What are the purposes of financial regulations

2.17 Summary

Financial regulations are laws and rules that govern the workings of financial institutions. Regulations of financial institutions basically focus on providing stability to the financial system, fair competition, consumer protection, and the prevention and reduction of financial crimes. By the mid-1970s, the global financial system witnessed market-oriented reforms that led to liberalization in financial systems such as the reduction of interest rate controls, removal of investment restrictions on financial institutions and line of business restrictions, and control on international capital movements. Financial innovation and rapid technological advancement are the drivers of regulatory reforms. Regulations differ from country to country. The current trend is for financial-sector regulation to move toward a greater cross-sector integration of financial supervision. In 1998, the adoption of the Basel Accord, which required international banks to attain an 8% capital adequacy ratio, was a major significant milestone in banking regulations. The collapse of the global financial system that led to the global crisis can be attributed to the systemic failure of financial regulation. Basel I defined bank capital and bank capital ratio based on a two-tier system. The Basel II framework consisted of Part 1 (the scope of application) and three pillars, the first of which is minimum capital requirements, the second is a supervisory review process, and the third is market discipline. The Basel III framework prepared new capital and liquidity requirements for banks. New initiatives including the FSF and the G-20 grouping have been established to address concerns related to the stability of the worldwide financial system.

International Trading

Regulators around the globe developed new financial regulation following the 2007–08 financial crisis. However, while US legislation provided a comprehensive new set of rules, European regulators developed a somewhat narrower set of regulations that focused on different regulatory objectives. Proprietary trading in the EU is covered by the European Market Infrastructure Regulation (EMIR), which was passed by the European Parliament in September 2010 and became effective in all member states at the end of 2012. EMIR contains a number of new provisions, including regulation of over-the-counter derivatives, short selling, and clearing requirements. However, EMIR does not require the separation of proprietary trading from regular banking activities as is required under the Volcker Rule in the United States. Because most European banks have always been universal banks (commercial banks that have not been separated from investment banks), their regulators have not enforced a separation in these businesses. UK regulators made different proposals in reaction to the 2007–08 financial crisis. The United Kingdom treasury set up the “Independent Commission on Banking” to make recommendations for making the banking system more robust. The commission did not recommend a full separation of investment banking and retail banking in the spirit of the Glass–Steagall Act but instead suggested that banks should “ring-fence” their retail division from their investment banking division. As a result, the United Kingdom has gone well beyond EU regulation.

In Asia, the China Banking and Regulatory Commission issued a new provision during 2011 to restrict banks’ proprietary trading activities (domestic and foreign). Under this new provision, nonhedged investments by banks must be limited to 3% or less of the banks’ total capital. Other major financial centers in Asia such as Singapore or Hong Kong have not imposed a version of the Volcker Rule.

Canada is a noteworthy example of a country that had limits on bank proprietary trading activities prior to the financial crisis. Before 2008, this seemed like a competitive disadvantage for Canadian banks, but it resulted in much less loss-making for these banks during the crisis.

Retrenching and cost-cutting European investment banks lost market share to US rivals for the 10th straight year during 2015. US banks also outperformed on returns, creating an average ROE of 12.4% that year, compared to 8.3% for European banks. US investment banks restructured and recapitalized sooner and were helped by being based in the world’s largest financial market. UBS started its retrenching earlier than other European banks, resulting in a higher ROE than competitors. Deutsche Bank is attempting to bring costs down to 70% of revenue, but this is still significantly higher than US banks that average below 60%. Deutsche Bank’s trading business has exited certain fixed income and currencies products where ROE has dropped following adoption of new capital rules. Credit Suisse has restructured, allocating more resources to its wealth management business and away from some of its trading businesses. The bank is reducing its foreign exchange and rates trading products, allowing it to redeploy capital and reduce risk-weighted assets. Barclays embarked on a plan to cut 19,000 jobs, including 7000 in its investment bank, focusing on returns rather than revenue. The bank significantly reduced its trading businesses as it attempted to reduce capital deployment and improve profitability.

Conclusion

This chapter provided an overview of the influence of financial regulations on hedge fund governance. In summary, these regulations have resulted in changes in the way hedge funds approach governance. Certainly, as with most regulations, they make it more expensive and complicated to conduct business. These expenses don’t just come from the army of lawyer, compliance, accounting, and support personnel required to navigate the requirements of these new laws and regulations. That is just the tip of the iceberg. There’s also the cost on productivity and then there is the ongoing cost of monitoring any changes to laws that monitor governance and implementing ongoing compliance. As noted above, in many cases these expenses are passed on to hedge fund investors.

Of course, it can be argued that these regulations have increased corporate governance and accountability. As we have outlined above, there is not necessary a single answer or perspective that can determine whether the cost, and burden, of such an enhanced regulatory environments is a good thing for governance. Certainly, as we discussed in this chapter, the threat of ongoing oversight from regulators due to hedge fund registrations regimes has made strides in promoting better oversight practices, but it is yet to be determined whether such registration regimes will make wholesale improvements to governance globally.

18.3.2 Securities and financial regulation

Another mode of potential cryptocurrency regulation is through securities or financial regulation. Such rules target and deal with very different regulatory interests from AML/CTF regulation: securities regulation deals with consumer protection and market integrity issues in the financial services sector, while financial regulation is concerned more fundamentally with issues of systemic risk and financial stability.

Singapore regulators have expressed that cryptocurrencies would not be considered “securities” under the Securities and Futures Act (the “SFA”) (Shanmugaratnam, 2014). This is consistent with Section 2(1) of the SFA, which defines “securities” as, inter alia, debentures or stocks issued by governments or private corporations, any right or option or derivative in respect of any such debentures or stocks, any unit in a collective investment scheme, or any unit in a business trust or its derivative. Cryptocurrencies are thus not subject to the investor protection and market integrity regulation under the SFA and the Financial Advisers Act in Singapore, including the various registration, disclosure, and antifraud obligations under those statutes.

However, this does not preclude investment products or investment schemes that are based on cryptocurrencies from being regulated under securities regulations. Distinct from the purchase and exchange of cryptocurrencies themselves, cryptocurrency-based financial products, such as ETFs or derivatives, involve the use of regulated investment structures and therefore attract the application of the relevant securities regulations.

For instance, cryptocurrency ETFs would constitute “collective investment schemes” under the SFA, with the shares of such ETFs qualifying as “securities” under the SFA. Similarly, cryptocurrency derivatives will likely fall within the regulatory umbrella of Parts VIA and VIB of the SFA and the requirements therein. Even though cryptocurrency derivatives are not currently defined as “specified derivatives’ contracts” under existing guidelines, according to the Securities and Futures (Reporting of Derivatives’ Contracts) Regulations 2013, which limits such contracts to interest rate and credit derivatives, Sections 124 and 125 of the SFA clearly envisage that the MAS may prescribe the regulations to apply to such derivatives. In any event, these cryptocurrency-based financial products are only at a very early stage of development and do not raise significant regulatory concerns yet.

As for financial regulation, the effects of cryptocurrencies on monetary policy and financial stability are currently unclear. Cryptocurrencies are not issued or backed by any governmental authority and, at current adoption levels, do not have sufficient market capitalization to significantly impact the supply of money or otherwise affect macroeconomic policy. In addition, cryptocurrency businesses, unlike banks, do not have access to public safety nets or central bank liquidity, and therefore, there is little or no justification for prudential regulation for safety and soundness concerns.

Cryptocurrency firms and businesses also do not pose the same systemic risks as banks do in the form of a structural vulnerability to “runs,” because they do not carry out maturity transformation, that is, the conversion of short-term liquidity needs of depositors into long-term funding commitments for borrowers. As the Diamond-Dybvig model (Diamond and Dybvig, 1983, p. 404) illustrates, it is the structural mismatch between the liquidity and maturity profiles of a bank’s funding structure—that is, the fact that banks borrow short to lend long—that gives rise to the potential for systemically destabilizing “runs” (Lim, 2014, pp. 83-84). Since cryptocurrency firms are not generally in the business of performing maturity transformation, and do not pose the same systemic risks as banks, financial regulations such as capital requirements or public insurance schemes are not appropriate.

That said, drawing the line between typical cryptocurrency firms and banks will become less clear-cut over time, as lending in cryptocurrencies and cryptocurrency fractional reserve banks becomes possible and more widespread. It is too early to tell whether this “financialization” trend will continue, but at present, cryptocurrency banking and lending services remain quite niche and do not yet pose any real regulatory concerns. Hasty regulation in this area would be both unwarranted and unwise and poses more risks than benefits.

Introduction

Until the middle of the 1990s, the institutional structure of financial regulation received little attention in either academic or policy-making circles. The operative assumption was that institutional structures of regulation were of secondary little importance when compared to other factors such as the scope and comprehensiveness of regulation, the resources devoted to the regulatory agency, the legal powers of the agency, and its relationship to the central bank. It was also generally assumed that the institutional structure of regulation had little bearing on either the efficiency or effectiveness with which regulatory function was discharged. Since the mid-1990s, however, an active and sometimes vigorous debate has emerged in which the advantages and disadvantages of different institutional structures have been more carefully assessed. There has been a greater awareness in policy makers and academics of the potentially wide range of institutional structures that are possible, and also of the suitability or otherwise of these structures in different economic, financial, legal, and political environments (G30, 2008). Although it cannot plausibly be argued that institutional structures are the primary determinants of regulatory effectiveness, there has been growing recognition that an inappropriate or outmoded structure can impede the attainment of supervisory goals. Unfortunately, this analytical case has sometimes been obscured by the political reaction to financial crisis, which can often result in structural reorganization to the neglect of other necessary regulatory reforms.

Introduction

This chapter draws lessons from the recent financial crisis for reforming financial systems, including lessons for macroeconomic policy, financial regulation, and the global financial architecture (for a review of the causes of the current global financial crisis, see the companion paper, Claessens et al., 2012). These are broad reform agendas for the future that can only be touched upon in this chapter (for more extensive treatments readers are referred to the working paper version of the paper, Claessens et al., 2010).

During the current global financial crisis, failures have surfaced in macroeconomic policies and the regulation and supervision of banks and nonbanking institutions. It is now clear that agencies involved in regulation, supervision, and crisis management did not always have clear mandates and tools commensurate with these mandates, and that there was a lack of international consistency and coherence of policies. The global financial crisis has also led to reconsideration of the benefits and costs of open financial markets, leading to calls for a reassessment of the global financial architecture.

The chapter starts with a review of the debate on whether macroeconomic policy should be concerned with asset price booms and increases in leverage. This has been a long-standing debate, but the financial crisis suggests that a revisiting of the paradigm prevailing in many markets – monetary policy should ignore asset prices – needs to be revisited, especially when asset prices increase are associated with increases in leverage. It also provides some suggestions for fiscal policy.

In terms of regulation and supervision, the financial crisis has highlighted, in abundantly clear ways, the deficiencies in national systems. The financial crisis has brought to light many weak elements, particularly regarding the treatment of systemic banks and other financial institutions; the assessments of risks and vulnerabilities; and the resolution frameworks for financial institutions and claims. The chapter first identifies principles and policy actions for redesigning prudential regulation and financial architecture in these areas in light of the current and past financial crises, with special emphasis on international dimensions, and then provides a number of specific suggestions for reform.

The global nature of the financial crisis has furthermore made clear that financially integrated markets have benefits, but also risks, with large real economic consequences. The crisis has shown how the international financial architecture has fallen behind a rapidly integrating international financial system. Surveillance, information sharing, crisis management, and liquidity support are all areas in which much progress is needed. The chapter summarizes current thinking on what international financial architecture reforms can best address these issues.

The chapter continues as follows. The section ‘Lessons for Macroeconomic Policy’ provides lessons for macroeconomic policy, the section ‘Lessons for Redesigning Prudential Regulation and Supervision’ for financial regulation and supervision, and the section ‘Lessons for Reform of the International Financial Architecture’ for reform of the international financial architecture. The section ‘Conclusion’ concludes with a number of areas of current debate and areas where more research would be useful to help guide policymakers.

4.3 The Effects of Stressed VaR in Capital Requirements for Market Risk in Frontier Markets

The care of the regulator to protect profitability appears weak, if we analyze the effects of the introduction of SVaR in financial regulation. Table 7.4 shows the results of the regulatory capital required without the adoption of SVaR as in the previous regulation.

Table 7.4. Average Value of Capital Requirements Without the SVaR Provision, Broken Down by Country and by Model Estimation

CountryHS (%)p (%)GARCH (%)EMWA (%)TGARCH (%)Argentina−14.5−12.5−12.2−11.8−12.1Bahrain−3.0−2.2−2.2−2.1—Bangladesh−4.94.1−3.8−3.6−3.8Botswana−2.7−1.9−1.7−1.7—Bulgaria−7.4−5.44.94.7—Côte d’Ivoire−5.84.54.44.24.4Croatia−7.4−5.6−5.2−5.2—Cyprus−11.1−9.1−9.1−9.0−9.1Estonia−11.9−8.8−8.2−7.9−8.1Jordan−7.0−5.7−5.4−5.4—Kenya−4.54.1−3.7−3.5−3.8Lithuania−5.34.1−3.8−3.8−3.8Macedonia−6.64.94.44.44.4Malta−3.9−3.0−2.8−2.8−2.7Mauritius−2.9−2.2−2.1−2.1—Nigeria−7.5−6.5−5.8−5.9−5.7Oman−5.2−3.9−3.5−3.5−3.6Qatar−6.6−5.4−5.5−5.1−5.4Romania−8.4−6.4−6.0−5.9−6.0Serbia−4.8−3.6−3.4−3.4−3.2Slovakia−7.34.94.84.7—Slovenia−6.3−5.8−5.4−5.1−5.4Sri Lanka−5.94.2−3.9−3.84.0Tunisia−2.5−2.1−1.9−2.0−2.0Vietnam−6.9−5.9−5.7−5.6−5.5EU−15.7−12.6−12.3−11.8−12.5USA−12.7−10.7−9.9−10.0−9.4

The introduction of the SVaR analysis leads to a considerable increase in the capital requirement. The new methodology results in a lower sensitivity of the capital requirement in respect to the model. The variable that becomes more important is the time horizon, inevitably affected by the crisis period identified in agreement with the supervisory authority. In frontier markets, the change in the law has led to an average increase in capital requirements of approximately 400%.

Finally, Table 7.5 shows the results, in the same manner, relative to estimated opportunity cost of the capital requirement.

Table 7.5. Average Value of the Cost of Capital Requirements, Broken Down by Country and by Model Estimation

CountryHS (%)p (%)GARCH (%)EMWA (%)TGARCH (%)Argentina−89.0−61.7−64.9−63.5−62.8Bahrain−16.2−10.1−10.4−11.3—Bangladesh—————Botswana−15.4−8.2−7.7−7.5—Bulgaria−41.4−28.2−28.5−30.2—Côte d’Ivoire—————Croatia−39.0−27.5−28.0−31.2—Cyprus−53.341.345.145.946.0Estonia−93.7−59.5−62.5−61.6−60.4Jordan−29.7−24.6−27.3−27.6—Kenya−25.4−17.9−17.8−18.0−16.6Lithuania−34.0−20.7−18.9−22.9−19.6Macedonia−42.4−27.6−24.5−26.6−25.5Malta−14.9−9.8−9.8−10.8−10.4Mauritius−22.5−16.0−16.1−17.1—Nigeria−24.3−19.9−21.3−22.8−21.1Oman−31.9−22.4−23.8−27.1−25.8Qatar−36.1−26.4−30.8−30.5−31.5Romania−12.8−31.7−33.3−36.2−33.2Serbia−27.5−19.4−18.6−21.5−18.5Slovakia−23.4−14.7−15.7−17.1—Slovenia−36.5−27.0−26.0−27.5−26.0Sri Lanka−21.0−14.9−16.7−17.1−15.9Tunisia−13.5−10.2−9.8−10.9−9.6Vietnam−31.3−29.2−28.0−28.8−27.9EU−97.6−61.9−64.9−63.4−62.9USA−79.7−59.6−65.8−72.3−69.2

The potential missing profits that a bank must give up due to regulatory reasons are noteworthy. On average, the model most favorable to the bank’s management produces a reduction in profits of 25% in frontier markets. In frontier markets, in contrast to developed countries, the low volatility and the lower capital requirement result in a reduction of the differences between the models adopted. The increase in the capital requirement for market risk is anticipated by market participants, and welcomed by the scientific community, bankers, and supervisors. The extreme dimension of this measure seems to punish bankers wishing to invest in riskier markets. Surprisingly, the frontier markets are not more risky, at least in terms of volatility, than developed markets. The new regulatory measure has a greater impact on markets where the level of volatility would result in more regulatory requirements and lead to more reduction in profits.

What are the major goals of financial regulation?

What is the purpose of the Financial Sector regulation Act?

Why is financial regulation probably necessary?

What are the main regulators of financial system?