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2020 Curriculum CFA Program Level II Economics

Economics of Regulation

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Introduction

Regulation can be described as a form of government intervention in markets that involves rules and their enforcement. It is an important topic because regulation not only has potential effects at the macro level on the economy but also has potential effects at the micro level on companies and individuals. Regulation may develop either proactively in anticipation of consequences of changes in the market environment or reactively in response to some occurrence(s). For example, changes that resulted from technological advances in the markets because of new means of communication and applications of computers have led to a variety of regulation, both proactive and reactive. Regulation has also developed in response to financial crises and undesirable behaviors or actions that have occurred in the past. Regulations are necessary because in some situations market solutions are not adequate. In other words, regulations exist to protect end users from market failings.

A significant challenge for financial regulators is how to deal with systemic risk (the risk of failure of the financial system) and the consequences of risk taking by financial institutions. Issues such as labor regulation, environmental regulation, and electronic privacy are also receiving increased attention.

How regulations are developed and applied can have significant impacts on businesses. Changes in regulatory framework and regulatory uncertainty can also have substantial effects on business decisions. So, one of the significant challenges facing professionals in the finance industry is to anticipate and understand the consequences of potential changes in the regulatory environment and of specific regulations.

Section 2 of this reading describes the economic rationale of regulation, including how regulation improves fairness in markets and addresses the danger to society of financial system failure. Section 3 provides an overview of regulators, the tools at their disposal, and how the work of regulators around the globe is interdependent. Section 4 describes the assessment of costs and benefits of regulation and highlights practical issues that arise from the implementation of regulation. A summary and practice problems conclude the reading. 

Learning Outcomes

The member should be able to:

  • describe the economic rationale for regulatory intervention;
  • explain the purposes of regulating commerce and financial markets;

  • describe anticompetitive behaviors targeted by antitrust laws globally and evaluate the antitrust risk associated with a given business strategy;

  • describe classifications of regulations and regulators;

  • describe uses of self-regulation in financial markets;

  • describe regulatory interdependencies and their effects;

  • describe tools of regulatory intervention in markets;

  • describe benefits and costs of regulation;

  • describe the considerations when evaluating the effects of regulation on an industry.

Summary

Knowledge of regulation is important because regulation has potentially far-reaching and significant effects. These effects can range from macro-level effects on the economy to micro-level effects on individual entities and securities.

Regulation originates from a variety of sources and in a variety of areas. A framework that includes types of regulators and regulation as well as areas of regulation that may affect the entity of interest (including the economy as an entity) is useful. The framework will help in assessing possible effects of new regulation. It can also help in assessing the effects of regulation on various entities.

More than one regulator may develop regulations in response to a particular issue. Each of the relevant regulators may have different objectives and choose to address the issue using different regulatory tools.

In developing regulations, the regulator should consider costs and benefits. In the analysis, the net regulatory burden (private costs less private benefits of regulation) may also be relevant. Potential costs and benefits, regardless of the perspective, may be difficult to assess. A critical aspect of regulatory analysis, however, is assessing the costs and benefits of regulation.

The following are some key points of the reading.

  • The existence of informational frictions and externalities creates a need for regulation. Regulation is expected to have societal benefits and should be assessed using cost–benefit analysis.

  • The regulation of securities markets and financial institutions is extensive and complex because of the consequences of failures in the financial system. These consequences include financial losses, loss of confidence, and disruption of commerce.

  • The focus of regulators in financial markets includes prudential supervision, financial stability, market integrity, and economic growth.

  • Regulatory competition is competition among different regulatory bodies to use regulation in order to attract certain entities.

  • The breadth of regulation of commerce necessitates the use of a framework that identifies potential areas of regulation. This framework can be referenced to identify specific areas of regulation, both existing and anticipated, that may affect the entity of interest.

  • Legislative bodies, regulatory bodies, and courts typically enact regulation.

  • Regulatory bodies include government agencies and independent regulators granted authority by a government or governmental agency. Some independent regulators are self-regulating organizations.

  • Typically, legislative bodies enact broad laws or statutes. Regulatory bodies issue administrative regulations, often implementing statutes. Courts interpret statutes and administrative regulations; these interpretations may result in judicial law.

  • Interdependence in the actions and potentially conflicting objectives of regulators is an important consideration for regulators, regulated entities, and those assessing the effects of regulation.

  • Regulation that arises to enhance the interests of regulated entities reflects regulatory capture.

  • Regulators have responsibility for both substantive and procedural laws. The former focuses on rights and responsibilities of entities and relationships among entities. The latter focuses on the protection and enforcement of the former.

  • Regulatory arbitrage is the use of regulation by an entity to exploit differences in economic substance and regulatory interpretation or in regulatory regimes to the entity’s benefit.

  • There are many regulatory tools available to regulators, including regulatory mandates and restrictions on behaviors, provision of public goods, and public financing of private projects.

  • The choice of regulatory tool should be consistent with maintaining a stable regulatory environment. “Stable” does not mean unchanging but, rather, refers to desirable attributes of regulation, including predictability, effectiveness in achieving objectives, time consistency, and enforceability.

  • In assessing regulation and regulatory outcomes, regulators should conduct ongoing cost–benefit analyses, develop techniques to enhance the measurement of these outcomes, and use economic principles to guide them.

  • Net regulatory burden to the entity of interest is an important consideration for analysts. 

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