What Is Financial Regulation?

Financial regulation refers to the rules and laws firms operating in the financial industry, such as banks, credit unions, insurance companies, financial brokers, and asset managers must follow. However financial regulation is more than just having rules in place – it’s also about the ongoing oversight and enforcement of these rules.

Why Is It Important?

One of the key purposes of establishing financial regulations is to maintain the integrity of the financial system. When a bank fails, it is unable to meet its obligation to depositors or other creditors, which can cause problems for the wider economy.

Financial regulations aim to enforce applicable laws; prosecute cases of market misconduct; license providers of financial services; protect clients; investigate complaints; and maintain confidence in the financial system. In some such way, we all depend on the financial system—from saving and accessing money, borrowing money to maintain business, taking out mortgage or insurance, to getting claims paid when something goes wrong.

Types Of Financial Regulation

Although the features of financial systems vary from country to country, depending on their stage of economic development and the structure and philosophies of government, it is possible to identify three common themes or objectives underlying financial regulation:

· A concern with the stability of the financial system and a desire to prevent financial crises – that is, situations where problems in the financial system have the potential to cause a contraction in economic activity through their effects on community wealth, credit flows, or confidence in the payments system. This objective is pursued through prudential supervision of key institutions, through oversight of arrangements for settling transactions among financial institutions, and through ‘crisis management’ when a problem does arise.

· A desire to protect the interests of users of financial services in situations where information about the characteristics of products, or the riskiness of institutions offering them, is hard to assess. This form of regulation – consumer and investor protection – attempts to improve the safety of investors’ funds and requires clear disclosure of financial information and appropriate standards of financial advice so that investors and borrowers are better able to make informed decisions.

· Encouragement of appropriate levels of competition among those offering financial services, in the interests of efficiency.

Prudential Supervision

Prudential supervision, in its narrower sense, is about encouraging prudent risk management by financial institutions whose failure could precipitate a financial crisis. It works through rules which minimise the chance that supervised institutions will become insolvent and, failing that, by crisis management procedures. As a by-product, it offers the public a relatively safe haven for those savings where security is more important than the return.

While both banks and insurance companies share a need for institution-based prudential supervision, banks have some special features which make them crucial for the maintenance of financial system stability.

Regulation Of Investment Products

Investment products offer returns based on the earnings of some specified pool of assets. These include unit trusts and the various products offered by funds managers to the public or to superannuation funds. While the products are clearly defined, the institutions which manage them range from specialised funds managers, insurance companies, and bank subsidiaries to friendly societies.

While substantial falls in the market value of investments, if sustained, will reduce wealth and consumption, these effects will generally be less pronounced than those which follow bank failure. Similarly, if the managing institution gets into difficulties, this has few implications for the unit holders; they will still be entitled to the market value of the underlying assets on liquidation or takeover by a new manager. Thus, these products are different in kind as well as a degree of risk to deposits or insurance policies.

Product And Advice Regulation

Product disclosure and advice regulation (often called consumer protection) permeate all areas of retail business activity. It deals with unfair and deceptive practices, misleading conduct, product safety and information, and dispute resolution.

Other areas of the economy have specific consumer legislation. Like situations where consumers make decisions that concern large amounts of their money (eg the licensing of builders, rules applying to the borrowing or investing of money). These specialised areas of consumer regulation are often backed up by some form of enforcement to see that retailers are complying with standards (eg health and building inspectors).

Regulation Of Financial Markets

Market efficiency is usually concerned with the liquidity, fairness, and orderly trading of markets. Participants should be able to buy or sell the products they want, in the volumes they require, and at true market prices. This requires an effective market infrastructure, transparent pricing mechanisms, good settlement and clearing procedures, and freedom from fraud and malpractice. Reliable settlement procedures and arrangements for handling a failure to settle also promote stability.

To promote market efficiency and stability, governments usually provide a legislative framework and allow the relevant industry or exchanges to establish detailed trading rules and enforcement procedures. The task is, of course, greatly simplified if the supervision of the market-makers and the regulation of products and advice are effective.

Regulation To Promote Competition In The Market

Most countries have regulatory bodies which aim to prevent anti-competitive practices, including price fixing, monopolies, and misleading conduct. They usually have the authority to prevent or challenge mergers or acquisitions which might reduce competition. Their responsibilities normally cover competition in all sectors of the economy since there is no justification to have a different (or very different) competition policy in financial services than elsewhere. Another aspect of competition regulation is the use of litigation, by both the regulator and aggrieved parties, to prosecute breaches of competition laws. Whereas prudential supervisors and regulators of products, advice, or markets continuously monitor the financial industry, competition regulators tend to focus more on specific incidents or proposals.

Other Regulation

Other types of regulation, with objectives other than stability or efficiency, impinge on the financial system. The financial system is a massive database of the economy’s financial transactions and wealth. Financial institutions are required to inform of suspicious or large cash transactions.

Taxation and social security regulations can also affect the choices people make about which financial product to purchase so they are also heavily regulated.

The Future Of International Financial Regulation

Financial regulation has changed significantly in the years since the global financial crisis of 2008 and again after the peak of the COVID-19 pandemic. Tougher, more detailed, and more complex standards now apply to all aspects of regulation worldwide.

This has extended to capital, leverage, liquidity, recovery and resolution planning, governance, culture, remuneration, retail and wholesale conduct, anti-money laundering and countering terrorist financing, systemic risk, and macro-prudential policy. Although banks have faced the fullest force of these reforms, the direction of travel has been similar across insurance, investment firms, and financial market infrastructure.

Overall, regulation and supervision are more likely to push on further than to be pushed back over the next years. In part, this will reflect in regulation moving into new areas (or expanding in existing areas) including fintech, cyber security, anti-money laundering, retail, and wholesale conduct, and potentially a raft of regulations driven by social objectives such as climate change and financial inclusion.

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