Regulation of financial services

Discuss 'The Economic Rationale for the Regulation of Financial Services'

Regulations are the tools of any country to protect and develop their economy. Though regulations are implied on every sector, it is found that there is a rationale for the regulation of financial services. This is because the financial services deal with the money that determines customer's welfare. The financial regulations have three main objectives like protecting customer, sustaining systematic stability and maintain the safety and soundness of financial institutions which are also a cause for rationale. The economic rationale for regulation is analyzed by the following components:

Externalities: Systemic Issues

Systemic issues are one of the reasons for regulating the financial services. Anyhow systemic issues are not related to all the firms, some systemic issues that banks needs regulations are:

  • The pivotal position of banks in clearing and payments systems: Banks obtain pivotal position in the economy because large number of borrowers depends upon banks for their financial needs and, more importantly payment system is managed by banks.
  • The potential systemic dangers resulting from bank runs: banks are considered about runs, which may have contagious effects. The externality is that the failure of an insolvent bank makes the depositors of other banks to withdraw deposits and this causes a solvent bank into an insolvent bank.
  • The nature of bank contracts on both sides of the balance sheet.

Adverse selection and moral hazard which are associated with safety-net arrangements. Systemic issues are also related with the following: (1) Solvent banks: regulations are essential to protect the solvent banks because depositors withdraw money by thinking that the bank is solvent, and individual depositors may take a rational and informed view by their own and depositors does not believe in lender of last resort. (2) Lender of last resort It can prevent systemic problems (i.e. solvent banks are treated as insolvent by deposit runs). There are certain costs and uncertainties attached to Lender of last resort and hence regulations can be formed in reducing the costs associated with the use of the Lender of last resort.

Market Imperfections and Failures

Market imperfections and failures is the second economic rationale for financial regulation. There would be no case for regulation if the financial services are placed in perfectly competitive markets (i.e. there were no information problems, conflicts of interest, externalities, agency problems etc) and consumer might have paid a cost for that regulation, because the un-regulated market outcome is sub-optimum. The ultimate rationale for regulation is to protect the consumer by correcting market imperfections or market failures. Some of the market imperfections and failures in retail financial services that create a rationale for regulation are:

  • Problems of insufficient information.
  • Problems of asymmetric information (consumers have less information than suppliers)
  • Agency costs
  • Principal-agent problems and issues related to conflicts of long term contract Apart from the above mentioned the imperfections also depend on the products and contracts like Multi-dimensional contract

Economies of Scale in Monitoring

There is a lot of risk involved in the financial contracts because of lot of cash is invested, and a continuous monitoring of the behavior of financial firms is required. The monitoring process is required not only because of the cash involved but also due to the changing behavior of supplier, difficulties in finding out the quality of the product at the time of purchase, long -term contracts, principal-agent problems. This is particularly significant for long-term contracts; since the consumer is unable to exit at low cost. It also applies for bank depositors, but however they can exit at fairly low cost. The solution for this problem is monitoring, but who is to going to monitor, is this customers, shareholders, rating agencies, etc. Because most (especially retail) customers are not in practice able to undertake such monitoring, there must be a regulatory agencies that is going to monitor the behavior of financial firms on behalf of customers. In effect regulatory agencies are formed to monitor the financial firms and provide necessary information relating to their contracts or products.

If there were no regulation and supervision by a specialist agency, consumers are required to spend more time, effort and resources in investigating and monitoring firms those supply financial services and this would involve two sets of costs:

(1) Substantial duplication, and hence excessive social costs, as all consumers would be duplicating the same processes, and

(2) The loss of the economies of scale that are derived through a specialist regulator/supervisor acquiring expertise and establishing effective monitoring systems.

Lemons and Confidence

Consumer confidence is one of the important concepts relating to the economic rationale for regulation in financial services; the confidence is built by the information that is available in the market, Sufficient and proper information about firms and their products will encourage the customers to buy the products and on the other hand if obtained information is insufficient and improper than the demand for products are reduced. In most of the cases consumers know that there are good and bad products or firms but, due to improper information, they are unable to distinguish them at the point of purchase because the quality of the products are only revealed after the lapse of time. Under some circumstances, and with known asymmetric information features, risk-averse consumers may exit the market altogether.

In its extreme form (Akerlof's lemons) the market breaks down completely. This is because of the asymmetric information the customers are buying the low-quality products which does not satisfy their needs and they might also forego the possibility of purchasing a high quality product. In the words of Davies (1999): 'Without regulation to give consumers some independent assurance about the terms on which contracts are offered, the safety of assets which underpin them, and the quality of advice received, saving and investment may be discouraged, again with damaging economic consequences'.

Regulations must help the customers, about the availability of both good and bad products. Another important role of regulation is to set minimum standards and thereby remove lemons from the market. By setting standards suppliers will also maintain standards and participate actively in the market.

The Grid Lock Problem

The value of the financial contracts are highly difficult to calculate on the basis of good or bad at the time of purchase ,the value can only determined in the long term in most of the cases. The customer's interests are completely diversified by the financial services for the short-term benefits. Benston (1998) explains that firms have a rational interest in not behaving against consumers' interests.

In most of the cases a gridlock occurs if there is no regulator to regulate the activities. Gridlock can arise when all firms know how they should behave towards customers but nevertheless adopt hazardous strategies because the firms secure short run advantages, and firms do not have any confidence in competitors that they will not behave hazardously. The hazardous behavior which can only be detected in the long run creates problems like adverse selection and moral hazard.

A firm that behaves better towards its customers than others will going to gain additional business even though the firms does not have any quality product. The moral hazard danger is that good firms are made to behave badly because they see bad behavior in others and also there is no assurance that competitors will behave well. At the end because of the fear of losing customers some good firms are also converted into bad ones.

Evidence for grid lock, is seen in the personal pensions mis-selling episode. Salespeople were paid on the basis of commission that largely depends on the number of sales made and salespeople sell the product irrespective to the buyers needs by convincing them and by making false promises which will mislead consumers.

The role for regulation is to set common minimum standards for all firms .These standards are fixed with the acceptance of all the firms and on the belief that everyone follows it. Regulation can break grid lock by guaranteeing that all firms will behave within certain standards. In this respect, regulations are very necessary to prevent the economic losses.

Moral Hazard

Deposit insurance and lender-of-last-resort are the safety net arrangements to which moral hazard rationale for regulation are linked. Both consumers and financial firms have potential moral hazards that are created by the safety net arrangements. Dowd (1996) says that with the help of lender-of-last-resort the banks can take an excess risk which will have adverse incentive effects. Four potential moral hazards are created by the deposit insurance they are:

1)Most of the consumers are less careful in the selection of banks and some consumers choose high-risk institutions by thinking that, if the bank does not fail they will receive higher interest rates on offer, and if bank fails they receive compensation.

2) With a view that depositors are protected, the financial firm may be induced to take more risk.

3) Depositors do not demand an appropriate risk premium in their deposit interest rates because of insurance.

4) Banks can hold lower levels of capital because of deposit insurance.

Consumer Demand for Regulation

One reason of economic rationale for regulation is because of public pressure and public demand .consumer demands regulation because he is more comfort and he feels more secure, however below are the reasons, why it can be rational for the consumer to demand regulation:

  • Reduced transactions costs for the consumer (e.g. saving costs in investigating the position of financial firms, costly analysis etc.)
  • Non availability of information and lack of knowledge to utilize the existing information.
  • A reasonable degree of assurance is demanded when transacting with financial firms.
  • Past experience of low performance by financial firms.
  • Only after the contract is signed and product is purchased the value of the contract is known by determining the behavior and the solvency of the firm.
  • To secure economies of scale in monitoring. The following diagram explains about the importance and role of regulations in maintaining the economy.


Regulations play a very important role in protecting economy of the country, mainly regulations are very necessary for financial services like banking and stock markets etc, because lot of cash is involved and it also determines the welfare of the individuals.

For any country maintaining economy is a very important and difficult task, the future of the country depends upon the economy. Countries with good economy gets more and more cash inflows by the ways of foreign direct investments [FDI], through which immense growth is achieved. Good economy is only obtained if the country is operating its financial services effectively, and the financial services can only be effective if there is a proper regulatory body regulating the operations.


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