Learning Module 3: Economics of Regulation

Learning Module 3 Economics of Regulation EXAMPLE 1 Rationale for Regulation 1. Which of the following is least likely to be a reason for the use of regulation? A. Systemic risk posed by the financial services industry B. Informational frictions in the form of private information C Extensive disclosure of operating and financial information by companies seeking to attract investors' attention Solution C is correct. Extensive disclosures are not a reason for the use of regulation. They may be the result of regulation or a reflection of good business practic es. The presence of systemic risk and informational frictions give rise to the need for regulation. 2. Prudential supervision is primarily concerned with: A. treatment of inducements in the provision of investment advice. B. provision of information about financial products to retail investors. C safety and soundness of the financial system Solution C is correct. The primary objective of prudential regulation is to ensure safety and soundness of the financial system. ANTITRUST REGULATION 1. Which of the following issues is is least likely to be the subject of antitrust rules? A. Privacy and data protection B. Anticompetitive behavior by dominant companies in a market Mergers and acquisitions by major companies Solution A is correct. Privacy and data protection issues are regulated, but only as part of regulations besides antitrust rules. ILLUSTRATION OF REGULATORY PROCESS This description by the US Securities and Exchange Commission (SEC) is illustrative of how the process works: "Rulemaking is the process by which federal agencies implement legislation passed by Congress and signed into law by the President. Major pieces of legislation, such as the Securities Act of 1933, the Securities Exchange Act of 1934, and the Investment Company and Investment Adviser Acts of 1940, provide the framework for the SEC's oversight of the securities markets. These statutes are broadly drafted, establishing basic principles and objectives. To ensure that the intent of Congress is carried out in specific circumstances and as the securities markets evolve technologically, expand in size, and offer new products and services the SEC engages in rulemaking." (www. sec.gov/about/whatwedo.shtml) FINRA On its website, FINRA states: FINRA is dedicated to protecting investors and safeguarding market integrity in a manner that facilitates vibrant capital markets. FINRA plays a critical role in ensuring the integrity of America's financial system- all at no cost to taxpayers. Working under the supervision of the Securities and Exchange Commission, we: Write and enforce rules governing the ethical activities of all registered broker-dealer firms and registered brokers in the U.S.; Examine firms for compliance with those rules, Foster market transparency; and Educate investors. EXAMPLE 3 Classification of Regulators 1. The media devotes considerable coverage to a regulatory body that has been given autonomy by the government and is empowered by statute. The regulatory body has recently raised the fees charged to the companies it regulates. The regulatory body in question is most likely to be a(n): A. self-regulatory organization. 8. government agency. C independent regulator. Solution C is correct. Independent regulators are given authority by the government and are empowered by statute. Unlike government agencies, they are funded by fees that they collect from the firms they regulate. 2. Which of the following is least likely to be a characteristic of a self-regulatory body? A. It represents and regulates its members. B. It carries out government policy. C. It can discipline members that violate its rules and principles. Solution B is correct. Self-regulating bodies do not carry out government policy. They are meant to be independent from government and immune to its influence. HOW IOSCO ENHANCES REGULATORY COOPERATION The member agencies of 10SCO have resolved, through its permanent structures, "to cooperate in developing, implementing and promoting adherence to internationally recognized and consistent standards of regulation, oversight and enforcement in order to protect investors, maintain fair, efficient and transparent markets, and seek to address systemic risks. to enhance investor protection and promote investor confidence in the integrity of securities markets, through strengthened information exchange and cooperation in enforcement against misconduct and in supervision of markets and market intermediaries; and to exchange information at both global and regional levels on their respective experiences in order to assist the development of markets, strengthen market infrastructure and implement appropriate regulation" EXAMPLE 4 Regulatory Interdependencies 1. A country's securities regulator is looking to attract a higher number of smaller companies to its capital markets. It proposes to ease hurdles that companies face when preparing to list shares on the country's stock ex change. The proposals include the lowering of the frequency of financial reporting, reducing the extent of disclosures required, and reducing the minimum size of company that can be accepted on the market. This is an example of: A. regulatory competition. B. regulatory coordination. C. regulatory capture. Solution A is correct. Regulatory competition occurs when regulators compete to provide a regulatory environment designed to attract certain entities. 2. Regulatory capture is most likely to be a concern where there is reliance on: A. SROS B. government agencies. C. government departments. Solution A is correct. Regulatory capture has been a concern when SROs are used. EXAMPLE 5 Regulatory Tools 1. Globalization of capital markets is most likely to result in increased concerns about: A. financial contagion. B. regulatory competition. C. both contagion and regulatory competition. Solution C is correct. Globalization is likely to result in increased concerns about contagion and regulatory competition. It is easier for a financial shock to spread. Governments may use their regulatory environment to attract ties from around the world. 2. The regulatory tools least likely to be used by self-regulating organizations are: A. price mechanisms. B. restrictions on behaviors. C provision of public goods. Solution A is correct. SROs are least likely to use price mechanisms. They typically regulate behaviors and often provide public goods in the form of standards. ILLUSTRATION OF COST-BENEFIT ANALYSIS To illustrate the issues that may be relevant to a regulator when considering a cost-benefit analysis, we focus here on a proposal for the introduction of new regulation in Europe to remove the red tape and compliance burdens faced by small and medium-sized enterprises (SMEs) when seeking an IPO of their shares or for issuing bonds on public markets. The proposed regulation is intended to address three problems. First, the "one-size-fits-all" approach to some areas of financial regulation has led to a perception that the costs of listing outweigh the benefits. Second, there has been a progressive decline in the number of smaller brokers and investment firms that specialize in trading shares of smaller companies. A small, local brokerage ecosystem is necessary to support smaller companies with the listing process. The third problem is the lack of investment in shares and bonds of small companies. The objective of the proposed regulation would, therefore, be to revive IPOs and bond offerings of small companies. The cost-benefit assessment would examine two proposals: first, whether some of the existing regulations, such as MiFID II and the Market Abuse Regulation (MAR), could be adapted to accommodate smaller issuers. The costs and benefits of (1) targeted changes and clarifications to the existing regulations or (2) an overhaul of the provisions would be examined relative to a "baseline scenario" where the existing rules under MiFID II and MAR do not change. The second proposal would examine the cost and benefits of the introduction of new provisions. These could include simpler delisting rules, rules enabling easy transfer of a listing from less regulated "small company growth markets" to regulated markets, and less stringent free float requirements to make it more attractive for issuers, investors, and market operators. A regulator carrying out a cost-benefit analysis would need to assess the positive impact on the companies' investment and growth rates as a result of easier access to capital. The costs the regulator would have to consider include the additional regulatory oversight over the small companies in question and the consequences of any impact of corporate failures among the listed smaller firms on investor confidence and, consequently, the remaining firms' cost of capital. COST-BENEFIT ANALYSIS 1. An investment adviser is discussing a client's portfolio exposure to the electric utilities sector. The sector's regulator has outlined series of proposals for new regulation, on which it is carrying out a cost-benefit analysis. The adviser makes two statements to the client about the regulator's cost-benefit analysis. Statement 1 "The regulator will assess and take into account as part of its cost-benefit analysis only the indirect costs of new regulation arising from changed economic decisions and behaviors." Statement 2 "Regulatory costs and benefits are easier to assess on a prospective, after-the-fact basis." Which statement is correct? A. Only Statement 1 is correct. B. Only Statement 2 is correct. C. Both statements are correct. Solution B is correct. Statement 2 is correct because actual costs and benefits may be available during retrospective analysis, allowing a more informed assessment of regulation. Statement 1 is incorrect because both indirect and implementation costs will be taken into account. EXAMPLE OF REGULATORY ANALYSIS The scenario outlined earlier (in "illustration of Cost-Benefit Analysis") considered pro- posed changes to the regulations concerning the IPO market for smaller companies. An analyst may wish to evaluate the impact of such changes to the rules in order to analyze prospects for a particular company (issuer) or to assess the portfolio fund flows into or out of the smaller companies segment. The analyst may also want to understand the Impact on companies in the brokerage business involved in that segment of the market. The analyst might consider a series of questions. One set of questions could concern the design of the proposal: Are there any exemptions from the new regulation, or will it apply to all small companies? What thresholds, if any, are used to determine whether a company is designated as small? Will the regulation be applied identically across all EU member states, or will each jurisdiction have an ability to tailor it to their own conditions/ Will the regulation be subject to review or withdrawal later? Another set of questions that an analyst might consider relates to the potential market and participant impacts: Who will benefit most from the regulation? Will it benefit high-growth companies in particular sectors or countries? What is the scale of the potential benefit associated with the regulation? What costs are associated with the regulation, and what is their scale? Will all participants face the same costs, or will they differ by market segment? Are the costs likely to be one-off in nature or recurring? Is the regulation likely to lead to market entry, expansion, or innovation by certain SMEs? Could the regulation lead to the potential exit of some existing providers of brokerage services or potentially crowd out other means of supplying capital and finance? How might the regulation change the behavior of SMEs? For example, will it reduce their reliance on bank loans? Finally, the analyst might consider any wider impacts of the regulation on the market, industry, and society: Will the regulation affect financial stability or resilience? Could the regulation widen the opportunities for other investors, allowing them to better diversify their portfolios? Could there be potential spillover effects, allowing firms, for example, to shift between "junior markets" and more regulated markets? Could the impacts on financial markets be greater in some EU member states than in others? What are the possible macroeconomic impacts of the regulation? For example, could it improve capital inflows? EXAMPLE 7 Analysis of Regulation 1. Jessica Wong, CFA, is an equity analyst responsible for the materials and industrial sectors in Europe. The regulatory authorities are preparing new rules on transportation, further limiting the age and exhaust emissions of the trucks used by industrial companies. What is likely to be of greatest concern to the analyst when evaluating the impact of the new rules on companies? A. Changes to costs related to the acquisition, operation, and maintenance of trucks B. Positive impact of reduced pollution on public health and subsequent health care cost savings in the wider society C The methods and techniques used by the regulator during its cost-benefit analysis Solution A is correct. The analyst will want to understand and analyze the impact of the proposed regulations on the performance of the companies she covers. Answers B and C relate to the cost-benefit analysis carried out by the regulatory authority. 2. Which of the following questions would be the least relevant for the analyst to ask? A. Will the costs be one-off in nature, or will they be recurring? B. Will all companies in the sector be affected equally? C What is the legal status of the regulator? Is it a government department, a government agency, or a self-regulating organization? Solution C is correct. The status of the regulator is the least important question. Answers A and B represent items that the analyst will find relevant when evaluating the impact of new regulations on the companies under coverage.