Financial Regulations

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The Policy Goals of Regulation
It is commonly understood that financial regulation should be designed to achieve certain key policy goals, including: (a)safety and soundness of financial institutions,(b) mitigation of systemic risk, (c) fairness and efficiency of markets, and (d) the protection of customers and investors. These broad goals, while clearly important, do not take into account an additional factor that has come to be regarded as critical in any well-functioning regulatory system; namely, minimum regulatory burden through efficiency and cost-effectiveness. It is fair to say that each of the four models of financial supervision is designed to achieve the policy goals of regulation, albeit in different ways. The differences in the models may be more acute when viewed through the prism of regulatory burden, that is, efficiency and cost-effectiveness. Each of the four policy goals is described in greater detail below. A. Safety and Soundness of Financial Institutions Effective regulation should be designed to promote the safety and soundness of individual financial institutions. Regulatory oversight that focuses on the solvency of institutions and the protection of customer assets is critical to a well-functioning financial system. Traditionally, banks and insurance companies have been regulated through a combination of rules and prudential examinations and supervision. Protection of an institution and its capital base was of paramount concern. For securities firms, at least in jurisdictions such as the United States, the regulatory approach has involved more rules-based enforcement, with prescriptive rules relating to capital firms, at least in jurisdictions such as the United States, the regulatory approach has involved more rules-based enforcement, with prescriptive rules relating to capital requirements, customer protection, and business conduct. The primary focus of securities regulators traditionally has been on customer protection, with the safety and soundness of the institution being one means of furthering that goal. Safety and soundness regulation involves a mixture of proscriptive rules and more prudential review and appraisal, with an emphasis on persuasion rather than through enforcement action involving fines, penalties, or other sanctions. B. Mitigation of Systemic Risk An overarching goal of financial supervision is to monitor the overall functioning of the financial system as a whole and to mitigate systemic risk. For some regulators, this goal is statutorily mandated; for others, it is implicitly understood and adopted. This would seem to be the most incontrovertible goal, and the most challenging to achieve. Financial systems cannot function effectively without confidence in the markets and financial institutions. A major disruption to the financial system can reduce confidence in the ability of markets to function, impair the availability of credit and equity, and adversely impact real economic activity. Systemic risk generally refers to impairment of the overall functioning of the system caused by the breakdown of one or more of the key market components. Systemically important players would include, among others, large, multinational banks, hedge funds, securities firms, and insurance companies. In addition, there are systemically important markets and infrastructures, in particular, the payments and clearance and settlement systems. C. Fairness and Efficiency of Markets Well-functioning markets are characterized by efficient pricing, which is achieved through market rules concerning the wide availability of pricing information and prohibitions against insider trading and anticompetitive behavior. They require transparency of all material information to investors. Regulatory schemes further these goals by mandating disclosure of key information, whether it is about business and financial performance, about the prices at which securities are bought or sold, or other key information that is...
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