Why does the financial industry need to be regulated - Research Paper Example

?Financial Regulation Who is considered part of the financial industry? Financial industry defined by a set of markets, instruments and financial intermediaries whose goal is to ensure the mobilization and efficient allocation of available savings to finance private and public needs while protecting capital investments under risk conditions, plays a fundamental role in any modern economy (Corduneanu). A sound financial industry primarily involves deep, efficient markets, solvent, operational financial intermediaries and a legal framework that clearly defines the rights and obligations of all participants. Financial markets are the core of any financial system architecture, holding a central position as they are a real catalyst for the overall economic activity. Depending on country-specific factors, culture and historical traditions, but also on the globalization of markets, national financial systems have both special features and common elements. Academic literature provides a classification of financial systems as follows: Bank-dominated financial systems (the German-Japanese model); Capital-market dominated financial systems (the Anglo-American model). If analyzing the characteristics of the financial systems over the past 30 years, we note the shift from the traditional bank-based orientation towards capital markets. Crucial elements of this change are monetary and financial integration processes and financial innovation. As part of financial industry, the US financial companies enhance money flows by offering various services in different areas: accounting, bank and credit unions, consultancy, insurance agencies, investment banking, professional services, security brokers, venture capital. With combined annual revenue of almost $65 billion, the US accounting and fiscal industry sums more than 90,000 companies (Richardson). The leading players providing accounting services include Price Water House Coopers, Deloitte Touche Tohmatsu, Ernst & Young, KPMG and H&R Block. The same recent statistical data reveal the structure of the US banking system shaped by 8,000 commercial banks, 1,400 savings banks and 10,000 credit unions with combined annual revenue of $600 billion. Bank of America, JPMorgan Chase, Citibank, and Wachovia are the most powerful commercial banks. The US banking market is highly concentrated, 50 largest institutions spreading more than 60% of the financial industry. The credit union environment displays a fragmented anatomy with 6% of industry revenue, much lower than commercial banks percentage (80%) and closer to savings banks, with a share of 14%. Financial planning and consultancy services shape an industry with annual revenue of $15 billion split between 10,000 US firms. Morningstar, Value Line and units of financial services companies are in the top. In the field of insurance services, the 130,000 US units generate annual revenue of $85 billion, having as market leaders March & McLennan, Arthur J. Gallagher and Aon. Investment banking is served by 2000 companies with annual revenue of almost $110 billion, with the largest 50 firms holding 90% of the sector. Morgan Stanley and Goldman Sachs are the key competitors. The securities brokerage industry includes less than 4000 bodies, while the major players in investment companies are Merrill Lynch, Charles Schwab, AG Edwards, and brokerage companies like Citigroup and Fidelity. Venture capital industry generates annual revenue of about $26 billion and has more than $250 billion under management. The most important companies include New Enterprise Associates, Kleiner Perkins Caufield and Byers, and Technology Crossover Ventures. Why does the financial industry need to be regulated? The empirical literature (Goodhart et al.) and practical experience point out three main reasons that justify government intervention in the financial industry: 1). Information asymmetry: unlike financial institutions, customers are much less informed, so that financial supervision aims to balance the situation; 2). Externalities: the collapse of an institution can affect the whole system. In this context, financial supervision strengthens financial stability and limits the effects of systemic falls; 3). Market power: some entities or financial infrastructures and payment systems, can exert undue influence on the market. Competition policy aims to protect consumers from monopolistic exploitation. In order to understand state intervention in the area of securities trading, market participants have to be familiar with the objectives of the authorities: Fraud prevention by introducing the incumbency of presenting correct and sufficient information about the issuer; To promote competitive spirit and fairness when trading; To enhance the stability of various specialized institutions involved in the circulation of securities; Limitation of foreign operators access on domestic markets; Ongoing control of the national economy. Often, the state creates regulations to achieve the above mentioned goals. National authorities intervene in rules implementation through specialized public institutions or private structures, state-mandated to monitor the process. The US places in the first category, alongside most of the European countries, while the United Kingdom for example, comes in the second. There are three main reasons that justify financial regulation: 1. It provides a safety net to prevent bankruptcy of banks, insurers or investment managers, that could mean losses for other market participants too; 2. It ensures the integrity of financial institutions and protects individual investors; 3. Acts like a watch dog of financial services, warning about potential trading of confidential information, malpractice and other financial crimes. Nowadays, both markets and operators are governed by a complex system of rules with the main scope of protecting investors. Given the increasing number of market participants, the regulation becomes more difficult and complex. As investors, intermediaries and even exchanges look to explore opportunities beyond national borders regulatory bodies should be prepared for cross-border actions. Globalization of markets and, through the latest techniques, of investors, asks for a proper regulation system, capable to face new financial realities. Financial crisis of 2007 has brought to the light the problems of capital market less regulated and controlled sectors such as mortgage market, asset-backed securities market or derivatives market. There is a whole plethora of causes with a regulatory-linked nature that contributed to the unfolding of the US crisis of 2007: Process of deregulation of the financial institutions; Application of the free/perfect market model; Inadequate management of systemic risk; Inexistence of macro-prudential supervision; Deficiencies of prudential regulations on bank capital and liquidity. Government intervention to support the banking system has raised the issue of free competition between banks and other financial institutions, including insurance bodies. In the US but not only-the UK, Belgium, Netherlands, insurers were deemed eligible to receive financial support and state guarantees, which translates into a violation of the spirit of free competition. The financial turmoil has shown that for systemically important financial institutions (SIFIs), self-regulation is just not enough. Strong attention given to micro-prudential supervision and the absence of aggregate risks evaluations is a very inefficient combination. As financial stability is an essential part of public interest, one of the main goals of the US authorities should be to regulate, supervise and monitor financial markets and SIFIs activity. Correlated with the implementation of free market model, financial deregulation also has its role in unleashing the US turmoil. Having in mind this idea, the former Federal Reserve governor, Alan Greenspan, has declared that he made a huge mistake assuming financial players could self-regulate. Thus, two main questions arise… Should financial regulation be strengthened? Should there be a return to guardian-state or to Keynes state interventionism theory? A mix of capitalism principles ongoing application, and an improved macro-prudential surveillance of financial industry players with a high potential of carrying systemic risks appears as one of the best fitted solutions. Brief history of the US financial industry regulations in the aftermath of the crisis Under crisis conditions, there is a strong need to rethink and reform the US financial system by introducing new instruments to measure and assess financial risk and to exercise greater control of investment funds, pension funds, life insurance funds or mortgages, inter alia. Thus, in 2008, the US responsible authorities decided some regulatory changes to arrest the panic followed by a few pieces of legislation (already implemented), as presented below: Housing and Economic Recovery Act (HERA) was adopted on July 25, 2008 to allow Federal Housing Administration to guarantee mortgage portfolios of various financial institutions implying a cost of $300 billion. It has also established the mortgage authority- Federal Housing Finance Agency that supervised Fanny Mae and Freddie Mac (holders of more than half of the US mortgage market); Economic Stimulus Act (ESA), adopted by the US Congress on February 13, 2008 to manage the implications of the financial crisis by cutting taxes for middle and low income people, supporting business investments and mortgage sector (a $152 initial budget has been approved to save Fanny Mae and Freddie Mac). Emergency Economic Stabilization Act of 2008 (EESA) known as the bailout of the US financial system, it authorized the US Secretary of Treasury to spend up to $700 billion to purchase distressed, mainly mortgage-backed securities. This document has offered significant government funds to a number of U.S. banks or foreign banks US branches (American Express received funds under the EESA being subsequently taken over by Standard Chartered Bank for $ 1.1 billion). Troubled Assets Relief Program of 200 (TARP) is a supportive platform created based on Emergency Economic Stabilization Act. Under this program, a number of US leading banks have accepted share investments of the Treasury: Goldman Sachs Group Inc., Morgan Stanley, JP Morgan Chase & Co., Bank of America Corp. (including Merrill Lynch), Citigroup Inc., Wells Fargo & Co.., Bank of New York Mellon Corp. and State Street. Bank of New York Mellon is the custodian for the shares issued by the above-mentioned banks. The initiative is based on a similar project launched during the Great Depression in the 30's, when the fund Reconstruction Finance Corporation helped in the same way 6000 banks for a total sum of 1, 3 billion USD (equivalent to 200 billion dollars today). According to more or less official sources such as CNN and Financial Times the $ 700 billion amount provided has been broken as follows: a) $168 billion covered different fund transfers to 116 banks in the US; b) $82 billion was used to capitalize on various banks; c) 40 billion dollars preferred shares purchase from American International Group so that the company could repay its loan originally received from the Federal Reserve; d) 20 billion dollars covered claimed losses under a program of the Federal Reserve Bank of New York aimed at providing funds to solve problems caused by asset-backed securities and mortgages; e) 50 billion dollars were placed at Citigroup; f) $13, 4 billion was used for GM and Chrysler. American Recovery and Reinvestment Act of 2009(ARRA) had as main objective the saving and rapid creation of jobs. It provided temporary relief programs to the most affected structures and supported investments in health, education infrastructure and green energy. The cost of the stimulus package was estimated at $787 billion, later revised to $831 billion between 2009 and 2019 (US Government). Dodd–Frank Wall Street Reform and Consumer Protection Act (2010). Financial regulation of the US agricultural commodity markets had proved its efficiency, although it has been adversely impacted by changes of market liberalization in the '90s. The signing by President Obama of "Dodd Frank Wall Street Reform" and the Consumer Protection Law of 21 July 2010 led to a significant strengthening of the regulatory framework in the field. Transparency requirements were the cornerstone of the law which stated that the limit positions have to be updated and applied to all markets of the same product. Having the Dodd Frank law active, the US enjoys a great advantage in terms of defining and implementing a new global financial regulatory framework. Current securities market regulatory boards The US financial market is regulated by two government bodies: the Securities and Exchange Commission (SEC) and the Commodity Futures Trading Commission (CFTC), with similar objective, namely to ensure the smooth functioning of the market and to prevent fraud and other financial abuses. Neither structure has complete authority to enforce all rules, as self-regulatory organizations-SROs (such as brokerage firms) have their role in assuring all participants’ proper behavior. Also, exchanges create own regulatory entities tasked with rules enforcement. FIRNA-Financial Industry Regulatory Authority (formerly the National Association of Securities Dealers) is the largest non-governmental independent regulatory agency for all securities companies operating in the US, with a primary objective of protecting capital market investors. The US SROs ensure that its members comply with the national securities legislation, under a jurisdiction comprising licensed individuals and companies within the membership area. Thus, investors, issuers and corporate officers do not fall under SRO umbrella. The US, among many other countries like the UK or Canada, considers central securities depositories (CSDs) as a form of SRO, as they offer vital market infrastructure services. CSDs are key players in setting standards and managing risks in the securities market. Although small regulators in the field of rules administration for profile industry participants, their space of action is limited to the use of clearing and settlement services. There are very few “pure SROs”, such as FINRA in the US and IIROC in Canada. In most cases, their single role is to regulate, function that clearly separates an independent SRO from an exchange SRO. Financial associations that act as both independent SROs and lobbying groups for their members (operating certain markets, such as OTC) are treated as hybrid entities (Carson). Table 1: Regulatory structures of the US securities market Regulated market Authority Market features and role of regulators Stock and corporate bond market The U.S. Securities and Exchange Commission (SEC) Financial Industry Regulatory Authority (FINRA) Most prominent markets with a large number or relatively small issuers, very active and visible regulated. SEC ensures efficient functioning of these markets. FINRA regulates more than 4,400 brokerage firms and over 161,450 branches with 630,000 employees. Treasury bond market Treasury Department’s Bureau of the Public Debt Issued by the US government the market is regulated by Treasury Department’s Bureau of the Public Debt and supervised by SEC. Derivatives market Commodity Futures Trading Commission (CFTC) National Futures Association (NFA) The market has its own regulatory bodies, with a similar structure as in the case of stock and bond markets. CFTC oversees market activities in agricultural and financial commodities, ensuring their liquidity and smooth functioning. NFA regulates 4,200 companies and has 55,000 employees working on different futures exchanges. Foreign exchange market Options and futures on currency Banks and oversight CFTC, the NFA, and the relevant futures exchanges Federal Reserve Banks and the U.S. Treasury Department The largest and most liquid in the world, not well regulated. Spot transactions are overwhelming and not regulated. Options and futures, treated as derivatives, are subject to regulation of CFTC, NFA or other futures exchanges. Banks are heavily involved in forex trading, being strongly regulated. FED banks and the Treasury pay close attention to these markets, in search for evidence of manipulation and money laundering. Source: authorial calculation after Steel et al. “Blueprint for a modernized financial regulatory structure.” The Department of the Treasury, March 2008 Several major US alternative trading systems (ATSs) have registered with the SEC as national securities exchanges with the aim of gaining significant advantages. An exchange is tasked with SROs duties and either discharges them directly, or contacts an SRO to perform its regulatory attributes. The outsourcing of various regulation functions to FINRA has raised the magnetism of registering as an exchange. The American regulatory system displays a complicated structure with two regulatory bodies, SEC and CFTC and various SROs (both exchanges and independent SROs). This translates into significant duplication and overlap, as many companies subject to regulation fall under the jurisdiction of multiple SROs. Thus, there is a strong need to rearrange the configuration of the system in order to benefit all market participants. Table 2: Models of self-regulation Model Country Limited Exchange SRO Model US (NYSE), Hong Kong SAR, China (HKEx), Singapore (SGX) Sweden (Nasdaq OMX Stockholm) Strong Exchange SRO Model US (CME), Australia (ASX)15; Japan (TSE, and Osaka Securities Exchange, or OSE); Malaysia (Bursa Malaysia) Independent Member SRO Model US (FINRA and the National Futures Association, or NFA), Canada (IIROC16 and the Mutual Fund Dealers Association, or MFDA), Japan (JSDA), South Korea (KOFIA), Colombia (AMV) Source: authorial calculation after Carson, J. „Self-Regulation in Securities Market” Policy Research Working Paper 5542, World Bank, January 2011 In the case of a limited exchange SRO model, a public body is the main regulator, relying on exchanges to fulfill specific regulatory function related to market operations (such as listing or market supervision). In the US, NYSE is the typical example. Similar to the aforementioned model, a strong exchange SRO model also includes a public authority as primary regulator. Exchanges (Chicago Mercantile Exchange in the US) have regulatory attributions that go beyond their market operations and include, inter alia, the regulation of business conduct. The independent member SRO model also implies a primary regulator in the form of a public structure. In this case, an independent SRO (a member organization, but not a market player) performs complex regulatory services. In the US, this is the role of FINRA or NFA. After analyzing several models of self-regulation, we note that the NYSE scheme of retaining responsibility in the case of trading regulation on its own market (ex post transferring member regulation to FINRA) is the model that prevails in Australasia. In the US, FINRA regulates all NYSE members. In the last decade, the consolidation trend of markets and SROs, issues regarding interest conflicts and questions raised by the SEC, have reshaped the self-regulatory system. Although the US is often seen as a reference example of strong self-regulation, the national model is no standard approach to be applied by all countries that rely on SROs. There are many reasons that support the idea, such as: Non-voluntary self-regulation nature; a recognized SRO membership is required for all broker-dealers; The existence of well-defined separate regulatory bodies for securities and future markets (the SEC and CFTC); Multiple SRO’s mean fragmented system, with companies subject to regulation of different SRO’s; The US market hosts both independent SRO’s and exchange SRO’s; Exchanges preference to transfer regulatory functions to independent SRO’s rather than to government bodies. In 2010, NYSE decided to outsource market regulation operations to FINRA. Subsequently, Nasdaq applied the same strategy in order to solve conflicts of interest. The exchanges are not responsible for the regulation of their members. FINRA has the following attributions: a) To regulate the business conduct, financial compliance and enforcement; b) Financial examination of all members; c) Mediation functions, role in investor arbitration; d) To train, test and license registered representatives; e) To offer regulation services to Nasdaq and other exchanges, for example the International Securities Exchange. The US self-regulatory structures have been defined as a peculiar mix of private sector self-regulation and delegated governmental regulation (Karmel). This combination is the result of three elements: 1) limited independence from the SEC, 2) mandatory nature of SRO membership, 3) acting in the certain fields, as stated by the SEC. The US industry mirrors the critical points of a system structure with two independent SROs (FINRA and NFA) and various exchange SROs. The American efforts to simplify this architecture have materialized in the creation of FINRA as a result of the merger of NASD and NYSE’s member regulation departments. Also, mergers between exchanges have lowered the number of SROs and duplication of SRO’ actions. Moreover, outsourcing of regulation to significant independent SRO’s like FINRA and NFA limited the scope of some exchanges functions. What is required to get your general securities license in the state or Colorado? The Series 7 license is the general securities representative license that provides the possibility to be a representative or broker, of FIRNA. This license allows an individual to take and place orders for a customer and it is a prerequisite for many other FIRNA exams (the Series 24, for example). In order to take the exam, the candidate must be sponsored by an eligible company in the financial industry that has to fill the Uniform Application for Securities Industry Registration or Transfer (U4) to register he/she for obtaining the Series 7 license. The examination for obtaining this license is based on 260 questions mainly about equity and debt instruments, options matrix and industry regulations, customer account handling, investment risk, retirement plans, break even points, spreads. A passing grade is conditioned by correct answers summing 70% of the complete questions set with a time span of 6 hours. A positive result allows the candidate to trade annuities, mutual funds, stocks and options. The purpose of the test is to assess the individual’s ability to operate as a Registered Representative (RR). Series 7 is the broadest of all licenses available to specialists in the investment industry, allowing individuals to assist their clients with a large array of transactions involving stocks, bonds, options, limited partnership and other complex financial products or services. As the base of the pyramid that supports further sophisticated specializations it is vital that licensees prove continued financial education, keeping up with significant industry trends that may impact future trading of their clients. One of the most important features of the Series 7 is that it doesn’t expire, unlike other industry licenses. Dodd Frank Act. Content and implication on the finance industry By creating Dodd-Frank law, US authorities are trying to prevent another crisis like the one in 2008, which plunged the country into recession, extended beyond borders and created chaos in the entire financial world. The original text of the Act contained such strict provisions that some described it as tantamount to crafting a Glass-Steagall for the 21 century, in other words, a complete separation of banking, investment banking and insurance activities (Fernandez). The main objectives of the new text are to enhance financial stability of the US market based on a higher level of accountability and transparency, to end “too big to fail” myth, to protect national taxpayers by ceasing bailouts and consumers from abusive financial services practices. On 21 July 2010, the US Dodd-Frank Wall Street Reform and Consumer Protection entered into force and introduced, inter alia, consolidated supervisory rules and a special set of features for systemically important financial institutions, the prevention of proprietary trading, investments in selected funds as well as certain types of banks derivatives operations, and tighter regulation of the securitization process, over-the-counter derivatives trading, credit rating agencies and hedge fund managers (Bankenverband). Dodd-Frank piece of legislation named after its two main authors, Senator Chris Dodd and Deputy Barney Frank also includes the establishment of new programs, boards and offices that will be integrated into existing regulatory structure. Among the new authorities we mention the Financial Stability Oversight Council, tasked with identifying risky practices that would endanger the economy, Consumers Financial Protection Bureau, which will operate under the authority of the Federal Reserve and will monitor the credit market and other financial services, Savings Supervision Bureau or Federal Bureau of Insurance as part of the Treasury Department with a close eye on the insurance industry. The creation of so many new structures could be seen by Dodd-Franck critics as a failure to streamline the complex US supervisory architecture. Federal Reserve will become the regulatory authority in the field of systemic risk and the supervisory body of the most important financial institutions (too big to fail). Dodd-Franck Act has expanded the role of CFTC, the federal regulatory body of derivatives markets, and the SEC. This law offers an alternative to financial institutions state rescue as regulatory bodies will identify and act in the case of any potential financial collapse. They would intervene and reduce the size of these companies without affecting the entire financial system. Also, regulatory authorities will determine the size and capital reserves hold by large non-banking financial institutions. Table 3: Major reforms in the Dodd-Frank Act Systemic risk regulation Securitization-Credit Risk Retention Financial Stability Oversight Council Financial Stability Oversight Council Office of Financial Research Elimination of the OTS Enhance Prudential Standards Deposit Insurance Reforms Living Wills Enhanced Regulation of Banking Entities Orderly Liquidation Authority Payment, Clearing and Settlement Systems Volker Rule Consumer Financial Protection Swaps Pushout rule Restrictions on Emergency Stabilization Bank Capital (Collins Amendment) Federal Reserve Governance Derivatives Pay it Back Act Hedge Funds Insurance Investor Protection International Sovereign Assistance Enhanced Regulation of Securities Markets Mortgage Market Reforms Credit Ratings Agencies Source: Guinn, R., Polk, D., “The Financial Panic of 2008 and Financial Regulatory Reform”, The Harvard Law School Forum on Corporate Governance and Financial Regulation, 2010 Many researchers and practitioners have considered derivatives, especially CDS, as the instrument responsible for the near collapse of the US financial industry. Still, there is no general consensus on the role of derivatives in the unfolding of the subprime crisis, so opinions do, however, vary. Based on that, Dodd-Frank act provides special attention to the field and is expected to have a mixed impact on derivatives operations of leading US banking institutions. Under the 716 Section of the law (the Pushout Rule), no advances from the FED discount window or any other credit facility are allowed. It is too early to identify the net effects of the Act on banks business derivatives, capital and margin requirements and regulatory limit positions. However, only banks that are swap dealers or security-based swap dealers may be considered swap entities subject to the Pushout Rule (only 75 of more than 8,000 US banks, according to ISDA). In January 2011, this handful of banking institutions included: 25 global banks with headquarters in the US; 25 non-US banks engaged in important derivatives trading in the US; 25 national banks. US Dodd-Frank Wall Street Reform and Consumer Protection Act provide both mechanisms regulators could use to divide large financial companies and significant restrictions. According to Richard Fisher, governor of Dallas Federal Reserve, Dodd-Frank reform goal was to reduce the concentration of power. After the crisis, banks have become too big to fail. He also expressed his opinion that the five US leading banks, namely JPMorgan, Goldman Sachs, Morgan Stanley, Bank of America and Citigroup, are too powerful and should be divided. The law includes, primarily, the protection of taxpayers and then banks, investors and lending agencies, controls the influence of large banks and aims to eliminate fraudulent practices of credit card companies. FED GAO audit report-mandated by the Dodd-Frank Wall Street Reform and Consumer Protection has found that between 2007 and 2009, FED managed 16.000 billion dollars, half of the secret funds, to the benefit of US leading banks. With this money, the US national debt of "only" 15.000 billion dollars could have been repaid. As every project, the Dodd-Frank Act has its critics, who argue that the financial sector reform violates the principle of the free movement of capital. In 2008, the US and the entire financial worlds experienced chaos. America struggled to stabilize the financial system by applying emergency measures. This powerful financial stress and the US reply has redesigned the parameters of financial regulation. The Dodd-Frank legislation is the most important revision of US regulatory requirements since 1930’, although it hasn’t solved all major issues. References 1. Bankenverband. US Financial Market regulation, International Affairs, 2012. Web. 5 April 2012 2. Carson, John. „Self-Regulation in Securities Market.” Policy Research Working Paper 5542, World Bank, Jan. 2011 Web 5 April 2012 3. Corduneanu, Carmen. Capital markets. Theory and practice. Timisoara: Mirton Publishing House, 2006. Print 4. Fernadez, Orlando. „The Dodd-Frank Act’s Pushout Role: Implications for the Derivatives Market”, Practical Law Company, 13 Jan. 2011. Web 7 April 2012 5. Goodhart, Charles. et al. Financial Regulation: Why, How and Where Now?, London: Routledge, 1998. Print 6. Guinn, Randall and Davis Polk. “The Financial Panic of 2008 and Financial Regulatory Reform”, Harvard Law School Forum on Corporate Governance and Financial Regulation, 2010. Web. 5 April 2012 7. International Swap and Derivatives Association. The Dodd-Frank Act and the Proposed EU Regulation on OTC Derivatives-Impact on Asian Institutions. Clifford Chance, Dec. 2010. Web. 7 April 2012 8. Karmel, Roberta S. “Should Securities Industry Self-Regulatory Organizations Be Considered Government Agencies?.” Brooklyn Law School, Legal Studies Paper 86, , Brooklyn, NY. 2008. Web. 4 April 2012 9. The US Government. One hundred eleventh Congress of the United States of America. Washington DC. 6 Jan. 2009 10. Richardson, Ray. „Major players in the US Financial Industry.” 2012. Web. 4 Aprilie 2012 11. Steel, Robert, Paulson, Henry and David Nason. “Blueprint for a modernized financial regulatory structure.” The Department of the Treasury, March 2008. Web. 7 April 2012 Read More