Topic 131-1

The Regulation of the Financial Institutions

Regulation of Financial Institutions1-2

Regulation relates to the setting of specific rules of behavior that firms have to abide by – these may be set through legislation (laws) or be stipulated by the relevant regulatory agency

Monitoring of these regulations refers to the process whereby the relevant authority assesses financial firms to evaluate whether these rules are being obeyed

Supervision is a broader term used to refer to the general oversight of the behavior of financial firms

Regulation of Financial Institutions

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Financial institutions are one of the most heavily regulated businesses in the world.

Many economists, financial analysts, and financial institutions have argued that regulation has done more harm than good.

Other observers, however, argue that government regulations have achieved some positive results for the financial institutions as well as for the public.

The Reasons Behind the Regulation of Financial Institutions

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Concern for the safety of the public’s funds To promote public confidence in the system To ensure equal opportunities and fairness in

the public’s access to financial services To prevent excessive money creation, and

hence excessive inflation To aid ‘disadvantaged’ economic sectors To ensure that important financial services

are provided reliably and at a reasonable cost

Does Regulation Benefit or HarmFinancial Institutions?

Regulations can benefit financial institutions

Regulations subsidize the growth of financial institutions and protect them from competition

Regulations tend to increase public confidence

Regulations spawn innovative escapes (regulatory dialectics) through loopholes in the regulations

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Does Regulation Benefit or HarmFinancial Institutions?

Regulations can harm financial institutions

Regulatory dialectics are not the most productive form of innovation

The time and energy spent on regulatory compliance activities are costly

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Types of Regulation1-7

The financial services industry is a politically sensitive one and largely relies on public confidence, the failure of one institution can immediately affect others, i.e. vulnerable to systemic risk

This is known as bank contagion and may lead to bank runs

3 possible types of regulation: Systemic regulation Prudential regulation Conduct of business regulation

Types of Regulation1-8

Systemic regulation concerned mainly with the safety and soundness of the financial system

All public policy regulation designed to minimize the risk of bank runs that goes under the name of the government safety net, which encompasses two main features Deposit insurance Lender-of-last-resort

Types of Regulation1-9

Prudential regulation is mainly concerned with consumer protection Monitoring and supervision of financial

institutions with particular attention paid to asset quality and capital adequacy

Conduct of business regulation focuses on how banks and other financial institutions conduct their business Information disclosure, fair business

practices, competence, honesty and integrity of financial institutions and their employees

Arguments against Regulation1-10

Regulatory arrangements, in particular the ‘safety net’ arrangements create moral hazard Deposit insurance and the LOLR can cause

people to be less careful Too-big-to-fail (TBTF) and Too-important-to-fail

(TITF) cases Agency capture, the regulatory process can be

‘captured’ by producers (banks) and used in their own interest, e.g. Basle Capital Accord has had too much input from banking sector participants

Arguments against Regulation1-11

Regulation is a costly business and the cost of compliance with the regulatory process will be passed on to consumers, resulting in higher costs of financial services and possibly less intermediation business Regulatory costs may act as a barrier to entry in the

market and this may consolidate monopoly positions However, none of these criticisms is enough to

reject financial regulation as regulation is always about making judgments and considering trade-offs between costs and benefits

Causes of Regulatory Reform Financial scandals/crises and political

pressures generated Internationalization

Throughout the world financial liberalization has provided a passport for banks to offer services cross-border and hence the debate about convergence of rules

Globalization Risks to financial stability are less confined

to national borders and thus calls for greater coordination between national regulators

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Causes of Regulatory Reform Consolidation

The emergence of financial conglomerates Financial innovation

New financial products and services emerge and gain in market significance often call for new regulation

Firms innovate to get around regulations and the regulators are always one step behind the market – the regulatory dialectic

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Basel Committee – its main goals Improve the quality of banking supervision

worldwide

Promote more effective corporate governance

Close gaps in international supervisory coverage

Level the playing field among international banks

Establish a safer and sounder banking system as a precondition for sustainable growth of an economy

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Basle I

The purpose was to prevent international banks from building business volume without adequate capital backing

The focus was on credit risk Set minimum capital standards for

banks

Basel II

To provide the right incentives for sound risk management

To deliver a prudent amount of capital in relation to the risk that is run

To maintain a reasonable level playing-field for all banks to operate in

The Growing Importance of Capital Regulation

While Basle I was directed at measuring credit (default) risk primarily, Basle II brings in refined estimates of market risk exposure and adds new capital requirements for operational risk (i.e. the risk of losses banks can suffer from such events as crime and destructive weather, the breakdown of internal information systems, failed transactions processing, workplace hazards etc.)

Bank capital must be sufficient to offset all of these potential risk exposures.

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Unfinished Agenda for Banking Regulation

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Slowly, banking is experiencing an era of deregulation, as legal constraints are lifted on a variety of banking activities.

Supervision of financial institutions in the future will rest primarily upon: government examinations (of market

data and the firms’ risk management systems)

capital requirements market discipline

Trends in the Regulation1-19

Regulation seeks to promote the safety and stability of financial institutions in order to preserve the confidence of the public and avoid institutional failures.

However, regulation can become a costly burden that significantly increases the operating costs of financial institutions and limits the cleansing effects of failure and competition.

Trends in the Regulation1-20

Increasingly, Market discipline is playing a bigger role Regulators are cooperating more Focus of regulation is moving away from

control over the services offered and geographic expansion to controlling risk taking

Increasing attention to public disclosure

Regulation of Financial Markets Three Main Reasons for

Regulation

1. Increase Information to Investors

2. Ensure the Soundness of Financial Intermediaries

3. Improve Monetary Control

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Regulation Reason: Increase Investor Information

Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets and may also keep investors away from financial markets

The Securities Commission (SC) requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation

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Regulation Reason: Ensure Soundness of Financial Intermediaries

To protect the public and the economy from financial panics, the government has implemented six types of regulations: Restrictions on Entry Disclosure Restrictions on Assets and Activities Deposit Insurance Limits on Competition Restrictions on Interest Rates

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Regulation Reason: Improve Monetary Control

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Because banks play a very important role in determining the supply of money (which in turn affects many aspects of the economy), much regulation of these financial intermediaries is intended to improve control over the money supply

One such regulation is reserve requirements, which make it obligatory for all depository institutions to keep a certain fraction of their deposits in accounts with the central bank

Reserve requirements help the central bank exercise more precise control over the money supply

BAFIA 19891-25

BAFIA 1989 was passed in Parliament and came into force on Oct. 1, 1989. It has effectively replaced the Banking Act 1973 and the Finance Companies Act 1969.

It is a comprehensive act and extends comprehensive powers to BNM to supervise a larger spectrum of financial institutions, with the direct responsibilities to regulate and supervise all licensed institutions (commercial banks, finance companies, merchant banks, discount houses and money brokers) and also regulate scheduled and non-scheduled institutions.

Financial Services Act 2013

The FSA came into force on 30 June 2013 consolidating the regulatory and supervisory framework for Malaysia’s banking industry, insurance industry, payment systems and foreign exchange administration matters.

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Financial Services Act 2013

Goals of FSA Maintain financial stability Enhance growth in financial sector Provide adequate consumer

protection

Also gives Bank Negara more powers, given the increasingly complex and interconnected environment.

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