Chapter 2: THE RATIONALE AND OBJECTIVES OF REGULATION
4. Objectives, intermediate goals and targets of regulation
4.3 Targets of regulation
Where the intermediate goals of regulation are in essence a transformation of the regulatory principles, the regulatory targets are empirically falsifiable magnitudes in the sense that they can be either missed or dismissed.
Targets can seem very similar to instruments if they
are broken down into finer detail. However, although they seem similar, they differ conceptually. For instance, to strive for internationally acceptable accounting standards is clearly a regulatory target, but it is through monitoring and supervision (as a type of regulatory instrument) that this target is ultimately met. Alternatively stated, as an instrument of financial regulation, monitoring and supervision can be executed in terms of various minimum standards, one of them being internationally acceptable accounting standards. However, other instruments – such as enforceable compliance structures in the private sector or detailed external audit requirements – could also be used to implement this specific accounting standard.
In short, targets are typically specific ratios, models, codes, manuals, systems or standards, which can be either approved or rejected by the authorities.
Examples of regulatory targets are a specific capital ratio, a specific value-at-risk model, a compliance manual, a code of business conduct, a specific trading system or an accounting standard.
Over time the regulatory targets are bound to change in line with the changing philosophy underpinning the regulatory regime of the nation. Tables 2.1, 2.2 and 2.3 give an overview of the various targets identified that could be aimed at by the regulatory authorities in South Africa. In Chapter 7, Section 3 most of these targets and their applicability to the regulatory regime are discussed in greater detail.
Box 2.7: Asymmetric information In a recent report, the UK Consumers Association (1998) argues as follows:
“The information imbalance that has arisen between the consumer and industry has enabled the sale of substandard products which has, in many cases, cost the consumer (and the taxpayer) dear. For example, in the personal pensions mis-selling saga, hundreds of thousands of consumers fell victim to disgraceful sales practices and poor advice ... Personal pensions and life products such as endowment plans can pose particular problems because of the hidden penalties for switching, inflexibility and high charges. In many cases it is next to impossible for consumers to work out exactly what the charges are because of the euphemisms and obscure language used to disguise charges. All this has meant that there is no real competition in these markets. The lack of transparency means consumers have been unable to compare products, shop around and so in turn exert competitive pressure.”
1. Competitive market infrastructure
• Establish a payments system that is open to all financial institutions
• Promote competitive trading, clearing and settlement systems
• Promote competitive listing requirements
• Stipulate minimum infrastructure standards
• Establish interrelated and competitive markets
• Establish regulatory neutrality towards foreign participants 2. Acceptable maturity and currency mismatches
• Promote accurate value-at-risk systems
• Promote management of forward currency book by the private sector
• Promote prudential debt-management systems in the public sector 3. Acceptable cross-market exposures
• Establish cross-market clearing and settlement facilities
• Establish legally binding netting agreements between markets 4. Sufficient market liquidity
• Establish a financial stability unit at the central bank
• Formalise the standby facilities of the central bank
• Remove (tax) constraints on market turnover
• Promote foreign participation in local markets
5. Securities markets as alternative to finance intermediation
• Remove constraints on commercial paper issues from banking legislation
• Establish a market in the bonds of SMMEs
6. Regulatory effectiveness, efficiency and economy
• Establish co-ordination agreements among domestic regulatory agencies (complex groups)
• Establish harmonisation agreements between home and host regulators (complex groups and highly geared non-financial institutions)
• Stipulate regulatory cost/benefit analysis
• Establish ratings of national regulatory agencies
Table 2.1: Intermediate goals and targets supporting systemic stability
Table 2.2: Intermediate goals and targets supporting institutional safety and soundness 1. Proper risk assessment
• Promote accurate value-at-risk systems
• Stipulate consolidated supervision
• Appoint specific non-executive board members to supervise risk management and management systems
• Appoint accredited private rating agencies
• Promote unsecured subordinated debt as a rating tool 2. Proper financial institutional infrastructure
• Adhere to minimum accounting and audit standards
• Adhere to minimum capital standards
• Adhere to corporate governance standards
• Adhere to compliance standards
• Establish an infrastructure for the verification of firms’ risk and control systems
• Establish an industry register of doubtful and bad debts 3. Suitable directors and staff
• Stipulate specific minimum suitability standards for directors and senior management
• Stipulate entry requirements for technical staff
• Link remuneration packages to compliance standards 4. Global institutional competitiveness
• Abolish foreign exchange controls
• Remove regulatory limitations on e-commerce and e-money
• Remove regulatory limitations on foreign firms
• Allow remote trading
• Allow international listings 5. Competitive neutrality
• Adhere to international agreements on regulatory minimum standards
• Encourage functional approach to regulation
• Encourage competitive neutrality between commerce and e-commerce
1. Integrity and fairness
• Encourage a code of corporate governance
• Encourage a code of business conduct
• Establish a policy to reduce financial crime and money laundering
• Encourage effective compliance manuals 2. Competence
• Stipulate “fit and proper” standards for compliance office 3. Adequate product/service competitiveness
• Remove constraints on competitive foreign products
• Remove regulatory exclusions granted to parastatals or public corporations 4. Transparency and disclosure
• Adhere to international codes of corporate governance
• Adhere to international codes of disclosure standards
• Establish government-defined benchmarks for better consumer information
• Inform the financial press
• Supply of competitive information on Internet by authorities 5. Adequate access to retail financial services
• Establish core banks in retail trading sector
• Open the payments system to non-bank financial institutions
7. Retail compensation schemes
• Stipulate ombudsmen arrangements
• Stipulate fidelity fund arrangements
• Establish bank deposit-insurance scheme
• Establish a single regulator for all market-conduct rulings
Table 2.3: Intermediate goals and targets supporting consumer protection
6. Protection of retail funds
• Establish Structured Early Intervention and Resolution regime
• Limit the use of retail investment funds as an instrument of social engineering
• Stipulate acceptable operational risk-management systems
• the pace of financial innovation and the creation of new financial instruments;
• the blurring of traditional distinctions between different types of financial firm;
• the speed with which portfolios can change through trading in derivatives; and
• the increased complexity of banking business.
All of the above factors create a fundamentally new – in particular, more competitive – environment in which regulation and supervision are undertaken.
These factors also change the viability of different approaches to regulation which, if it is to be effective, must constantly respond to changes in the market environment in which regulated firms operate.
Three observations are made at the outset of the analysis and which inform the analysis that follows:
• The elements of the economic rationale for regulation (discussed in Chapter 2) are relevant to a consideration of the focus of this chapter – i.e. the optimum regulatory strategy. In particular, regulation needs to be framed around, and justified in terms of, issues such as market imperfections, as such issues are the foundation for an economic rationale for regulation.
• The existence of an economic rationale for regulation and a consumer demand for it do not justify everything that the regulator does.
• The case for regulation in no way excludes a significant role for other mechanisms so as to achieve the desired objectives of systemic stability, institutional safety and soundness, and legitimate but limited consumer protection.
The central theme of this chapter is that the various components of the regulatory regime need to be combined and balanced, and that though all are necessary, none alone are sufficient. Regulation, therefore, is not an alternative to, for instance, market discipline, but a complement to it. Indeed, a key issue
Chapter 3
THE REGULATORY REGIME
1. Introduction
Essentially, regulation is about changing the behaviour of regulated institutions. Regulation can be endogenous inside the financial firm as well as exogenous. A major issue, therefore, is whether regulation should proceed through externally imposed, prescriptive and detailed rules, or by the regulators creating incentives for appropriate behaviour.
A robust financial system requires three particular properties: (i) proper decision making and control within financial institutions with effective risk analysis, as well as management and control systems;
(ii) an efficient regulatory and supervisory regime for financial institutions; and (iii) sound incentive structures for all parties, including regulators.
This chapter considers various alternative approaches to achieving the objectives of financial regulation falling under the concept of a regulatory regime, which is far wider than the rules and monitoring conducted by regulatory agencies. The focus will be on how the components of a regulatory regime are to be combined to produce an optimum regulatory strategy for achieving regulatory objectives as opposed to particular ways of addressing specific regulatory problems.
Chapter 4 develops the regulatory regime into a regulatory strategy framework based on the target-instrument approach.
2. Alternative approaches
Financial systems are changing substantially to an extent that may undermine traditional approaches to regulation, particularly to the balance between regulation and supervision, and the role of market discipline. The following issues are of particular importance:
• The strong impact of globalisation on local firms;
to consider is the potential danger that regulation could, under some circumstances, blunt the application of other mechanisms.
Internationally there is a definite shift within the regulatory regime to maximise its overall effectiveness and efficiency in the following ways:
• Less emphasis is being given to formal and detailed prescriptive rules dictating the behaviour of regulated firms.
• A greater focus is being given to incentive structures within regulated firms and to determining how regulation might have a beneficial impact on incentive structures.
• The view is that market monitoring and market discipline of financial firms should be strengthened within the overall regulatory regime.
• There is a growing recognition of the need for greater differentiation between regulated firms, different types of consumers and different types of financial business.
• Greater emphasis is being placed on internal risk analysis, management and control systems. Externally imposed regulation in the form of prescriptive and detailed rules is becoming increasingly inappropriate and ineffective. More reliance should be placed on institutions’ own internal risk analysis, management and control systems. This relates not only to quantitative techniques such as value-at-risk (VaR) models, but also to the management and compliance
“culture” of those who handle models and supervise.
There should be a shift of emphasis towards monitoring risk-control mechanisms, and a recasting of the nature and functions of external regulation away from generalised rule-setting towards establishing incentives and sanctions to reinforce such internal control systems.1
• It is recognised that corporate governance mechanisms for financial firms need to be strengthened so that, for instance, owners would play a greater role in the monitoring and control of firms, and compliance issues would be identified as the ultimate responsibility of a nominated director of the main board.
All of these, and other trends, are reflected in the recent Basel consultation document on new approaches to capital adequacy regulation of banks.
As a simplification, there are two alternative approaches to regulation. At one end of the spectrum the regulator lays down fairly precise regulatory requirements that are applied to all regulated firms.
There may be limited differentiations within the rules, but the presumption is for a high degree of uniformity.
At the other end of the spectrum is what is termed contract regulation. Under this regime, the regulator sets down a clear set of objectives and general principles. It is then for each regulated firm to demonstrate to the regulator how these objectives and principles are to be satisfied by its own chosen procedures. In effect, the regulated firm self-selects its own regulation but within the strict constraints of the objectives and principles laid down by the regulator.
Once the regulator has agreed with each firm how the objectives and principles are to be satisfied, a contract exists between the regulator and the regulated firm. The contract requires the firm to deliver on its agreed standards and procedures. In the case of non-performance on the contract, sanctions would apply and the regulator would have the option of withdrawing the choice from the regulated firm (which would then have to accept a standard contract devised by the regulator).
The advantage of this approach is that a regulated firm would be able to minimise its own costs of regulation by submitting to the regulator a plan that, while fully satisfying the requirements of the regulator, would best suit its own particular circumstances.
The case for regulation, discussed earlier (Chapter 2, Section 2), does not mean that official regulation is to be the exclusive route through which the objectives set for regulation are met, or to imply that reliance can be
1 For instance, the recently issued consultative document by the Basel Committee on Banking Supervision (Basel Committee, 1999) explicitly recognises that a major role of the supervisory process is to monitor banks’ own internal capital management processes and “the setting of targets for capital that are commensurate with the bank’s particular risk profile and control environment. This process would be subject to supervisory review and intervention, where appropriate”.
placed on it. On the contrary, regulation should be viewed as part of a collective regulatory strategy.
Such a strategy would include official supervision, incentive structures, market discipline, rules for intervention, corporate governance arrangements and disciplining mechanisms on regulatory agencies. This is the essence of the regulatory regime and is discussed in greater detail below.
Even within the purely regulation component of a broader regulatory strategy, there is a wide range of options available, and in particularly with respect to the degree of discretion exercised by the regulatory agency.
When considering this wider perspective of regulation, six themes in particular emerge and need to be emphasised:
• Regulation needs to be viewed and analysed not solely in the narrow terms of the rules, regulations and edicts of regulatory agencies, but in the wider context of a regulatory regime. The concept of a regulatory regime has seven components:
(i) The rules and regulations established by regulatory agencies – the pure regulation component;
(ii) official monitoring and supervision by regulatory agencies;
(iii) intervention arrangements in the event of there being compliance failures of one sort or another;
(iv) the incentive structures and contracts faced by regulatory agencies, consumers and, more particularly, by regulated firms;
(v) the role of market discipline and monitoring;
(vi) the role of corporate governance arrangements in financial firms; and
(vii) the disciplining and accountability arrange-ments applied to regulatory agencies.
• A regulatory strategy to achieve the objectives set for regulation should not be restricted to a view of what rules and supervision are established by a regulatory agency. A regulatory strategy is about optimising the combination of the seven components of the regime. The strategy also needs to be considered in the context that there are often
trade-offs to be made within the range and between the components in order to maximise the overall impact. In some circumstances the greater the emphasis on one of the components, the weaker the power of one or more of the others, even to the extent of perhaps reducing the overall impact.
Equally, different combinations of the components may achieve the same degree of effectiveness in meeting the objectives but at different costs. The possibility needs to be considered that if more emphasis is given to detailed, extensive and prescriptive rules, this might weaken the role of incentive structures, market discipline and corporate governance. In other words, rules may weaken incentive structures and market discipline.
• Public (and particularly academic) debate about regulation is often too polarised with too many dichotomies established – what are often posed as alternative approaches are in fact not alternatives but complementary mechanisms. It is emphasised that the skill in formulating regulatory strategy is not so much in choosing between the various options, but in combining the seven key components of the regulatory regime. The skill of the regulator in devising a regulatory strategy lies in how the various components in the regime are combined, and how the various instruments available to the regulator are used (these are listed in Section 4 below), including their potential impact on other components of the regime. So, although there may be negative trade-offs to consider, the relationship between the components of the regime may also be positive in that, for instance, regulation could itself focus on creating appropriate incentives within regulated firms.
Therefore, it is not a question of choosing between either regulation or market discipline, or between regulation and supervision on the one hand and competition on the other. The concept of a regulatory strategy discussed here is that the above are not to be viewed as alternatives but components of an overall approach to achieving the objectives that are set for regulation. A key issue for the
regulator to consider is how its actions not only contribute to the objectives directly, but how they impact on the other components of the regime.
More particularly, the issue is how regulation affects incentive structures within firms and also the role that can be played by market monitoring and discipline.
• The optimum mix of components within the regulatory regime will change over time as market conditions and structures and hence the regulatory philosophy change. It is argued that, in current conditions, there needs to be a shift in the structure of the current strategy in some respects: (i) less reliance should be placed on detailed and prescriptive rules, and more emphasis should be given to the other components (most especially market discipline); and (ii) official supervision should focus more on incentive structures, an enhanced and strengthened role for market discipline and monitoring (in ways which will be outlined below), and a more central role for corporate governance arrangements within financial firms.
• Consumers, financial firms and different types of financial business are not homogeneous, which means that the optimum regulatory approach is likely to differ for different consumers, financial firms and financial business. This has been recognised by the regulatory authorities in some countries. However, it is argued that there should be more differentiation. One approach that should be considered is contract regulation, as outlined above. In effect, what is involved here is a regime of self-selecting regulatory contracts.
• Given the power and discretion that the regulatory agencies have, their own accountability and disciplining mechanisms need to be constantly emphasised.
When considering the above theme, the importance of trade-offs within the regulatory regime should be emphasised. In terms of regulatory strategy, a choice is to be made about the balance of the various components and the relative weight to be assigned to
each. In this way, a powerful role for official regulation may be chosen with little weight assigned to market discipline, or a relatively light touch of regulation but with heavy reliance on the other components. A given degree of investor protection can be provided by different combinations of rules,
each. In this way, a powerful role for official regulation may be chosen with little weight assigned to market discipline, or a relatively light touch of regulation but with heavy reliance on the other components. A given degree of investor protection can be provided by different combinations of rules,