Financial regulation: Do we need a cop or guide?
Financial services regulation in any country or market is usually based on a framework of laws, rules and regulations, and is aimed at ensuring financial stability and protection of consumers and market participants. To achieve these goals, it is more important for financial regulation to rely on effective monitoring and oversight of the financial markets in that country, usually referred to as supervision. Much as in the case of regulation and policing in other spheres of society and commerce, which a government wishes to regulate, financial regulation also involves enforcement.
Although governments tend to regulate a wide range of industries, financial regulation takes a far higher level of importance and seriousness, because of the critical role played by financial markets in the overall economy and in facilitating the commercial aspects of the society at large. This is reflected in the fact that financial regulation is closely monitored and assessed by multilateral organisations like the IMF, as part of their assessment of a country’s economic strength and its sustainability.
The global financial crisis, which unfolded a few years back, clearly demonstrated the importance of appropriately designed financial regulatory framework for every market. The adverse consequences of inappropriate financial regulation are likely to affect the wider economy and public policy objectives in terms of slowing down economic growth, denial of choice in financial services for consumers, failure in achieving high levels of financial inclusion, loss of jobs and even loss of savings for ordinary people.
Appropriateness vs strength
It is not without reason that appropriateness was stressed and not strength, while outlining the importance of financial regulation earlier. In the aftermath of the crisis, many of the leading financial regulators launched a comprehensive effort of writing lots of rules and expanded their already gigantic rulebooks.
Their approach was focused on strengthening their regulatory framework and addressing loopholes, which in their opinion were largely responsible for the collapse in their financial markets. In most cases, the regulators went through this massive rule-writing to comply with international standards and the adverse consequences of some of those ill-directed efforts are already being felt in many parts of the world, particularly in Europe. Many countries are likely to suffer from such adverse effects over the next few years, in terms of lack of credit for their businesses, high cost of banking and other financial services for consumers, emergence of alternative service providers (shadow banks) among others. Shadow banks and similar alternative service providers are often unregulated and are likely to result in much lower levels of overall utility for the consumers and businesses.
It is critical to ensure that the regulatory framework of a market is appropriate to the culture, size, level of sophistication and complexity of its financial services industry and its local economy. It is also important for the rules to reflect the operating practices and business culture of the country and take in to account practices developed by the local business environment in dealing with issues, like say managing conflicts of interest. As part of the regulatory reforms, the global standardsetters have proceeded to emphasise on standardising the rules
It is critical to ensure that the regulatory framework of a market is appropriate to the culture, size, level of sophistication and complexity of its financial services industry and its local economy
across the world which has limited the ability of national regulators to customise global standards to their market with the aim of achieving the intended outcomes of financial stability and consumer protection. The resulting standard rules framed to address the crises of the West are being applied to markets like the GCC without much consideration of the need or their suitability to local environment.
In addition to the rule-writing frenzy, some of the regulators across the world have also been trying to demonstrate their presence by indulging in some heavy use of the stick they carry, enforcement powers. This is by no means intended to absolve the offenders penalised over the past six to seven years, but there are also cases where regulators have brandished their enforcement stick.
In any sphere of law-enforcement, it has been a reasonably accepted notion that forward-looking, risk-based approach-focused on the causality, to tackling offences or crimes is far more effective and efficient in relation to enforcement based approaches which rely on rear-view mirrors and focus on waiting to catch offenders. It is common sense to understand that addressing the root cause of a problem is a better way not only to treat the problem but also to find a lasting solution.
It is far more effective for markets, consumers and the industry for the regulator to play the role of a good guide and focus on monitoring the markets, business and operations of market participants, emerging economic environment and identify risks or issues which need to be tackled as well as guide market participants to manage the risks. This proactive approach which forms the bedrock of effective supervision, helps in identifying problems early and forge a coordinated approach to tackle them along with guiding the regulated community as willing partners. This approach to emphasise on supervision and oversight rather than on regulation (rule-writing) and enforcement is likely to be far more effective and efficient in achieving the overall goals of financial services regulation.
Effective supervision involves working with market participants to understand their objectives, business models, strategies, practices, risks and other issues so that the regulator can identify the risks early and provide useful guidance to ensure effective risk management, good governance and facilitate compliance with all applicable legislation. Although this supervisory approach has been recognised as effective, it is not favoured by many regulators as it does not highlight their contribution to the wider world as much as them cracking their enforcement whip does, which explains partly the reason for overreliance on enforcement.