The structure of financial regulation
| Date | 01 April 1998 |
| Pages | 326-350 |
| DOI | https://doi.org/10.1108/eb024984 |
| Published date | 01 April 1998 |
| Author | Richard Dale,Simon Wolfe |
| Subject Matter | Accounting & finance |
Journal of Financial Regulation and Compliance Volume 6 Number 4
The structure of financial regulation
Richard Dale and Simon Wolfe*
Received (in revised form): 13th
July,
1998
*University of Southampton, Highfield, Southampton, SO17 1BJ; fax: 01703 593844;
e-mail: sstjw@socsci.soton.ac.uk
Richard Dale graduated from the London
School of Economics and subsequently
qualified as a barrister-at-law at Lincoln's
Inn.
After working as a merchant banker at
NM Rothschild and Sons, Dr Dale won a
Rockefeller Foundation fellowship at the
Brookings Institute in Washington DC.
More recently he was a Senior Houblon
research fellow at the Bank of England. Dr
Dale is currently Professor of International
Banking and Financial Institutions at
Southampton University and Visiting Pro-
fessorial Fellow at Queen Mary and West-
field College, London University.
Simon Wolfe, PhD, is a Lecturer in Finance
in the Department of Management,
Univer-
sity of Southampton. He has carried out
research for the European Capital Markets
Institute and is currently conducting
research into the financial implications of
environmental legislation.
ABSTRACT
Several recent developments (notably, the
breakdown of traditional distinctions between
different types of financial activity, the globali-
sation of financial markets and increasing
emphasis on systemic stability as a regulatory
objective) have prompted policy-makers to
search for an 'optimum' regulatory structure
that is adapted to the new market environment.
Further impetus has been given to this debate
by the radical overhaul of
regulatory
structures,
along quite different lines in Australia, the UK
and Japan, and the on-going deliberations
within the US Congress over structured finan-
cial reform.1
This paper examines alternative ways of
organising the regulatory function in the context
of the new financial market environment. The
first section reviews the objectives, targets and
techniques of regulation. The second section
describes
the new market environment and the
restructuring of the financial services industry.
The third section assesses the implications of
this new environment for the structure of
regu-
lation. The fourth section
addresses
the interna-
tional dimension. The final section provides a
summary and
conclusion.
The paper is
based
on a presentation made at
the World Bank Conference, El Salvador, June
1998.
SECTION 1: OBJECTIVES, TARGETS
AND TECHNIQUES OF REGULATION
Objectives of regulation
The case for regulating financial institu-
tions can be made on three broad grounds.
First, there is the consumer protection
argument. This is based on the view that
depositors and investors cannot be expected
to assess the riskiness of financial institu-
tions they place their money with, nor to
monitor effectively the standard of service
provided by such institutions. The consu-
mer protection rationale gives rise to three
categories of regulation: first, compensation
schemes designed to reimburse all or part
of losses suffered through the insolvency of
financial institutions; secondly, regulation
in the form of capital adequacy require-
ments and other rules aimed at preventing
insolvency; and finally, conduct of business
Journal of Financial Regulation
and Compliance, Vol. 6, No. 4,
1998,
pp. 325-350
© Henry Stewart Publications,
1358-1988
Page 326
Dale and Wolfe
or market practice rules intended to ensure
that users of financial services are treated
fairly. This last type of regulation reflects
market imperfections arising from, inter
alia, asymmetric information, principal-
agent problems, and the fact that the value
of a financial product or service may only
be determinable well after the point in
time at which it is purchased.
The consumer protection rationale for
regulation is closely related to another con-
cern. If depositors or investors are to be
reimbursed for losses incurred through the
insolvency of financial institutions then
there will be little or no incentive to exer-
cise care in the choice of depository or
investment institution. This, in turn, means
that risky institutions will be able to attract
business with the same ease and on the
same terms as more prudently run firms,
thereby undermining financial market dis-
cipline and increasing the incidence of
insolvencies. The ensuing losses must then
be borne by the deposit insurance scheme,
investor protection fund, or ultimately, the
taxpayer. Prudential constraints on finan-
cial institutions' risk-taking then become
necessary in order to limit such losses and
to offset the regulatory incentives in favour
of excessive risk-taking.
A third objective of financial regulation
is to ensure the integrity of markets,
embracing such diverse matters as money-
laundering, market manipulation, price dis-
covery, fairness (for instance, in terms of
access to information) and, above all, trans-
parency. Market integrity focuses on the
organisation of the market as a whole
rather than on the bilateral relationships
between financial institutions and their cus-
tomers (ie conduct of business).
Among supervisors themselves the ratio-
nale for financial regulation that gives most
cause for concern is systemic risk, that is,
the risk that the failure of one or more
troubled financial institutions could trigger
a contagious collapse of otherwise healthy
firms. It is, above all, their alleged suscept-
ibility to contagious disturbances that dis-
tinguishes financial institutions from non-
financial firms. In the words of a member
of the Board of Governors of the Federal
Reserve System:
'It is systematic risk that fails to be
controlled and stopped at the inception
that is a nightmare condition. ... The
only analogy that I can think of for the
failure of a major international institu-
tion of great size is a meltdown of a
nuclear generating plant like Chernobyl.
The ramifications of that kind of failure
are so broad and happened with such
lightening speed that you cannot after
the fact control them. It runs the risk of
bringing down other banks, corpora-
tions,
disrupting markets, bringing down
investment banks along with it. ... We
are talking about the failure that could
disrupt the whole system.'2
These, then, are the main considerations
behind the regulation of financial institu-
tions:
consumer protection, moral hazard
(a consequence of consumer protection),
market integrity and systemic risk. In
addition, it should be noted that a further
major regulatory objective is to achieve
competitive equality — between financial
institutions from different countries,
between functionally distinct financial
firms (banks, securities firms and insurance
companies) that carry on the same kinds
of business, and between rival financial
centres. Concerns about competitive
equality do not provide an independent
justification for financial regulation but
they do often provide an important
impetus to international regulatory coordi-
nation initiatives. For instance, the Eur-
opean financial market directives have
been framed with the explicit objective of
achieving a 'level playing field', and the
original motivation behind the Basle
Page 327
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