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Raya University College of Business & Economics Department of Accounting &
Finance Study material for Financial institutions and markets

CHAPTER-FIVE
REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS
5.1. INTRODUCTION
Financial institutions are the most heavily regulated of all businesses in the world. Around
the globe these financial service firms face strict government rules limiting the services
they can offer; territories they can enter; the makeup of their portfolios of assets; liabilities,
and capital, and even how they price and deliver their services to the public. Variety of
reasons have been offered for heavy government interference into the financial
institutions’ sector, including protecting the public‘s savings and ensuring that consumers
receive an adequate quantity and quality of financial services that are reasonably priced.
Many economists, financial analysts, and financial institutions have argued over the years
that government regulation has done more harm than good for both financial institutions
themselves and for the public they serve. In particular, government restrictions supposedly
have allowed non-regulated or less regulated financial service firms to invade the markets
and capture many of less regulated financial services, who are not sufficiently free to
compete effectively. Moreover, regulations are often backward looking, addressing
problems which have long since disappeared, and they may compound this problem of
―relevancy‖ by changing much more slowly than the free marketplace, inhibiting the
ability of the regulated financial institutions to stay alongside with new technologies and
changing customer tastes.
Other observers, however, argue that government regulations have achieved some positive
results in the financial institutions’ sector, reducing the number of failed financial service
firms, promoting more stable financial markets, and reducing the incidence of racial, age,
and sex discrimination in public access to financial services.
Dear student, in this chapter we will see the rationale for financial institutions regulation,
the aim and principles of regulation and also the regulation of depository and non-
depositor y institutions.
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BY: Birhanu Abadi (Assistant professor) ------------ email. birhanuabadi12@gmail.com
5.2. Reasons behind Regulation of Financial Institutions
Elaborate government rules controlling what financial institutions can and cannot do arise
from multiple causes. One is concern about the safety of the public‘s fund, especially the
savings of millions of individuals and families. The reckless management and ultimate loss
of personal savings can have devastating consequences for a family‘s future economic
wellbeing and life style, particularly at retirement. While savers have a responsibility to
carefully evaluate the quality and stability of financial institutions before committing their
funds to it, governments have long expressed a special concern for small savers who may
lack the financial expertise and access to quality information necessary to be able to
correctly judge the true conditions of a financial institution. Moreover, many of the reasons
that cause financial institutions to fail-such as fraud, embezzlement, deteriorating loans, or
manipulation of the books by insiders-are often concealed from the public.
Related to the desire for safety is a government‘s goal of promoting public confidence in
the financial system. Unless the public is confident enough in the safety and security of
their funds places under the management of financial institutions, they will withdraw their
savings and thereby reduce the volume of funds available for productive investment to
construct new buildings, purchase new equipment, set up new business, and create new
jobs. The economy‘s growth will slow and, over time, the public‘s standard of living will
fall.
Government rules are also aimed at ensuring equal opportunity and fairness in the public‘s
access to financial services. For example, in an earlier era many groups of customers-
women, members of racial minority groups, the elderly, and those of foreign birth- found
that their ability to borrow money on convenient terms was often severely restricted.
Consumers of financial services were not well organized then, and the discriminatory
policies of lending institutions seemed to change very slowly, particularly in markets
where competition was less intense. While many economists believed that the potent force
of competition generated by both domestic and Foreign Service suppliers would eventually
kill off the vestiges of discrimination, other observers argued that such an event might take
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a very long time, particularly in those markets where financial firms colluded with each
other and agreed not to compete.
Many regulations in the financial sector spring from the ability of some financial
institutions to create money in the form of credit cards, checkable deposits, and other
accounts that can be used to make payments for the purchase of goods and services.
History has shown that creation of money is closely associated with inflation. If
uncontrolled money growth outstrips growth in the economy‘s production of goods and
services, prices will begin to rise, damaging specially those consumers on fixed incomes,
as their money balances can buy fewer and fewer goods and services. Thus, the regulation
of money creation has become a key objective of government activity in the financial
sector.
Regulation is justified as the most direct way to aid so-called ―disadvantaged‖ sectors in
the economy- those groups that appear to need special help in the competition for scarce
funds. Examples include new home buyers, farmers, small businesses, and low income
families. Governments often place high social value on subsidizing or guaranteeing loans
made to these sectors of the economy.
Finally the enforcement of government rules for financial institutions has arisen because
governments depend upon these institutions for many important services. Governments
borrow money and depend upon financial institutions to buy substantial proportion of
government IUOs. Financial institutions also aid governments in the collection and
disposal of tax revenues and in the pursuit of economic policy through the manipulation of
interest rates and money supply. Thus, governments frequently regulate financial
institutions simply to insure that these important financial services will continue to be
provided at a reasonable cost and in a reliable manner.
What are we to make of these reasons so often posed for the extensive government
regulations applied to many financial institutions? Few of them can go unchallenged. For
example, while safety is important for many savers, no government can completely remove
risk for savers. Indeed, in the long run, it may be more efficient and far less costly for
governments to promote full disclosure of the financial conditions of individual financial
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institutions and let competition in a free marketplace discipline poorly managed,
excessively risky financial service firms.
Similarly, there is no question that discrimination on the basis of sex, race, religious
affiliation, or other irrelevant factors is repugnant, but can we be more effective by
eliminating discriminating by some method other than by writing and struggling to enforce
complicated rule books and by requiring endless compliance reports? Perhaps the same
ends could be achieved by lowering the regulatory barriers to competition and by making it
easier for customers hurt by discrimination to recover their damages in court.
Certainly the ability of financial institutions to create money needs to be monitored

carefully, because excessive money growth can easily generate inflation and weaken the
economy. But, aren‘t there already enough tools available to control money growth? For
example, when money grows too fast, a central bank like the Federal Reserve System can
use its powerful tools (like deposit reserve requirements or open market operations) to
slow money growth. And wouldn‘t it be more efficient to pay direct money subsidies to
disadvantaged groups (such as new home buyers) rather than to directly reach these groups
by regulating financial institutions and interfering with the free operation of the financial
services markets? As for providing a reliable stream of financial services to governments,
wouldn‘t profit motivated financial institutions be likely to provide these services if it were
profitable to do so?
In brief, there are no absolutely irrefutable arguments justifying the regulation of financial
institutions. Much depends on your personal political philosophy regarding society‘s goals
and whether these goals are each more likely to be achieved by an unfettered marketplace
or by collective action through government laws and regulations. As we shall see shortly,
there is a trend today toward gradually allowing private markets to discipline risk taking by
financial institutions and minimize the role of government. Progress toward deregulation
of the financial sector is slow, however, and can easily be derailed if financial institutions
abuse the new liberties that may soon come their way.
5.3. Aims Financial Regulators
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The specific aims of financial regulators are usually:
 To enforce applicable laws

 To prosecute cases of market misconduct
 To license providers of financial services
 To protect clients, and investigate complaints
 To maintain confidence in the financial system
5.3.1. Financial System Regulation
Regulation may be applied to facilitate the general operation of markets, to enhance safety
or to pursue social objectives. This section provides a basic framework for considering
whether and, if so, where and how each of these purposes of regulation should be applied
in the financial system.
5.3.2. General Market Regulation
All markets, financial and non-financial face potential problems associated with the
conduct of market participants, anti-competitive behavior and incomplete information.
These common forms of market failure have justified at least a minimum level of
regulatory intervention in markets on an economy wide basis. Such intervention generally
takes the form of:
 Conduct regulation such as criminal sanctions for fraud and prohibitions on anti-
competitive behavior; and
 Disclosure regulation such as general prohibitions on false and misleading
statements contained in fair trading laws.
There are some markets where this minimum level of economy wide regulation is
considered to be inadequate. These markets, or their products, have characteristics which
warrant more specific disclosure and conduct rules than apply in other industries. In many
cases, it is also considered necessary to establish a separate regulatory agency to conduct
such specialized regulation.
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A key question for the Inquiry was to decide where conduct and disclosure regulation of
financial markets is best left to general economy wide arrangements and where more
regulation specialized is required. As a general principle, greater regulatory consistency
and efficiency will result from economy wide regulation. Consequently, this should always
be preferred unless a clear case for sector specific arrangements can be demonstrated.
The Inquiry examines the case for specialized regulation in:
 Financial Market Integrity

 Retail Consumer Protection and
 Competition Policy
5.3.3. Financial Market Integrity
Market integrity regulation aims to promote confidence in the efficiency and fairness of
markets. It seeks to ensure that markets are sound, orderly and transparent. Financial
market prices can be sensitive to information, and this raises the potential for misuse of
information. For this reason, regulators around the world impose specific disclosure
requirements (such as prospectus rules) and conduct rules (such as prohibitions on insider
trading) on financial market participants. The complexity of financial products and
markets, their intrinsic risks including those due to limited information and the
detailed knowledge required to deliver efficient regulation in this area argue strongly for
continued specialized regulatory arrangements.
Consumer Protection
Consumer protection refers to the forms of regulation aimed at ensuring that retail
consumers have adequate information, are treated fairly and have adequate avenues for
redress. There are close links and no clear dividing line between consumer protection and
market integrity regulation in retail markets since both use the same regulatory tools,
namely disclosure and conduct rules. For example, prospectus requirements can promote
both consumer protection and confidence in the efficiency and fairness of retail financial
markets.
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Specialist consumer protection in the financial system is justified on two grounds. First, the
complexity of financial products increases the probability that financially unsophisticated
consumers can misunderstand or be misled about the nature of financial promises,
particularly their obligations and risks. This, combined with the potential consequences of
dishonor, has led most countries to establish a disclosure regime for financial products that
is considerably more intense than disclosure rules for most non-financial products.
Secondly, financial complexity also increases the incidence of misunderstanding and

dispute. Given this, and the high cost of litigation, a number of countries have imposed
specific regulation of financial sales and advice and established low-cost industry
complaints schemes or tribunals for resolving disputes.
Competition Regulation
Competition regulation refers to laws which ensure that all markets are competitive. Two
main areas of concern are market concentration and collusion which can lead to
overpricing of financial products and under provision of services essential to economic
growth and welfare.
While financial products are complex and any assessment of competition requires detailed
analysis of markets, the key features relevant to competition assessment in this sector are
not unique. The application of economy wide competition regulation to the financial
system ensures regulatory consistency. Anti-competitive behavior is not unique to
financial markets, and it is preferable to establish both the bounds of acceptable
competitive behavior and rules for mergers and acquisitions which are common to all
industries. Accordingly, the case for specialized arrangements in this area is relatively
weak.
5.4. Principles of Regulation
Competitive Neutrality: Competitive neutrality requires that the regulatory burden

applying to a particular financial commitment or promise apply equally to all who make
such commitments.
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It requires further that there be: minimal barriers to entry and exit from markets and
products; Ø no undue restrictions on institutions or the products they offer; and markets
open to the widest possible range of participants.
Cost Effectiveness
Cost effectiveness is one of the most difficult issues for regulatory cultures to come to
terms with. Any form of regulation involves a natural tension between effectiveness and
efficiency. Regulation can be made totally effective by simply prohibiting all actions
potentially incompatible with the regulatory objective. But, by inhibiting productive
activities along with the anti-social, such an approach is likely to be highly inefficient.
The underlying legislative framework must be effective, including by fostering compliance

through enforcement in cases where participants do not abide by the rules. However, a
cost-effective regulatory system also requires:
 a presumption in favor of minimal regulation unless a higher level of intervention

is justified;
 an allocation of functions among regulatory bodies which minimizes overlaps,
duplication and conflicts; an explicit mandate for regulatory bodies to balance
efficiency and effectiveness;
 a clear distinction between the objectives of financial regulation and broader social
objectives; and
 the allocation of regulatory costs to those enjoying the benefits.
Transparency
If there is a general perception that a particular group of financial institutions cannot fail
because they have the imprimatur of government, there is a great danger that perception
will become reality. Transparency of regulation requires that all guarantees be made
explicit and that all purchasers and providers of financial products be fully aware of their
rights and responsibilities. It should be a top priority of an effective financial regulatory
structure that financial promises (both public and private) be understood.
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Flexibility
One of the most pervasive influences over the continuing evolution of the financial system
will be technology. While it is not possible to forecast with any certainty the precise
impact that technology will have on the shape of financial services and service delivery, it
is certain that the impact will be considerable. These developments make flexibility
critical. The regulatory framework must have the flexibility to cope with changing
institutional and product structures without losing its effectiveness.
Accountability
Regulatory agencies should operate independently of sectional interests and with

appropriately skilled staff. In addition, the regulatory structure must be accountable to its
stakeholders and subject to regular reviews of its efficiency and effectiveness.
The fundamental costs brought about by regulations which are of major concern to
financial institutions as they alone are responsible for them. These are; 1. -
Administrative costs of the compliance of the regulated firms.
1. The cost of dedicated capital to comply with requirements.

2. Contributions of funds needed to compensate failure.
3. Loss of competition
4. Instability due to lack of diversification
5. Loss of comparative advantage over foreign competitors
6. A moral hazard
5.5. Does regulation benefit or harm financial institutions?
For many years a controversy has been brewing as to whether government regulations help
or hurt financial institutions. One of the earliest arguments on the positive side was
propounded by economist George Stigler (1971), who suggested that regulated industries,
far from fearing regulation, actually invite government interference, expecting to benefit
from it. In the early history of the United States, for example, the railroads often prospered
because government subsidized their growth and protected them from competition.
Because regulators may prevent or restrict entry into an industry, the firms involved may
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earn excess profit (―monopoly rents‖) due to the absence of strong competitors.
Therefore, the lifting of regulatory rules (deregulation) may bring about decreased profits
for financial institutions.
A more balanced view on the benefits and costs of regulation has been offered by Edward
Kane (1983). He suggests that, on the positive side, regulation tends to increase public
confidence in the regulated industry. Thus, customers may trust their banks ‘stability and
reliability more because they are regulated, increasing customer loyalty to regulated firms
and helping to shelter them from risk. Moreover regulation may lead to a curious form of
―innovation‖ which Kane labels as the regulatory dialectic. He believes that regulated
firms are constantly searching for ways around government rules in order to increase the
market value of their business. Once they find a regulatory loophole that attracts the
regulators ‘attention, new rules are imposed to close the gap. But this leads to still more
―innovation‖ by regulated business in order to escape the new restrictions. The result is a
continuing chain reaction: regulators spawn innovative escapes that, in turn, give rise to
new rules in a never ending struggle between the regulators and the regulated. Many
observers of the banking industry in recent years see clear evidence of these dialectic
process bankers finding ways to offer prohibited services, like security underwriting and
sales of insurance, spawning still more restrictive rules.
Notice, too, that the so-called ―innovation‖ brought on by the regulatory dialectic is not
the most productive and efficient form of innovation from society‘s point of view. Instead
of developing ways to lower costs and deliver financial services more efficiently to the
public, financial institutions are spending their time and energy looking regulatory
loopholes-something they wouldn‘t do if the regulations weren‘t there in the first place.
This ―wasted time and energy, Kane believes, places regulated firms at a disadvantage
vis-a–vis their unregulated competitors. Other factors held equal, the market share of the
regulated firms begins to fall. Many economists believe that this has happened to banks
and other depository institutions in recent years, as security dealers and mutual funds,
facing fewer regulations, have captured many of the banking industry‘s biggest and most
profitable customers, reducing the share of the financial services marketplace controlled by
depository institutions.
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On balance, then, regulations of financial institutions may be a ―tale of two cities,‖
delivering both the best of times and the worst of times. Regulation may increase the profit
of regulated institutions ‘profitability and shelter them from risk, resulting in fewer
failures, but perhaps at the price of costlier services and less efficient financial firms. In
return for greater stability and greater public confidence in financial institutions, customers
must expect to be less well served in terms of prices charged and quality of services
delivered.
@ QUICK CHECK
Justify the importance of regulating financial institutions
Describe the principles of regulation
Discuss the aims of financial regulation
5.6. Regulation of Commercial Banks
Due to their importance in the financial system, commercial banks are typically the most
regulated of all financial institutions. One of the areas where the state and federal
regulators have exercised the most influence over banking is controlling what new
geographic markets banks can enter with their offices.
Another method of the regulation of commercial banks is through the regulation of the
services that banks can offer. Even as banks have sought greater freedom to expand
geographically, they have also fought for, but only occasionally won, new service powers
in order to retain their existing customers and attract new ones. Unfortunately, regulations
have been tight and sometimes unyielding in this area out of concern for bank safety (as
service innovation can be highly risky) and because of a desire to protect certain non-bank
financial institutions, such as credit unions, savings and loans, and insurance companies,
from tough bank competition.
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For example, probably the most influential law in American history in defining bank
service powers was the Glass-Steag all Act (or Banking Act) of 1933. This sweeping law
confined bank service powers essentially to the making of loans and the taking of deposits,
while insurance services were largely relegated to insurance companies, and home lending
was centered in savings and loan associations and savings banks. U.S. bankers also lost an
important service power they possessed in the decades before Glass-Steag all- the power to
assist their largest corporate customers by purchasing corporate stock and then reselling it
in the open market. Foreign banks have continued to offer corporate bond and stock
underwriting services to American companies, and U.S. banks are active in the security
underwriting business overseas through a variety of affiliated organizations, but they have
clearly lost customers to security dealers and foreign banks (principally from Canada and
Western Europe) in domestic underwriting, except for underwriting those types of
securities where exceptions have been granted from federal restrictions. Bankers have
avidly sought security underwriting powers because this business can be highly profitable
and it complements traditional lending services.
One of the most rapidly expanding areas of banking regulation today centers around
disclosure rules— regulations requiring financial institutions to reveal certain information
to customers (in an effort to encourage shopping around and avoid deception) and to
regulators (to improve supervision of the banking industry). For example, banks could be
required to disclosure of all the interest and fees associated with selling loans and deposits
to individuals who are bank customers. Similarly, in case of home mortgage, banks could
be required to report to the public and to regulators the locations of both their approved
and rejected applications for loans to purchase or improve homes as a check on possible
discrimination in lending. Another could be a requirement on banks and other depositories
to notify customers and regulators in advance when branch offices are to be closed.
In addition to the spread of interstate banking and the explosion in branching activity by
banks, another major trend reshaping the regulation of banks and other financial
institutions today centers upon their capital —the long-term funds invested in a financial
institution, mainly by its owners. For example, when stockholders buy ownership shares in
a bank, they have a claim against the bank‘s earnings and assets. However, a bank‘s
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stockholders bear all the risks of ownership. If the bank fails to generate sufficient
earnings, the stockholders may receive no dividend income and, if the bank fails, they
close everything. When a bank chooses to take on more risk, its owners should be asked to
increase their financial commitment to the bank by supplying more capital. Because
stockholders capital is expensive to raise and could be lost completely if the bank fail, the
owners of the bank are likely to monitor the bank‘s risk taking more closely, pressuring
management to be more prudent in taking on additional risk.
The tremendous changes in banking regulation in recent years- including the adoption of
nationwide banking and the spreading internationalization of bank regulation as evidenced
by the Basel Agreement on bank capital- might lead us to think that there is little left to do
in reshaping the future structure of bank regulation. Nothing could be further from the
truth! Banking in the United States (and in most other countries of the world) remains
heavily burdened by constraining government rules. Slowly and along a zigzag path,
banking is experiencing an era of deregulation, as legal constraints are being lifted on a
few banking activities.
5.7. Regulation of Insurance Companies
While not quite as heavily regulated as commercial banks, insurance intermediaries face
tough rules that are imposed primarily by state governments, which create insurance
commissions to regulate the industry. The fundamental purpose of insurance company
regulation is to ensure that the public is not overcharged or poorly served and to guarantee
adequate compensation to insurance companies themselves. A new company must be
chartered under the rules of a particular home state. Once chartered, each company must
submit periodic reports to state commissions, its agents must be licensed by the states, and
the terms of its policies (including the premium rates it charges policyholders) must be
approved by state insurance commissions. Both the courts and state commissions insist
that any investments of incoming policyholder premiums must conform to the common
law standard of a ‗prudent person.
5.8. Regulation of Pension Funds
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Because pension funds have risen rapidly to hold the bulk of the retirement savings of
millions of workers, they have been subject to much heavier regulation by the courts and
government agencies. Because employers- the principal creators and managers of pension
plans- have an incentive to take on considerable risk in an effort to minimize the cost
burden they must carry, many pension plans even today remain only partially funded —
that is, the market value of their assets plus expected investment income does not fully
cover all the benefits promised to pension plan members. While English common law
requires pension plans to be ―prudent‖ managers of their members‘retirement savings,
many pensions have branched out into riskier investments, including real estate
development projects and derivative securities contracts.
5.9. Regulation of Finance Companies
Finance companies are among the most important lenders and businesses in recent years.
The bulk of regulation of this industry is at the state level and focuses principally on the
making of consumer loans. Several states impose maximum loan rates so that finance
companies are limited in the amount of interest they can charge consumers, which tends to
limit the volume of credit extended to riskier households. The states, trying to protect
consumers, also usually spell out the rules for installment loan contracts and the conditions
under which automobiles, furniture, home appliances, or other household assets can be
repossessed for nonpayment of a loan extended by a finance company.
@ QUICK CHECK
Describe how commercial bank are to be regulated
Describe how insurance companies are to be regulated
Describe how pension funds are to be regulated
Describe how financial companies are to be regulated
14

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Raya University College of Business & Economics Department of Accounting &

Finance Study material for Financial institutions and markets

REGULATION OF FINANCIAL MARKETS AND INSTITUTIONS

Certainly the ability of financial institutions to create money needs to be monitored

5.3. Aims Financial Regulators

 To enforce applicable laws

5.3.1. Financial System Regulation

5.3.2. General Market Regulation

The Inquiry examines the case for specialized regulation in:

 Financial Market Integrity

5.3.3. Financial Market Integrity

Secondly, financial complexity also increases the incidence of misunderstanding and

5.4. Principles of Regulation

Competitive Neutrality: Competitive neutrality requires that the regulatory burden

The underlying legislative framework must be effective, including by fostering compliance

 a presumption in favor of minimal regulation unless a higher level of intervention

Regulatory agencies should operate independently of sectional interests and with

1. The cost of dedicated capital to comply with requirements.

Justify the importance of regulating financial institutions

Describe the principles of regulation

Discuss the aims of financial regulation

5.6. Regulation of Commercial Banks

5.7. Regulation of Insurance Companies

5.8. Regulation of Pension Funds

5.9. Regulation of Finance Companies

Describe how commercial bank are to be regulated

Describe how insurance companies are to be regulated

Describe how pension funds are to be regulated

Describe how financial companies are to be regulated

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