Objectives of Market Regulation

The objectives of market regulation are to control fraud, control agency problems, promote fairness, set mutually beneficial standards, prevent undercapitalized financial firms from making excessively risky investments, and ensure that long-term liabilities are funded.

1. Control Fraud: Market regulators put systems in place to prevent fraud as financial customers aren’t always sophisticated enough to do so themselves.
2. Control Agency Problems: Regulators solve agency problems by setting minimum standards of competence for agents like the CFA or GIPS.
3. Promote Fairness: Regulators aim to reduce profits that insiders could extract from the markets. Laws against insider trading, for instance, help to level the playing field.
4. Set Mutually Beneficial Standards: Regulators help analysts easily compare companies by requiring compliance with accounting standards set by IASB, FASB, and others.
5. Prevent Excessive Risk: Regulators require financial firms to maintain minimum levels of capital so that the firms honor their commitments and so that the firm’s owners have some “skin in the game.”
6. Ensure Liabilities are Funded: Regulators watch over insurance companies and pension funds to ensure adequate reserves are maintained to cover liabilities because managers of these entities tend to underestimate long-term liabilities, especially when there is an incentive not to do so.

Question

As a market becomes more regulated, what would probably become more common?

1. The collapse of financial firms.
2. Insiders with an edge over other market participants.
3. Conservative liability estimates by insurance companies and pension funds.

Solution

The correct answer is C.

Regulation in the financial industry strives to create fairness and reduce the advantages enjoyed by insiders over regular investors. It plays a crucial role in preventing excessive risks that can lead to financial firms going bankrupt. Additionally, unregulated insurance companies and pension funds tend to use aggressive estimates to maximize their reported profits. When regulated, these entities are encouraged to adopt more conservative estimates, promoting financial stability and transparency in the industry.

A is incorrect. Increased regulation generally aims to enhance the stability and transparency of financial markets, reducing the likelihood of collapses by imposing stricter standards and oversight.

B is incorrect. Regulations are typically designed to prevent insider trading and level the playing field. Increased regulation often includes measures to reduce the advantages of insiders and improve market fairness. Thus, the occurrence of insiders having an edge over other participants should decrease.