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PowerPoint Slides

for ProfessorsSpring 2010 Version

This file as well as all other PowerPoint files for the book, “

Risk Management and Insurance: Perspectives in a Global Economy

” authored by Skipper and Kwon and published by Blackwell (2007), has been created

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for classes where the book is used as a text. Use or reproduction of the file for any other purposes, known or to be known, is prohibited without prior written permission by the authors.

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 [Slide Master]

W. Jean Kwon, Ph.D., CPCU

School of Risk Management, St. John’s University

101 Murray Street

New York, NY 10007, USA

Phone: +1 (212) 277-5196

E-mail:

Kwonw@stjohns.edu

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Risk Management and Insurance: Perspectives in a Global Economy 8. Regulation of Private-Sector Financial Services

Click Here to Add Professor and Course InformationSlide3

Study PointsPrivate-sector financial services

Government’s role in regulating private-sector financial servicesOverview of financial services regulationStructure of regulatory authoritiesGovernmental actions affecting financial services regulation3Slide4

Private-sector Financial Services

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Financial intermediariesDefinitionFirms/entities

that bring together providers and users of fundsFunctionsMarket financial services products offered through the financial intermediation processNot actually manufacture (underwrite) all of the products they sellMatch savers with investors, thus obviating the need for savers to locate investors directly and vice versa NotesAll financial intermediaries issue their own claims.Financial intermediaries would not exist in a perfect market.

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Types of Financial IntermediariesDepository institutions

Security firms (investment banks)Insurance companiesMutual fundsPension fundsFinancial conglomeratesFinancial conglomerates

Product integration or advisory integration

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Financial conglomerates and financial services integration in Chapter 25

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Government’s Role in Regulating Private-sector Financial Services

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Why Regulate Financial Services?Market imperfection

Information asymmetry – the “lemons” problemMarket powerNegative externalities – possibility of systematic risksRisk of cascading failureSimultaneous withdrawal by depositors (caused by a loss of confidence in the financial institutions)8Slide9

Public Interest Theory of RegulationRegulation is:

To serve the public interest by protecting consumers from abuse.To maximize economic efficiency, including preventing or making right significant societal or consumer harm that results from market imperfections9Slide10

Private Interest Theories of Regulation Theories

Peltzman (1976) – Self-interested regulators engage in regulatory activities consistent with maximizing their political support.Meier (1988) – Regulation is shaped by bargaining between private interest groups within the existing political and administrative structure.Stigler (1971) – Regulation is “captured” by and operated for the benefit of the regulated industry.Regulation unduly influenced by special interests could result in:

Restrictions on entry of new domestic and foreign entrants

Suppression of price and product competition

Control of inter-industry competition from those selling similar or complementary

products

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When is Regulatory Intervention Justified?Only if the three conditions are met:

Actual or potential market imperfections exist.The market imperfections do or could lead to meaningful economic inefficiency or inequity.Government action can ameliorate the inefficiency or inequity.11Slide12

Government FailuresDifficulty in identification and formulation of goals

Principal-agent problems where government employees are agents for the publicRent-seeking behavior engaged by the regulatedThe problem of capture (related to the rent-seeking behavior)12

Government ImperfectionsSlide13

Financial Services Regulation13Slide14

Regulatory InterventionsPrudential regulation

Concerned with the financial condition of the financial intermediaryEvolved primarily because of information problems and negative externalities (especially for banking)Market conduct regulationGovernment prescribed rules establishing inappropriate marketing practicesEvolved primarily because of information problemsCompetition policy (antitrust) regulationConcerned with actions of the intermediary that substantially lessen competition

Remains

the most critical element in government oversight

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Commercial Banking RegulationCommercial banks are subject

to oversight in every national market.Every major market provides for some type of deposit insurance on the savings of customers.Banks are subject to oversight by the nation’s central bank and/or a banking regulator.15Slide16

The Basel Committee on Banking Supervision (BCBS)

Two principlesNo foreign banking establishment should escape supervisionSupervision should be adequateThe Basel Capital AccordA banking credit risk management framework with a minimum capital standard of 8%Basel II (newer)

Minimum capital requirements

Supervisory review of an institution’s internal assessment process and capital adequacy

Effective use of disclosure

Insight 8.1

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Securities RegulationFocuses on both the new and secondary issues markets, mandating certain disclosures to prospective purchasers about the securities

To rectify buyers’ information asymmetry problemsThe Sarbanes-Oxley (SOX) Act17Slide18

International Organization of Securities Commissions (IOSCO)Objectives

and Principles of Securities Regulation (IOSCO Principles)ISOCO Assessment Methodologies18Slide19

Insurance RegulationFocused chiefly on monitoring and preventing insolvenciesAimed more at protecting policyholders from losses occasioned by insurer insolvency

International Association of Insurance Supervisors (IAIS)Promotes cooperation among insurance supervisorsSets international standards for insurance regulation and supervisionIssues principles, standards and guidance papers on issues related to insurance supervision19

Insurance regulation and taxation is discussed in Chapter 24.Slide20

Financial Conglomerate RegulationDetails of financial institution regulation vary not only from country to country but from financial sector to financial sector.

Permissible activities (Table 8.1)The majority of countries allow joint banking and securities activitiesMost permitting banks to undertake securities activities within the bank itselfFew, if any, countries permit insurance underwriting within a bankThe Joint Forum on Financial Conglomerates (Joint Forum)Consists of the Basel Committee, IOSCO and the IAIS

Examines the common interests of the three financial services and develops principles and identifying international best

practices

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Structure of Regulatory Authorities21Slide22

Structure of Regulatory Authorities22Slide23

Governmental ActionsAfter the Asian and other financial crises of the late 1990sFinancial services regulation has become less diverse

The major intergovernmental organizations involved in financial services regulation playing more active and constructive rolesThe trend toward allowing mutual insurers and banks to convert to shareholder-owned firmsPrivatization of banks and insurance firms in several countriesSignificant combinations of banks and insurance firms23Slide24

Governmental Actions (2007 Credit Risk Crisis)Contagion of credit risk around the world

Coordination at the government and inter-government organization levelMovement back to stringent regulationGovernments loss of confidence in self regulationMore emphasis on risk-capital (solvency) and market conduct regulationIncrease in government takeover (control) of financial institutionsSearch for newer sources of capital by financial institutionsSovereign funds

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Future ProspectsRisk-based prudential regulationNew disclosure-based financial regulatory model evolving internationally

Integrated international approaches to accounting standards, securities regulation and financial institution regulationInterest in common international financial regulation in areas for which such would be feasible25Slide26

Discussion Questions26Slide27

Discussion Question 1Explain carefully why government regulation of private-sector financial service firms is considered necessary.

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Discussion Question 2Debate the following proposition: “government regulation of insurance premium rates is justified.”

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Discussion Question 3What are the essential differences between government supervision of banks and of insurers? Why do these differences exist?

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Discussion Question 4Examine the structure of financial regulation in your home country and compare it with the structure in another economy. Do you find any significant differences in the structures or in the accompanying regulatory objectives? Elaborate your findings.

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Discussion Question 5Offer your answers to the questions posed in Note 2 of this chapter.

“Could there be a “chicken and egg” problem here? Could regulation that shields consumers from the consequences of their mistakes or from failing to become better informed about the quality of financial intermediaries result in their expecting government protection? Is it possible that the market might devise its own means of minimizing the effects of mistakes and providing consumers with adequate information were government intervention at a lesser level?”31