Potential Approaches to the Development of Institutional Structures

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Introduction

The UK’s HM Treasury, in its document ‘A new approach to financial regulation: judgment, focus and stability’, has proposed altering the institutional structure of financial regulation in the UK.The following essay examines the different potential approaches to the development of institutional structures of financial regulation in the United Kingdom. The essay also critically discusses the different potential approaches to the development of institutional structures of financial regulation, assessing both their advantages and disadvantages.

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Institutional structures entail the agencies that are concerned with regulating and supervising the financial institutions such as the commercial banks and central banks. The central bank is therefore one of the institutional strictures and has the role of ensuring that the economic systems are stable. The central bank thus plays a crucial role in determining the institutional structure in any country and there have been concerns over the past few years on whether the central bank should be the single agency of regulating and supervising the financial system. In 1997, The UK decided to do away with the excess supervisory and regulatory agencies and the responsibility was vested with the Financial Services Authority (MacNeil, & O’Brien, 2010, 62).

The main advantages of regulation are to ensure that the financial system is stable, to enhance safety of the financial istitutions, to protect the consumers and investors and to maintain consumer confidence with regards to the financial system. There are four different potential approaches to the development of institutional structures of financial regulation which includes the institutional approach, the functional approach, the integrated approach and the twin peaks approach (Acharya, et al., 2010, 75)

The functional approach

The functional approach with regards to financial supervision entails the supervisory oversight that is characterized with the establishment of only one agency. The functional approach resulted as a result of such factors as technological innovation which saw the financial markets performing the very roles of the banks, the emergence of financial derivatives e.g. options and contracts and the financial innovations which have enhanced competition in the financial markets. This approach thus applies the prudential measures on banks and other financial institutions. Under the functional approach, all the financial institutions have their own regulator which ensures that the businesses are conducted in a safe and sound manner. The functional approach is common in such countries s Spain, France and Italy (Llewellyn, 1999, 38).

Advantages of functional approach to financial regulation

The presence of many financial institutions is ideal as far as the financial system is concerned. In functional approach, similar rules are applied by the regulator to all the business entities and this helps to enhance consistency. The application of same rules to the entire financial institutions is advantageous since it helps to abolish the regulatory arbitrages and thus allow greater regulatory specialization. This implies that with functional approach to financial regulation regulator has the responsibility of overseeing the activities that are carried out by the financial institutions (Global Association of Risk Professionals, 2009, 34-35).

Disadvantages of functional approach to financial regulation

The functional approach is characterized with inconsistency in regulatory positions as it is hard for a particular regulator to determine the kind of activities that falls under his jurisdiction. Usually, functional approach to financial regulation leads to duplication of similar activities among the regulators (Mwenda, 2006, 78).

The functional approach also has interagency challenges and this could cause jurisdictional conflicts between the various regulators. This approach is also difficult to apply as it requires the definition of the main activities of financial system such as lending, risk management e.t.c.Also,this approach requires the establishment of specific regulatory agencies that are responsible for overseeing the financial functions( Kern,2006,19-20).

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The functional approach in financial regulation is disadvantageous due to the fact that it requires the banks and other financial institutions to have many regulators and this is expensive. The presence of many regulators has the effect of duplicating the efforts and this is indeed disadvantageous to the financial institutions. Numerous regulators also lead to inefficiency with regards to communication and much time and effort is wasted as they coordinates and communicates among themselves.

In order to fully address the systematic risks, it is necessary to have at least one regulator who has sufficient information of all the financial institutions. A functional approach to financial regulation lacks regulators who have adequate information relating to all the functions so a particular business entity in order to mitigate the systematic risks (Cox, 2010, 20-22).

The integrated approach

The integrated approach entails the financial supervision in which a common universal regulator is vested with the role of conducting both the conduct of business and prudential regulation for the entire financial service sector. This approach is characterized by presence of only one global regulator that ensures that all the financial institutions operate in a safe and sound business environment. The integrated approach has been common in the past few years. The European Union members have embraced the integrated approach with the United Kingdom announcing the merging of securities and banking regulation to form a joint Financial Services Authority and a single regulator was thus created and vested with the role of enhancing soundness of the financial institutions (Blair, et al., 2009, 21).

Advantages of integrated approach to financial regulation

An integrated approach to financial regulation is beneficial as it helps to improve the financial system supervision and thus helps to enhance global banking.

The integrated approach helps to maximize the economies of scale and this is so especially with staff and skills’ recruitment. Few agencies are characterized with lower institutional costs. An integrated approach helps to enhance efficiency in sharing the resources, support services and information technology systems.

It is an important approach of overcoming the weaknesses that are associated with financial supervision and regulation i.e. this approach is usually reliable in supervising the financial conglomerates (Davies, & Green, 2008, 17).

An integrated approach is necessary since it helps to solve the problems that are associated with ineffective communication among the supervisory bodies. Adopting an integrated approach to financial regulation is necessary since it helps to minimize the regulation gaps by ensuring that only one body is responsible for the control of banks and other financial institutions.

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The integrated approach is beneficial because it has clear cut lines of supervision and regulation and this avoids the confusion over jurisdiction. Integrated approach has streamlined focus and this clarity is essential since it helps to achieve higher- quality supervisory effects (Gray, & Hamilton, 2006, 23).

Adopting an integrated approach to financial supervision is necessary because it facilitates a broad perspective of the supervised business organization. This implies that the business compliance with supervisory and regulatory can be tested.The supervisor thus can view the business entity in a wider perspective and thus make appropriate changes where necessary (Hudson, 2009, 32).

Disadvantages of integrated approach to financial regulation

The integrated approach to financial regulation is ineffective in the case of large market i.e. an integrated approach that supervises and regulates across the entire business organizations has the effect of dividing its workflows so as to be able to manage its business entities.

The integrated approach also has some communication challenges in case of a large market (Benston, 1998, 58).

The twin-peak approach

The twin peaks approach of financial supervision is characterized by lack of separation of the regulatory functions between the two regulators i.e. one regulator is concerned with performing prudential supervision whereas the other one focuses on the conduct of business regulation. For this approach to be beneficial there is need for a memorandum of understanding between the regulators so as to help clarify the roles of each agency.Twin-peaks approach to financial regulation is currently used by Holland and Australia. Other countries such as the United States and France are considering to adopt the twin-peaks approach.(Buckham, Wahl, & Rose, 2010,80).

Advantages of twin-peaks approach to financial regulation

This approach is advantageous in that, each regulator focuses on a particular objective and thus mitigating the systematic risk. The twin-peaks approach of financial regulation usually harnesses the central banks’ capabilities so as to mitigate and reduce the systematic risks. The twin peak approach is therefore more attractive as compared to other approaches such as the integrated approach as the agency is geared with the aim of mitigating the risks (Newton, 1998, 103).

Usually, the twin-peaks approach makes use of the macro prudential tools which plays an important role of containing the systematic risks. Also, the twin-peaks approach is important as it promotes the use of prudential methods that facilitates in internalizing the systematic risks associated with settlement systems (Tarullo, 2008, 86).

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Also, this model helps to protect the investors and consumers and this enhances greater confidence with regards to financial system. The twin peaks approach protects the investors and consumers through the business conduct. The twin-peak approach ensures that there is fairness in business dealings as it emphasizes mostly on transparency and disclosure of information. This model provides the business entities with an environment where they can take risks and thus both the investors and the consumers are becomes aware of the possible failures. The consumers and investors awareness is important since it enables them to decide as to whether or not to enter into a business transaction.

The investors have the benefits of mitigating their risks through such actions as diversification of financial assets and therefore, the awareness of possible business failures enhances market confidence. (Brunnermeier,.et.al. 2009, 53).

The twin-peaks approach to financial regulation uses macro-prudential policies so as to counter the build up that arises from the financial imbalances i.e. it ensures that financial stability is enhanced by addressing the systematic risk sources. The twin-peak approach has the effect of raising the financial intermediation cost and this helps to reduce the amount of credit available to firms and individuals. The macro-prudential policy plays an important role of ensuring that the financial institutions do not collapse as a result of mismanagement. This is important since it helps to avoid the financial crisis and also to enhance the consumers’ and investors’ confidence. (Goodhart. et. al. 1998, 49).

The twin-peak approach is important as it helps to reduce the problem of interagency coordination and thus improving the partnership and coordination between the central government and other local agencies.

The twin- peak approach also plays an important role of ensuring that the incentives that are devised by central banks of mitigating systematic risk are indeed (Bazley, & Haynes, 2007, 32).

Disadvantages of twin-peaks approach to financial regulation

The twin- peaks approach to financial regulation requires three regulators who are responsible for enhancing financial soundness, integrity and protecting the consumers.Usually, the regulatory issues are almost similar for the three regulators and thus duplication of tasks (Institute of Economic Affairs, 2007, 45).

The Institutional approach

With the institutional approach to financial regulation, there are several financial institutions that operate and the approach is founded on a model that does not exist. This approach is currently being used by Hong Kong and it is under stress in the past few years following the modification of the financial services. The institutional approach is concerned with the legal status of a business entity. The legal status has the role of determining the regulator that is responsible of regulating the financial institutions in order to ensure that they operate in a sound and safe environment. (Mills, 2008, 29).

Advantages of the institutional approach to financial regulation

Institutional approach is beneficial since it helps to deal with the regulatory issue. This approach has various regulators who are concerned with regulating particular institutions and this thus implies that all the regulatory issues are effectively dealt with.

The institutional approach to financial regulation is beneficial in that the legal status helps to determine the legality of business activities and this implies that unlawful business practices are not allowed. Also, the regulators have the authority of expending and reinterpreting the scale of acceptable business activities and this implies that businesses entities that have diverse legal status can operate in similar business activities while being regulated by various regulators (Booth, 2003, 96).

Disadvantages of the institutional approach to financial regulation

Institutional approach is usually faced with the problem of interagency coordination i.e. there are disparate regulators who in turn leads to inconsistency when it comes to applying the rules (Morris, 2009, 91).

The institutional approach to financial regulation is also characterized with lack of a common regulator who has adequate information of the entire financial system. This thus implies that adopting the institutional approach does not help in mitigating the systematic risks (Hutter, 2010, 76).

The different regulators in this approach require being experts in various fields in order for the financial institutions to perform various functions. the adoption of this approach is not beneficial because it is hard to determine the competitive neutrality position for instance the banking and insurance has different regulators despite the fact that they sells more or less the same products (Southern Methodist University & Institute of International Banking and Finance, 2000, 78).

The institutional approach to financial regulation may not hold for long. The financial institutions are currently being engaged in diverse financial products as opposed to past when they were involved in only few products. The institutional approach is thus faced with the challenge of inconsistency by various regulators e.g. there are inconsistencies with respect to investor protection laws (Global Association of Risk Professionals, 2009, 34-35).

Conclusion

As a result of the global financial crisis that was experienced in 2008, there have been new measures that have been put in place so as to regulate the financial institutions and one of the measures that have been forwarded is to strengthen the micro-prudential policies. Micro-prudential policies are important since they help to avoid the risk of financial institutions’ failures.

There are four potential approaches to the development of institutional structures of financial regulation i.e. institutional approach, twin-peaks approach, functional approach and integrated approach. The institutional approach is concerned with the legal status of a business entity and it determines the kind of regulator which oversees the regulatory functioning functional approach, each function of the firm is regulated by a different regulator.

The integrated approach is characterized by only one global regulator which ensures that financial institutions operate in a safe and sound manner. The twin-peaks approach is characterized by a single regulator which supervises the financial institutions to ensure that they operates in a safe and sound enviroment.However,each of the four approaches to the development of institutional structures has both advantages and disadvantages.

This therefore implies that there is no one structure that is ideal in regulating the financial system. A perfect structure is hard to adopt implying that different countries use the imperfect approaches. The financial institutions have been characterized by significant changes over the last two decades and therefore the financial regulators are bound to embrace these changes. These changes have enabled consumer and investors’ protection and increased efficiency and effectiveness s of the regulation. The regulation should be aimed at protecting the consumers so as to enhance their welfare.

Reference List

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Hutter, B., 2010. Anticipating Risks and Organising Risk Regulation. Cambridge: Cambridge University Press.

Institute of Economic Affairs., 2007. Economic affairs, Volume 7. LondonLongman in association with the Institute of Economic Affairs.

Kern, A. 2006., Global Governance of financial systems: the international regulation of systemic risk. Oxford: Oxford University Press.

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Tarullo, D., 2008. Banking on Basel: The Future of International Financial Regulation. Washington DC: The Peterson Institute for International Economics.

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