Economics of Regulation
READING 7
ECONOMICS OF REGULATION
EXAM FOCUS
Regulations have important implications for economic growth and for valuation of companies. Understand the implications of regulations on financial markets, the cost-benefit analysis of regulation, regulatory interdependence, and implications for valuation. There is a lot of new terminology introduced in this topic review that needs to be memorised.
MODULE 7.1: ECONOMICS OF REGULATION
LOS 7.a: Describe the economic rationale for regulatory intervention.
Video covering this content is available online.
Economic Rationale for Regulation
Regulations are often required when markets cannot provide efficient solutions (also known as Pareto optimal, which means that one cannot make any participant better off without making some other participant worse off) for certain problems. Regulations are needed in the presence of informational frictions, externalities, weak competition, and for pursuing social objectives.
Informational frictions occur when information is not equally available or distributed. A situation where some market participants have access to information unavailable to others is called information asymmetry. Regulations are put in place in an attempt to ensure that no participant is treated unfairly or is placed at a disadvantage due to asymmetrical information.
Externalities are costs or benefits that affect a party that did not choose to incur that cost or benefit. For example, a polluter may not bear the full cost of their actions; in that case the negative externality may justify regulatory intervention.
Weak competition can lead to fewer choices, higher prices, and lack of innovation. Antitrust regulations (discussed later) seek to mitigate this problem by preventing behaviour that reduces or distorts competition.
Social objectives are achieved via provision of public goods (for example, roads and police protection). A public good is a resource that a person can enjoy without making it unavailable to others (non-rivalrous) and for which it is difficult to exclude non-payers (non-excludable). Since people share in the consumption of public goods but do not necessarily bear a cost proportionate to consumption, regulations and government provision are necessary to ensure an optimal level of production of such public goods. Regulatory obligations imposed on firms (for example, requiring telecommunications firms to serve rural markets) can also serve social objectives.
LOS 7.b: Explain the purposes of regulating commerce and financial markets.
Regulation serves multiple purposes across commerce and financial markets:
- Regulating commerce. Government regulations provide an essential legal and institutional framework to facilitate business decision-making. Examples of regulations covering commerce include company laws, tax laws, contract laws, competition laws, labour laws, banking laws, bankruptcy laws, and dispute resolution systems.
- Regulations may either facilitate or hinder commerce. For example, protections of intellectual property facilitate long-term investments in research. Similarly, trade agreements promote international commerce. Lack of enforcement or poor protection of intellectual property rights globally remains a concern. With increasing use of big data by businesses, privacy and data protection rules are concerns best addressed by regulation.
- Regulating financial markets. Financial market regulations include regulation of securities markets and of financial institutions. Regulation of financial markets is critical to prevent failures of the financial system and to maintain the integrity of markets. The objectives of securities regulation include three interrelated goals: protect investors, create confidence in the markets, and enhance capital formation.
Regulation of Security Markets
Ensuring the fairness and integrity of capital markets and thereby protecting investors is a key role of financial market regulators. Several observations about securities markets regulation are important:
- Disclosure requirements are a key element of securities markets regulation. Disclosures provide transparency (i.e., reduce information asymmetry) in financial markets and hence promote investor confidence.
- Many securities regulations are directed toward mitigating agency problems. In financial markets, investors often work through intermediaries (agents) whose interests may diverge from those of investors. Regulations imposing fiduciary duties seek to mitigate such agency problems.
- Historically, regulations have focused on protecting small (retail) investors; this explains relatively lax regulatory coverage of hedge funds and private equity funds that are marketed only to qualified investors.
Regulation of Financial Institutions
Prudential Supervision
Prudential supervision refers to the monitoring and regulation of financial institutions to reduce system-wide risks and to protect investors. Prudential supervision is important because the failure of one financial institution can have a far-reaching impact and may result in a loss of confidence that spreads through the financial system. Due to the high mobility of capital internationally, shocks in one part of the system can affect the whole system, leading to global contagion. Prudential supervision focuses on diversification of assets, maintaining an adequate capital base, and robust risk management activities by financial institutions.
The cost-benefit analysis of financial market regulation should include hidden costs. For example, deposit insurance such as the FDIC (Federal Deposit Insurance Corporation) in the United States may incentivise excessive risk-taking by banks (a moral hazard problem).
LOS 7.c: Describe anticompetitive behaviours targeted by antitrust laws globally and evaluate the antitrust risk associated with a given business strategy.
Antitrust Regulation
While regulations may sometimes hinder foreign competition (to protect domestic businesses), they generally seek to promote competition among domestic businesses. Antitrust laws promote competition by monitoring and restricting activities that reduce or distort competition.
Regulators often block mergers that lead to excessive concentration of market share. Anticompetitive behaviours such as price collusion, discriminatory pricing, bundling, and exclusive dealing are often prohibited. Internationally, companies must evaluate product and marketing strategies in the context of multiple, varying regulatory regimes; for instance, a multinational may be subject to both U.S. antitrust laws and EU antitrust laws.
When evaluating an announced merger or acquisition, an analyst should consider the anticipated regulatory response as part of the analysis.
LOS 7.d: Describe classifications of regulations and regulators.
Regulations can be classified as:
- Statutes - laws made by legislative bodies.
- Administrative regulations - rules issued by government agencies or other bodies authorised by the government.
- Judicial law - legal principles or findings established by courts.
Regulators
Regulators can be government agencies or independent regulators. Independent regulators are recognised by governments and have the power to make and enforce rules; they are usually funded independently and therefore politically independent. An example is the Public Company Accounting Oversight Board (PCAOB), an independent regulator established by the U.S. Congress to oversee audits of public companies; it is primarily funded by annual fees paid by public companies, brokers, and dealers.
Industry self-regulatory bodies (SRBs) are private organisations that represent as well as regulate their members. Members of SRBs must adhere to their rules. SRBs may have inherent conflicts of interest that can reduce their effectiveness, especially where a more formal regulatory structure exists. Nevertheless, SRBs increase the overall level of regulatory resources, utilise industry professionals with relevant expertise, and allow formal regulators to devote resources to other priorities.
Self-regulating organisations (SROs) are SRBs that are recognised by the government and given enforcement powers. Like independent regulators, SROs are independently funded and are politically independent. SROs regulate member behaviour and often provide public goods in the form of standards. Because of governmental recognition, SROs are considered a form of independent regulator.
Outside bodies are not regulators themselves, but their work is frequently referenced by regulators. Examples include standards-setting bodies such as FASB and IASB.
LOS 7.e: Describe uses of self-regulation in financial markets.
FINRA (Financial Industry Regulatory Authority) is an SRO recognised by the SEC in the United States. FINRA's primary objective is to protect investors by maintaining the fairness of the U.S. capital markets. FINRA has authority to enforce securities laws and regulations. Similar SROs exist globally.
The use of SROs in civil-law countries is not common; in such countries, formal government agencies usually fulfil the regulatory role. In civil-law countries, non-independent SRBs may support formal regulation via guidelines, codes of conduct, and continuing education. In common-law countries such as the United Kingdom and the United States, SROs have historically enjoyed recognition and a substantive role in market regulation.
LOS 7.f: Describe regulatory interdependencies and their effects.
Regulatory Interdependencies
Regulation does not always conflict with the interests of the regulated. However, the theory of regulatory capture holds that, regardless of the original purpose behind a regulatory body's establishment, it may become influenced or effectively controlled by the industry it is meant to regulate. Regulators often have prior experience in the industry and strong ties to its participants; such connections can affect the regulator's ability to render impartial decisions. Regulatory capture is more likely a concern with SROs than with government agencies. For example, regulatory capture concerns are often cited regarding the commercialisation of financial exchanges.
Regulatory differences between jurisdictions can lead to regulatory competition, in which regulators compete to provide the most business-friendly regulatory environment. Regulatory arbitrage arises when businesses shop for a jurisdiction that allows a specific behaviour instead of changing the behaviour; it also entails exploiting differences between the economic substance and the legal interpretation of a regulation.
To avoid regulatory arbitrage, cooperation at a global level to achieve a cohesive regulatory framework is often necessary. For example, regulations limiting greenhouse gas emissions should be consistent globally; otherwise polluters may simply relocate to less restrictive jurisdictions, undermining the regulation's objective. Similarly, efforts to reduce the risk of a global financial crisis have been hampered by the lack of a cohesive global regulatory framework.
Even within a country, there may be conflict between objectives of different regulatory bodies, producing an inconsistent overall regulatory framework. For example, regulations seeking higher fuel efficiency standards for automobiles may conflict with regulations from another agency seeking to make automobiles safer.
LOS 7.g: Describe tools of regulatory intervention in markets.
Tools of Regulatory Intervention
Three broad regulatory tools are commonly available to regulators:
- Price mechanisms. Price instruments such as taxes and subsidies can be used to pursue regulatory objectives; for example, sin taxes (on alcohol or tobacco) are often used to deter consumption, while subsidies (for green energy) can encourage specific economic behaviours. According to the Coase theorem, if an externality can be traded and transaction costs are absent, the allocation of property rights will be efficient and resource allocation will not depend on the initial assignment of property rights. SROs and outside bodies are least likely to use price mechanisms directly.
- Restricting or requiring certain activities. Regulators may ban certain activities (for example, use of specific chemicals) or require specific actions (for example, filing of annual reports like the 10-K by publicly listed companies) to further regulatory objectives.
- Provision of public goods or financing of private projects. Regulators may provide public goods (for example, national defence) or fund private projects (for example, small-business loans or student loans) depending on political priorities and objectives.
New regulatory tools are continually developed as governments face new challenges. For example, following the financial crisis of 2008, to reduce systemic risk and financial contagion the Financial Stability Board and the G20 introduced the bail-in tool to deal with the failure of a financial institution. Under this framework, a clear set of rules was designed to ensure that the cost of failure is borne by shareholders and creditors rather than by taxpayers. Regulatory tools developed in response to past events may not necessarily work well under different future circumstances; the effectiveness of the bail-in process, for instance, continues to be evaluated.
Sometimes, a combination of regulatory tools may be more effective. For example, to deter consumption of unhealthy food products regulators may both tax the product category and require appropriate nutritional labelling.
The effectiveness of regulatory tools depends critically on the enforcement abilities of regulators (for example, their ability to sanction violators). Enforcement should produce the desired effect of compliance. For instance, investor-protection regulations that specify sanctions for violations must ensure that sanctions fall on responsible individuals (management) rather than only on companies (and ultimately on shareholders), otherwise the sanctions may harm those the regulations intended to protect.
LOS 7.h: Describe benefits and costs of regulation.
Cost-Benefit Analysis of Regulation
A regulatory framework must be assessed in terms of the costs of the framework relative to the benefits it provides. U.S. federal regulatory agencies are required to conduct a cost-benefit analysis prior to issuing major regulations.
Costs and benefits of regulations may be easy to identify but difficult to quantify. The cost of a regulation is not limited to implementation costs (that is, the cost of operating a government agency for monitoring and supervision); an analyst should also consider the cost to the private sector.
Regulatory burden (also known as government burden) refers to the cost of compliance for the regulated entity. Net regulatory burden is defined as regulatory burden minus the private benefits of regulation.
Regulators should be aware of unintended consequences. For example, regulations mandating an increase in automobile fuel efficiency standards may encourage consumers to drive more (the rebound effect), reducing the regulation's intended benefit. Regulatory burden is generally difficult to measure as it includes indirect costs related to changes in economic behaviour.
Because regulatory costs are difficult to assess ex ante, many regulatory provisions include a sunset clause that requires regulators to revisit the cost-benefit analysis based on actual outcomes before renewing the regulation.
LOS 7.i: Describe the considerations when evaluating the effects of regulation on an industry.
Regulations can help or hinder a company or an industry. Regulations may shrink the size of one industry (for example, if it is heavily taxed) while increasing the size of another (for example, an industry receiving subsidies). Analysts should review the impact of current and proposed regulations on an industry or company because regulations can have a large impact on valuation.
Regulations are not always costly for those that end up being regulated. If a regulator is captive, regulations may end up benefiting the regulated entities.
Regulations may introduce market inefficiencies. For example, past government bailouts of financial institutions have conveyed an implicit guarantee of rescue; as a result the credit spreads on bonds issued by some financial firms may not fully reflect their true credit risk.
Certain regulations are sector-specific while others have broad implications across sectors. Some industries face greater exposure to particular regulatory areas: environmental laws have greater implications for mining, oil and gas sectors than for retail or health care; labour laws are most relevant to labour-intensive industries.
MODULE QUIZ 7.1
Use the following information to answer Questions 1 through 7.
Gyaneshwar Dharampal, CFA, is one of the newer analysts at Paramus Funds and has been assigned to cover the global financial services industry. Dharampal is currently reviewing the Zambolan financial services industry. Zambola is a rapidly growing emerging market country. The Zambolan currency is known as the Zu.
The governance of commercial banks in Zambola is covered by the Zambola Financial Institutions Act as amended (2018) (the act). The act provides the regulatory framework for security markets, commercial banks, and other financial intermediaries.
The Zambolan Finance Commission (ZFC) has enforcement and supervisory powers over commercial banks. In its regulatory role, ZFC specifies minimum capital requirements and underwriting standards for loans and investments for commercial banks in Zambola. Currently, the minimum credit rating for bonds eligible for investment by commercial banks is stipulated to be B as rated by JBL Services, an independent rating agency.
The act also provides that the operation of the Zambolan stock exchange be supervised by the Exchange Association (a self-regulating organization). To promote independence of the Exchange Association, the act exempts it from supervisory review by ZFC.
To curb predatory lending, the act imposes a ceiling on interest rates that banks can charge on consumer loans. However, a recent decision by a Zambolan high court overturned that provision of the act. In response, in the new revenue bill, the Zambolan government included punitive taxes on earnings of commercial banks that are attributable to interest rates higher than the previously specified ceiling.
Dharampal notes that a new regulation would impose additional taxes on Zambolan manufacturers and require them to make certain workplace safety-related modifications. He estimates that the tax revenue from the new regulation would be 100 million Zu. The tax revenue would be used to cover the salaries of newly hired personnel at the government agency in charge of enforcing the regulation. The aggregate cost to the manufacturing sector for compliance with the new regulation is estimated to be 300 million Zu. It is also estimated that the aggregate benefit to private sector builders as a result of the new regulation would be 30 million Zu.
Finally, Dharampal notes that Zambola is in the process of introducing a national health care system wherein taxes on tobacco and alcohol will fund government-subsidised health care.
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The removal of the interest rate ceiling on consumer loans is most likely an example of a(n):
- A. judicial law.
- B. statute.
- C. administrative regulation.
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JBL Services is best described as a(n):
- A. self-regulating organization.
- B. government agency.
- C. outside body.
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Which of the following is not a good reason to delegate supervisory authority to the Exchange Association?
- A. Increase in overall regulatory resources.
- B. Exemption from supervisory review by ZFC.
- C. Additional knowledge and expertise of industry professionals.
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Which of the following is most likely to be a concern related to the regulatory authority of the Exchange Association?
- A. Regulatory arbitrage.
- B. Regulatory capture.
- C. Regulatory competition.
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The Zambolan government's action of charging punitive taxes on interest earnings of commercial banks is best described as a:
- A. price mechanism.
- B. restriction on certain activities.
- C. provision of a public good.
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The net regulatory burden of the new workplace safety regulation is closest to:
- A. 170 million Zu.
- B. 270 million Zu.
- C. 430 million Zu.
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Based on the information provided, which sector of the Zambolan economy is most likely to grow?
- A. Commercial banks.
- B. Health care.
- C. Alcoholic beverage producers.
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Which of the following would least accurately be described as regulations of commerce?
- A. Antitrust regulations.
- B. Dispute resolution regulations.
- C. Prudential supervision regulations.
KEY CONCEPTS
LOS 7.a
Regulations are needed in the presence of informational frictions and externalities. Informational frictions arise when there is information asymmetry.
Externalities relate to the provision and consumption of public goods.
LOS 7.b
Examples of regulations covering commerce include company law, tax law, contract law, competition law, banking law, bankruptcy law, and dispute resolution systems. Governments may facilitate or hinder commerce.
Financial market regulations seek to protect investors and ensure stability of financial systems. Securities market regulations include disclosure requirements, measures to mitigate agency conflicts, and rules to protect small investors.
Prudential supervision is the regulation and monitoring of financial institutions to reduce system-wide risks and protect investors.
LOS 7.c
Regulators often block a merger that would lead to an excessive concentration of market share. Anticompetitive behaviour such as discriminatory pricing, bundling, and exclusive dealing is commonly prohibited.
LOS 7.d
Regulations can be classified as statutes, administrative regulations, or judicial law.
Regulators can be government agencies or independent regulators. Self-regulating organisations (SROs) are given government recognition and authority. Self-regulatory bodies (SRBs) do not have government recognition and both represent and regulate their members. Outside bodies are not regulators themselves, but their products or standards may be referenced by regulators.
LOS 7.e
When properly supervised by regulatory agencies, SROs have been effective in carrying out regulatory objectives. Use of SROs is more prevalent in common-law countries than in civil-law countries.
LOS 7.f
The regulatory capture theory assumes that a regulatory body will be influenced or controlled by the industry that it regulates. Regulatory differences between jurisdictions can lead to regulatory competition, where regulators compete to provide a business-friendly environment. Firms may engage in regulatory arbitrage to exploit differences between the substance and interpretation of regulations.
LOS 7.g
Regulatory tools include price mechanisms, restrictions on or requirements of certain activities, and provision of public goods or financing of private projects.
LOS 7.h
Regulatory burden refers to the cost of compliance for the regulated entity. Net regulatory burden is the regulatory burden minus the private benefits of regulation. Indirect costs of regulations must be included in cost-benefit analysis but are difficult to measure ex-ante. Sunset clauses require cost-benefit re-evaluation before regulation renewal.
LOS 7.i
Regulations can have material impacts on industries and companies. Certain industries have greater exposure to particular regulations. Analysts should review current and proposed regulations since they can materially affect company and industry valuations.
ANSWER KEY FOR MODULE QUIZZES
Module Quiz 7.1
1. A
A Judicial law is the finding of the court and is applicable in this case. Statutes are laws made by legislative bodies, while administrative regulations are rules issued by government agencies or other bodies authorised by the government. ((<>)LOS 7.d)
2. C
C JBL Services is neither a government agency nor an SRO and is best described as an outside body. The work of such outside bodies is sometimes referenced by regulatory authorities in their regulations. ((<>)LOS 7.d)
3. B
B The Exchange Association is an SRO and hence increases overall regulatory resources. Its members also bring knowledge and expertise of industry professionals. However, due to the inherent conflict of interest in an association regulating its own members, adequate regulatory oversight would be necessary. ((<>)LOS 7.e)
4. B
B The Exchange Association is exposed to conflict of interest in regulating its members. Hence, regulatory capture (where a regulatory body is influenced or controlled by the industry that is being regulated) is a concern. Regulatory differences between jurisdictions can lead to regulatory competition; regulators compete to provide a business-friendly regulatory environment. Firms may also resort to regulatory arbitrage to exploit the difference between the substance and interpretation of a regulation. Neither regulatory competition nor regulatory arbitrage is applicable in this case. ((<>)LOS 7.f)
5. A
A Taxes and subsidies as regulatory tools are examples of price mechanisms. ((<>)LOS 7.g)
6. B
B Net regulatory burden is the cost of compliance for the regulated entity minus the private benefits of regulation. ((<>)LOS 7.h)
7. B
B Everything else held constant, sectors being taxed (i.e., commercial banks, alcohol, and tobacco) would be expected to shrink, while sectors that are subsidised (i.e., health care) would be expected to grow. ((<>)LOS 7.i)
8. C
C Prudential supervision deals with regulating financial markets rather than regulating commerce. Antitrust regulations and dispute resolution regulations are elements of the regulation of commerce. ((<>)LOS 7.b)
TOPIC QUIZ: ECONOMICS
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