Focus of securities market regulation must change

Rachana Baid | Updated on: Jun 29, 2022
There’s more to risk than size of entity

There’s more to risk than size of entity | Photo Credit: bluestocking

In regulating securities markets, systemic risk should be seen in terms of ‘too interconnected to fail’ and not just ‘too big to fail’

Economic literature makes a distinction between a ‘bank-oriented’ and a ‘market oriented’ system. The former is defined as one where banks and financial institutions are the dominant source of financing, whereas in the latter, funds are raised primarily via the securities markets. Although both forms of financing coexist in all jurisdictions, countries differ in terms of the relative weight given to each model.

Traditionally, the key objective of banking regulations has been the avoidance of systemic risk. There are historical reasons for this. The Great Depression influenced financial sector regulations not only in the US but also in the other parts of the world, resulting in a wall between banking and securities market activities.

The key focus of securities market regulations has been to reduce information asymmetry between the issuers of securities and the investors. Hence, disclosure and registration requirements are the cornerstone of securities market regulations. Investors in securities markets are perceived to be susceptible to unscrupulous behaviour of the managers of securities market firms, and hence there are firm-specific prudential regulations. Securities market regulations have been designed to protect investors.

The reason for the difference in regulatory treatment of banks and securities firms is based on many assumptions. The assumptions emanate from the way banks and securities market firms operate in the process of flow of funds. Securities firms segregate investors’ funds from the firm’s own funds. Hence any negative occurrences on the firm’s own assets would not become a cause for concern to the investors.

Configuration of balance sheet

The second reason flows from the way the balance-sheet of securities firms is configured. Unlike banks, securities firms do not mobilise money by way of deposits. This liability structure protects the firms from runs, which banks are vulnerable to. Unlike the opaque nature of bank assets, the assets of securities firms are more liquid and mostly marked to market, and have a ready secondary market available. The result of these structural differences led to the assumptions that securities firms are less vulnerable to shocks than banks and hence less likely source of systemic risk.

Just as how the Great Depression created a wall between securities markets and banks, the Global Financial Crisis highlighted the bridge between them. The crisis raised questions regarding the aforementioned assumptions.

Since the last few decades, securities markets have been gaining ground in terms of size and importance. It is widely accepted that size is the most important variable when assessing the potential for systemic risk. Typically, size is considered in terms of absolute size of the entity. However, there is an increased realisation that size has to be looked at in many other ways. For example, many small firms carrying out similar activities can lead to significant size.

Interconnectedness matters

Size is also relevant in terms of inter-connectedness of the participants. Globalisation of markets, financial innovations and technological advancements have increased the linkages or interconnections. Many firms may not appear large enough to reach “too-big-to-fail” status, but if they are highly connected to others they could become “too interconnected to fail” and thus become systemically important.

Inter-connectedness is observed in securities market participants — brokers, dealers, custodians, pooled investment vehicles like mutual funds, AIFs, etc. Further, leveraged positions of many smaller market participants in the securities markets can have a bigger impact on the financial system, and with a potential for contagion.

Market infrastructure entities that provide key services, such as clearing and settlement, typically have only one or a few market participants that provide a product or activity and, therefore, carry concentration risk, which is another dimension of size.

There is a paradigm shift in the way funds flow in the financial sector. Flow of funds is shifting from the “saver-borrower model” to the “investor-issuer model”. This shift has expanded the scope and importance of securities markets. In the saver-borrower model, banking regulators play an important role in containing systemic risk. In the investor-issuer model, the securities market regulator is required to have greater focus on avoidance of such risk.

In July 2010, IOSCO adopted new principles of securities regulation including the need for processes to monitor, mitigate and manage systemic risk. It’s time for securities markets regulators to explicitly recognise “reduction of systemic risk’ as a key objective.

The writer is professor at School of Securities Education, National Institute of Securities Markets (NISM). Views are personal

Published on June 29, 2022
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