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Regulatory architecture of the securities markets

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The paper analysis key drivers that underpin the process of institutional design, and the extent to which these drivers predetermine regulatory outcomes. The authors identify low salience of rules, dependence on stakeholders who have vested interest in the final shape of regulation, and ever-increasing heterogeneity or regulatory preferences from business stakeholders as the three key drivers. Some policy implications and recommendations are derived from the observations.

FSC Research Workshop 2018
1 November 2018
Policy paper contribution
Source: Financial Risk and Stability Network

Authors:
Jure Jeric, PhD Candidate, University of Oxford
Cristiano Boaventura Duarte, PhD Candidate, University Paris 13 and Federal University of Rio de Janeiro

PDF  >  Regulatory architecture of the securities markets

The paper has been prepared as an accompanying contribution to the Financial Stability Conference 2018 held October 31 in Berlin and presented at the FSC Research Workshop the day after at TU Berlin. Researchers from various institutions and with different backgrounds had been invited to draft policy-oriented contributions on selected aspects of the conference to be presented at the workshop, published and enclosed in the conference report.
Introduction:

Highly technical legal matters, such as financial regulation, pose one of the largest challenges for policy makers in their attempts to devise a sustainable economic system. The challenge is even more arduous as different institutional choices inevitably shape distributional repercussions. Thus, in order to understand the challenge of achieving a commonly beneficial financial architecture, it is necessary to analyse the key drivers that underpin the process of institutional design, and the extent to which these drivers predetermine regulatory outcomes.

There are three key drivers of financial regulatory design: first, low salience of rules (general public’s low awareness of specific issues beyond overall financial stability); second, dependence on stakeholders who have vested interest in the final shape of regulation; and third, ever-increasing heterogeneity or regulatory preferences from business stakeholders, particularly since the Global Financial Crisis.

The first two drivers – salience and dependence on stakeholders’ expertise – tend to translate into unsatisfactory reality that private interest groups remain largely unopposed in devising the ‘rules of the game’ in self-serving ways (Ramanna, 2015a).

First, regulators (who are assumed to work in the public interest, although there is a scope for capture) need to rely on industry representatives’ expertise as their knowledge is tacit or implicit rather than codified or explicit. The information asymmetry is more pronounced in sectors more linked to financial innovations, such as esoteric finance. Consequently, it is easier for industry representatives to shape regulations according to their own interests. Furthermore, regulators can also be “behind the curve” as stakeholders quickly discover regulatory loopholes as a way of circumventing regulation/supervision within the existing legal framework, or even by engaging in regulatory arbitrage with other jurisdictions.

Second, the capture of regulations by special-interest groups is a threat in many areas of public governance, but a relatively higher awareness among the public of this possibility induces intermediaries such as politicians or the media to act as safeguards for the public interest. In line with broad academic consensus, poor financial regulation was one of the main culprits of the GFC.

However, the third driver – significantly increased heterogeneity of regulatory preferences and new non-bank financial/non-financial agents – provides a counterbalance to the unsatisfactory reality of mostly unopposed rules. In aftermath of the GFC, regulators and policy makers are presented with unique circumstances when major financial stakeholders more often compete among themselves for different regulatory outcomes rather than acting as a unified set of stakeholders. This in turn increases the scope for policy makers and regulators to capitalise on preference heterogeneity by imposing more stringent rules with a view of long-term economic stability and a sustainable financial architecture.

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