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Topic 13
The Regulation of
the Financial
Institutions

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Regulation of Financial
Institutions
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

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Regulation of Financial
Institutions

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 publics funds

To promote public confidence in the system

To ensure equal opportunities and fairness in

the publics 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 Harm

Financial Institutions?
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Regulations
institutions
Regulations

can

benefit

financial

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

Does Regulation Benefit or Harm

Financial Institutions?
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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

Types of Regulation
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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 Regulation
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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 Regulation
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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 Regulation

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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 Regulation

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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 tradeoffs between costs and benefits

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Causes of Regulatory
Reform

Financial scandals/crises
pressures generated
Internationalization

political

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

and

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

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
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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.

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 Regulation

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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 Regulation

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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

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Regulation of Financial
Markets

Three
Main
Regulation

Reasons

for

Information

to

1.

Increase
Investors

2.

Ensure
the
Soundness
Financial Intermediaries

3.

Improve Monetary Control

of

Regulation Reason:
Increase Investor Information
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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

Regulation Reason: Ensure Soundness

of Financial Intermediaries
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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

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 1989
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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

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The FSA came into force on 30

June 2013 consolidating the
regulatory
and
supervisory
framework
for
Malaysias
banking
industry,
insurance
industry, payment systems and
foreign exchange administration
matters.

Financial Services Act 2013

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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.