Comment on the different structural models of financial regulations existing worldwide

By Mr Ramjunum Randhirsingh ID : 1020291 MSC Finance Yr 1 Financial Services Law

Submitted to Mrs V Mooneeram

What Is Financial Regulation? Financial regulation is the process in which an authoritative commission oversees the various laws and statutes that dictate how banking companies can perform business. While most of these rules were put in place to protect consumers from illegal banking practices, they also serve to ensure that lending institutions remain within the state and federal guidelines that allow for them to be licensed. A large part of financial regulation is locating and prosecuting the businesses that operate outside of the law for personal gain, which seems to happen quite often. Even though the guidelines for financial regulation vary by region, they are almost always designed to give consumers and businesses alike a fair way to exchange and invest money. Investors may be familiar with the term "insider trading," which indicates when a person or company uses firsthand knowledge that is not available to the public in order to make a profit. While it may seem unfair to punish these types of investment tips, almost every financial regulation authority seeks to keep a level playing field for everyone. Another large aspect of financial regulation is determining the fairness of the way banks lend money. Many regions have limits on the amount of interest that can be charged annually on a loan, and some financial institutions may attempt to bypass this stipulation by adding excess fees or other expenses. When abuse of the system is discovered, it often results in a substantial fine for the violating party, and severe cases can result in the revocation of the operating license within that locality. Other types of financial regulation dealing with consumer loans are the repayment terms, when collection attempts can be made, and what litigation processes are available to lenders. Consumers are equally held responsible when it comes to financial regulation, and banks will often help the authorities prosecute offenders when any type of fraud is conducted. For example, criminals are known to participate in a technique known as "kiting," which essentially means moving money to and from several accounts at once in order to remove more funds than were deposited. This criminal act is made possible because financial regulation dictates the maximum amount of time that a consumer's deposit can be held before it is made available for spending, and scam artists manipulate the system so that the funds will become available before the bank realizes that fraud occurred. Financial regulation is designed in many areas to protect both the consumer and the financial institution equally, but unfortunately, there are often members of both parties that seek to exploit it.

What is Financial Deregulation? Financial deregulation can refer to a variety of changes in the law which allow financial institutions more freedom in how they compete. Whether such changes are beneficial or harmful to the economy as a whole has been widely debated. It is important to note that financial deregulation does not mean removing all rules or regulations. The best known form of financial deregulation in the United States came in 1999 when Congress repealed sections of the Glass-Steagall Act. This act, passed in 1933 during the depression, meant that any one company could only act as a commercial bank, an investment bank or an insurance company. A commercial bank offered savings and loans services to customers, while an investment bank carried out functions such as selling securities, trading in foreign currencies and assisting firms in mergers. The repeal of this act meant firms could now carry out the functions of two or all three of these types of institution. One of the main arguments in favor of repealing the act in this way was that it would limit the effects of economic cycles on individual firms. For example, people are more likely to save during a downturn, but more likely to invest when they are better off. Financial deregulation would therefore theoretically mean firms could grow in size and bring in business more consistently. It was also argued that deregulation would make firms more competitive. They would be able to work more efficiently, particularly where two firms from different sectors merged and pooled their resources. This could also help business as a whole because the competition and efficiency would make it cheaper for companies to obtain funding for capital investment. Critics of financial deregulation have argued that it either caused or fuelled the banking crisis which began in 2007. They say that removing the barriers between different types of financial institutions caused conflicts of interest. For example, a company which had previously been a commercial bank, and had many consumer and business customers, might now take too many risks because it was trying to compete in the investment and insurance sectors. Critics have also argued that deregulation allowed individual financial institutions to become so big that government would have to step in when they struggled rather than let them fail and risk damaging the entire economy.

What Is the Sarbanes-Oxley Act of 2002? The Sarbanes-Oxley Act of 2002 was a landmark piece of financial legislation in the United States, designed to overhaul the regulatory framework pertaining to publicly traded companies. This legislation was passed in response to a series of high-profile cases of accounting fraud that rocked headlines in the early 2000s, including scandals at energy company Enron and telecommunications company Worldcom. The legislation was designed to limit the possibility for accounting fraud on this level in the future. The bill was spearheaded by a bipartisan team led by Sen. Paul Sarbanes (D-Md.) and Rep. Michael G. Oxley (R-Ohio). It includes a number of sections, each designed to address specific regulatory shortcomings the authors felt had contributed to sloppy accounting practices at public companies. Applying to all companies traded publicly, the act also included provisions for the Securities and Exchange Commission (SEC) to make new rules, and established the Public Company Accounting Oversight Board to monitor many of the reforms in the act. Several provisions of the Sarbanes-Oxley Act of 2002 were important. All were intended to increase accountability and transparency, making it harder for companies to commit acts of accounting fraud. One section, 404, proved to be contentious, as it required companies to establish better internal controls and report on the effectiveness of those controls. Critics of the Sarbanes-Oxley Act of 2002 argued that this section would disproportionately impact small companies, due to the high cost involved in implementing such controls. Another section of interest, 303, mandates that members of senior management must verify and certify the accuracy of accounting reports. This holds management accountable for false or questionable financial reporting. Section 802 established criminal penalties for violating the law, stressing that instead of simply being a civil wrong, some forms of accounting fraud could be considered criminal under the Sarbanes-Oxley Act of 2002. Also known as the SOX Law, the Sarbanes-Oxley Act of 2002 was almost unanimously approved by Congress, with a few holdout representatives voting against it. After signing it into law, President George W. Bush indicated he felt it was one of the most important pieces of financial regulation in the United States since the 1930s, when significant overhauls were passed to address the failures that led to the Great Depression. While the Sarbanes-Oxley Act of 2002 certainly closed numerous regulatory loopholes and tightened oversight, critics argued that companies interested in fraudulent practices would find new ways to circumvent the law, staying one step ahead of legislation.

Three models of financial regulation

1. There are three main models of financial regulation in operation around the globe. The first is functional regulation, whereby separate regulators oversee different types of financial company. Most countries have moved away from that model, on the solid grounds that financial markets themselves have become more interlinked and companies more promiscuous. The US is a prominent exception. Americans have remained as committed to a highly complex form of functional regulation as they are to suit trousers that ride above the ankle.

2. The second model is unitary regulation, with a single institution covering most if not all of the financial sector. Although this model is often associated with London and the Financial Services Authority, the Scandinavians started the trend on the back of the banking crises there in the early 1990s. Following the UK switch a number of other countries, including Japan, South Korea and Germany, did the same. Now more than 50 countries operate something similar, although no two models are precisely the same. Time was - way back in August 2007 when the unitary authority strategy was carrying all before it. In the ANR era (After Northern Rock) some of the gilt has gone off that brand, although the underlying logic remains strong. Integrated financial regulationin which banking, securities, and insurance regulation is combined within a single agencywas first tried in Scandinavia more than a decade ago. Although international interest in the idea has recently been kindled by the United Kingdom's recent, dramatic decision to form the Financial Services Authority, many countries considering this type of supervisory arrangement may have more to learn from the Scandinavian experience. Denmark, Norway, and Sweden not only have longer experience with operating integrated regulatory agencies but also introduced them for reasons that are more relevant to developing and transition countries than those that influenced more recent converts to integrated regulation, such as Australia and the United Kingdom. First, Scandinavian interest in the concept of integrated financial regulation predated, to a large extent, the financial trends that have led to its adoption in other industrial countries. The chief argument advanced for integrated regulation during the last few years is that it has been made necessary by the creation of new financial instruments, owing to the unbundling and rebundling of services offered by different types of financial services firms. Consequently, the boundaries of the banking, securities, and insurance sectors have blurred. Integrated financial sector supervision offers a response to these developments by bringing all regulatory functions together within a single organization. Many developing and transition economies have yet to experience this type of financial innovation, however. Hence, developing the ability to respond to such innovations is less important to them than developing effective supervisory capacity. The three Scandinavian countries embarked on supervisory integration for other reasons that also concern developing and transition economies. The first was the need to respond to the

development of financial conglomeratesin which banking, securities, and insurance businesses are combinedthat were coming to play a dominant role in their financial sectors. Equally important were their desires to build supervisory capacity and to achieve synergies and economies of scale in countries with comparatively small financial sectors. Given all these considerations, it is appropriate to examine the Scandinavian experience with integrated supervision to determine whether it holds any general lessons for other countries contemplating such a move.

Scandinavian experience Norway was the first country to establish an integrated financial sector supervisory agency in 1986, followed by Denmark in 1988 and Sweden in 1991. There are a number of similarities in the general outline of their systems. The scope, powers, and governance arrangements of the three agencies bear a strong family resemblance. The Scandinavian agencies each have a broadly similar regulatory scope. They regulate banks, nonbank investment firms, and insurance companies, mainly to ascertain their solvency. How such firms conduct business and other consumer protection concerns are not the agencies' primary responsibilities, but instead are assigned to various ombudsman schemes. The agencies have similar staffing levels and are funded by levies on the regulated industries rather than by general government revenues. Such funding secures the agencies some independence from their finance or economic ministries, to whom they ultimately report. Their independence in each country is further buttressed by a supervisory board, which oversees the general policy and operations of the agency. The strongest guarantee of agency independence in the three Scandinavian countries, however, is the transparency of the political process, which means that any directives ministers give to the regulatory agency are open to public scrutiny. The backgrounds to regulatory consolidation in these countries also had a number of common features. First, each agency was formed at the end of a long process of regulatory consolidation. One consequence was that only the merger of the banking and insurance inspectorates was needed to bring an integrated supervisory agency into being. Second, the merger of the banking and insurance regulatory bodies took place against a background of enhanced linkages between banks and insurance companies. Finally, banking supervision had always been the responsibility of an agency separate from the central bank. This meant that the central bank's powers did not have to be reduced to form the agency. The Scandinavian countries were also influenced by broadly similar considerations in their decisions to integrate. As noted above, the growth of "bancassurance" businessthat is, business done by financial conglomerate groups engaging in both banking and insurancewas a powerful reason for creating an integrated agency, because it would permit better supervision of financial conglomerates. Equally influential, however, was the argument that an integrated agency could achieve significant economies of scale. Centralizing regulatory functions and activities permits the development of joint administrative, information technology, and other support functions. It

also facilitates the recruitment and retention of suitably qualified regulatory personnel, because an integrated organization can offer them better career opportunities than small specialized agencies. Finally, it permits the regulatory authority effectively to deploy staff with scarce skills and experience. This economies-of-scale argument might also be referred to as the smallfinancial-system rationale for integration, because it is especially applicable to countries with small financial systems. A decade after integrated agencies were established in Scandinavia, there is a strong consensus on the benefits of integrated supervision. In none of the three countries have any regrets been expressed about the decision to integrate financial supervision, and the new agencies are widely viewed as having delivered significant benefits. The small-financial-system rationale for integrated supervision is viewed as having been conclusively vindicated by experience. All three agencies believe that they have achieved efficiency gains and economies of scale. There is also little doubt that the creation of integrated agencies has, in a number of different ways, significantly improved the standing of financial regulation in Denmark, Norway, and Sweden. First, the creation of a (comparatively) large, quasi-autonomous regulatory body has brought financial sector regulation a higher status within national governments than separate specialist agencies could have. Integrated regulatory agencies have been more successful than specialist agencies in securing the funding needed to carry out their responsibilities. Second, the creation of a high-profile agency of sufficient size to offer a degree of career progression for its staff has helped to overcome problems of staff recruitment and retention. This, in turn, has enabled each country's integrated regulatory agencies to develop a cadre of professional staff. Although integrated regulation has contributed to improved regulatory standards and the building of supervisory capacity, it has made only limited progress to date in improving coordination of the supervision of financial conglomerates. One reason is thatexcept in Norway administrative reorganizations were not accompanied by radical reviews of existing legislation. This has resulted in the absence of a single, coherent financial services statute under which conglomerates can be regulated. A second reason concerns the agencies' internal organizations. Most started life by preserving their predecessor agencies as separate divisions within the new organizations, an arrangement that has not significantly improved their ability to communicate. More recent attempts at reorganization have resulted in matrix management structures that are still being refined. It is too early to say whether these new organizational forms will help the integrated agencies to bring about the hoped-for improvements in the supervision of financial conglomerates.

Effects on developing and transition countries So, what light does the Scandinavian experience shed on whether developing and transition countries should adopt an integrated model of supervision? Several special characteristics of developing and transition countries differ from those of Scandinavian countries. In many

developing and transition countries, banking supervison has, rightly, been seen as a priority, given that their financial sectors are dominated by banks. Accordingly, these countries have made significant efforts to strengthen their banking supervisory functions, which are almost always carried out by their central banks. A real risk of creating an integrated supervisory agency in this environment is that it may lead to a reduction in banking supervisory capacity, as professional staff opt to leave rather than to lose the pay and status usually associated with being a central bank employee. The reputation of banking supervison may also suffer if it is associated with weaker securities and insurance supervisory agencies. Maintaining the banking supervisory function within the central bank may also have another advantage. In many transition economies, central banks have been established with strong guarantees of their independence, which can help to shield banking supervision from undue parliamentary or ministerial influence. Even the process of legislating to bring a new integrated supervisory authority into being will entail a variety of risks, not least that it could open a Pandora's box of issues as various special interests struggle to control the new legislation. Even if the legislative process proceeds smoothly, a dangerous vacuum of authority could be created as the new agency struggles to establish its credibility. These considerations suggest that embarking on integration in a developing or transition country could have serious potential drawbacks. The Scandinavian experience suggests, however, that it could have some benefits as well, and both sides of the argument need to be carefully balanced. The Scandinavian experience has indicated that the strongest justification for creating an integrated supervisory agency is the small- financial-system rationale. This consideration also seems to apply to many transition and developing countries because, even though their populations are often much larger than those of the Scandinavian countries, their financial systems, measured in terms of assets or capital, are approximately the same size or smaller. Human resources will inevitably be thinly spread in any small financial system. But in many of the developing and transition countries, this problem is compounded by the fact that they are still building up their human capital. One of the clear benefits from the Scandinavian experience is that integrated supervision has permitted the formation of a relatively strong cadre of regulatory professionals. Where such a cadre is still being developed, the argument that all the relevant human capital should be concentrated in a single organization becomes particularly strong. Another aspect of the small-financial-system rationalethe desire to achieve economies of scale in support and infrastructure servicesis also relevant to developing and transition countries. These benefits should not be underestimated in an environment of severe budgetary constraints on agencies. It should also be noted, however, that there are other possible approaches to obtaining the same economies of scale. Finlandas noted in the boxoffers an alternative model to that of the integrated supervisory agencies adopted in the other Scandinavian countries. The financial-conglomerate argument may also be relevant, despite the fact that transition and developing country financial systems remain bank dominated, with comparatively undeveloped securities markets and few nonbank financial intermediaries like insurance companies or mutual

funds. In these countries' markets, a wide range of financial services are often provided by banks. In such cases, the bank regulatory agency might regulate not only banks but also all other types of financial intermediaries and activities to help ensure that all banks' activities are subject to effective consolidated supervision. The important point is that the organization of regulation must reflect the organization of the industry it regulates. A final argument in favor of integrated supervision is that it is well adapted to financial sectors undergoing rapid change and innovationfor example, as a result of recent financial liberalization. Integrated supervision makes it comparatively difficult for potential problems to disappear through the cracks between regulatory jurisdictions. The financial sectors of many transition and developing countries are undergoing rapid transformation, especially in the immediate aftermath of liberalization. The emergence of new types of financial intermediaries and new financial products may leave conventional regulatory structures struggling to keep pace. A decision to create an integrated supervisory agency also raises the issue of its relationship with the central bank. In some developed country markets, the formation of integrated agencies has been encouraged by the separation of banking supervision and monetary policy functions associated with central bank independence. By contrast, as mentioned earlier, there are strong reasons for retaining banking supervision as a central bank function in developing and transition countries. If a decision is taken to remove banking supervision from the central bank, careful consideration will need to be given to crisis-management arrangements. In this respect, the Scandinavian experience has comparatively little guidance to offer, because banking supervision has never been a central bank function there. By contrast, in the United Kingdom, the Financial Services Authority was formed in part from the Bank of England's banking supervision division. One consequence is that the United Kingdom has adopted a more formalized approach to crisis managementbased on a tripartite memorandum of understanding among the finance ministry, the central bank, and the integrated supervisory authoritythan have the Scandinavian countries. This might also serve as a model for other countries considering integration of their financial supervisory agencies. Provided a central bank has strong guarantees of its independence, there may be a case for establishing the integrated supervisory agency as an autonomous agency administratively connected to the central bank, following the Finnish model. Alternatively, these functions could be merged within the monetary authority, as in Singapore. An argument against pursuing either approach is that doing so may encourage moral hazard by implicitly extending the central bank's guarantee of support across the whole financial sector. If the integrated agency is not associated with the central bank, however, it will need to be operationally and financially independent of government.

3. The third scheme is known in the trade as Twin Peaks whereby two regulators are established: one for prudence, focusing on capital soundness, and one to monitor the general conduct of business standards. So far only two countries have followed this prescription, originally devised by UK academics: Australia and the Netherlands. They have done so in subtly but importantly different ways. In Amsterdam the central bank is the prudential regulator. In Sydney there is a separate authority, leaving the Reserve Bank with scrutiny of the payments system and responsibility for financial stability. The birth of twin peaks Wallis considered that the optimal regulatory structure would have a single regulator capable of dealing with each of four identified facets of market failure which were: market misconduct; information asymmetry; anti-competitive behaviour; and systemic instability. However, Wallis did not ultimately favour the single agency or mega-regulator model because it was thought that: the existing agencies, with changes to their powers and functions, will perform best with their own distinct cultures; at that stage in the history of our financial system and regulatory arrangements, fusion of those agencies functions and approaches would be premature; a single regulator with all of these functions might become excessively powerful; and those functions might be too extensive to be combined in one agency with full efficiencies.

Benefits and challenges surrounding the Twin Peaks model One of the major strengths of the Australian model is that APRA and ASIC can independently pursue their prudential and corporate regulation/consumer protection/market integrity objectives, while taking appropriate account of the others differing perspectives. That said, to function properly, the twin peaks model requires a high degree of commitment from both agencies at Commission/Board and operational level to achieve continuing real time information sharing about emerging risks and mutual concerns. This is more of a challenge than ever given the impact of globalisation. Indeed, IOSCO says that, as a result of the increasing internationalisation of financial activities, the information required for market supervision can be beyond the reach of national regulatory authorities in particular

jurisdictions. Thus, international cooperation between regulators internationally is necessary for the effective regulation of domestic markets. Much of Australias market conduct and disclosure regulation is affected by international issues, ranging from the activities of global financial institutions in our markets, enforcement matters involving offshore transactions, complex cross-border ownership structures and policy issues involving international regulatory standards.

INTEGRATED v. MULTIPLE AGENCIES: THE CASE FOR INTEGRATION The arguments in favour and against various structures can be outlined by considering the case for and against the fully-integrated prudential agency. One school of thought argues in favour of a single agency for the prudential regulation and supervision of all financial institutions irrespective of their functions. We do not here consider the issue of incorporating conduct of business regulation and supervision within the same agency that is responsible for prudential arrangements. The focus is on integration of prudential supervision. Several arguments might favour the creation of a single integrated agency for prudential regulation and supervision of all firms: The distinction between functional and institutional regulation does not apply in the case of a financial system made up of specialist financial institutions. In the case of financial conglomerates, an integrated agency enables a group-wide picture of the risks of an institution to be more clearly observed and supervised. This is most especially the case when financial conglomerates themselves adopt a centralised approach to risk management and risk-taking. In this case, there is merit in having an institutional structure of supervision that mirrors the practice of regulated institutions. As a result, a more rapid response to emerging group-wide problems should be possible. To the extent that financial institutions have steadily diversified, traditional functional divisions have been eroded. Although there are various ways of addressing overall prudential requirements for diversified institutions, a single, integrated supervisor might be able to monitor the full range of institutions' business more effectively, and be better able to detect potential solvency risks emanating from different parts of the business. In particular, Taylor (1966) argues: A regulatory system which presupposes a clear separation between banking, securities and insurance is no longer the best way to regulate a financial system in which these distinctions are increasingly irrelevant. Taylor recognised that there would be some grey areas within the overall structure proposed, but believed that: any system is bound to have its anomalies and illogical ties; it is sufficient that the Twin Peaks model has fewer than the alternatives. There may be economies of scale within regulatory agencies (most especially with respect to skill requirements and recruitment of staff with appropriate skills and qualifications). If so, the smaller the number of agencies the lower should be the institutional costs. A single regulator might be more efficient due to shared resources etc, and in particular IT systems and

support services. The argument for economies of scale might apply particularly to the small country case. It is likely to be the case that an optimal staff deployment within a unified agency would be easier to achieve than with a specialist and fragmented institutional structure. Similarly, there might also be economies of scope (or synergies) to be reaped between different areas of prudential regulation of different types of institution. There is less scope for incomplete coverage with some institutions or lines of business slipping through the regulatory and supervisory net because of a lack of clarity about which agency is responsible. There may even be damaging disputes between agencies in a multi-agency structure. The interests of competitive neutrality in regulation and supervision as between different types of firms conducting similar business might be easier to sustain within an integrated supervisory regime. A single agency should, in principle, avoid problems of competitive inequality, inconsistencies, duplication, overlap, and gaps which can arise with a regime based upon several agencies. There might be merit in having a simple supervisory structure, and one which is readily understood and recognised by regulated firms and consumers. The trend for some bank credit risks to be traded and absorbed outside the bank means that bank risks may be absorbed by different types of financial institution in that a loan originally made by a bank may eventually emerge on the balance sheet of a different institution or the credit risk may effectively be absorbed elsewhere. The distribution of all types of risks in the financial system has become increasingly complex and sometimes difficult to disentangle. Equally, the distinctions between different financial products has become increasingly blurred which questions the case for regulating them differently. The potential danger of a fragmented institutional structure is that similar products (products providing the same or similar service) are regulated differently because they are supplied by different types of financial firm. This may impair competitive neutrality. It is more likely that a consistent approach to regulation and supervision as between different types of institution will emerge. Regulatory arbitrage should be more easily minimised. A potential danger with multiplicity of agencies is that overall effectiveness may be impaired as financial firms engage in various forms of regulatory and supervisory arbitrage. The problem has been put by Abrams and Taylor (2000) in the following way: regulatory arbitrage can involve the placement of a particular financial service or product in that part of a given financial conglomerate where the supervisory costs are the lowest or where supervisory oversight is the least intrusive. It may also lead firms to design new financial institutions or redesign existing ones strictly to minimise or avoid supervisory oversight. (Abrams and Taylor, 2000). This can also induce competition in laxity as different agencies compete in order to avoid a migration of institutions to competing agencies. If expertise in regulation is in short supply, it might be more effectively utilised if it is concentrated within a single agency. Such an agency might also offer better career prospects. Accountability of regulation might be more certain with a simple structure, if for no other reason than it would be more difficult for different agencies to pass the buck.

 The costs imposed upon regulated firms might be reduced to the extent they would need to deal with only one agency. This was a particularly significant issue in the UK when, prior to the creation of the FSA, a financial conglomerate might be regulated and supervised and required to report to nine regulatory agencies. In a major study by Luna Martinez and Rose (2003) which was based on a survey of around eighty countries, an analysis was offered of the reasons given by countries that have recently adopted an integrated supervisory agency even though most have stopped short of a unified agency.

Is There an Optimal Model for Supervision? Our presentation of the main regulatory models of the financial system should have made clear how hard it is to establish which alternative offers a decisively superior arrangement. In real life we find a prevalence of "mixed" approaches which borrow in heterogeneous fashion elements that are proper to more than just one model. The institutional model could be considered a good candidate only in a context with rigidly separated financial segments, and where no global players are at stake. Nowadays, we think that this picture does not apply to the major advanced countries, where we do observe high integration in financial markets and intermediaries and a strong presence of poli functional groups and conglomerates (see CEPS, 2000). The most evident problems with regard to the functional supervisory model are the following: i) it might call for too many regulators, corresponding to the numerous functions and activities that the intermediaries perform; ii) it does not explicitly address questions regarding the stability (possible failures) of the single institutions. Hence, we think that modern financial systems should rely on either a single regulator or independent agencies, each one responsible for one of the three objectives of regulation. However, we are particularly concerned with the possible conflict of interest in pursuing different objectives when these are assigned to the same agency. Clearly, the "single-regulator" model is truly affected by the possible incompatibility among the supervisory objectives. In the credit sector, for instance, we find a clear trade-off between competition and stability (at least in the short run). The need to safeguard stability led, particularly in moments of economic and financial tension, to the use of instruments designed to limit competition, such as institutional barriers to entry in the market, or to the legal imposition of limits to operative activities. In financial systems where banks are prevalent but not efficient enough to compete cross-border, the objective of competition is usually sacrificed more easily than that of macroeconomic stability. The consequence is a stable environment in terms of the number and identity of the intermediaries. But this is obtained by altering the free play of competition through measures that prevent exit of inefficient actors from the market. The UK example is interesting. According to the Financial Services and Markets Act 2000 FSA has 4 regulatory objectives which can be reconducted to prudential regulation and investor protection: market confidence, public awareness, the protection of consumers, the reduction of financial crime. Apparently there is no reference to the efficiency objective. But (Section 2(3)), in discharging its general functions the Authority must have regard to: ; the desirability of

maintaining the competitive position of the United Kingdom which seems to be more an objective of a policy maker rather than the one of a super partes regulator and supervisor. Another case is that of the possible conflict between the objectives of stability and transparency. Again with regard to the banking sector, scarce transparency in fund gathering activities (e.g., in the issue of securities) might allow the application of interest rates below market rates. Such behavior could be considered functional to the strengthening of the stability of banks, but it would result in direct injury to investors. The most immediate response to this important problem might be to attribute to different authorities different objectives of supervision, that is to adopt the regulatory model by objectives as the benchmark for advanced financial systems. This solution could be designed so as to avoid an excessive proliferation of authorities and thus limit the increase in both direct and indirect costs of regulation18 . This solution, in order to be effective and to avoid the conflict of interest among the different objectives, should be accompanied by a coordination committee participated by the members of the three different authorities and, eventually, of the central bank.

Objectives of Financial Regulation

So what are the objectives of financial regulation? Professor Charles Goodhart suggests that it is to influence the behaviour of intermediaries so that the policy objectives are achieved. Of course the policy objectives can be very different in different economies. But there is a regulatory cycle that applies in every economy. Once you have defined your policy objectives, like any decision cycle, there must be a set of processes or procedures to achieve these objectives. The operation of these regulatory processes results in a set of policy outcomes. As the old saying goes, "the road to hell is paved with good intentions" or in regulatory speak, the outcomes do not fit your objectives. You therefore need a policy review to see whether the objectives are wrong or the processes are wrong. Which brings us back to Malcolm Sparrow's classic example of policy objectives and policy outcomes. That is the case of income tax non-filers. The policy objective is to collect as much tax as possible. The tax collection process was based on filing an income tax form, upon which the tax was collected. When the US Inland Revenue reviewed this problem, it discovered to its horror that the biggest tax loophole was that of the non-filers. If a person does not file the income tax form, you can't tax him. There was no process to tax the non-filer and there was no process to catch the non-filer. So the policy outcome was that people who were reporting and paying tax bore the tax burden, while the non-filers did not pay tax at all. In other words, the processes did not meet the policy objectives, and the result may be a wrong policy outcome. Surely we need to review many of our own financial regulatory processes or procedures that were put into place in the 1980s or 1990s to see whether they meet policy objectives of the 21st century? What Malcolm Sparrow suggests is that you need to clearly define your objectives, then lay down effective processes to achieve the desired policy outcome. If the outcomes do not fit the objectives, the credibility of the regulator is eroded. Everyday I ask myself, "Have I picked important problems, fixed them and then told everybody?" It sounds like common sense, but common sense is not too common. The bit about "tell everybody" is important, because as financial regulators, we have to be tough in enforcing the law. Many of us

do very good work but we don't tell anybody. Because the public does not understand what we are doing, they may not support us when we need laws that give us the powers to enforce the law effectively. Hence, we need to explain what we do to the public in order to achieve regulatory credibility. The International Organization of Securities Commissions (IOSCO) sums up the objectives of securities regulation as: Protection of investors Ensuring fair, efficient and transparent markets Reduction of systemic risk The UK Financial Services & Markets Act 2000,sets out the objectives of the FSA as promoting : market confidence public awareness the protection of consumers the reduction of financial crime

Conclusion
To conclude, what I am trying to say is that the markets are changing so fast that financial regulators have to change with the times. Such dramatic market changes imply that regulation is still a craft and not a science. We must make regulatory judgements every day, to ensure that the markets we supervise are resilient to shocks. To do our job properly, we must have the range of tools and judgement to use them effectively. But regulators are also human. We need to be independent but we are not independent of the environment in which we work. Our rules and regulations shape our environment and our environment shapes us. We need to understand our environment, understand our strengths and weaknesses and what our role is in shaping the incentives structure in the financial system. No other job presents such formidable challenges. So, as a comfort to all young aspiring regulators in this Summer School, our craft may be tough, unpopular and thankless, but it is an important one.

References Financial Regulation and Supervision in the Euro Area: A Four-Peak Proposal Giorgio Di Giorgio* and Carmine Di Noia** Preliminary Version: January 2001
Allen F. and Santomero A., 1997, "The Theory of Financial Intermediation", Journal of Banking and Finance, n. 11

INSTITUTIONAL STRUCTURE OF SUPERVISION: THE BASIC ISSUES David T Llewellyn Professor of Money & Banking, Loughborough University

FINANCIAL

REGULATION

AND

The Art of Financial Regulation Managing Stability in Changing Times Andrew Sheng Chairman of the Securities and Futures Commission
The integration of financial regulatory authorities the Australian experience

by Jeremy Cooper , Deputy Chairman , Australian Securities and Investments Commission