Summary of the course 'Financial Regulation' in the year 2023/2024.
Contains all lectures and is a very extensive summary.
MAN-BCU2038, 3rd year of the specialization Financial Economics.
, Lecture 1 — Introduction and Background
Regulation exists because of? -> Asymmetric information
> With failures somewhere in the whole system, not able to keep economy safe -> Use regulation
> Everything is connected (banks, economies, suppliers, customers)… We should regulate to
avoid major shocks (in ation, interest), keep con dence, and keep thing working as they should
Economic Theory and Financial Regulation:
> Market failure: Whenever it doesn’t deliver a Pareto-e cient allocation of resources
> In case of a failure, the markets needs to be regulated
First Welfare Theorem:
> First theorem of welfare tells us that the Free Market will achieve Pareto-e ciency provided that:
> Perfect competition // Full information // No externalities
> In practice… Not always perfect competition, Information asymmetry, and externalities exist
Rationale for Financial Regulation:
> Protection against monopolies, Consumer/investor protection, Systemic risk (externalities), and
Steering function of measures (e.g. taxes)
Example: The Onion King
> Started trading onion derivatives; bought up all onions in the market, driving up prices. Then, he
started short selling stu until prices dropped again. Now illegal to trade Onion Futures (1956)
Protection against monopolies:
> Lot of economic regulation concerned with preventing unwanted concentration of market power
> Most of nance is pretty competitive, not so much a problem (only Dutch banking concentrated)
One potential issue: Platform E ects
> E cient to have a single exchange, single clearing system, single payment system
> Platform becomes more useful the more people use it… This tends to become a spiral towards
a single platform which gains some monopoly power (One Solution: Regulate!)
Consumer protection:
> Many consumers of nancial products lack information and understanding —> Need to be
protected against themselves:
> Risks: Bank/Insurance/Funds screwing their consumer over or failing/collapsing
> Preventing Screwing Consumers over: Conduct of Business regulation
> Preventing Collapses/Failings: Prudential Regulation (liquidity, solvency, riskiness, etc.)
Prudential versus Systemic Regulation:
> Systemic (macro-prudential) regulation aims to prevent contagion & widespread nancial crises
> (Micro-) Prudential regulation aims to maintain solvency and liquidity of individual institutions
Conduct of Business / Behavioral Regulation:
> Regulating information disclosure, competence, fair business practices, marketing, honesty
> Example: Woekerpolis in Netherlands —> Insured payo dependent on investment returns
(turned out only a part of premium was invested, rest went to investment fees instead)
> Regulatory tools: Licensing, nes, ethics… Can be self-regulated or externally (like the AFM)
Wholesale versus retail:
> Institutional investors expected to be in a better position to evaluate o ers than normal
household investors…
> These ‘Retail investors’: Less experienced, less ability to evaluate, not able to monitor contracts
> Consequence: Retail investment is regulated more heavily!
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, Reasons for prudential regulation, even in the absence of systemic concerns:
> Why not letting bad companies fail and let the market work it’s magic?
> Asymmetric Information: Very di cult for consumers to judge solvency of nancial
institutions, market unlikely to function
> Moral Hazard: Value of investment or contract is determined by the behavior of the
institution after the contract is signed and has your money
> Very large potential losses
> Potential claim on a compensation or deposit insurance fund
> Prudential Regulation also aimed at protecting those who nance a safety net (tax payers)
Systemic issues:
> Also systemic rationales for regulates, besides prudential and consumer protection:
> Large costal costs (externalities) or a failure of a nancial institution
> Banks especially are both inherently unstable and inherently contagious…
> One bank failure likely leading to panics, credit exposure and asset re sales -> A ecting
households and rms, often have to be bailed out by tax payers… (higher taxes)
Why banks are special:
> Banks are especially in need of regulation: — They manage payment systems —
-> Banks are inherently unstable due to maturity mismatch (maturity of deposits and loans)
> Banks are more connected than other industries, prone to contagion
> Banks are the main source of lending; Considerable Moral Hazard (lender of last resort)!
Economies of scale in monitoring:
> Many nancial contracts are long term and need constant monitoring due to basic PA problems
> Value of contracts depend on actions of nancial institutions after contract is signed
> If every consumer monitors individually, the incentives to do so would be low, leading to free-
riding problems. Specialized monitoring agency (economies of scale) may be more e cient !
Supply of regulation:
> Financial regulation o ered in response to consumer demand; but not o ered in market setting
> Likely to be over- or undersupplied
> Financial regulation eliminating all possibility of failure is likely to bee too expensive
> Regulating away risks from investors regulates away the very function of nancial contracts
> Regulation may crowd out necessary monitoring by consumers; moral hazard of regulation
> Consumers assumes safety/good conduct
> Firms only seek to narrowly comply with regulatory requirements/rules
The threat of Over-Regulation: Lack of Proportionality
> Although perceived cost of regulation to voters is basically free, there are real costs:
> Services not o ered due to high entrance barriers // Lack of entrances decreases
competition (higher prices) // Compliance cost passed on to consumers (hard to measure)
> Therefore, some argue that regulation is oversupplied (disproportional, costs exceed bene ts)
The threat of Under-Regulation: Lack of Proportionality
> On the other hand, issue of regulatory arbitrage: rm domiciling in most regulatory favorable
jurisdiction… ‘The Delaware E ect’ -> Had lower regulations, lowest taxes, most freedom, etc.
> Leading to a Race to the Bottom in an attempt to attract investment, resulting in an undersupply
of regulation and the exposure of the consumer to unnecessary risks
> Or could lead to under taxation
> Some see the Race to the Bottom e ect as inherently damaging, while others see it as healthy
counter to the threat of over-regulation
Internal vs External Regulation:
> Shift in emphasis from external regulation to internal monitoring and self-regulation
> Banks and nancial institutions have gotten increasingly large and complex
> Idea: let banks manage their own risk, regulators guide them, improve and validate risks
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, Lecture 2 — Regulation in the NL, EU, and US
— The Netherlands —
History: Oldest Public Company was The VOC
> United di erent companies from di erent Dutch cities that had been competing for trade with
the East Indies and had damaged others ships
> So, Johan van Oldebarnevelt united di erent companies into one government sanctioned
monopoly, the VOC, and came with another innovation to nance the VOC:
> Issue shares to the public, in turn allowed to freely trade these securities; called Actien
> Share in pro ts of the VOC. These Actien were very volatile; ships could get lost, etc.
First Regulation:
> Initially no role for the government: self-regulation through the Vereeniging door de
E ectenhandel (VvdE)
> Stock market had its own regulation, enforce by delisting companies that didn’t comply
> Emergency law in response to 1914 stock market crash: Beurswet 1914
> Stock exchange needed to get permission from Ministry of Finance
> In 1946, Beschikking Beursverkeer extended this; company getting listed? Ministry of Finance…
European Prompts:
> For a long time self-regulation worked more or less with satisfaction. However, European
Economic Community (EEC) started issuing directives that had to be implemented into Dutch Law
> EU Directives have to be implemented in national law, EU Regulations apply directly
> 1979: Directive on admission guidelines to stock markets // 1980: Directive on
requirement for IPO prospectuses // 1982: On nancial disclosure by publicly listed rms
Dutch Financial Regulation Laws:
> In 1985, the Wet E ectenhandel for the rst-time regulated stock trading outside of the stock
exchanges, in 1990 partly replaced by the Wet Toezicht Beleggingsinstellingen
> The rst ‘real’ nancial regulation in the NL could be considered the 1989 article 336a in the
Wetboek van Strafrecht, making insider trading a crime
Dutch Financial Regulation Laws:
> At the same time, it was decided that enforcement of existing nancial regulation should no
longer lie with the Ministry of Finance, but an independent entity: Stichting Toezicht
E ectenverkeer (later, AFM)
> 1992, Wet Toezicht E ectenverkeer, superseded the Beurswet of 1914, stating that:
> Government has duty to ensure functioning of nancial markets
> Investor protection mainly served by maximizing disclosure and transparency
Wet op het Financieel Toezicht:
> The Wet Toezicht E ectenhandel and the Wet Toezicht Beleggingsinstellingen were changed
over the years to implement new rules
> 2007, all the di erent laws merged into the new: Wet op het Financial Toezicht (WFT)
> WFT formalized the ‘twin peaks’ model of functional supervision: separating prudential
and transparency supervisions in two di erent agencies: DNB and AFM
> Will prevent confusion and overlapping jurisdictions
> In special market circumstances (crises) allowed to make binding regulation
Twin peaks:
> Instead of one single regulator of nancial sector, have two regulators (peaks) that are focused
on the two most important goals of nancial regulation: Behavioral and Prudential
> Behavioral: Conduct of business, consumer protection, disclosure, transparency, etc.
> Prudential: Maintain solvency, liquidity ratios, equity ratios, safeguard whole nancial system
Twin Peaks:
> Making clear who does what, should avoid unnecessary turf battles & Behavioral supervision
may require a di erent attitude, skillset, and pro le compared to prudential regulation
> While micro- and macro-prudential supervision are highly related and should be done under one
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