Economic Rationale for Regulation of Financial Markets

Updated: Jan 6


In this short note we revisit the notion of financial regulation. We delve deeper into the intricacies of economic rationale behind international financial regulatory framework and argue to the importance of financial regulation, monitoring and supervision to be set in place on a global basis[1]. Firstly, we start exploring Llewellyn (1999)[i] assessment of the economic rationale of financial regulation and here we cut the narration into systemic and non-systemic perspectives. Secondly, we narrow down the focus on financial products and amplify the notion of financial products and services being different to other customer driven products or services. Lastly, we conclude that the “new” economic rationale for financial regulation is driven by the natural progression of current structural and technological changes across the banking and finance industry. In data driven world, we argue that global regulators form ever-critical link across the industry participants and stakeholders and add value to the design and shape of “new” global financial regulatory framework.


Firstly, let us explore and analyse Llewellyn (1999) assessment from a slightly different angle. We break the narration into non-systemic and systemic design views. Based on the author the systemic factors to consider are i) potential systemic issues due to externalities, ii) correction of market imperfections and failures, iii) the need for monitoring of financial firms and the economies of scale, iv) potential for grid-lock associated with adverse selection and moral hazard problems and v) moral hazard lender of last resort and deposit insurance schemes. On the other hand, the non-systemic factors are mostly driven by the consumers, i) the need for consumer confidence in the banking and financial systems and ii) consumer demand for regulation to gain a degree of assurance and lower transaction costs.


In short, following from the above breakdown, the financial regulation can be defined as i) prudential e.g. systemic coverage and ii) conduct of business regulation e.g. non-systemic , how financial firms conduct business with their customers. We note that from the systemic perspective it is the fear of market failures that is the driving economic rationale. Inability of markets to clear leading to liquidity shocks and valuation imbalances. Hence the need for a regulator to re-start the market clearing mechanisms and to allow the market participants to ascertain their property ownership claims and rights. On the non-systemic side, it is the need to protect the “small” and vulnerable members of the ecosystem. There are various dimensions to a failure in this space, one of which, is fraud and misrepresentation. As we expand on this point further below and based on Llewellyn (1999) “the key issue is the extent to which regulation can effectively and efficiently address these and reduce the probability of them occurring”.


On the fraud and misrepresentation dimension, the key question then is whether regulation in its entirety can protect retail or wholesale customers. This may appear to be in need due to the recent events stemming from United States v. Heine[ii] ruling and recent appeal decision whereby pending tabulation “A panel of federal appeals court judges vacated their convictions on conspiracy to commit fraud and making false bank entries. Heine and Yates, formerly the two top executives at Bank of Owego, were indicted in 2017 and accused of engineering several plots to hide problem assets or otherwise to make the bank look stronger than it was”[iii]. The point of this case is the protection against economic loss for the bank as well as for the customers. Hence, the economic rationale in this case is driven by provision of fair banking and financial environment allowing for enhanced level of customer confidence.

Secondly, building on the previous discussion of customer confidence we argue that financial products and services different from other consumer products and services and hence the need to provide regulatory oversight is required supporting our previous assertion of customer protection against fraud and misrepresentation. Generally, many financial transactions are viewed as incomplete contracts, whereby the value of these contracts are determined post the point of entry leading to opportunistic behaviours on the part of financial firms, entering the space of informational asymmetries and moral hazard when dealing with principal-agent or fiduciary driven relationships. Another variation to non-financial customer products is the lack of transparency and potential illiquidity leading to separation between listed market price and actual fair price of the product or service provided. Hence, once again, this is driving force and legitimate economic rationale for regulators to step in and provide guide-rails protection mechanisms aiming to protect against case of fraud and misrepresentation, as an example. One approach, from the regulatory standpoint, here is the provision of mandatory (or voluntary) disclosure and reporting requirements and mechanisms.


Lastly, it is becoming evident that technological advances and recent structural reshaping of the role of banks and other licensed financial institutions across the global financial systems require fresh view on the role of global regulatory bodies. We argue that this globalization and digitization of the finance and banking industry, with the raise of FinTech as well as TechFin operators, is seen as an additional economic rationale for global approach to banking and financial regulation[iv]. Regulators are forming central role in data analytics and data collection funnels. Based on Goshen and Parchomovsky (2006) the essential role of securities regulators is to create a competitive market space for sophisticated professional investors and analysts so called “informational trader”[v]. The notion of protecting the work of information traders fits into the notion of global marketplace whereby banks and financial institutions are crossing the legal jurisdictions and are breaking the silos of what has been possible in term of creation of new digital products as well as services. The authors provide three broad categories of regulation, to which we fully subscribe, i) mandatory disclosure duties and requirements, ii) restrictions on fraud and manipulation and iii) restrictions of insider trading. Overall, due to the ability of global regulators to connect with the sophisticated investors, information trader, and request vast amount of valuable data points and data streams as part of the mandatory disclosure requirement schemas from these market participants it now possible to apply cost-benefit analysis (CBA) in regulatory framework[vi]. As per Posner and Weyl (2014) this is an opportunity to expand on CBA approach across finance related regulatory bodies. The economic rationale for financial regulation in this case is to provide level playing field for information traders with enhanced technological capabilities to fit into the new paradigm of financial ecosystem – data driven regulation approach.


Should banks and financial markets be regulated at national level or at international level?


To expand on the previous discussion, here we assert that banks and financial markets should be regulated on international level. International Organization of Securities Commissions (IOSCO) in cooperation with leading global Law Faculties can be designed to form a base for this proposed new global regulatory framework. The major advantage of this global approach is to align with the recent technological advances and developments across the industry. Specifically, the market participant’s capabilities are being enhanced with respect to product and service offerings by speed of information dissemination, computing capabilities and overall technological advances in product and service deliveries, for instance implementation of artificial intelligence (AI) based algorithmic solutions or utilization of AI driven payment systems. The obvious major disadvantage is the requirement to align global jurisdictions and global market participants and stakeholders and most importantly the lack of ability to effectively enforce compliance with existing rules and regulations.


Based on Carvajal and Elliott (2007) the core issues related to enforcing global regulations across the globe, in many countries, are driven by several factors, namely, insufficient legal reach and authority, lack of supporting resources, local politics that is observed to be the major component and a barrier to succeed in global implementation.[vii] The authors observe that more complex the area of interest the more challenging the implementation of globalization. One of the major findings is


“…the lack of independence from the government and the political process appears to be the greatest challenge to the strength of the regulator, followed by a lack of legal authority and limited resources. Regulators frequently lack sufficient powers to license—and de-license—market operators and intermediaries and to conduct enforcement actions, and this lack of authority impedes their ability to operate an effective and credible enforcement program…”


Notwithstanding, we strongly argue for global implementation of regulatory frameworks and systems in line with our previous discussions supported by Llewellyn (1999) assessment. We believe the following two areas are better regulated on international level as opposed to national level namely i) applied artificial intelligence (AI) space and ii) environment, social and governance (ESG) space.



References:

[1] Here we provide basic definitions of these terms, “distinction needs to be made between regulation (the establishment of specific rules of behaviour), monitoring (observing whether the rules are obeyed), and supervision (the more general observation of the behaviour of financial firms).” Llewellyn (1999)

[i] Llewellyn D., (1999), “The Economic Rationale for Financial Regulation”, FSA Occasional Paper Series [ii] United States v. Heine, Case No. 3:15-cr-238-SI, 06-04-2018 <link> [iii]Appeals Court Throws out Conviction of Former Bank of Oswego Executives, OREGONLIVE, Oct 8, 2021 <link> [iv] Arner D.W., Barberis J., Buckley R.P., (2016),” FinTech, RegTech and the Reconceptualization of Financial Regulation” Northwestern Journal of International Law and Business [v] Goshen Z., Parchomovsky G.,(2006),”The Essential Role of Securities Regulation”, Duke Law Journal, Vol 55. No.4 [vi] Posner E.A., Weyl E.G., (2014), “The Case for Cost-Benefit Analysis of Financial Regulations”, Regulation [vii] Carvajal A., Elliott J., (2007), “Strengths and Weaknesses in Securities Market Regulation: A Global Analysis”, IMF Working Paper WP/07/259

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