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Tuesday, Mar 23, 2004

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Role of government in regulating financial markets

S. Venu

GLOBAL financial markers are currently perceived to be in crisis. Debate over regulatory reform in the financial sector has, consequently, assumed national prominence. Institutionalists have traditionally argued for government intervention when the market fails to produce a socially desirable outcome.

While these arguments cannot be denied, it may be suggested that the technological change inherent in a financial innovation can, in fact, promote a progressive institutional change that enhances social welfare.

The problems of inefficiency or inequity in the financial sector may, consequently, be ameliorated by technological change. This implies that government regulatory intervention may not always be necessary in the event of a failure of the market to provide an optimum outcome.

Governance is that broad field of economics which concern the design of institutions through which exchange is conducted.

The economic theory of regulation, a subfield of governance, most often examines how collective action by individuals, through the auspices of government, affects the incentives of participants in private markets.

The theory of governance, and area of commonality between certain aspects of institutional and neoclassical economics, also examines how economic institutions evolve, both through technological innovations and bargaining between coalitions of individuals whose welfare depends on the pattern of trade within these institutions.

Regulation of financial markets is best examined within this context. Institutional structure, which includes legal restrictions, traditional practices, and regulatory policy, constitutes the technology of exchange.

Alternative structures may, at any particular time, vary widely in terms of their economic efficiency.

The institutional approach to regulation more explicitly considers broader issues of governance and institutions as the technology of exchange. The basic postulates of the institutionalist approach to regulation are:

  • The need for government intervention exists because industrialised societies give rise to concentration of power, increased uncertainty, performance failures, uncompensated costs, and adverse distributional effects.

  • Regulation must endeavour to promote public interest or social values that cannot be derived exclusively from monetary or market-oriented measures.

  • When properly applied, regulation seeks to promote higher levels of efficiency and greater individual choice. Regulation can convert emergent values into allocative decisions that better reflect social wants.

  • Strategies of actors in the regulatory process can have a significant impact on the outcome.

  • Since the evolutionary process makes any set of goals and methods provisional and intermediary, it follows that the form of regulatory intervention may change over time.

    The twin objectives of efficiency and equity may, however, often be mutually incompatible in practice.

    The traditional neoclassical theory of regulation focusses on how these objectives can be attained through government intervention, and much of that theory involves an examination of the relative costs of the state pursuing such goals.

    The choice of policy instruments is directly related to the choice of regulatory objectives and involves the means by which the incentives of individual market participants are influenced by government in order to achieve specific goals.

    These means can range from direct legal edicts or command and control procedures to broad regulations incorporating a role for market incentives.

    The role of government in financial markets must be to contribute to the development of an efficient system for financial governance, which includes the organisation of a reliable payments system and clearing mechanism, standardised accounting procedures, and a uniform legal code through which financial contracts can be enforced.

    Appropriate public policy involves measures which insure that these market incentives are indeed operative and, more particularly, that information germane to financial exchange is produced and disseminated to the most efficient extent possible.

    One role for government in establishing an efficient structure for public financial governance involves the standardisation and refinement of techniques for financial accounting.

    Conventional or generalised accounting procedures are static in nature, focussing on realised values of elements of the random income streams comprising most marketable financial assets.

    A second role for government lies in reducing transactions costs in financial markets, especially the costs of enforcing financial contracts.

    These costs, such as those involved in lending, may be relatively high owing to both legal restrictions on lenders taking contingent positions in the investments of their borrowers and the legal costs associated with the liquidation of collateral assets in the event of borrower default.

    The government should also seek to ensure the continuous disclosure of portfolio holdings by intermediaries. By creating the opportunity for competing intermediaries to credibly commit to such strategic disclosure, in the context of an imperfectly competitive credit market, internalities will be reduced and incentives for prudent financial management enhanced.

    The disclosure of information relevant to private financial exchange, which also includes the trading strategies of the central bank and fiscal budgeting of government agencies, such as the UTI in India, active in private credit markets, can help coordinate investment planning among private individuals and firms in the nascent or thin domestic credit markets, such as those for community-based lending.

    Another role for government involves measures to mitigate the adverse incentive effects created by its inability to credibly refrain from offering loan guarantees which insure the debt of large and politically influential intermediaries.

    Traditional regulatory methods involve restricting the strategies available to such intermediaries by:

  • imposing capital adequacy requirements;

  • restricting ownership between intermediaries and certain classes of borrowers, such as manufacturing firms, and;

  • imposing restrictions on yields paid on the deposit liabilities of these intermediaries.

    These measures are intended to inhibit the incentives that bank managers have to increase the volatility of earnings, by insuring that equity-holders in any financial institution have and appreciable portion of their own wealth exposed to the risk of insolvency, rather than relying primarily on that of depositors or, through mis-priced government loan guarantees, that of the general public.

    A final role for government in developing economies is to address the difficulties posed to uninformed or neophyte traders by their participation in private financial markets.

    Incentives, possibly including subsidised educational programmes, could be offered to such traders to acquire and maintain sufficient expertise to infer and evaluate the risks they are facing.

    Given the current state of knowledge about financial markets, as well as the obvious difficulties in devising and implementing an effective policy of monitoring and enforcing compliance, the social costs posed by refining traditional forms of financial regulations, such as capital requirements, may exceed the benefits to such refinement.

    Vital directions for future theoretical and empirical research into efficient financial governance must focus on both the costs of implementing financial regulations and the capacity for the endogenous resolution of extant inefficiencies by private financial institutions through the process of financial innovation.

    (The author is Chennai-based management consultant.)

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