Economics of Regulation Exam Prep

ECO Learning Module: 3 Economics of Regulation 1. INTRODUCTION Knowledge of the basic types of laws that affect economies, financial systems, industries, and businesses is useful to an analyst. Regulations may develop both pro-actively and reactively. • Pro-active regulations are those that are developed to address expected consequences of future changes in the environment. • Reactive regulations are those that are developed in response to the consequences of changes in the environment that have occurred in the past e.g. regulations developed in response to financial crisis. Examples: • Regulations associated with dealing with systematic risk; • Labor regulation; • Environmental regulation; • Electronic privacy regulation etc. 2. • Restrictions on and/or mandate how businesses interact with others (i.e. other businesses, consumers, workers, and society); or • Constraints on and/or mandate with regard to internal operations of businesses. Importance of Regulations: Knowledge of regulation is crucial for analysts and investors because • Regulation has potentially extensive and significant effects on the economy and on individual companies and securities. • Changes in regulatory structure and regulatory uncertainty may have considerable effects on business decisions. • Regulatory structure has substantial impact on business operations and business environment. • Regulation plays an important role in helping markets function effectively. ECONOMIC RATIONALE FOR REGULATION When there are no frictions (e.g. costs for or restraints on trading and asymmetrical information) and externalities, the market solution is considered as economically efficient or Pareto optimal and no regulatory intervention is needed. Market failure occurs when freely functioning markets fail to efficiently or optimally allocate resources, leading to loss of economic efficiency. Main causes of Market Failure: a) Externalities that result in divergence between private and social costs and/or benefits. • Negative externality causes market to produce a larger quantity than is socially desirable e.g. pollution. • Positive externality causes market to produce a smaller quantity than is socially desirable e.g. roads, parks. b) Public goods and common resources: Market failure occurs in public goods because their consumption provides shared benefits to market participants and generates spillover effects; as a result, markets would not produce the optimal amount of these goods e.g. national defense and standard setting. c) Monopolies and lack of competition Regulatory Framework: A regulatory frameworks refers to a set of rules or standards of conduct e.g. d) Imperfect Asymmetry: It includes • Adverse selection: It refers to a problem when (before entering into an agreement/contract) one party has better information than other party. • Moral hazards: It refers to conflicts of interest that arise as a result of delegation of decision making to agents or post-contractual behavior that adversely affects the interest of other (ignorant) party. Rationale for Regulations: • Markets do not always work effectively, and as a result regulation plays a crucial role in helping markets function effectively. • Regulations provide important protection e.g. regulations that protect the health and safety of workers, food products, environment etc. • Regulation also plays an important role in protecting consumers. Some wide range of issues address by regulations listed below. These issues are classified based on their objectives. o o o Safety Privacy Protection ECO Learning Module: 3 o o o o Environmental Labor or employment Commerce or trade Financial System ECONOMIC RATIONALE FOR GOVERNMENT REGULATIONS Objectives of Financial Market (securities) Regulation: • To protect consumers and investors (primarily small investors) by mitigating agency, adverse selection and moral hazard problems*. • To provide investors access to important information for investing in and valuing financial instruments purposes. • To ensure safe, sound and stable financial institutions to: o Promote financial stability o Reduce system-wide risks • To develop confidence in the financial markets by maintaining the integrity of the markets. • To enhance and promote capital formation. • To promote smoothly operating payments system. • To maintain access to credit for entities. • To meet macroeconomic goals i.e. o Price stability o Increasing employment levels o Promoting economic growth *Generally, it is difficult for regulators to set suitability standards for large investors (e.g. who invest in hedge funds, private equity, and VC funds); hence, for such large investors, regulatory bodies tend to follow a “buyer beware” rule. Rationale for the Regulation of Financial Markets The regulation of securities markets and financial institutions is critically important to avoid losses associated with failures in the financial system that have significant and far-reaching consequences e.g. • Losses to specific parties • Loss of confidence among market participants • Loss of savings and access to credit e.g. in bank failures • Disruption of trade Securities regulations include: • Monitoring and supervision of financial institutions • Registration requirements • Disclosure requirements, including financial reporting requirements, accounting standards, proxy proposals and contests, mutual fund disclosure rules, and price transparency disclosure rules etc. • Regulations related to governance of listed companies, proxy voting in companies, best execution requirements on broker/dealers, treatment of “soft dollar” expenses in the trading process etc. Insurance against losses offered by regulators: Regulatory bodies may set up funds by charging premiums or fees that are used to provide insurance to financial institutions against expected losses. However, such insurance may create a moral hazard problem and encourages market participants to take unduly greater risk. Uses of Self-Regulation in Financial Markets: • Due to technical expertise, market professionals may have better understanding about the technical aspects of financial market regulation. • Since SROs are highly flexible, they may have greater ability to adapt to new developments. • In SROs, since the directors and policymakers are elected by the members themselves, they are more willing to comply with those rules and regulations. • Self-regulation also provides cost savings to federal government e.g. saving on enforcement and inspection costs. • Self-regulation tends to generate lower regulatory burden on businesses. • Self-regulation promotes better functioning of the market. • Self-regulation improves corporate governance and reporting. ECO Learning Module: 3 Practice: Example 1, Volume 1, Reading 8. 3. REGULATION OF COMMERCE The major role of Government regulation is to: • Facilitate business and investment decisions and to facilitate the coordination and acceptance of responsibilities by developing a regulatory framework for contracting and setting standards, for financial liability and dealing with bankruptcy. • Promote local, national, regional, and global trade. 4. ANTITRUST REGULATION AND FRAMEWORK Competition and antitrust laws: They set up rules that prohibit anti-competitive acts like price fixing, price discrimination, predatory pricing, monopolistic conduct (e.g. mergers and acquisition of major companies), and deceptive practices. 5. • Support and promote domestic business interests e.g. by subsidizing domestic industries, using tariff and/or non-tariff barriers, restricting foreign ownership or capital flows. o However, such regulatory policies tend to generate unfair competition by giving an unfair competitive edge to domestic producers. Practice: Example 2, Volume 1, Reading 8. CLASSIFICATION OF REGULATIONS AND REGULATORS Classification of Regulations and Regulators Classification of Regulators: A. Legislative bodies: They have the authority to enact laws (called statutes) at a broad level. However, it is the responsibility of regulatory bodies to implement those set of rules and laws. B. Regulatory bodies: They have the legal authority to enact and enforce rules and regulations within the parameters of the mandate given to them. These include: a) Government agencies e.g. U.S. Securities and Exchange Commission (SEC). SEC regulates the securities markets in the U.S. b) Independent regulators: They are recognized by a government body or agency but are not government agencies. Unlike government agencies, • They do not depend on government funding. • They are protected from political influence and pressure, to some extent. • They may represent self-regulating organizations, private, non-governmental organizations. C. Courts: In regulatory context, they perform following roles: • They help to interpret regulations and laws; • They define permitted and not permitted regulatory practices; • They impose sanctions for regulatory violations. NOTE: However, classification of a regulator is not always clear. Classification of Regulations: A. Statutes: Laws enacted by legislative bodies e.g. Dodd-Frank Ac, enacted by the U.S. Congress. B. Administrative regulations or administrative law: Regulations enacted by government agencies or other regulators. C. Judicial law: Interpretations of regulations and laws by courts. Accounting standard setting bodies: Typically, they are private sector, non-profit, self-regulated organizations e.g. IASB and FASB. • They provide a set of rules and requirements to prepare financial reports in accordance with specified accounting standards. • Those set of rules and standards are recognized and enforced by the regulatory authorities. ECO Learning Module: 3 Economics of Regulation Credit ratings agencies: Typically, they are private sector, profit-oriented entities. They provide credit ratings for the entities. • Ratings have an important impact on the pricing of bonds and structuring of portfolios. • Any regulation associated with credit reporting agencies are recognized and enforced by the regulatory authorities. Benefits of Credit-rating agency Model: • The rating agencies tend to provide objective guidance for financial instruments for regulatory purposes. • The rating agencies tend to have economies of scale in information production, which generates large private incentives to outsource the required information. Limitations of Credit-rating agency Model: Rating agencies may have conflicts of interest with rating seeking entities, resulting in a mismatch between ratings of securities and the degree of risk and quality of securities. • Such entities may engage in regulatory arbitrage (discussed below) to obtain higher rating. • Unfortunately, transferring credit rating authority to other organizations does not imply any useful fundamental changes. Self-regulatory organizations (SROs): SRO is a selfregulating, private, non-governmental organization and an independent regulator that is recognized by a government agency or body. SROs can be exchanges, industry associations, or some form of peer group e.g. Financial Industry Regulatory Authority (FINRA), the International Organization of Securities Commissions (IOSCO) that regulates a significant portion of the world’s capital markets. • They are granted the legal authority and enforcement power by a government agency or body. However, the authority that is received from their members rather than government bodies does not have the force of law. • SRO sets and issues standards and guidance for market participants; whereas, regulatory authorities recognize and enforce the standards and guidance. • SROs do not depend on government funding; rather, they are funded independently. • SROs both represent and regulate their members who mutually agree to comply with the rules and standards set by SRO. • SROs may face pressures from their members. • It is important to note that all self-regulating organizations are not necessarily independent regulators. E.g. the Public Company Accounting Oversight Board (PCAOB), a non-profit corporation that oversees the audits of public companies, is an independent regulator; but it is not an SRO. Role of SROs: The role of SROs varies among countries. • In some countries, SROs have specific regulatory authority and enforcement powers. • In some countries, SROs are not recognized as independent regulators. • The role of SROs is limited in countries where civil law systems prevail and the market primarily depends on government supervision. • The SROs have extensive and substantial role in countries where common law systems prevail and the market primarily depends on self-regulation. It is important to understand that the regulatory authorities have the responsibility to oversee and supervise corporate governance of SROs to ensure that they act in a manner consistent with a fair and efficient market. Statutory boards: They represent non-government entities, but they are subject to specific legislations that govern their operations. • Mostly, they are funded independently and generate revenues by charging fees on some or all of their services. • Nevertheless, when revenues are insufficient to meet their operating expenses, they may receive funding from government. NOTE: Unions based regulatory bodies: For example, European Commission (EC). Objectives of Regulations: Regulation plays an important role in following aspects: • Safety of food, products; • Privacy of financial information; • Protection of intellectual property by setting standards and processes that define and govern patents, trademarks and copyrights; • Protection of environment e.g. by mitigating pollution; • Labor or employment regulations e.g. workers’ rights, employment practices; • Commerce or trade regulations e.g. consumers’ rights and protection, investors’ protection antitrust; • Financial system regulations e.g. prudential supervision of institutions, capital requirements, insider trading; • Setting technical standards for technology and electronic tools and resources; ECO Learning Module: 3 Economics of Regulation Important to Note: It is important for an analyst to consider the type of regulation that affects the industry/business being analyzed e.g. Regulators are responsible with regard to both substantive and procedural laws. • Oil, gas, and mining companies are sensitive to regulatory changes with respect to environmental issues. • Labor-intensive industries may be sensitive to regulatory changes with respect to labor conditions and rights. • Pharmaceutical and technology companies may be sensitive to regulatory changes with respect to intellectual property rights. Classification of laws and regulation based on difference between development and enforcement of regulation: 6. A. Substantive Law: It defines the legal relationship between the citizen and the state and among citizens themselves by defining their legal rights and responsibilities. B. Procedural law: It develops the methods of protection and enforcement of the substantive laws (i.e. legal rights). Practice: Example 3, Volume 1, Reading 8. REGULATORY INTERDEPENDENCIES requirements and risk management practices for larger international banks. The outcomes of regulations vary among different: • Orientations of the regulators; • Objectives; • Jurisdictions with different perspectives or different trade-offs; Regulatory capture theory: According to this theory, regulatory agency will be captured (controlled) by the industry/companies being regulated i.e. regulators develop regulations that are in the best interest of the regulated industry. Regulatory competition: It refers to a situation where various regulators compete among themselves to attract certain entities by providing a favorable regulatory environment. It may adversely affect the effectiveness of enhanced regulation in particular countries. Regulatory cooperation and coordination is needed to deal with global issues i.e. systematic risk, moral hazard, global warming, and nuclear power regulation etc. For example, the BASEL Accords are developed to establish and promote internationally consistent capital Features of ideal and effective regulations: It must be stressed that the regulatory and government policies should be • To regulate and monitor the safety and soundness of financial institutions; • To promote financial stability; • To reduce system-wide risks; • To protect customers of financial institutions; Important to Note: Bank supervisors (unlike securities commissions) tend to avoid disclosing the results of the bank’s tests of financial institutions in order to promote financial stability and avoid systematic risk arising from loss of confidence. Objectives of securities commissions, per IOSCO: Regulatory arbitrage: It refers to a situation when entities take advantage of loopholes in regulatory systems to avoid certain types of regulation e.g. by conducting business, creating products and services in certain locations with reduced regulatory costs and/or oversight. 6. Objectives of BASEL Committee/Bank Supervisor: • To protect investors; • To ensure that markets function in a fair, efficient, and transparent manner; • To reduce systematic risk; Refer to Exhibit 1. IOSCO’s Objectives 7 Principles of Securities Regulation Practice: Example 4, Volume 1, Reading 8. REGULATORY TOOLS • Predictable; • Clear; • Consistent over time; ECO Learning Module: 3 • Potentially able to impose sanctions on violators of the regulations i.e. regulators should have comprehensive enforcement powers. o Sanctions can be in the form of monetary fines/fees/settlement; o In accounting frauds, sanctions may involve redistribution of funds from current stockholders to the stockholders who were the specific victims. • Efficient and effective in achieving their objectives (i.e. achieving goals at minimum costs); occur regardless of the initial allocation of property rights. Impediments to developing effective regulations to mitigate systematic risk: It is quite difficult to assess the degree of effectiveness of regulations and regulatory changes with respect to dealing with systematic risk because: • The amount of data on systematic crises is very limited. • The types and sources of systematic risk in future are likely to be different from past. • The effectiveness of a regulation is hard to assess on ex-ante and ex-post basis. • Some regulations may have unintended effects i.e. they may increase another source of risk in an attempt to reduce one source of risk. Impediments to imposing sanctions on violators of the regulations: It is difficult to: • detect violations; • identify exactly the culprits; • impose sanctions on individuals (i.e. companies’ executives) who are able to fight using corporate resources due to indemnification provisions in their employment contracts. Regulatory tools: a) Price mechanisms: They are used to create the appropriate marginal incentives and to efficiently allocate resources. These include: 1) Taxes: Taxes can be used to reduce environmental pollution. 2) Subsidies: Subsidies can be used to provide financial support to high growth small businesses or domestic businesses. Limitation: Use of price mechanisms to regulate markets may create barriers to entry in a market, resulting in decrease in competition and increase in market power of few firms. b) Regulatory mandates and restrictions on behaviors i.e. 1) Setting rights and responsibilities 2) Restricting some activities e.g. insider trading, short selling. 3) Mandating some activities e.g. capital requirements for banks, registration with a securities commission for certain activities. 4) Provision of public goods and services e.g. defense, transportation infrastructure. It depends on the political philosophy of the country/government, structure of the government, and the country’s GDP. 5) Providing funds to finance private projects e.g. loans to individuals or companies for specified activities. It depends on the political philosophy of the country/government, structure of the government, and the country’s GDP. Coase Theorem: According to the coase theorem, when an externality can be traded and there are no transaction costs, the socially efficient outcome will Regulatory Responses: Examples of regulatory responses include: Conflict of interest policies: It refers to a situation where a potential employee of a regulator has conflict of interest with the regulated entity e.g. spousal employment, a marketable position in an investment portfolio etc. In such cases, potential regulatory responses include: a) Ban on involvement in the company e.g. employment etc. b) Resolution of the conflict of interest; c) Disclosure of the conflict of interest; Trading restrictions on insiders: In refers to a situation when a person/entity has some inside non-public information. In such cases, potential regulatory responses include: a) Ban from trading on non-public information; b) Disclosure of insider trades; c) Requirement on a company to impose a blackout period during which insiders are not allowed to trade on the company’s stocks; NOTE: The amount of acceptable total pollution generated by a firm can be determined using two approaches i.e. 1) Historical usage (i.e. the amount of pollution produced in the past). However, amount of pollution allocated based on historical usage may change the marginal incentives. 2) Allocation based on some political negotiations: However, amount of pollution allocated through political process is subject to considerable lobbying. Negative Externalities: These include systematic risk and financial contagion (i.e. when financial shocks spread to and infect other healthier economies), pollution, global warming etc. ECO Learning Module: 3 Economics of Regulation • Some of the negative externalities tend to have substantial negative effects and implications that are difficult to fully quantify and assess. Practice: Example 5, Volume 1, Reading 8. • Regulations can be established to mitigate negative externalities e.g. the Dodd-Frank Act developed to mitigate systematic risk. 8. COST-BENEFIT ANALYSIS Basic Concepts of Cost-Benefit Analysis There are costs and benefits associated with any regulation, and it is important that policy makers should consider all of the associated costs and benefits of regulations. • Before enforcing any regulations, regulators and policy makers should consider all the associated direct and indirect costs (e.g. costs of competition restrictions); because failure to address indirect costs and possible spillover effects can result in a less effective policy and impose unnecessary economic costs in a market. o For example, before providing subsidies to some industries or sectors whereas taxing others, government should make sure that the benefits of subsidizing some industries outweigh the potential costs of distorting competition and shrinking size of some sectors by heavy taxation. • Regulators and policy makers should ensure that the appropriate regulatory tool is selected so that government can achieve its intended policy objective with minimal costs i.e. should focus on net regulatory burden. Net regulatory burden = Private costs of regulation – Private benefits of regulation o Costs include adverse impact on competition within a market, choice and the effective workings of the market. 9. Practice: Example 6, Volume 1, Reading 8. ANALYSIS OF REGULATIONS When an analyst makes a recommendation, he should evaluate the effect of a particular regulation on the individual company or industry as various regulations effect different industries differently. Analyst’s opinion on the impact of regulation is incorporated in his industry or company analysis. Such as: • Some common steps analysts should take to assess the impacts of existing/proposed regulations on the current or future prospects for companies/industries are as follows: Ø Ø Assessment of the likelihood of regulatory change Evaluate the probability that the proposed regulation will materialize. Key factors to consider may include: o cost-benefit analysis framework used by the regulator o extent of engagement with the regulated companies o public or political pressure Assessment of the impact of regulatory change on a sector Impact on revenues: Analysts should be conscious of the anticipated actions taken by the regulatory bodies which may impact the company’s revenues such as limits on prices, tariffs, fees/charges, banning of certain products. Analyst should also consider possible actions and alternative ways taken by the companies to mitigate the negative impact of regulations. • Cost impact: Sometimes regulatory bodies require certain industries to incorporate certain features such as new equipment, advanced safety features, disclosure and data protection requirements, regular inspection, costly wastewater treatment, labor laws, high ESG standards, risk control requirements, money laundering prevention systems etc. ECO Learning Module: 3 Economics of Regulation Analysts should incorporate such costs when evaluating a company’s projected profitability numbers. • Business risk: Some industries have to follow stringent regulatory rules. The violation of the rules may involve fines, compensation to customers, bans on certain activities etc. Though quantifying the impact of such events is challenging for analysts, however analysts should be able to anticipate the likelihood of such events and incorporate the risks to adjust the discount rate that is used to value the company. Practice: Example 7, Volume 1, Reading 8. Practice: End of Chapter Practice Problems for Reading 8 + FinQuiz Questions