Why are the Financial Intermediaries Regulated Finance Essay

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Globalization, demutualization, deregulation and the ever increasing growth and obscurity of abstruse derivative markets all stand centre stage in a debt driven financial saga which almost brought the world’s most advanced financial services industries to their knees. Politician’s attempts to vilify those within the financial markets often obscures the truth that political power, especially in emerging economies, can often be held to blame for crises within financial sectors. Both lax governmental intervention and failings within the United Kingdom’s regulatory framework have meant both a failure to recognize and appropriately respond to the systemic shocks within the financial services industry. Until the perpetual nature of a laissez-faire approach is ratified the elliptical nature of a boom, bust and bail out cycle is destined to reoccur. The objective of this paper is to emphasize the importance of the regulation of intermediary institutions. The rationale and reasons why in practice they are regulated and in what way regulation satisfies its demand, whilst also taking into consideration the impact of regulation on the performance of intermediaries. Past events have shown that financial service industries are prone to periods of instability resulting in extensive economic costs, leading many to the assumption that a more efficient and effective regulatory regime may be required. The importance of regulation through studying past events is clearly evident. Empirical studies such as (Benink & Llewellyn, 1995), have explored the rationale behind banking crises, namely those within Scandinavian countries during the 1990’s reaching the conclusion that even in relatively mature economies the risks of poor supervision, lax regulation and asymmetries of information are detrimental to a strong and stable economy. Comparisons can also be seen in the development of banking crises across Asia. The theories raised in (Drage, Mann, Michael, & England, 1998) through the study of destabilizing effects on capital flows, show that the banking crises across Asia have shown similar comparisons between financial instability and the risks of poor supervision. Institutions are affected by a multitude of varying forces making the nature of large institutional failures idiosyncratic. While each failure and banking crises has its own unique characteristics, studies, such as (Westernhagen, et al., 2004) suggest a similar correlation between cases of failure within the European Union and financial liberalization. Reinforcing the argument that the risks from poor or under regulated financial markets and lax supervision are largely detrimental to financial stability. The way in which intermediaries are regulated within the economy has changed dramatically in order to adapt to an evolving environment. Through liberalization, deregulation, globalization and advancements in technology the landscape of intermediation has evolved. With the development of institutions that operate within a global market offering a range of universal products, the once traditional distinctions between types of financial institutions have become blurred. The erosion of traditional distinctions [1] , geographical borders and distinct product markets has further complicated the issues facing effective regulation. In terms of the importance of an intermediaries stability, it runs parallel to its growth; which is due in part to an evident relationship between the development of efficient financial intermediaries operating within a global market and long term economic growth, as concluded in (Levine, 2004) and the macroeconomic risks associated with instability and systemic shock. In essence, the economic cost of instability grows in line with the growth of financial institutions due to their corresponding growing importance in economic prosperity [2] . As an economy matures, an intermediary’s role, in terms of credit, diminishes as a direct result [3] . A negative correlation exists between this diminishing credit role and an increased standing within capital markets [4] . This relationship has resulted in an increased consolidation of the banking industries within mature economies, driving forward the formation of universal banking conglomerates with fewer banks offering a wider range of products [5] as a result, benefiting from economies of scale and scope. With the globalization of trade, intermediaries have had to adapt to increased international demands for capital [6] , resulting in the formation of multinational banking institutions with a greater exposure to equity markets [7] . Raising issues as to how to and who should be responsible for the supervision of institutions acting across boarders and through offshore financial centers. Within the United Kingdoms regulatory structure, there are four distinct areas of regulation and supervision that exist. Those four areas being, prudential regulation [8] , systemic regulation [9] , consumer protection [10] and lastly competition [11] . The United Kingdom adopts a unified agency model in which both prudential and consumer protection regulation is the responsibility of a single agency, the Financial Services Authority. Both prudential regulation and consumer protection regulations are considered to be statutory objectives of the FSA. Systemic regulation however, although considered to be a statutory objective of the FSA, remains the responsibility of the central bank, The Bank of England. Lastly, although competition is not a statutory objective of the FSA, it is required to take into consideration the implications of its regulatory and supervisory framework on competition within the financial services industry at all times. Regulatory structures across the globe vary greatly in design whether that is in legal structure, application or enforcement. The development of a financial regulatory system is endogenous in nature, developing from within the targeted industry resulting in a market orientated system characterized by the principals of said market. The development of a regulatory system is consequently greatly affected by the particular factors affecting the system, meaning the regulatory treatment of one countries banking institutions may differ greatly to another’s. Although banking regulations may vary between nations, the overall objectives of a regulatory system remain the same. For the purposes of this paper and to clearly distinguish between the economic rationale behind regulation and the reasons in practice why regulation is actually imposed, a distinction will be made between the raison d’être, the objectives and the reasons why in practice regulation takes place. Although a variety of demands are placed on regulatory schemes the core objectives of regulation remain the same and can be summarized into three core principals. They are, to ensure sustained systemic stability whilst allowing for unhindered growth, to protect the consumer and to maintain the safety and stability of the financial institutions within the regulated market. The economic rationale for the regulation and supervision of intermediary institutions lies in its ability to overcome market imperfections and failures. In order to ensure this does not hinder growth, regulation should be limited to this purpose. The concept of protecting the ultimate consumer from possible costs associated with market imperfections and failures is one of the fundamental reasoning’s behind the regulation of intermediary institutions. In the absence of an efficient regulatory scheme it is these market imperfections, notably those that arise from externalities and asymmetries of information, that reduce consumer welfare and result in Pareto [12] inferior economic consequences. In contrast, and as discussed in the study (Davies, 1993) when markets achieve a Pareto optimal outcome there bares no justification for restrictive public intervention. With the erosion of geographical restrictions on intermediaries and an increase in interbank exposure, the importance of systemic stability has been amplified. Systemic regulation is found to be justified when the social costs of an intermediary’s failure out ways that of the private costs. Intermediaries are said to hold crucial positions within the economy due to the governments use of banking institutions to affect monetary policy, the fact that they manage the payment system and the crucial role they play in satisfying demand for finance that without the nature of intermediation, may not be able to be satisfied elsewhere. As discussed, the financial services industry is prone to periods of instability, which is compounded by an increased susceptibility to financial frailty, systemic risk, and panic, the latter acting as a contagion within the financial services industry. The spread of fear that an institution is unable to honor its contracts can create a domino affect, leading to a ‘run’ on a banking institutions assets, as with Northern Rock in 2007 when it became the first British bank in 150 years to experience a bank run. Intermediaries are susceptible to runs due to the unique nature of their balance sheets. Intermediaries carry out the function of maturity transformation, transforming liquid short-term deposits into long term illiquid loans with tentative values. In the event of a bank run, an institution is forced to dispose of illiquid assets to ensure solvency in meeting the demands of depositor withdrawals. This raises some significant issues with regards to asymmetric information. Firstly, illiquid assets are valued higher on a going-concern basis than that of liquidation, this is due in part to the fact that the market valuation of the assets could decrease due to the failure of a single institution and that in the case of disposal a potential buyer may impose a premium associated with risk which acts to further diminish the value of the asset. Secondly, the value of an institutions loans are in part affected by the inside knowledge attained by the institution over the life of the asset, such as the relationship between the customer and institution whilst managing the account which value cannot be transferred to a secondary market with absolute creditability. (Benston G. J., 1998) examines the rationale behind systemic banking regulations and argues that the failure of an intermediary may not necessarily pose a substantial cost, this is due to the homogenous nature of banking products and ease in which business may be transferred to other institutions. However, as raised in the studies (Llewellyn, 1999) (Slovin, Sushka, & Polonchek, 1993) and (Davies, 1993) even with temporary disruptions to the payment system and cash flows can have detrimental wealth effects for borrowers. Due to the nature of the contagion, a single bank’s insolvency has the potential to cause depositors to withdraw deposits from other institutions causing solvent institutions to become insolvent. The potential externality of one institutional failure is its potential ability to affect overall systemic stability, whether that be due to a shift in the perception of depositors or interbank exposure. Studies such as (Summer, 2003) treat systemic risk as the simultaneous failure of heterogeneous banking institutions, showing particular detail to mutual credit exposures [13] . The study concludes that for regulation to be efficient in tackling systemic risk a regulator must be able to quantify the aggregate exposure of the intermediary sector and in turn determine whether or not the risk the sector bears is acceptable in order to ensure systemic stability. If done so, regulation can be critical in mitigating the risk of systemic instability and provide stability to the payments system within the financial services industry. Empirical studies such as (Benston, Eisenbeis, Horvitz, Kane, & Kaufman, 1986) have shown little in the way of conclusive evidence that a run on a solvent institution can cause insolvency, however although the risk may be low of a single failure causing systemic instability, the fact remains if it were to occur the macroeconomic repercussions would be vast and as such the case for systemic regulation is significant. The use of fixed-amount creditor protection schemes and the central bank as a lender of last resort, compliance regulation and systemic regulation respectively, can in part alleviate the pressures of systemic shock. (Benston G. J., 1998) argues that the rationale for a run on an intermediary is unjustified in the case of deposit insurance. However, the potential risk of a run differs dependant on whether the insurance cover is 100% of the deposit or less. If the coverage is total, then potential risks of moral hazard emerge in which banks may be induced into riskier levels of activity whilst operating with lower capital reserves, whilst consumers may seek out institutions operating with higher risk for the potential of greater returns in the knowledge that in the event it becomes insolvent they will be fully compensated. This risk is compounded with the affect of competition as discussed in (Davies, 1993) in which competition is found to erode the value of a banking institutions charter and cause institutions to take part in more risky behavior. In the presence of insurance, risk can be said to be subsidized in that, depositors are less likely to demand an appropriate risk premium on their return. In the case of partial insurance, as is the case in the United Kingdom in which deposit insurance is limited to 50,000GBP, see (Financial Services Authority , 2008), rationale to withdraw deposits to reduce loss still exists. Studies such as (Llewellyn, 1999) have found a similar correlation between institutions and consumers taking part in higher risk activities and the central banks role as lender of last resort in which they conclude ‘risk-taking may be subsidized as the appropriate risk-premium is not reflected in deposit interest rates as depositors believe banks will always be rescued.’ (Llewellyn, 1999). In discussing the concern that banks may be induced into riskier levels of activity with lower capital reserves, a case for the use of prudential regulation such as minimum capital requirement legislation also arises, which within the European Commission is based upon the Basle approach [14] . The use of minimum capital requirement relies on the premise that by holding sufficient capital intermediaries internalize any adverse effects of high risk investing and thus choose to invest more prudently. Whilst combating moral hazard in this way is possible, studies such as (Hellmann, Murdock, & Stiglitz, 2000) suggest a risk of Pareto inefficient outcomes resulting from intermediaries being forced to hold inefficiently high reserves. Detractors of the use of both investment insurance schemes such as the ICS and the central bank as lender of last resort, believe that the current insurance schemes against loss provide no disincentives to take part in riskier lending activities and that the lack of disincentives means that a financial firms behavior is likely to be adversely affected by their ability to pass on the cost of risk to others, as discussed in greater detail in the studies of (Kane, 1989) & (Cole, McKenzie, & White, 1995). It is these moral hazard points outlined above and the severity of the possible social and private costs associated with intermediary failures that provide a valid case for the regulation and supervision of financial intermediaries, yet it is important to note that for a regulatory scheme to be efficient, it would need to be constructed as to diminish the extent in which compensation schemes can be exploited. Another economic rationale for the use of regulation is directly related to its ability to overcome market imperfections and failures. If imperfections and failures were present, yet, there was an absence of regulation then the consumer would bare the associated costs. In contrary, in a perfectly competitive market absent of the aforementioned externalities there would be no justification for regulation. The penultimate goal of regulating in concern to market imperfections and failures is to correct any that may be welfare reducing. The main issues affecting the consumer relate to or are closely associated to asymmetries of information. For instance, problems associated with asymmetries of information [15] can have effect on agency costs, which are susceptible to manipulation in order to exploit the customers lack off understanding of critical information. This results in the inability of the consumer to be able to accurately ascertain the true cost of the transaction at the point of purchase. Another example would be, inexact definitions of financial products and associated contracts and a possible further lack of understanding of new complex financial instruments such as derivatives and there associated risks. The rationale for consumer protection regulation centre’s around the fact that consumers may be less equipped to asses the financial stability the institutions they are investing in and in turn would bare the consequences of the possibilities of moral hazard issues arising due to a principle-agent [16] issues and other market failures. In a perfectly competitive market, with a complete lack of the aforementioned externalities, the above considerations would impose considerable cost to the consumer. Studies; such as (Davies, 1993) suggest that the level of competition has a direct effect on market failures in that ‘in the presence of competition, information asymmetry can lead to market collapse’ (Davies, 1993). It is important to note at this point regulation and competition are not in conflict. In fact, effective competition is beneficial in terms of consumer protection and efficient regulation has the ability to reinforce competition by reducing market imperfections that act as barriers to competition. As discussed in greater detail in (Benston G. J., 1998), the associated costs of regulation for the consumer and the potential benefit accrued to the institution is that it often decreases competition however this is in examples of foreign financial services industries and does not generally apply to the United Kingdoms financial sector. There are circumstances in which asymmetric information can adversely affect demand, the best-known example of this phenomenon being (Akerlof, 1970). This paper, on asymmetric information, provides an analysis of the second hand car market in which the existence of low quality vehicles and the inability to distinguish between high and low quality products drives down the average market valuation and as a results forces the higher quality products out of the market resulting in an excess in supply rather than a the desirable market equilibrium where demand is equal to supply. This situation also means that a consumer may be less likely to purchase a second hand car due to the risk of obtaining a low quality product or a ‘lemon’. In terms of the financial services industry, in a situation where a consumer is aware of low quality products in the market, financial firms, even with high quality products, may be tarnished by general perception. Compliance regulation, which is focused on the control of a financial institutions business conduct with respect to protecting the consumer, is in a unique position to tackle this issue by providing industry standards for financial products, in essence driving the ‘lemons’ out of the market. Documented cases in which stricter compliance regulation would have benefited the consumer include the likes of the largely publicized miss selling of personal pension plans between the period of 1988 – 1994, see (Financial Ombudsman Service, 2003). A lesser-known issue arising from asymmetric information is that of the gridlock problem. This issue refers to a situation in which a group of intermediaries are aware of how to act in the best interests of there customers even in the absence of regulation, yet rather than do so they opt to take part hazardous lending activities for there own short term advantage. Two issues arise from this, the possibility of moral hazard and the likelihood of adverse selection. The former discussed in detail in (Goodman, 1990) which concludes that competitive conditions may cause gridlock behavior by encouraging intermediaries to mirror the behavior of others and as a result incurring excessive risk in the process. Again this type of market failure can be associated with the scandal of miss sold pension plans between 1988-1994 in which the competitive environment provided additional pressure in which many institutions were induced to mirror one and another taking part in riskier activities for there own short term gain rather than for the customers best interests. Re-enforcing the argument for compliance regulation of intermediary institutions within the United Kingdom. The demand generated by the consumers, if satisfied within reason [17] , has the potential for welfare gains and as a result has the potential to overcome these market imperfections and avoid considerable costs from intermediary and market failures. Consumers may place demands on intermediaries that may only be satisfied by regulation. The rationale for this could include issues arising from past bad experience of dealing with financial firms, a requirement for a sufficient level of assurance in dealing with institutions, to be able to benefit from economies of scale in terms of monitoring costs and lower transaction costs (saving costs in being able to accurately determine the price of a contract with a firm based on its behavior and financial position) and a simple preference to be proactive rather than reactive in preventing institutions from acting in a hazardous behavior rather than claiming once they have acted in such a manner. Regulation may also benefit consumers suffering from matters associated with asymmetric information, for instance the consumer may not having enough information or be unable to efficiently utilize the information that they may have. A risk adverse customer may even be willing to pay above and beyond the cost of the contract for the benefits of regulation to mitigate the likelihood of loss on his or her transaction. However as identified in (Llewellyn, 1999) the major limitation of this rationale is that ‘the consumer may have an illusion that regulation is a free good in which case demand is distorted’ (Llewellyn, 1999). The effect of regulation on the performance and behavior of intermediaries is an ambiguous subject mainly due to the lack of empirical evidence. One of the most common areas of discussion is the use of prudential regulation such as the capital requirements raising issues regarding the opportunity cost of capital, the cost of holding capital in reserve rather than investing which can have a negative effect on performance. As concluded in the study (Altunbas, Carbo, Gardener, & Molyneux, 2007) inefficient banking institutions within the European Union tend to hold more capital. As per the critical study of the Basel II regulatory framework, (Manthos, Molyneux, & Fotios, 2009), it is suggested that market discipline solely impacts productivity growth and that overall restrictions on the activities of intermediaries actually have a positive effect on productivity and growth. Consumers are not the sole benefactors of an efficient regulatory regime. This is evident through various areas of regulation. Prudential regulation for instance has the potential to reduce individual firms risks. In terms of consumer protection regulation, introducing industry standards enhances consumer confidence, which helps to remove ‘lemon’ products from the market. This increases both the efficiency and the reputation of the market, which counters that which suppresses demand for products. As for the gridlock issue, regulation gives individual intermediaries an assurance that all firms are acting in the same, and more importantly, appropriate way. As discussed, the rational for the regulation of intermediary institutions lies in the associated welfare benefits, however that regulation comes at a cost. There is an inherent tendency to over regulate and although there is an unmistakable demand for regulation whether that be economic or on behalf of the consumer, the cost must not out way the benefit of regulating in order for regulation to have warrant. As (Llewellyn, 1999) concludes, an adverse relationship exists in between the effectiveness of regulation and the efficiency. In essence, that although pursuing legitimate objectives of regulation are in the interests of the overall economy, pursuing them too far may exceed the benefits accrued and whilst external regulation of the financial services industry is evidently important, it does not mitigate the requirement for internal delegated monitoring carried out by intermediaries. Financial intermediaries organizational structures are ideally suited to be able to transform supervisory costs by way of delegating monitoring and in turn minimize the cost of financial distress and monitoring costs. Through diversification, an intermediary is able to delegate monitoring by transforming monitored debt into unmonitored. In essence the importance of deposit contract monitoring is diminished where as the monitoring of loan contracts becomes essential. As discussed in (Diamond, 1996) and (Diamond, Financial Intermediation and Delegated Monitoring, 1984) if an intermediary is competitive and fully diversified then they are in a unique position to provide low cost delegated monitoring increasing their risk tolerance to each individual loan whilst still providing risk for incentive purposes yet at a lower cost. Due to the costs of institutional failure, banks derive a benefit from monitoring risk, which is derived from avoiding inefficient liquidation in favor of a concession from the borrower. In cases of which they are unable to reduce risk via monitoring, they should look to hedge risk appropriately by means such as futures markets or interest swaps. In summary and by way of conclusion, this paper attempts to highlight a motive for the regulation of intermediary institutions. That motive being to remedy market failures that in the absence of an efficient regulatory scheme would result in considerable cost to the consumer. In order to ensure this does not hinder growth, regulation should be limited to this purpose. Efficient regulation has the potential to accrue welfare benefits for all stakeholders and with an intermediaries role in affecting monetary policy, the management of the payment system and the role they play in satisfying demand for finance, regulation for systemic purposes is in the interests of the overall economy. This is compounded further by discussing the evolving landscape of the financial services industry, that with an ever-increasing consolidation of the banking sector provides sufficient rationale for the use of a unified agency model. However strong the case may be for regulation it is important note that it does not mitigate the requirement for internal delegated monitoring carried out by intermediaries and that external regulation of intermediaries is not a replacement, yet rather a complimentary service, to the internal supervision and responsibilities of financial intermediaries.

Figure 1: International demand & supply for capital Sources: IMF, World Economic Outlook database as of September 24, 2010. (McKenzie & Maslakovic, 2009) Figure 2.1: Diminishing Banking Share of the World Financial System Sources: International Financial Statistics, International Monetary Fund; Size of World Bond Market Capitalization, Merrill Lynch and Emerging Stock Market Fact book, Standard & Poor. (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009) Figure 2.2: Affects of a maturing domestic economy on intermediaries credit roles. Sources: International Financial Statistics, International Monetary Fund; Size of World Bond Market Capitalization, Merrill Lynch and Emerging Stock Market Fact book, Standard & Poor. (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009) Table 1: International Examples of Financial Conglomeration. Table 1 continued: Source: World Bank Regulation and Supervision (2003); and Global Survey 2003, Institute of International Bankers. (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009)
Unrestricted – A bank may own 100 percent of the equity in any nonfinancial firm. Permitted – A bank may own 100 percent of the equity in a nonfinancial firm, but ownership is limited based on a bank’s equity capital. Restricted – A bank can only acquire less than 100 percent of the equity in a nonfinancial firm. Prohibited – A Bank may not acquire any equity investment in a nonfinancial firm. Figure 3.1: Changing Structure of Banking Institutions Market Capitalization Sources: International Financial Statistics, International Monetary Fund; Size of World Bond Market Capitalization, Merrill Lynch and Emerging Stock Market Factbook, Standards & Poor’s. (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009) Figure 3.2: The Changing Structure of Global Financial Assets Sources: Bank for International Settlements; International Monetary Fund, International Financial Statistics database; The World Bank, World Development Indicators database. (Stephanou, 2009) Notes: Data is shown for year-end. Debt securities are the outstanding stock of securities issues domestically and internationally. Equity securities are stock market capitalizations. Financial depth is the sum of bank deposits and all types of securities as a percentage of GFP Figure 4: Contribution of Financial Services to GDP Sources: International Financial Services London Research Report in association with The City of London & UK Trade and Investment, www.IFSL.org.uk, IFSL Research: Economic Contribution of UK Financial Services December 2009. (International Monetary Fund, 2010) Figure 5: Ownership of Banks by Region. Sources: World Bank Survey of bank regulation and supervision. Fitch Ratings. Note: The figure shows the un-weighted averages for each region. (Stephanou, 2009). Table 2: Key International Standards of a Sound Financial System Sources: Financial Stability Forum (2001) (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009) Box 1: Core Principles of an Effective Banking Supervisory Framework Source: Cesare Calari and Stefan Ingves, “Implementation of the Basel Core Principles for Effective Banking Supervision, Experiences, Influences, and Perspectives, “International Monetary Fun and World Bank, (September 2002), 13. (Barth, Gan, & Nolle, Global Banking Regulation & Supervision: What Are the Issues and What Are the Practices?, 2009)

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