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2.8 Regulation

Learning Objective

  1. What are the major goals of financial regulation?

Like investors, borrowers are concerned about the total net costs (all costs plus all benefits) of different types of finance. One big consideration is government and self-regulation. Compared with most other parts of modern capitalist economies, the financial system is relatively heavily regulated. Regulators like the Securities and Exchange Commission (SEC, which oversees exchanges and OTC markets), the New York Stock Exchange (NYSE, which oversees itself as an SRO or self-regulating organizationen.wikipedia.org/wiki/Self-regulatory_organization), and the Commodities Futures Trading Commission (CFTC, which oversees futures market exchanges) monitor and regulate financial markets. Other regulators, including the Office of the Comptroller of the Currency (which oversees federally chartered commercial banks), the Federal Deposit Insurance Corporation (FDIC, which oversees almost all depositories), and sundry state banking and insurance commissions, monitor financial intermediaries. Companies that wish to avoid direct regulatory scrutiny due to its high cost tend to use intermediaries rather than markets. For example, instead of selling shares to the public, which would require following the many rules of the SEC and the NYSE (or other exchange or OTC market), a company might decide that it would be cheaper to obtain a long-term bank loan or sell bonds to life insurers, mutual funds, and other institutional investors in a direct placement.

Regulators serve four major functions. First, they try to reduce asymmetric information by encouraging transparencyIn general, the opposite of opacity. In this context, transparency means a relatively low degree of asymmetric information.. That usually means requiring both financial market participants and intermediaries to disclose accurate information to investors in a clear and timely manner. A second and closely related goal is to protect consumers from scammers, shysters, and assorted other grifters, as well as from the failure of honest but ill-fated or poorly run institutions. They do the latter by directly limiting the types of assets that various types of financial institutions can hold and by mandating minimum reserve and capitalization levels. Third, they strive to promote financial system competition and efficiency by ensuring that the entry and exit of firms is as easy and cheap as possible, consistent with their first two goals. For example, new banks can form but only after their incorporators (founders) and initial executives have been carefully screened. Insurance companies can go out of business (exit) but only after they have made adequate provision to fulfill their promises to policyholders.

Finally, regulators also try to ensure the soundness of the financial system by acting as a lender of last resortDuring a financial crisis or panic, a lender of last resort makes loans when no one else will., mandating deposit insuranceInsurance that pays off if a bank defaults on its deposit liabilities., and limiting competition through restrictions on entry and interest rates. The first two forms of regulation are relatively uncontroversial, although many believe that the lender of last resort function should not be combined with a too big to fail (TBTF) policy, and that deposit insurance can increase risk-taking by bankers. Limiting competition is a highly controversial means of ensuring safety because it extends privileges to existing institutions over new ones. Little surprise, then, that the regulated companies themselves are often the strongest supporters of that type of regulation!

Stop and Think Box

For decades, the Federal Reserve capped the interest rates that banks could pay on checking deposits at zero and the interest rates that they could pay on time or savings deposits at around 6 percent per year. What was the intended economic effect of those restrictions? Why didn’t existing banks lobby for their repeal until the Great InflationPeacetime inflation rates in the United States in the 1970s were higher than any time before or since. of the 1970s?

The restrictions were put in place to limit competition among banks, allowing them to be profitable without assuming too much risk. Existing banks were more than happy to reap relatively riskless profits until inflation exceeded the interest rates that they could legally pay. At that point, disintermediation was rampant. In other words, many people pulled their money out of banks and put them directly into the market, via money market and stock and bond mutual funds.

Key Takeaways

  • Regulators attempt to maximize macroeconomic stability and transparency and to minimize investor risk and loss.
  • The policies they implement to do so, however, can be controversial and are not always effective.