is argued that typically conduct of business
supervision is more publically visible and politically expedient than the necessarily
confidential micro prudential problems affecting individ ual financial services firms.
Therefore is there a tendency for conduct of business objectives to dominate the
other objectives of the regulator over a period of time. This is a current debate in the
UK where it is considered by some that the FSA was more concerned with conduct
of business regulation and failed to spot the problems both at Northern Rock Bank
and at the HalifaxBankofScotland (HBOS) which resulted in the collapse of both
banks in 2007 and 2008. The FSA admitted that it devoted too much attent ion to
consumer protection ahead of the Northern Rock crisis and announced that in future
it intends to place more emphasis on prudential regulation.
A third concern can be a conflict between the culture within the regulator itself as
conduct of business regulation tends to be dominated by lawyers whereas
economists tend to be more involved in the macro prudential issues.
%oodhart also pointed out that a single regulator could become too powerful and
with monopoly power there may be a tendency to over regul ate. The argument is
that with multiple regulators there exists the possibility of consumers of financial
services to move to suppliers under a different regulator and indeed for the financial
firms to shift regulators themselves which would in theory prev ents over burdensome
or arbitrary regulation. Also there may be a tendency that a single regulator with
monopoly power can become less flexible and more bureaucratic over time.
Twin Peaks
Twin peaks refers to the regulatory regimes which split the regulation into two distinct
areas which are prudential regulation and code of business. The responsibility for
each type of regulation is given to separate agency. This is an example of objectives
based supervision with prudential regulation being designe d to promote the safety
and soundness of the institutions and therefore it could be argued of the financial
system itself, and the conduct of business regulation directed at consumer
protection.
This form of regulation has been adopted in both Australia an d the Netherlands.
Ireland has adopted a slightly different view on this while having two agencies these
are operated from within the one organisation. Under this regime the two main areas
are seen as separate. The main argument being that whereas under a unified
structure it is considered that there is a considerable overlap between the two types
of regulation as it is argued that prudential regulators have a strong interest in the
way business is done as any wrong doing could damage the confidence in the
institution and lead to its downfall. Others argue that the two types of regulation are
in conflict in terms of both regulatory objectives and supervisory style and culture.
The prudential regulator is seen more as a remedial ³doctor´ whereas the conduct o f
business regulator is portrayed as an enforcement ±led ³policeman´ approach.
Therefore if these two supervisory functions are combined in to a single regulator
then this can lead to internal conflicts and the possible mis -allocation of resources.
While mentioned earlier in the unit that this choice of regulatory structure has been
given consideration by both the US and the %30 as a means of taking the
supervisory structures forward it is not without its own shortcomings. In particular the
responsibilities of the two agencies need to be carefully designated to avoid overlap
and duplication. The separation of the two areas does not eliminate the possibility of
conflict between them. For example it is possible that the conduct of business
regulator may wish to take action against a firm for mis-selling but the sanctions in
the opinion of the prudential regulator may threaten the very existence of the firm
itself and the latter may prefer for alternative sanctions to be levied that would not
impact so severely on the financial viability of the firm. It would be hoped that the two
bodies through communicating with each other would be able to resolve any
potential problems but consideration would have to be made if there was no
agreement as to where the situation would be resolved. As mentioned above the
collapse of a firm for wrongdoing could have an adverse impact on the system as a
whole.
¯
In this unit we have:
O Examined the arguments for and against enforced and self regulation
O Examined the different regulatory models sectoral; unified and twin peaks
O Discussed the trends within the supervisory frameworks and examined the
advantages and disadvantages for each.