Why Regulate?

3.1 The Need for Regulation

Financial services are heavily regulated due to three unique characteristics :

  1. Information Asymmetry: Financial services cannot generally be tested at the time of purchase since there is a time-lag between the purchase and its actual effect.

  2. Systemic Risk: The financial system is closely integrated and inter-linked. Failure of one firm often affects other firms, and the entire financial system is affected.

  3. Moral Hazard: In a competitive market with thin spreads, firms often take high risk to maximise return, making them more susceptible to default .

3.2 Objectives of Regulation

Regulation aims to achieve multiple objectives :

  • Protection of Investors: As the weakest participants, investors need protection from malpractice, fraud, and collapse. Regulations mandate larger disclosure of information to address asymmetry .

  • Systemic Stability: Preventing the failure of individual institutions from triggering a broader crisis.

  • Soundness and Safety: Ensuring the integrity of financial institutions .

  • Consumer Protection: The explicit protection of consumers of financial services .

  • Market Efficiency: Providing adequate scope for innovation and freedom of operation to improve the system’s efficiency .

3.3 The Spectrum of Regulatory Approaches

Regulators face a fundamental choice in how they regulate :

  • Rules-Based Regulation: Prescribing specific actions firms must take or avoid.

  • Principles-Based Regulation: Setting out broad principles and expecting firms to interpret and apply them .
    The appropriate balance between these approaches is a central theme in financial regulation .

 
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