Chapter 3 – Role of the Government

Why Regulate Financial Markets? What should the output of a financial market be?

Efficient and Low Cost… What conditions would produce this outcome if left to

itself? Competitive Markets The Government should “regulate” when

Markets are not competitive Markets can not maintain a competitive state Markets that would become competitive are too slow

to reach this state Production Efficiency vs. Information Efficiency

Chapter 3 – Role of the Government

Forms of Regulation Disclosure (Information Efficiency)

Asymmetric information and agency problems Some argue there is no need for disclosure

regulation…the market will do this voluntarily Activity Regulation (Production Efficiency)

Rules governing the NYSE, insider trading, etc. Permissible Functions (Production Efficiency)

Glass-Steagall Act – Financial Modernization Act Permissible Agents (Information Efficiency)

Limit Foreign Participation in Markets

Chapter 3 – Role of the Government

U.S. Regulation (After the Fact Reaction) New Securities – 1933 Secondary Markets – 1934 Relationship Regulations – Self Regulating

Organizations (SROs)…NASD, NFA (Futures) work with government agencies such as SEC, CFTC, etc.

Examples – all futures contracts are “approved” by CFTC for economic rational in hedging

NASD sets standards and disciplines equity dealers

Market Management Regulation Federal Reserve System (Independent) for currency

and money supply

Chapter 3 – Role of the Government

Regulation in Japan Power resides with Minister of Finance (MOF) and the

Bank of Japan MOF has seven bureaus and the Securities

Bureau controls the securities markets Strong central control – very restrictive on foreign

participation in markets, especially issuing securities

Real Estate Market Crash and Stock Market Plunge – Loosening of Controls and Increase Foreign Participation

Foreign Firms trying to participate in pension fund management, securities underwriting, etc.

Chapter 3 – Role of the Government

Regulation in Germany Strong Banking State

Bundesbank – controlled bond market Eight Regional Stock Markets – Majority of activity and

ownership controlled by banks INTERBANK MARKET CURRENT PRESSURE ON BANKS TO REDUCE

EQUITY POSITIONS

Deutsche Terminborse – Derivatives Market European Central Bank now controls monetary policy

and currency (EURO) European Economic and Monetary Union (1/4/99)

Chapter 3 – Role of the Government

Regulations in the United Kingdom Following Big Bang of mid 80s – UK now has large

commitment to disclosure for regulation Parallel to U.S. in many ways… SIB (Securities Investment Board) and SEC Bank of England and Federal Reserve Bank Financial Services Act of 1986 and Securities Act of

1933 Insider Trading banned in 1985 and extended in 1994

Allows strongest foreign participation in financial Markets – underwriting and listing

Chapter 3 – Role of the Government

Three Reasons for Market Regulation and Reform Financial Crisis

SOX Meltdown of 2008

Innovation Keeping a level playing field Foreign Competition – Flow of business out

Globalization Technologies have “shrunk” the world

Chapter 3 – Role of the Government

Question 2 “The Securities and Exchange Commission

ensures that securities issued in the United States are not risky and therefore are acceptable investments for the general public”

Agree or Disagree? Disagree – The SEC sets standards for

disclosure and approval of sale implies that sufficient information has been supplied for investors to reach their own conclusions on the risk level of the equity offering

Chapter 3 – Role of the Government

Question 3 Why do countries regulate their money

supply? Control Economic Activity

This activity is viewed as the main instrument of the government to control economic activity

The regulation of money supply impacts the ability (supply) to borrow and thus can “stimulate” or “slow-down” business investment activity

The control of economic activity indirectly impacts inflation and deflation

Chapter 3 – Role of the Government

Question 5 Identify two key elements in the United

Kingdom’s Big Bang of the mid-1980s? First Element – Movement to Disclosure

Regulation Prior to this point in time disclosure regulation

was minimal – insider trading prominent and accepted

Second Element – Open up financial markets to foreign investment firms

Underwriting and Listing