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The United States Securities and Exchange Commission home page. It contains vast SEC resources, laws and regulations, investor information, and litigation.

Ensuring the Soundness of Financial Intermediaries

Asymmetric information in financial markets means that investors may be subject to adverse selection and moral hazard problems that may hinder the efficient operation of financial markets. Risky firms or outright crooks may be the most eager to sell securities to unwary investors, and the resulting adverse selection problem may keep investors out of financial markets. Furthermore, once an investor has bought a security, thereby lending money to a firm, the borrower may have incentives to engage in risky activities or to commit outright fraud. The presence of this moral hazard problem may also keep investors away from financial markets. Government regulation can reduce adverse selection and moral hazard problems in financial markets and increase their efficiency by increasing the amount of information available to investors.

As a result of the stock market crash in 1929 and revelations of widespread fraud in the aftermath, political demands for regulation culminated in the Securities Act of 1933 and the establishment of the Securities and Exchange Commission (SEC). The SEC requires corporations issuing securities to disclose certain information about their sales, assets, and earnings to the public and restricts trading by the largest stockholders (known as insiders) in the corporation. By requiring disclosure of this information and by discouraging insider trading, which could be used to manipulate security prices, the SEC hopes that investors will be better informed and be protected from some of the abuses in financial markets that occurred before 1933. Indeed, in recent years, the SEC has been particularly active in prosecuting people involved in insider trading.

Asymmetric information can also lead to widespread collapse of financial intermediaries, referred to as a financial panic. Because providers of funds to financial intermediaries may not be able to assess whether the institutions holding their funds are sound, if they have doubts about the overall health of financial intermediaries, they may want to pull their funds out of both sound and unsound institutions. The possible outcome is a financial panic that produces large losses for the public and causes serious damage to the economy. To protect the public and the economy from financial panics, the government has implemented six types of regulations.

Restrictions on Entry. State banking and insurance commissions, as well as the Office of the Comptroller of the Currency (an agency of the federal government), have created very tight regulations governing who is allowed to set up a financial intermediary. Individuals or groups that want to establish a financial intermediary, such as a bank or an insurance company, must obtain a charter from the state or the federal government. Only if they are upstanding citizens with impeccable credentials and a large amount of initial funds will they be given a charter.

Disclosure. There are stringent reporting requirements for financial intermediaries. Their bookkeeping must follow certain strict principles, their books are subject to periodic inspection, and they must make certain information available to the public.

Restrictions on Assets and Activities. There are restrictions on what financial intermediaries are allowed to do and what assets they can hold. Before you put your funds into a bank or some other such institution, you would want to know that your funds are safe and that the bank or other financial intermediary will be able to meet its obligations to you. One way of doing this is to restrict the financial intermediary from engaging in certain risky activities. Legislation passed in 1933 (repealed in 1999) separated commercial banking from the securities industry so that banks could not engage in risky ventures associated with this industry. Another way is to restrict financial intermediaries from holding certain risky assets, or at least from holding a greater quantity of these risky assets than is prudent. For example, commercial banks and other depository institutions are not allowed to hold common stock because stock prices experience substantial fluctuations. Insurance companies are allowed to hold common stock, but their holdings cannot exceed a certain fraction of their total assets.

Deposit Insurance. The government can insure peoples deposits so that they do not suffer any financial loss if the financial intermediary that holds these deposits should fail. The most important government agency that provides this type of insurance is the Federal Deposit Insurance Corporation (FDIC), which insures each depositor at a commercial bank or mutual savings bank up to a loss of $100,000 per account. All commercial and mutual savings banks, with a few minor exceptions, are contributers to the FDIC's Bank Insurance Fund, which is used to pay off depositors in the case of a bank's failure. The FDIC was created in 1934 after the massive bank failures of 1930-1933, in which the savings of many depositors at commercial banks were wiped out. Similar government agencies exist for other depository institutions: The Savings Association Insurance Fund (part of the FDIC) provides deposit insurance for savings and loan associations, and the National Credit Union Share Insurance Fund (NCUSIF) does the same for credit unions.

Limits on Competition. Politicians have often declared that unbridled competition among financial intermediaries promotes failures that will harm the public. Although the evidence that competition does this is extremely weak, it has not stopped the state and federal governments from imposing many restrictive regulations. First are the restrictions on the opening of additional locations (branches). In the past, banks were not allowed to open up branches in other states, and in some states, banks were restricted from opening additional locations.

Restrictions on Interest Rates. Competition has also been inhibited by regulations that impose restrictions on interest rates that can be paid on deposits. For decades after 1933, banks were prohibited from paying interest on checking accounts. In addition, until 1986, the Federal Reserve System had the power under Regulation Q to set maximum interest rates that banks could pay on savings deposits. These regulations were instituted because of the widespread belief that unrestricted interest-rate competition helped encourage bank failures during the Great Depression. Later evidence does not seem to support this view, and restrictions like Regulation Q have been abolished.

In later chapters, we will look more closely at government regulation of financial markets and will see whether it has improved the functioning of financial markets.

Financial Not surprisingly, given the similarity of the economic system here and in Japan,

Regulation Abroad Canada, and the nations of Western Europe, financial regulation in these countries is similar to financial regulation in the United States. The provision of information is improved by requiring corporations issuing securities to report details about assets and liabilities, earnings, and sales of stock, and by prohibiting insider trading. The soundness of intermediaries is ensured by licensing, periodic inspection of financial intermediaries' books, and the provision of deposit insurance (although its coverage is smaller than in the United States and its existence is often intentionally not advertised).

The major differences between financial regulation in the United States and abroad relate to bank regulation. In the past, the United States was the only industrialized country to subject banks to restrictions on branching, which limited banks' size and restricted them to certain geographic regions. (These restrictions were abolished by legislation in 1994.) U.S. banks are also the most restricted in the range of assets they may hold. Banks abroad frequently hold shares in commercial firms; in Japan and Germany, those stakes can be sizable.

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