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 to ensure that long-term liabilities are funded.
- Control Fraud: market regulators put systems in place to prevent fraud as financial customers aren’t always sophisticated enough to do so themselves.
- Control Agency Problems: regulators solve agency problems by setting minimum standards of competence for agents like the CFA or GIPS.
- 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.
- Set Mutually Beneficial Standards: regulators help analysts easily compare companies by requiring compliance with accounting standards set by IASB, FASB, and others.
- 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.”
- 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.
As a market becomes more regulated, what would probably become more common?
A. The collapse of financial firms
B. Conservative liability estimates by insurance companies and pension funds
C. Insiders with an edge over other market participants
The correct answer is B.
Regulation should promote fairness and therefore reduce the advantage that insiders have over less sophisticated investors. Also, by preventing excessive risks, financial firms should have a higher margin of error and thus be less likely to become insolvent. Since unregulated insurance companies and pension funds have a tendency to utilize aggressive liability estimates (usually in order to maximize reported profit), more regulation would probably encourage these entities to become more conservative in their estimates.
Reading 36 LOS 36l:
Describe objectives of market regulation