Is Corporate Regulation Protecting Consumers or Making Life Harder?

 

15 July 2011.

As far back as the Middle Ages, history provides plenty of lessons on the effects of the failure of financial institutions, of consumer ignorance being exploited through the sale of inappropriate securities, pension plans, and mortgages, and of high and opaque charges for financial products and services. Arguably, regulation has become imperative today, given the increasingly transnational nature of financial markets.

 

 

15 July 2011.

As far back as the Middle Ages, history provides plenty of lessons on the effects of the failure of financial institutions, of consumer ignorance being exploited through the sale of inappropriate securities, pension plans, and mortgages, and of high and opaque charges for financial products and services. Arguably, regulation has become imperative today, given the increasingly transnational nature of financial markets.

Another factor is the growth of large multinational organizations, now possibly more powerful than some nations. They pose particular risk and regulatory problems because they can both create and manage risks, sometimes on a global scale. Crises can have catastrophic effects nationally and internationally. Anticipating risks and organizing for their control have thus become an integral part of risk regulation regimes, which aim to influence the risk management practices of organizations. Their objectives are to make sure that organizations give high priority to risk management, to shape motives and preferences, and to influence organizations’ objectives and practices accordingly.

So what’s the downside of corporate regulation?

Organizational Risks

The capacities of financial organizations to identify and manage risks vary according to many factors. Financial organizations are often reliant on risk modeling, which itself relies on the availability of good quality data. But the past is not always a good predictor of the future (particularly where data are drawn from a period of benign economic conditions), and data may be incomplete, poorly collated, and historically limited. Moreover, staff will vary in their ability to interpret these data.

Organizations need to be open to identifying new risks and understanding that circumstances and personnel change, and these may well change the risks an organization faces. Stress testing—assessing the potential impact of alternative scenarios—can usefully supplement risk modeling by introducing risks that may not be evident from past data. Organizations tend to run these stress tests by assuming that the shocks are specific to them rather than systemwide, and they find it difficult to translate the results into positive action. They may fail to recognize that specific shocks can generate contagion and other externalities. These are some of the lessons of 2007, when liquidity dried up across the financial system.

[quote]Risk modeling had been undertaken in a period of economic optimism and firms overestimated their ability to identify and control the risks associated with the innovative new products they were developing. [/quote]

The enforcement of regulation is crucial, but the tensions and ambiguities surrounding regulation are often reflected in the sanctioning system, where most fines are smaller than the profits made by breaching the regulations, which therefore may not constitute a deterrent to risk-taking. The main deterrent may be the stigma attaching to being caught and sanctioned, but the evidence that these have any significant effect is contradictory.

The Financial Services and Markets Act 2000 brought about a major reorganization of regulation in the United Kingdom. It exemplifies many of the key reasons for regulating financial organizations. For example:

• It was a reaction to regulatory problems caused by crises that suggested an apparent inability of current regulatory regimes to cope.
• It aimed to simplify a diverse, complex, and fragmented regulatory system that had evolved piecemeal over time and was inefficient and costly. The Act amalgamated nine regulatory agencies, which employed over 2,000 staff and regulated many thousand authorized firms and registered individuals, into one organization, the Financial Services Authority.
• It responded to changes in the regulatory environment, namely a changing industry and a “global” world.
• Financial services are important to the economy, and the Act was designed to maintain confidence in this sector. 
• In addition to improving consumer protection, the new regulator was mandated to raise the financial capability of the consumer by requiring the consumer to be given more information.

Boards and senior management need to set out clear risk policies and fully integrate those policies in the controls and culture of the organization. Secondly, it’s important to take a wider view of risk management and embrace alternative scenarios and be able to take responsibility for the risks these poes.

 

What are the challenges for authorities? Have your say below.

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