Objectives of regulation
The ultimate objectives of regulation need to be narrowly defined:
• Promotion of financial stability.
• Promotion of fair and healthy competition.
• Promotion of consumer protection.
The first two objectives may be rolled together under the heading "high degree of economic efficiency"
Promotion of financial stability
"Financial stability" is usually seen as having two elements, i.e. price stability and stable conditions in the financial system. A central bank defines these two elements as follows39:
"Price stability is achieved when changes in the general price level do not materially affect the economic decision-making processes. Although relative price movements will still have an impact on production, consumption, saving and investment, the rate of inflation or deflation would be so low that it would no longer be an important factor in economic decision making."
"Stable conditions in the financial sector are achieved when there is a high degree of confidence that the financial institutions and financial markets are able to meet contractual obligations without interruption or recourse to outside assistance. Such stable conditions do not preclude the failure of individual financial institutions. A financial institution can fail and be allowed to fail even under stable financial conditions. It is only when the whole, or an important part, of the financial sector is at risk, that the situation can be described as financially unstable"
These two elements of financial stability are interrelated. It will be evident that financial regulation pertains to the second element, i.e. stability of the financial sector (or "promotion of financial stability", as the heading of this section states). This objective may be split into two categories:
• Systemic stability.
• Institutional safety and soundness.
Systemic stability means that the financial system is not compromised in any way, i.e. that the financial system is not subjected to shocks caused by the participants themselves through reckless trading, poor market infrastructure and inefficient clearing and settlement systems, lack of market liquidity, inefficient payments system and ineffective security delivery system (the latter is also called "delivery versus payment").
Institutional safety and soundness is closely related to the aforementioned and means that the authorities have to ensure that the intermediaries that make up the financial system are profitable, have sufficient capital to cover risk exposures, are competitive internationally, and are driven by "fit and proper" management and directors. Promotion of institutional safety and soundness also means that the regulator should not impose regulatory hurdles that would impair their safety.
Promotion of fair and healthy competition
A major objective of the regulator is the promotion of fair and healthy competition in the financial system. This ensures competitiveness internationally, and fair pricing for the consumers of financial products. Healthy competition and fair pricing also aids in the efficient allocation of financial capital.
Another important dimension here is the effectiveness of monetary policy. Monetary policy can only be effective in an environment of intense competition amongst financial intermediaries, and this applies particularly to the banks.
Promotion of consumer protection
A crucial objective of the regulator is to protect the consumer against the failure of intermediaries and against fraud. Fraud may take many forms, such as manipulation of share prices, concealment of crucial information from the investor / depositor, the sale of inappropriate policies (just to "earn" the commission), insider trading, and the misuse or plain stealing of the investor's funds. With the exception of the latter, these methods of fraud are possible because of the problem of "asymmetric information".
The job of the regulatory authorities in this regard is to promote integrity, transparency and disclosure of information of participants' firms and products. For this reason much emphasis is placed on the integrity of directors and managers of suppliers of financial products, as well as the agents for these products. Proper education of the suppliers and consumers is part of the job of the regulator.