Principles of Financial Regulation - Riassunti

WHAT DO FINANCIAL INTERMEDIARIES DO?

The service provided by the intermediaries is called investment service: they are broker-dealers that do various activities, that can be divided into two main groups:

• Activities aimed at overcoming transaction costs:
• Reception and transmission of orders in relation to one or more financial instruments (service provided by the smaller intermediaries, that are not allowed to participate in the stock exchange)
• Execution of orders on behalf of clients
• Dealing on its own account: the intermediary is executing an order of the client by dealing on its own account (ex. a client wants to sell a share and the intermediary buys it)
• Activities aimed at overcoming the asymmetry of information between investors and issuers:
• Investment advice: the intermediary recommends the investor what to buy and what to sell
• Portfolio management: the intermediary directly performs the strategies for the investors
• Activities that are aimed at both problems:
• Underwriting of

financial instruments and/or placing of financial instruments on a firm commitment basis: intermediaries, in the interest of issuers, place in the primary market, securities of new issuance. They can either place financial instruments with or without a firm commitment basis (in the first case the intermediary tells the issuer that he'll buy all the securities of new issuance and then he'll place them, in this case the risk of not having the security placed goes to the intermediary) or placing of financial instruments without a firm commitment basis: in this case the risk of not having the security placed remains to the issuer

WHY DOES THE LAW REGULATE THESE SERVICES?

We have 3 main reasons:

1. Intermediaries raise another problem of asymmetry of information, between themselves and the investors, as they have more information about the market.

2. Here this problem is also worse with respect to the issuers-investor relationship as the relationship between investors and intermediaries is

based on trust, and this trust can be exploited by the intermediary. So, the law intervenes to protect the investors.

On the other hand, regulation protecting one party may be very useful for "good intermediaries" to signal that they are of good quality.

Another reason that explains why the law regulates this services is to avoid negative externalities: an intermediary breaking the trust of the investor has negative externalities, as investors think that all the other intermediaries are as bad as the ones who breach the trust.

In this case the regulation needs to internalize this negative externalities: this idea is called prudential regulation: a regulation aimed at assuring that the intermediaries are managed prudently, avoiding systemic risks and assuring the stability of the intermediary. (this problem relates also to banks)

A third rational is having a safe net: the law tries to avoid the disaster, but, if the disaster actually occurs, the solution provided by the law is

As the investors knows that he's very much protected, he could exercise less care than it would if there was no regulation.

If we consider both costs, we understand why the regulation of financial intermediaries is articulated in proportion to the need of protection of investors (the more the investor is professional, the less it needs protection).

PRUDENTIAL AND PROTECTIVE REGULATION

PRUDENTIAL REGULATION

Prudential regulation for intermediaries follows the same logic as for banks, but the tools are different. Typically, there are two ways of operating:

• Access regulation: the access to the market of financial intermediation is governed by the law (a financial intermediary is required an authorization). By doing so, the law screens out the intermediaries who don't offer enough insurance. Screening out is very efficient but is also problematic as it reduces the freedom of an enterprise. This is an ex-ante regulation.
• Risk management: the law sets some rules to avoid that the risk gets

out of control. Risk management has two features:

• flexibility: the law gives the single intermediary a good degree of flexibility in identifying how this organizational structure should be. The law simply states that the intermediaries should have organizational arrangements to manage the risk (which is a standard)

Then, a crucial part of prudential organization are the systems of control:

• conflict of interest: as banks can provide both banking activity and investment services, there could be conflicts of interests. For example, the bank could suggest investing in bonds issued by a company, so that it has money to repay a credit with the same bank.

These conflicts can be managed in many ways:

• the traditional approach was disclosure: these conflicts had to be simply disclosed. This strategy works very poorly
• so, managing conflicts of interest is done through organizational requirements: intermediaries should be organized in a way in which conflicts of interest are identified, described and managed (ex.

When there's a possible conflict of interest, the top levels of the organization should take responsibility for that)

PROTECTIVE REGULATION

Protective regulation is the regulation directly targeting the relationship between investors and financial intermediaries, in order to manage the asymmetry of information and of power.

Investor's protection has been controversial as a regulation technique, as there was this idea that protecting investors was not a good idea, from an economic perspective this protection would increase the cost of compliance for intermediaries and they would pass this cost on the investors by raising the price of their services: a lot of people will pay for this protection, but only a small percentage will be protected.

Because the people that are actually protected are the people that have the money to enforce a legal provision: the investor protection redistributes the resources from the poor to the rich.

This idea is a typical neoclassical economic

that it doesn't exist (perfect agents do not exist, and there can be any kind of cognitive mistakes, such as overconfidence or much more fear than needed)

So, even though the agents have all the information, they may not take rational decisions.

2. Also, disclosure determines, in the other part of the relationship, a lot of trust, that can be exploited, so there can be opportunistic behaviour to disclose enough to gain trust, but not the actual relevant information.

So, there's an asymmetry of power between investor and intermediary (caused by trust), and disclosure does nothing to balance it.

Any time there's an imbalance of power, to rebalance it the law provides the weaker party some rights.

This is what happened in 2004 with financial intermediaries: the law imposed on intermediaries to act on the best interest of the client.

So, there was a shift from considering intermediaries as sellers, imposing them disclosure obligations, in considering intermediaries agents, imposing a