CHAPTER 12

ECONOMICS OF REGULATION
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1. INTRODUCTION
Regulation is important because of its impact on individuals, businesses, and
the economy.
Regulation may be proactive or reactive.
A challenge with financial regulation is managing systemic risk.
- Systemic risk is the risk of the failure of the financial system.
Uncertainty regarding regulation is a risk that affects business decisions.

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2. OVERVIEW OF REGULATION
Regulations may be enacted by
- statutes (that is, laws);
- established by government
agencies or other regulators,
which are administrative laws
and regulations; or
- interpretations of courts (that
is, case law).

Administrative
Laws and
Regulations

Statutes

Judicial Law

Independent regulators get

their authority from government
bodies or agencies.
Outside bodies may be referred
to by regulatory authorities.

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Regulations

SELF-REGULATION IN FINANCIAL MARKETS

A self-regulating organization (SRO) is a nongovernmental entity that
represents and regulates its members.
- Some independent regulators are SROs, which may have authority from a
government body or from its members.
- SROs are similar to statutory bodies in some countries.
- The use of self-regulatory bodies varies among countries.
SROs are not considered regulators unless they are given authority by a
government body or agency.

U.S.
Securities
and
Exchange
Commission

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FINRA (self-regulator)
PCAOB (independent regulator)
FASB (outside body)

CLASSIFYING REGULATIONS AND LAWS

We can classify regulations by objectives:
Safety

Commerce and trade

Privacy

Consumers rights

Protection

Investor protection

Environmental

Antitrust

Labor and employment

Financial system

We can classify regulations by function:

- Substantive law focuses on the rights and responsibilities of entities and the
relationships among entities.
- Procedural law focuses on the methods of administering substantive law
and the process for determining the rights of parties.

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ECONOMIC RATIONALE FOR REGULATION

Regulation may be necessary if market solutions are not sufficient.
- Although the market solution is the most efficient allocation of resources, the
market may not be frictionless, with constant returns to scale and without
externalities.
Regulation is needed when there are informational frictions and externalities.
- Informational frictions include asymmetrical information and agency
problems.
Regulations are needed to supply a public good (e.g., defense) that has shared
benefits but which may not be funded without regulations.

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REGULATORY INTERDEPENDENCE
The regulated firms and industry may benefit (regulatory capture) from being
regulated.
- Example: regulations may restrict competition
When there are differences in regulations across jurisdictions, there may be
regulatory competition and regulatory arbitrage.
- Regulations can be designed to attract entities (e.g., incorporation laws).
- Entities can shop for regulatory environments in which they may be able to
exploit differences in regulations.
The interdependency of countries regulators, each with different objectives, is
important because without coordination, countries may be at a competitive
disadvantage.
Overlapping jurisdictions can result in conflicts, such as bank stress test results
(generally not available to the public) and securities regulations disclosure
requirements.

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TOOLS OF REGULATORY INTERVENTION

Tools available:
- Taxing (to encourage or discourage certain decisions)
- Restricting activities (such as insider trading)
- Mandating activities (such as minimum capital standards)
- Imposing of sanctions and penalties (such as punitive fines for insider-trading
violations)
Choosing the appropriate tool is difficult, and more than one tool may be
applied for a given situation or problem.
- Consistency in the application of tools is desirable.
It is difficult to judge whether specific actions by regulators are effective
because financial systems are dynamic and complex.

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3. REGULATION OF COMMERCE
Commerce is regulated by the government for many reasons, including
dealing with externalities (e.g., pollution) and public goods,
promoting commerce,
protecting labor (e.g. working conditions),
protecting consumers (e.g., product safety),
protecting intellectual property,
ensuring privacy of customers,
ensuring an appropriate legal environment (e.g., contracts, permits),
supporting and protecting domestic business interests (e.g., fair competition),
and
promoting competition in the domestic market (e.g., antitrust laws).

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APPROPRIATE LEGAL FRAMEWORK

(IOSCOS FRAMEWORK)
(1) Company Law
1.1 company formation
1.2 duties of directors and officers
1.3 regulation of takeover bids and other
transactions intended to effect a change in
control
1.4 laws governing the issue and offer for sale of
securities
1.5 disclosure of information to security holders
to enable informed voting decisions
1.6 disclosure of material shareholdings
(2) Commercial Code/Contract Law
2.1 private right of contract
2.2 facilitation of securities lending and
hypothecation
2.3 property rights, including rights attaching to
securities, and the rules governing the
transfer of those rights

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(3) Taxation Laws

3.1 clarity and consistency, including, but not limited
to, the treatment of investments and investment
products
(4) Bankruptcy and Insolvency Laws
4.1 rights of security holders on winding up
4.2 rights of clients on insolvency of intermediary
4.3 netting
(5) Competition Law
5.1 prevention of anti-competitive practices
5.2 prevention of unfair barriers to entry
5.3 prevention of abuse of a market dominant position
(6) Banking Law
(7) Dispute Resolution System
7.1 a fair and efficient judicial system (including the
alternative of arbitration or other alternative dispute
resolution mechanisms)
7.2 enforceability of court orders and arbitration
awards, including foreign orders and awards

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ANTITRUST LAWS
Antitrust regulations are intended to prohibit abusive and anticompetitive
behavior, including exclusive dealings and refusals to deal, pricing
discriminations, and predatory pricing.
- Example of antitrust concerns: software bundling by Microsoft
- Example of use of antitrust for competitive advantage: Microsoft EU claims
against Google
A challenge is that antitrust issues may involve many different regulators.
- In the United States: Department of Justice, Federal Trade Commission, etc.

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4. REGULATION OF FINANCIAL MARKETS

Goals of securities regulation:
- Protect investors
- Create confidence in markets
- Enhance capital formation
Goals of regulating financial institutions:
- Protect consumers and investors
- Ensure safety and soundness of institutions
- Smooth payment system
- Provide access to credit
Regulation of financial markets is necessary because the consequences of
failures in the financial system are significant.
- Potential consequences of failures: financial losses, loss of confidence, and
disruption of commerce
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THE REGULATION OF FINANCIAL MARKETS

Regulation of markets
- maintains integrity of markets,
- acts as a referee for fairness,
- maintains financial stability, and
- ensures appropriate and fair disclosures.
- Disclosures include financial statements, accounting standards, periodic
disclosures, and price transparency disclosures.
Securities market regulation focuses on
- reducing agency problems (e.g., governance, fee disclosure, proxy voting,
and soft-dollar expenses) and
- protecting retail investors (but not necessarily large investors).

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PRUDENTIAL SUPERVISION
Prudential supervision is the regulation and monitoring of the safety and
soundness of financial institutions.
- Promote financial stability
- Reduce system-wide risks (systemic risk)
- Protect customers of financial institutions
Prudential supervision also relates to confidence in the financial system.
- Diversifying assets
- Managing and monitoring risk taking
- Ensuring adequate capitalization

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5. COSTBENEFIT ANALYSIS OF REGULATION

Regulatory burden is the cost of regulation to the regulated entity.
Net regulatory burden is the private cost of regulation minus the private
benefits of regulation.
Benefits include a more competitive environment, reduced risk to the financial
system, and enhanced market liquidity.
Costs of regulation may be direct (e.g., compliance attorneys, pollution control
equipment) or indirect (e.g., lost sales, lower returns).
Costs and benefits are difficult to estimate, despite there being mandated cost
benefit analyses by the government.
- A sunset provision would require a costbenefit analysis as part of the
renewal of a regulation.

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6. ANALYSIS OF REGULATION
Regulations may focus on a sector, an industry, a company, or a security
depending on the purpose of the regulation.
Examples of sector regulation: the regulation of the financial sector postfinancial crisis (e.g., capital standards, risk management)
- Trade-off: increase stability of industry versus reduce growth opportunities
and returns.
Example of industry regulation: discount window borrowing by banks
- Issue: whether this information should be disclosed to investors
Example of security regulation: collateralized mortgage-backed securities
- The DoddFrank Act prohibits references to ratings in regulations of
securities as a result of the financial crisis problems.
Keys to the evaluation of the effects of regulation include, Who is helped and
why? Are there any unintended consequences? What is the effect on other
stakeholders?
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CONCLUSIONS AND SUMMARY

Legislative bodies, regulatory bodies, and courts typically enact regulation.
Regulatory bodies include government agencies and independent regulators
granted authority by a government or governmental agency. Some independent
regulators may be self-regulating organizations.
Typically, legislative bodies enact broad laws or statutes; regulatory bodies issue
administrative regulations, often implementing statutes; and courts interpret
statutes and administrative regulations, which may result in judicial law.
Regulators have responsibility for both substantive and procedural laws. The
former focuses on rights and responsibilities of entities and relationships among
entities. The latter focuses on the protection and enforcement of the former.
The existence of informational frictions and externalities creates a need for
regulation. Regulation is expected to have societal benefits and should be
assessed using a costbenefit analysis.
Regulation that arises to enhance the interests of regulated entities reflects
regulatory capture.
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CONCLUSIONS AND SUMMARY

Regulatory competition is competition among different regulatory bodies to use
regulation to attract certain entities.
- Regulatory arbitrage is the use of regulation by an entity to exploit differences
in economic substance and regulatory interpretation or in regulatory regimes to
the entitys benefit.
Interdependence in the actions and potentially conflicting objectives of regulators
are important considerations for regulators, those regulated, and those assessing
the effects of regulation.
There are many regulatory tools available to regulators, including price
mechanisms (such as taxes and subsidies), regulatory mandates and restrictions
on behaviors, provision of public goods, and public financing of private projects.
The choice of regulatory tool should be consistent with maintaining a stable
regulatory environment. Stable does not mean unchanging, but rather refers to
desirable attributes of regulation, including predictability, effectiveness in
achieving objectives, time consistency, and enforceability.

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CONCLUSIONS AND SUMMARY

The breadth of regulation of commerce necessitates the use of a framework
that identifies potential areas of regulation. This framework can be referenced
to identify specific areas of regulation, existing and anticipated, that may affect
the entity of interest.
The regulation of securities markets and financial institutions is extensive and
complex because of the consequences of failures in the financial system.
These consequences include financial losses, loss of confidence, and the
disruption of commerce.
The focus of regulators in financial markets includes prudential supervision,
financial stability, market integrity, and economic growth among others.
Regulators should conduct ongoing costbenefit analyses of regulations,
develop techniques to enhance their measurement, and use economic
principles to guide them.

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