3

The Goals and Strategies of Financial Regulation

3.1 Introduction
Financial regulation governs one of the most important systems in an economy—the
financial system. The primary purpose of financial regulation is to improve the
functioning of that system. The design of financial regulation is thus ultimately an
exercise in economics—applying the analytic tools of economics to determine the legal
and regulatory framework best suited to correcting the failures of a financial system.
The standard starting point of economics for regulation is ‘if it ain’t broke, don’t fix
it’. In other words, if there is no clear evidence of a failure of markets, do not interfere
with them. To understand why, consider the ‘welfare properties’ of competitive
markets. The invisible hand of competition guides participants in well-functioning
market economies to allocate resources in ways that achieve economically efficient
outcomes. They use information on prices to determine where to sell their products
and where to purchase their inputs. They make employment decisions on the basis of
wages and salaries and investment decisions in relation to the cost and returns on
different forms of capital. Instead of relying on a large bureaucratic machine, capitalist
economies run on the basis of decentralized markets that determine prices, wages,
interest rates, and cost of finance on the basis of decisions made by a large number of
individuals and institutions acting independently.1
It is a remarkable feature of market economies that the invisible hand helps guide
them towards efficient outcomes where resources are allocated appropriately, produc-
tion is efficiently undertaken, and savings and investment reflect future as well as
current benefits. For the most part, they work pretty well and attempts to interfere with
them are often counterproductive, leading to worse rather than better outcomes.2
While the desirability of competitive markets is well established and the alternative
of central planning has now been firmly discredited, it is not always the case that free
markets yield appropriate outcomes. Particular features of financial markets make
them especially prone to malfunction. So long as the consequences of individual
purchases and sales are rapidly and readily observable, it is comparatively easy to
ensure the smooth functioning of markets. But when, as in the case of finance, the
consequence of actions may not be revealed for extended periods of time, perhaps years
or decades, then the potential for failure and the complexities of correcting it are much
greater.
This gives rise to what economists describe as ‘market failures’—the failure of
markets to achieve the economically efficient outcomes with which they are generally

1
We leave aside for present purposes the effects of central bank intervention through monetary policy.
2
For a counterview that markets are subject to endemic failure see GA Akerlof and RJ Shiller, Phishing
for Fools: The Economics of Deception and Manipulation (Princeton, NJ: Princeton University Press, 2015).

Principles of Financial Regulation. First Edition. John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey N.
Gordon, Colin Mayer, and Jennifer Payne. © John Armour, Dan Awrey, Paul Davies, Luca Enriques, Jeffrey
N. Gordon, Colin Mayer, and Jennifer Payne 2016. Published 2016 by Oxford University Press.
52 Principles of Financial Regulation

associated. Where such failures arise, there is a prima facie case for actions to be taken
to correct the failures. However, the case is only prima facie—and not definitive—
because the costs of remedying the deficiency may be greater than the benefits.
There are therefore at least three stages involved in designing a regulatory system.
The first is to determine the nature and extent of any market failures that exist. The
second is to establish the set of possible regulatory interventions and to identify
the appropriate combination required to remedy each failure. The third is to evaluate
the costs or side effects of such remedial intervention and to determine whether they
are so great as to outweigh the benefits. If the costs of a particular intervention exceed
the benefits, then either an alternative remedy needs to be sought or the failure in
question may be permitted to remain uncorrected.
It is a central proposition of this book that not only are financial systems particularly
prone to failures, but their remedies are also often subject to unintended and undesir-
able consequences. In fact, the design of financial regulation is not just about the
identification of market failures and appropriate remedies, but also their translation
into law (an imperfect instrument to guide human behaviour) via the (no less imper-
fect) political process. We will come back to the political and legal challenges of
designing an effective regulatory system in Chapter 4.
Like the regulatory process just described, this chapter will proceed by stages. It will
begin in section 3.2 by setting out the economic theory of the efficiency of markets. It
will describe how competitive markets yield economically efficient outcomes and the
conditions under which they possess these properties.
Section 3.3 describes common market failures that can arise in financial markets and
the ways in which they can justify regulation to correct them. It will discuss the primary
sources of market failures arising from asymmetries of information, negative exter-
nalities, public goods, imperfect competition, and behavioural biases in consumer
decision-making.
Section 3.4 considers the goals of financial regulation, as described by regulators and
policymakers. It reviews seven areas often listed by governments and public-sector
bodies as being major goals of financial regulation: protection of investors and other
users of the financial system (especially consumers of retail financial products), finan-
cial stability, market efficiency, competition, the prevention of financial crime, and
fairness. The goals of financial regulation are frequently in conflict. In particular, the
book points to the conflict that may arise between goals such as investor or consumer
protection and the stability of the financial system as a whole. The goals of financial
regulation must therefore be traded off against each other, and to do that, govern-
ments and regulators need to have clearly defined objectives and preferences amongst
the goals.
The final stage is to identify the various strategies and tools that are available to
regulators and relate them to the achievement of the goals of regulation. In section 3.5,
we will outline seven regulatory strategies—which we term entry, conduct, informa-
tion, prudence, governance, insurance, and resolution—denoting various ways in
which regulatory intervention can be structured.
This framework of market failures, goals, objectives, and strategies will underpin the
analysis of the rest of the book. The book will elaborate on how the translation of
 The Goals and Strategies of Financial Regulation 53

market failures into regulatory strategies is undertaken in different areas of the

financial system and how conflicts in the attainment of goals should be resolved
through a regulatory objective function. By the end of this chapter, you should have
a basic understanding of the framework of financial regulation and the combination of
economic analysis and public law in its design—an understanding that will prepare you
to appreciate the more detailed descriptions in the subsequent chapters of the book.

3.2 The Efficiency of Markets

The purpose of regulation is to assist markets in functioning better than they would do
in its absence. The most important criteria by which economists judge how well an
economy is functioning relate to the efficiency with which the economy produces and
allocates resources. The starting point is that most resources such as commodities, raw
materials, labour, and capital are scarce. They are therefore expensive to employ and
need to be utilized as efficiently as possible.
Efficiency in this sense has three meanings. The first is that resources have to yield as
much output as is possible from the given set of scarce resources—the inputs. The more
output that is produced from a given level of input, the greater is what economists term
the level of ‘productive efficiency’. However, this does not in itself ensure that resources
are well deployed because they may be employed in activities that are not particularly
highly valued. The second criterion is therefore that they are not only as productively
efficient as possible but also allocated as well as they could be to those activities
and individuals that value them the most. This is correspondingly termed ‘allocative
efficiency’.
The guiding determinant of the value associated with different activities and prod-
ucts is the price that customers are willing to pay for them. The greater the price that
individuals are willing to pay for goods and services relative to the cost of producing
them, the higher is the level of the ‘surplus’ associated with them. That surplus may go
to the consumers in the form of what is termed their consumer surplus—the amounts
that they would be willing to pay for the goods and services that they consume, over
and above the price that they actually have to pay for them. Alternatively, the surplus
may go to producers in the form of profits—the difference between the revenue that
they earn from selling the products and the costs of producing them.
The combination of ‘allocative’ and ‘productive’ efficiency together ensures that
resources are allocated to their most valuable activities in the lowest-cost way. How-
ever, there is a third dimension, which is particularly relevant to the financial markets
discussed in this book. It concerns the allocation of resources over time as well as
between activities and individuals. Resources should be allocated as efficiently as
possible between different points of time—between this year and next year, or between
the current generation and future generations—as well as within years and generations.
This is termed ‘dynamic efficiency’. It is particularly relevant to the subject of this book
because, as described in Chapter 2, one of the distinguishing and complex features of
financial markets is their role in promoting savings and investment over extended
periods of time. The financial system is therefore central to the achievement of dynamic
efficiency.
54 Principles of Financial Regulation

One of the most significant insights of economics is to demonstrate how markets

contribute to the attainment of allocative, productive, and dynamic efficiency. Markets
indeed have this property, provided several conditions are fulfilled: there must be a
large number of well-informed producers and consumers of goods and services, acting
independently, in markets in which everything is priced. The remarkable feature of
such markets is that large numbers of individuals acting entirely independently in
pursuit of their own self-interest can achieve the three aspects of efficiency to a degree
that bureaucrats in centrally planned economies could only dream. The so-called
‘invisible hand’ of the market acts through these self-interested individuals to deliver
efficient production and consumption decisions.
This is sometimes known as the ‘Pareto-optimal’ property of competitive markets
after Vilfredo Pareto, an Italian economist who defined efficiency as existing if there
was no alternative allocation of resources that could make at least one person better off
while making no one else worse off.3 In other words, competitive markets are efficient
in achieving outcomes in which there are no alternative allocations and employment
of resources across activities, individuals, and time under which anyone would be
better off.
It is an almost magical feature of competitive markets that they possess this property,
and it underpins the hallowed status they command in modern economies. However,
there are two important caveats associated with this result which make it much more
complex than it at first seems. The first caveat is that it only holds if the various
conditions associated with the existence of perfectly competitive markets are fulfilled. If
they are not and there are ‘market failures’, then it may be possible to achieve superior
allocations of resources than those associated with unencumbered markets and the
intervention of governments and regulators may be required to achieve them.
The second caveat is that to say that the allocation of resources resulting from
perfectly competitive markets is ‘Pareto optimal’—that is, no one can be made better
off without someone else being made worse off—does not necessarily ensure that the
allocation of resources is desirable. It may involve a disproportionate allocation of
resources to a small number of people, with the vast majority of people having access to
very little. Such an outcome might be Pareto efficient in the sense that there is no
alternative allocation that makes a majority of the population better off without the
minority being made worse off, but it is not a socially desirable outcome. In other
words, it does not satisfy the second set of criteria by which economists judge the
merits of markets, that is, ‘distribution’. An efficient allocation may not involve a fair
distribution of resources and the intervention of government may be required to ensure
that resources are allocated in a fair as well as an efficient manner.
Fairness is normally associated with the degree of inequality of income and wealth in
an economy. A highly competitive economy may be a highly unequal one, which may
justify government intervention to redistribute resources to the most needy even when
market failures do not require it. The neediest include the most vulnerable members of
society—the sick, old, and uneducated—as well as the poorest. As respects financial

3
V Pareto, ‘Il Massimo di Utilità Dato dalla Libera Concorrenza’ (1894) 9 Giornale degli Economisti
48, 58.
 The Goals and Strategies of Financial Regulation 55

regulation, fairness underpins measures to protect the vulnerable from the unscrupu-
lous. Complexity makes financial markets particularly prone to high and extensive
levels of relative vulnerability on the part of large numbers of individuals. Even some of
the healthiest and best-educated members of society are at risk of being exploited by
others when they invest in complex financial instruments.
The starting point for our analysis of the regulation of financial markets will
therefore be the efficiency properties of competitive markets. It is a benchmark against
which to judge the performance of markets. But it is only a starting point, because we
then have to determine how well they match up against it, the extent to which there are
market failures that undermine efficiency, and—in turn—the extent to which they can
be corrected by regulation. We will on occasion also consider the role that regulation
can play in achieving distributionally fair, as well as economically efficient, outcomes
and protecting the most vulnerable from the most unscrupulous.
Having introduced the idea of perfect markets, in section 3.3 we now consider five
types of market imperfections that can lead to market failures.

3.3 Market Failures

3.3.1 Asymmetric information
As a consumer of financial products, one of the most serious problems you face is that
the products on offer are often complex and difficult to evaluate. For example,
distinguishing between different investment funds is complicated by the fact that it is
hard to observe the financial assets that are purchased by the fund, or the charges that
are levied. These sources of uncertainty are particularly serious in the case of large
transactions such as home mortgages or pension plans. These involve substantial
borrowing and investment decisions over long periods of time, such that even relatively
small mistakes can cumulate into large losses by the time the product matures.
The problems of uncertainty are made worse by the fact that consumers of such
products are less well informed than the sellers. There is what in the parlance of
economists is described as an ‘asymmetry of information’ between buyer and seller,
with the buyer in general being less well informed about a particular financial product
than a seller. It is costly for purchasers to educate themselves sufficiently to be as well
informed about the financial products they are being offered as the sellers.
One of the consequences of asymmetries of information is that purchasers are
particularly vulnerable to unscrupulous sellers offering financial products that are
not as good as they are claimed to be or as appropriate for an individual purchaser
as other products available on the market. Consumers may thus face the problem of
‘adverse selection’ of what are termed ‘lemons’.
George Akerlof first described the problem in the context of the market for second-
hand cars.4 Sellers of second-hand cars know more about the defects of their vehicles
than purchasers and, as a consequence, they tend to offload defective cars onto

4
GA Akerlof, ‘The Market for “Lemons”: Quality Uncertainty and the Market Mechanism’ (1970) 84
Quarterly Journal of Economics 488.
56 Principles of Financial Regulation

unsuspecting purchasers. But the problem is actually worse than that, because pur-
chasers who are unable to ascertain the quality of a product will offer no more than the
prevailing price for a product of average quality. Knowing this, sellers will only offer
purchasers cars whose real value is at best equal to, and likely less than, the average
price that they are being offered, driving the average quality of cars on the market, and
therefore the price purchasers are willing to pay, further down. When that is the case,
purchasers face a systematic adverse selection problem, such that the only available cars
on the market are ‘lemons’. Adverse selection therefore not only disadvantages buyers,
but also causes the market for second-hand cars to collapse. Asymmetries of informa-
tion have similar effects on financial markets. Not only do they result in the unfair
treatment of buyers, they may also cause financial markets to shrivel or implode.5
The response of the market is to seek ways of mitigating problems of asymmetry of
information and to provide signals of reliable quality that purchasers can trust.6 One
such signal is a warrant or guarantee of the quality of the product. The second-hand car
salesman may offer to buy back the car if it is shown to be defective within a particular
period of time. The seller of financial investments may guarantee performance over
certain periods of time. Alternatively, there may be agencies that certify the quality of
the car by undertaking independent inspections and evaluating the reliability and
creditworthiness of sellers of financial products.
The information asymmetries in financial markets are often intense, and the time
lapse between the parting of investors from their money and when they are to get it
back can be long. As a consequence, it may take too long before investors understand
that the ‘signals’ of quality and reliability originally provided were actually worthless.
Market mechanisms may, in other words, be too weak to discourage attempts to exploit
vulnerable customers.7
To explore this point further, we can use heuristically distinctions drawn by econo-
mists according to how easy it is for consumers to determine the characteristics
of goods and services. First, there are ‘search goods’, whose characteristics can be
identified before they are purchased. So for example, one can go to a market and
determine the quality of fruit and vegetables that are being bought by inspecting them.

5
Information asymmetry is of course also problematic after a product has been purchased. To the extent
that the consumer’s payoffs depend on actions to be taken by the supplier—for example, the selection of
investments—and it is costly for the consumer to observe which actions the supplier does take, then the
supplier has an incentive to take actions that benefit itself, rather than the consumer. The losses associated
with such hidden actions are known as ‘agency costs’ (see MC Jensen and WH Meckling, ‘Theory of the
Firm: Managerial Behavior, Agency Costs and Ownership Structure’ (1976) 3 Journal of Financial Eco-
nomics 305). In the context of the current discussion, the anticipated level of agency costs for a particular
product—and the likely efficacy of any contractual solutions offered—can be understood as simply another
dimension of the things understood less well by the consumer than the financial firm at the outset.
6
A ‘signal’ in this context means a way of credibly conveying information about quality. A good signal is
something that it is materially more costly to do for a vendor of a low-quality product than for a high-
quality product vendor.
7
For example, Bernard Madoff, an investment adviser who committed one of the largest frauds in
history, developed an exceptional reputation for his services by for many years paying clients steady
‘returns’ on their investments, regardless of the vicissitudes of the market. These payments were made
from funds subscribed to Madoff by subsequent clients: see DB Henriques, The Wizard of Lies: Bernie
Madoff and the Death of Trust (New York, NY: Times Books, 2011). Such a strategy can only be followed for
so long as income from new clients is no less than returns due to existing clients.
 The Goals and Strategies of Financial Regulation 57

However, in some cases it may not be possible to assess the quality of the product until
one has actually consumed the good. These are termed ‘experience goods’. Even more
problematically, in some cases, it may not be possible to ascertain quality even after
consumption. For example, the success of a medical intervention or surgery may
be hard to assess after it has happened because the counterfactual of what would
have happened had a different procedure been followed is almost impossible to assess.
These are known as ‘credence goods’, where their quality has to be taken on trust
or faith.
Financial products and services frequently fall into the credence category because
there are no reliable benchmarks against which to evaluate performance. How well a
collective investment fund ‘should have’ performed over a particular period is difficult
to judge. It may have underperformed relative to a benchmark index, such as the FTSE
or S&P index, but was that because it was lower risk than the benchmark, because the
fund manager made poor stock selections (due to incompetence or conflicts of inter-
est), or simply because of bad luck? For such products, information asymmetries are
particularly pronounced.

3.3.2 Negative externalities

The interconnection of financial institutions and markets means that the actions of one
actor, or group of actors, can have an adverse impact on other actors—a ‘domino
effect’. This in turn can have powerful adverse implications for the economy as a whole.
In particular, the failure of financial institutions can upset the payments system, with
the result that ordinary transactions become difficult or impossible to process. More-
over, the failure of banks leads to the loss of their specialist expertise in selecting and
monitoring business projects for financing.8 The failure of one or more important
banks in which depositors or other creditors suffer losses can lead to ‘runs’ on other
banks and cash-hoarding by still other banks, all of which will dramatically reduce the
flow of credit to non-financial firms. A financial sector crisis can rapidly become a
general economic crisis.
In economic terms, we can understand these effects as negative externalities. Exter-
nalities arise when a person or institution takes actions that impose costs (benefits) in
the case of negative (positive) externalities on other parties for which that person is not
fully charged (compensated). They occur when prices and incentives do not adequately
reflect the consequences of actions taken.
A divergence of this kind may arise between the interests of those who own and
operate financial institutions, and the interests of society at large. To be sure, the
shareholders of a financial institution suffer if it fails. However, because losses are
distributed so widely, the shareholders may bear only a fraction of the overall loss to
society associated with failure. What is at issue are actions that increase the risk of

8
BS Bernanke, ‘Nonmonetary Effects of the Financial Crisis on the Propagation of the Great Depression’
(1983) 73 American Economic Review 257; MB Slovin, ME Sushka, and JA Polonchek, ‘The Value of Bank
Durability: Borrowers as Bank Stakeholders’ (1993) 48 Journal of Finance 247; JK Kang and RM Stulz, ‘Do
Banking Shocks Affect Borrowing Firm Performance? An Analysis of the Japanese Experience’ (2000) 73
Journal of Business 1.
58 Principles of Financial Regulation

failure. Where financial institutions are paid to take on risks, this money can be paid
out to shareholders as dividends during good times, but is not repayable by them
should the institution fail. Consequently, shareholders take the profits associated with
risk-taking, but do not bear more than a fraction of the costs associated with failure, in
cases where failure has systemic consequences. As a result, shareholders may push
institutions to take on more risk—that is, to tolerate a higher probability of failure—
than is desirable from the viewpoint of society as a whole.9 Indeed, a growing body of
empirical research finds that those banks in which the board of directors was most
closely aligned with the interests of shareholders—that is, had the ‘best’ corporate
governance on conventional measures—took on the greatest level of risk prior to the
financial crisis, and suffered the greatest losses during the crisis.10
There is a remarkable theory in economics, known as the ‘Coase theorem’, after
Ronald Coase who first described it in a 1960 paper.11 The Coase theorem states that
bargaining between the various parties affected by externalities will always lead to
efficient outcomes provided that the costs of negotiation and bargaining are sufficiently
small. To illustrate, if investors in one bank are potentially adversely affected by the risk
of failure of another bank, then they can offer a sufficient inducement to the latter bank
to reduce its risk-taking to the point that at the margin, the cost of reducing it further is
just equal to the benefits that investors in the first bank thereby derive.
Coase demonstrated that this same efficient outcome is derived irrespective of
whether the investors in the first bank have to bribe the second bank to reduce its
risk-taking or the second bank has to compensate the investors in the first bank for
accepting the effects of its risk-taking. In other words, it does not matter whether the
second bank has the right to take whatever risks it sees appropriate or the first bank has
the right to operate without the second bank imposing risks of failure on it. Provided
that these ‘property’ rights are clearly specified, it does not matter who holds the
entitlements at the outset—bargaining and negotiation will lead to the same efficient
outcome.
The Coase theorem rests critically on the assumption that negotiation or bargaining
costs are small. If they are not, then the efficient outcome will not be achieved and the
result of negotiation depends on how property rights are allocated: in the foregoing
example, to the first or the second bank. In particular, if, as in the case of the financial
crisis, there are a large number of individuals (for example, investors in our first bank
discussed above) that are affected by the failure of particular institutions, then it is
difficult or costly for them to coordinate in negotiation with the banks. Furthermore, it

9
See J Armour and JN Gordon, ‘Systemic Harms and Shareholder Value’ (2014) 6 Journal of Legal
Analysis 35. Armour and Gordon develop a distinction between diversified shareholders, whose entire
portfolio is damaged by the failure of a systemically important firm, and concentrated shareholders, whose
losses are limited to write-off of own-bank share values. The shareholders who are significant for corporate
governance purposes tend to be concentrated shareholders who are under-diversified and who will thus fail
to internalize systemic losses.
10
See eg A Beltratti and R Stulz, ‘The Credit Crisis Around the Globe: Why Did Some Banks Perform
Better?’ (2012) 105 Journal of Financial Economics 1; DH Erkens, M Hing, and P Matos, ‘Corporate
Governance in the 2007–2008 Financial Crisis: Evidence from Financial Institutions Worldwide’ (2012)
18 Journal of Corporate Finance 389. These issues are discussed further in Chapter 17.
11
RJ Coase, ‘The Problem of Social Cost’ (1960) 3 Journal of Law and Economics 1.
 The Goals and Strategies of Financial Regulation 59

may be even harder for these individuals to identify in advance which banks are taking
risks that might endanger their solvency and what the consequences of their failure
would be.
In these cases where private negotiation is expensive or infeasible, the government
may be able to ‘internalize’ externalities better than the private parties involved by
setting taxes and subsidies which reflect their costs and benefits, or by regulating the
activities of financial institutions in such a way as to prevent them from creating
damaging negative externalities. Systemic risks are classic examples of negative exter-
nalities that individuals and institutions cannot effectively internalize and which
governments need to correct through taxation or regulation.

3.3.3 Public goods

Banks also create positive externalities when they contribute to the liquidity of financial
markets. For example, the provision of a payments system that allows customers to use
their deposits to undertake transactions creates what is termed a ‘public good’—a good
or service from which everyone can benefit, even if they have not contributed to, or
paid for, the provision of that good or service. The classic examples of public goods
outside of the financial sector are the provision of a nation’s defence or national and
local public parks.
The economic problem with public goods is that since people can enjoy the benefits
of them without paying for them—what is termed ‘free-riding’12—the revenue that
they generate falls short of the sum total of the benefits that they create. The result is
under-provision of public goods that are privately provided.
There are a number of possible solutions to the public good problem. The first is that
the providers of public goods can be in public ownership. The scale of provision of
public goods is then determined, not by market processes, but through the stated
preferences of the public at large for the provision of these goods and services. For
example, the government can be responsible for the provision and operation of a
country’s payment system.
A second possibility is that the consumers of the public goods or the government
subsidize private providers of public goods to the extent that the revenue the providers
raise falls short of the value that consumers derive from them. For example, other
market participants or the government may subsidize those providing liquidity to
securities markets (‘market makers’) for the services that they provide.
Third, if the providers of public goods are granted a monopoly licence to be the sole
providers in their respective markets, then they may be able to set prices at levels which
reflect the benefits that consumers derive from them. The problem with this solution is
that charges will then be well in excess of the—essentially zero—cost of giving
consumers access to the public good (for example, admitting them to a public park)
and their use of the public good will then fall well below what it should be.

12
The term ‘free-rider’ originally derives from the practice, common in the early days of rail transpor-
tation, of riding a train without paying a fare.
60 Principles of Financial Regulation

Since public good problems are endemic in financial markets, we will see examples
of a variety of methods for trying to resolve the markets failures they create.

3.3.4 Imperfect competition

In section 3.2, we described the efficiency properties of competitive markets over three
distinct dimensions: productive, allocative, and dynamic efficiency. Competitive mar-
kets rely on the existence of a large number of small producers, the free entry and exit
of firms into and out of markets, and a large number of well-informed consumers who
can switch costlessly between producers and suppliers. If these conditions are not
fulfilled, then producers will be able to charge prices in excess of the cost of provision of
the goods and services, and resources will not be appropriately allocated to where they
yield the greatest benefit.
Market imperfections are endemic in financial markets. For example, four large
banks have traditionally dominated the retail commercial banking market in the
UK. The UK competition authorities regularly scrutinize them for possible monopoly
abuse.13 Entry into the retail banking market in particular is very expensive, so long as a
branch network is needed to establish a sufficient customer base, and provides incum-
bent retail banks with a considerable competitive advantage. And, as described in
section 3.3.1, asymmetric information is pervasive in financial markets, so incumbents
can exploit their market power without consumers even noticing it. As a consequence,
competition in many parts of financial services is far from perfect and the distortions
associated with imperfectly competitive markets, compounded by information asym-
metries, are widespread: excessively high prices, poor quality service, and the sale of
defective or inappropriate products.
Competition authorities, such as the Office of Fair Trading (‘OFT’) in the UK, the
Department of Justice (‘DOJ’) and the Federal Trade Commission (‘FTC’) in the US, or
the European Commission in the EU, are responsible for protecting customers against
the effects of anti-competitive practices and monopoly abuses. In the case of regulated
markets, such as financial services, it has also increasingly become the responsibility of
regulators, as well as competition authorities, to promote competition and police
competitive abuses.

3.3.5 Biases in individual decision-making

Up to this point, we have considered market failures in the context of parties who act
rationally in relation to the information that is available to them. So, for example, to the
extent that purchasers of financial services are at an informational disadvantage relative
to sellers (as discussed in section 3.3.1), their rational response is to desist from
engaging in trades that are likely to be overpriced or inappropriate. But investors
who cannot process information rationally may not respond in this way. Their beliefs

13
For example, in 2014 the UK’s Competition and Markets Authority (‘CMA’) launched an investiga-
tion into the supply of personal current accounts and services to small and medium-sized enterprises
(SMEs) in the UK.
 The Goals and Strategies of Financial Regulation 61

about the value of financial products and services may be biased, prejudiced, swayed by
crowds and herd mentality, and/or derived from the application of simple rules of
thumb that are inaccurate.14 The result can be that they buy products that they do not
need, should not possess, and come to regret.
Irrational beliefs do not just create disappointed investors. They also lead to a
misallocation of resources. The rational response of producers to irrational preferences
of consumers is often not to seek to correct them but to pander to them. The response of
banks to customers’ concerns about their inability to service loans due to ill-health or
unemployment led to the promotion of a new form of insurance in various European
countries—payments protection—which was unnecessary for customers but hugely
profitable for providers. Concerns amongst small and medium-sized companies in
various European countries about possible increases in interest rates prompted the
mis-selling of interest rate swaps. In both cases, banks profited from pandering to
customers’ irrational concerns by selling them unnecessary and/or overpriced products.
Biases in consumer behaviour pose a substantial challenge to regulators. If pur-
chasers of financial services behave rationally, then the role of the regulator is to protect
them from deceptive or inappropriate conduct on the part of sellers and to ensure that
what they get is what they wanted. However, if consumer preferences are subject to
biases, then the function of regulation potentially becomes a much more complex one,
not aligning financial services so much with what (distorted) consumer preferences
actually are, but with what analysis suggests that they should be, but for the bias in
question. So for example, the appropriate pricing of payments protection insurance
and interest rate swaps in the UK should then have been based not on customer
perceptions of the associated risks but on unbiased expectations. This potentially
involves regulators in much more paternalistic intervention in the operation of markets
than a rational view of consumer behaviour would warrant.

3.4 The Goals of Financial Regulation

Having described the merits and defects of markets, the next stage is to determine what
policymakers can legitimately be seeking to achieve through regulation—namely, the
goals of regulation. While the goals of regulation are not always articulated in economic
terms, an underlying thesis of this book is that considerable insights are provided by so
doing. Economics starts from market efficiency (and distribution) as the defining
considerations and derives a set of goals based upon these. Regulation is then under-
stood as the means of rectifying relevant market failures.
Characterizing the goals of regulation in this way helps to develop focused criteria
for assessing the merits of particular regulatory strategies. The criteria are linked to
the underlying functioning of the financial system which the regulation is seeking
to improve and are independent of the legal system within which the regulation is

14
For reviews, see T Gilovich, D Griffin, and D Kahneman (eds), Heuristics and Biases: The Psychology
of Intuitive Judgment (Cambridge: CUP, 2002); D Kahneman, Thinking, Fast and Slow (Cambridge: CUP,
2011); C Sunstein, ‘Empirically Informed Regulation’ (2011) 78 University of Chicago Law Review 1349.
These issues are treated in more detail in Chapter 10.
62 Principles of Financial Regulation

operating. Consequently, these criteria provide a framework that can in principle be

used to understand and assess financial regulation in any jurisdiction.
In this section, we review the goals of financial regulation, as articulated by regu-
lators, and relate them to the economic rationales we have discussed. We identify six
discrete goals and argue that each of these can helpfully be understood as responding to
a particular type of market failure.

3.4.1 Protection of investors and other users of the financial system

The protection of users of the financial system is an important goal of financial
regulation. That said, regulators do not typically refer to the category of persons to
be protected as ‘users’ generically, but rather by a series of sector-specific names. The
use of different names in the regulatory framework obscures the fact that they each
respond to similar economic concerns, and so it is useful to group them together.15
Perhaps the best known of these goals is ‘investor protection’. This is an explicit goal
of securities regulation. The US Securities Act 1933 and Securities Exchange Act of
1934 were introduced with the express goal of protecting investors from fraud and
other malpractices associated with securities issuance and trading during the bubble of
the 1920s.16 ‘Investor protection’ now also features at the centre of European securities
regulation, the importance of which is emphasized by the preambles to the principal
Directives.17 In relation to issuers of securities, investor protection is understood
largely in terms of mandating the disclosure of relevant information. The concern is
that without this information, would-be investors will be unable to assess clearly the
risks they are taking on, and will consequently be unwilling to advance funds. If we
relate this back to the economic rationales for regulation, the underlying concern is
asymmetric information giving rise to an adverse selection problem.
Problems stemming from asymmetric information also arise in relation to situations
where an investor relies on a financial firm for judgements about investment choices or
execution of trades, and/or for safe custody of assets. In this case, the regulatory goal is
described as ‘client protection’,18 or where the financial firm is a US broker-dealer,

15
An attempt was made in the UK to overcome this balkanization of terminology through the adoption
in the Financial Services and Markets Act 2000 (‘FSMA 2000’) of the term ‘consumer protection’ as an
umbrella concept encompassing the protection of all the users of the financial system for the purposes of
defining regulatory objectives (see now FSMA 2000, s 1G). However, this terminology has not been more
widely adopted: in the US or EU, and indeed in other contexts in the UK, the term ‘consumer’ more usually
refers only to individuals acting in a personal capacity: see section 3.4.1, especially n 28. Moreover, even in
the UK, the unification of terminology is no longer comprehensive, as the Prudential Regulation Authority
has since 2013 been tasked with the discrete goal of ‘policyholder protection’ in relation to insurance firms:
FSMA 2000, s 2C(2).
16
See eg J Seligman, ‘The Historical Need for a Mandatory Corporate Disclosure System’ (1983) 9
Journal of Corporation Law 1. See also Commodity Exchange Act of 1936 (US), 7 USC §5(b); Trust
Indenture Act of 1939 (US), §302)(a) (expressing investor protection rationale).
17
See eg Directive 2003/71/EC (Prospectus Directive) [2003] OJ L345/64, recitals 10, 12, and 16;
Directive 2014/65/EU (Second Markets in Financial Instruments Directive or ‘MiFID II’) [2014] OJ
L173/349, recitals 7, 39, 45, 57, 58, 97, and 133; Directive 2004/109/EC (Transparency Directive) [2004]
OJ L390/38, recitals 1, 5, and 7.
18
See Investment Advisers Act of 1940 (US), §201(1); MiFID II, n 17, recitals 5 and 80; Art 4(1)(9) and
Annex II.
 The Goals and Strategies of Financial Regulation 63

‘customer protection’.19 Here the risks for the client or customer are not only those
inherent in the investments selected, but also that the financial firm may make poor
investment choices, or may fail to segregate, or—worse still—misappropriate assets.
These risks arise from actions the financial firm may take during the life of the
relationship, which are very difficult for the client to monitor. Once again, the economic
problem is asymmetric information, in this case giving rise to agency costs. A number of
regulatory measures seek to reduce these risks. These include licensing requirements,
custodial requirements, and measures to control conflicts of interest and enhance
competence. A large part of these measures governs how the intermediary must operate
its business and so they are called ‘conduct of business’ rules. Functionally, they can be
thought of as mandatory terms of the contractual relationship between the client and
the intermediary, responding to agency costs.
Agency problems are also present in relation to financial intermediaries such as
banks, insurance companies, and mutual funds. Bank depositors, insurance policy
holders and mutual fund investors each transfer funds to such financial intermediaries
in return for claims against the intermediary’s balance sheet. The value of these claims
depends on how the intermediary invests the funds thereby raised. In each case, there is
the potential for agency costs stemming from the difficulty of monitoring the inter-
mediary’s actions. Regulations seeking to control these agency costs are framed in
terms of ‘depositor protection’,20 ‘policy holder protection’,21 and ‘investor protec-
tion’,22 respectively. Together, the body of regulation that governs the risks associated
with the business model of a financial intermediary is often referred to as ‘prudential’
regulation, the idea being that it instils prudence in the regulated firm so as to protect
those who rely on the firm.
It is worth asking why information asymmetries between end users of the financial
system and financial intermediaries should be thought to justify extensive regulation,
when functionally similar problems arise in relation to many other services. A short
answer is that most important non-financial services that involve extensive informa-
tion asymmetries—and consequent agency costs—are in fact subject to regulation:
witness for example the cases of doctors and lawyers. A more nuanced response asserts
that the problems are particularly severe in relation to finance: the business model of
financial firms is unusually opaque,23 and the business of financial firms, namely
money, is particularly prone to abuse. For example, the notorious fraudster Bernie
Madoff maintained his investment scheme for nearly thirty years because his consistent

19
See eg Securities Investor Protection Act of 1970 (US), §5.
20
See eg Directive 2013/36/EC (Capital Requirements Directive IV or ‘CRD IV’) [2013] OJ L176/338,
recital 47; Federal Deposit Insurance Act (US) §3(l), 12 USC §1813(l).
21
See eg Directive 2009/138/EC (‘Solvency II’) [2009] OJ L335/1, recital 16 and Art 27.
22
See eg Investment Company Act of 1940 (US), §1; Directive 2009/65/EC, as amended by Directive
2014/91/EU (Undertakings for Collective Investment in Transferable Securities Directive, or ‘UCITS V’)
[2009] OJ L302/32, recitals 8 and 10.
23
For example, ratings agencies disagree much more about the credit rating of bonds issued by financial
institutions than for non-financial firms: see DP Morgan, ‘Rating Banks: Risk and Uncertainty in an
Opaque Industry’ (2002) 92 American Economic Review 874. See also RP Bartlett, ‘Making Banks Trans-
parent’ (2012) 65 Vanderbilt Law Review 293.
64 Principles of Financial Regulation

out-performance attracted increasing sums that in turn funded the payouts to his
clients.24

3.4.2 Consumer protection in retail finance

‘Consumer protection’ is an express goal of the new US Consumer Financial Protection
Bureau, established by the Dodd–Frank Act of 2010.25 Similarly, it is also the express
goal of certain EU consumer financial legislation, which forms part of the corpus of
European consumer protection law more generally.26 ‘Consumers’ in these contexts are
defined as individuals acting outside the course of their business,27 a definition we
generally adopt throughout this book.
For transactions involving consumers, the rationale for regulation is significantly
broader than for most types of user of the financial system, encompassing not only
asymmetric information but also behavioural considerations. There is a potential role
for regulation to protect consumers from exploitation of their biases and inaccurate
judgements. The types of regulatory intervention calculated to further the goal of
consumer protection might therefore be quite different from those aimed at assisting
more sophisticated users. We discuss the particular issues relevant to the regulation of
consumer finance in Chapter 10.
Although the definition of ‘consumer’ as an individual acting in their personal
capacity is widely used in consumer law, financial regulation includes some more
idiosyncratic usage.28 In US and EU financial regulation, the term ‘consumer’ is
principally used in the regulation of consumer credit—that is, referring to consumer
users of the financial system who are also borrowers. This is an artefact of the
continued sectoral division of regulation, in which consumers so defined form just
one of many categories. In other contexts, individuals investing modest sums on
their own account are referred to as ‘retail’ investors, clients, customers, and so on.
Throughout the book, we refer to ‘consumers’ and ‘retail’ users of the financial system
largely interchangeably.29

3.4.3 Financial stability

The financial crisis has highlighted the central importance of another goal of financial
regulation, namely the stability of the financial system as a whole. In section 3.3.2 we

24
See n 7.
25
Dodd–Frank Act of 2010 (US), §1001 (short title of Title X is ‘Consumer Financial Protection Act of
2010’).
26
See eg Directive 2008/48/EC on Credit Agreements for Consumers (‘Consumer Credit Directive’)
[2008] OJ L133/66; Directive 2011/83/EU on Consumer Rights (‘Consumer Rights Directive’) [2011] OJ
L304/64.
27
See Dodd–Frank Act of 2010 (US) §1002(4)–(5); Consumer Credit Directive, Art 3(a); Consumer
Rights Directive, Art 2(1).
28
For example, in UK financial regulation, the term ‘consumer’ is used in a much broader sense, to refer
to all users of regulated financial services or investors in financial instruments (see n 15). However, this sits
awkwardly alongside English law’s more conventional use of the term ‘consumers’ for the purposes of
consumer contract law: see eg Consumer Rights Act 2015 (UK), s 2(3). See also Chapter 10, section 10.1.
29
Minor differences between the two definitions are discussed in Chapter 10, sections 10.1 and 10.5.
 The Goals and Strategies of Financial Regulation 65

considered how the failure of one institution can have a ‘domino effect’ on the entire
financial sector and repercussions for the economy as a whole.
The unpredictable and extensive nature of the losses inflicted by a systemic failure
makes it practically impossible for parties who might suffer losses to contract in
advance with financial institutions whose choice of activities will affect their probability
of failure.30 Consequently, it is desirable for financial regulation to address this type of
externality.
Prior to the financial crisis, there was thought to be almost complete overlap between
the goals of user protection and financial stability, at least as regards banks. Prudential
regulation designed to minimize the probability that a bank should fail was thought to
be adequate to protect both the bank’s depositors and the rest of the financial system.
Most obviously, capital adequacy requirements, already referred to in the investor
protection discussion, were thought of as being necessary to preserve financial stability
as well.31 Similarly, deposit insurance schemes, initially introduced in the US after the
Great Depression to protect depositors, had the serendipitous consequence of making
bank runs less likely, as depositors had little to fear from bank failure.32 Perhaps for this
reason, the UK’s financial regulatory regime did not at the time of the financial crisis
mention financial stability as a goal at all: it was believed that maintaining market
confidence and protecting users of the financial system would necessarily entail
financial stability.33
This equation of goals has been undermined by events leading up to the financial
crisis. First, as respects bank runs, sophisticated investors proved themselves just as
capable as unsophisticated consumers of engaging in ‘run’-like behaviour.34 Yet insur-
ance schemes protect only retail depositors—that is, consumers. Second, it is unneces-
sary for an institution to fail for a systemic shock to be triggered. The ‘domino effect’
model of transmission of contagion focuses on the way in which liabilities on the
balance sheet of the failed institution are assets on the balance sheet of other institu-
tions, which transmits a shock following its failure. However, a shock may also be
transmitted through correlated investment strategies. Where one institution suffers a
liquidity shock and needs to sell assets quickly, this sale may depress the market price
(especially if the assets are illiquid) and reduce the value of these assets on other
institutions’ balance sheets. This in turn might trigger a need for these institutions to
liquidate assets in order to deleverage or to hold back cash that otherwise might have

30
Moreover, the law of tort, which may be understood as a private law mechanism for controlling
externalities, fails to be effective in relation to the financial sector, because the losses inflicted are exclusively
economic, for which recovery is generally unavailable in tort. See Armour and Gordon, n 9, 46–7.
31
See eg CRD IV, n 20, recitals 47 and 91 (‘protection of depositors’). See also SG Hanson, AK Kashyap,
and JC Stein, ‘A Macroprudential Approach to Financial Regulation’ (2011) 25 Journal of Economic
Perspectives 3.
32
DW Diamond and PH Dybvig, ‘Banks Runs, Deposit Insurance, and Liquidity’ (1983) 91 Journal of
Political Economy 401. On the history of deposit insurance, see CW Calomiris and EN White, ‘The Origins
of Federal Deposit Insurance’, in C Goldin and GD Libecap (eds), The Regulated Economy: A Historical
Approach to Political Economy (Chicago: University of Chicago Press, 1994), 145.
33
See now Bank of England Act 1998 (UK) (as amended by the Banking Act 2009 and the Financial
Services Act 2012), s 2A; Financial Services and Markets Act 2000 (UK) (as amended by the Financial
Services Act 2012), s 2B(3).
34
GB Gorton, Slapped by the Invisible Hand (Oxford: OUP, 2010).
66 Principles of Financial Regulation

been lent out either to other financial firms or non-financial firms. Third, it has become
clear that techniques designed to mitigate the risk of failure at a single institution are
inadequate to mitigate systemic risk.
The most striking lesson of the financial crisis was the inadequacy of contemporary
prudential regulation for preserving financial stability. This has resulted in a host of
new measures: special regulation for institutions which are deemed to be ‘systemically
important’, and even a new type of regulation—so called ‘macroprudential’ regulation—
which is intended to focus on the stability of the system as a whole. This is discussed in
detail in Chapter 19.

3.4.4 Market efficiency

Legislators and regulators view the facilitation of ‘efficient capital markets’ as part of
their goal.35 However, and rather confusingly, this term is often used in a way that does
not relate to the efficiency of capital markets in the more conventional senses discussed
in section 3.2, but what is called their ‘informational’ efficiency. We therefore need to
understand what this latter concept is, and how it is related to other senses of efficiency.
Capital markets serve to allocate funds to projects which firms wish to pursue, most
obviously when new securities are issued to fund a new project. However, there is a
puzzle. Many markets in the financial system are secondary—that is, the trade occurs
between investors. To be sure, such trade reallocates the assets between investors, with
the asset ending up in the hands of someone who values it more than the original
owner. However, unlike primary markets for capital, secondary markets do not affect
directly the actions of the firms who have issued the claims. Such trades do not affect
the capital available to firms, and consequently do not affect managers’ resource
constraints.
The existence of secondary markets, as we have seen in Chapter 2,36 has the benefit
of providing liquidity for investors—that is, they can exit the investment quickly if they
need cash for whatever reason. The availability of this liquidity will in turn make
investors more willing to buy securities in the primary market, because they know that
should they suffer a financial shock, they will be able to liquidate their investment
quickly. Moreover, the existence of a secondary market in which lots of trading
occurs—said to be a ‘liquid’ market—enables capital markets better to perform the
function we described of aggregating information about the value of activities.
The value of most physical assets depends on the attributes of the asset, which can be
determined by examination (consider residential real estate, for example). Conse-
quently, such an asset market can in principle achieve allocative efficiency. However,
the value of financial assets—stocks or bonds, for example—depends on the resolution
of many uncertainties regarding the firm’s investment policy and on the control of
agency costs associated with the firm’s management. In short, these values, rooted in
the firm’s expected revenue stream, are affected by uncertainties and thus will evolve

35
See eg Prospectus Directive, n 17, recitals 10 and 46 (‘market efficiency’); MiFID II, n 17, recital 164
(‘efficiency…of the overall market’); Transparency Directive, n 17, recital 1 (‘market efficiency’).
36
Chapter 2, section 2.3.2.
 The Goals and Strategies of Financial Regulation 67

over time as uncertainties are resolved. Each new piece of information will affect
valuations. If there are no secondary markets, then we must rely on primary markets
to assess the expected value of a firm’s investment strategy at the outset. This will be
difficult to do. Secondary markets allow for an exchange of financial assets where, on
the announcement of new information, a different investor to the one holding the asset
now values it more highly.37
This not only ensures that the financial assets are in the hands of the investors who
value them most highly, but it also allows the market price to act as a real-time estimate
of the present value of the firm’s expected future revenue streams, given its current
management and investment policy. The speed and accuracy with which the market
price responds to the release of new information is said to be its ‘informational
efficiency’.38 The informational efficiency of public securities markets is much debated
and the subject of an extensive literature. It is discussed in Chapter 5.
Why is informational efficiency desirable in terms of the functioning of the financial
system? Informationally efficient markets stimulate liquidity. To see this, consider a
market that is known not to be informationally efficient. In such a market, some parties
will assume that their counterparty is buying/selling on the basis of superior informa-
tion and thus would shade the price at which they will transact. (This is called
‘widening the bid-ask spread’.) Other parties would prefer to delay trading until they
believe all relevant information has been incorporated into the price. Both scenarios
will reduce the number of parties willing to trade and consequently will impede
liquidity. Greater liquidity in turn helps to mobilize investors to participate in the
market.
Informationally efficient secondary markets also open up new possibilities for
monitoring the performance of firms’ investment policies. In particular, the market
price acts as a continuous-time assessment of the value of the firm under the current
investment policy. If managers’ actions can be guided by the market price, then this can
help to ensure that the firm’s investment decisions are allocatively efficient.39 For this
to work well, however, not only must the market incorporate new information rapidly
into the price but as much information as possible.
Regulation can help to facilitate the production of such information. Although good
firms would benefit from credible disclosure of their attributes, through a lower cost of
capital, managers would also be concerned about revealing details of their business
model to competitors. Managers may also be reluctant to subject their performance to
evaluation by fully informed stock prices. Thus, left to their own devices, corporate
managers would likely make less information public than is socially desirable. Corpor-
ate information is, in other words, a public good. Mandatory disclosure can thus be

37
This helps us understand why secondary trading in stocks is robust while secondary trading in bonds
much less so. Bondholder returns are capped at repayment of principal and interest and for most firms that
issue public debt, repayment risk is stable. Bond prices are therefore less ‘information sensitive’ than those
of stocks.
38
See the discussion in Chapter 5, section 5.2.
39
J Dow and G Gorton, ‘Stock Market Efficiency and Economic Efficiency: Is There a Connection?’
(1997) 52 Journal of Finance 1087.
68 Principles of Financial Regulation

understood as subsidizing the production of this information.40 There is some empir-

ical support for the assertion that increasing the scope of mandatory disclosure is
associated with more accurate pricing of securities in public equity markets.41 This in
turn helps advance allocative efficiency, for the reasons we have seen.

3.4.5 Competition
Financial regulation is also concerned with promoting competition in the sector. While
there are specialist competition (antitrust) laws and regulators in most jurisdictions,
the task of promoting competition in the financial sector is also partly dealt with by
financial regulators.
The most obvious example of the promotion of competition concerns the removal of
barriers to international competition. In the European Union in particular, much of the
legislative policy concerning the financial system has been concerned with establishing
pan-European markets in which firms can compete with others throughout the EU.42
This has been achieved in two steps. First, Member States have been required to drop
restrictions on international firms within the EU and to give credit to the regulatory
regimes in place in other Member States. As a result, a financial services firm that is
licensed to operate in any EU member state is treated as having a ‘passport’ to market
its services throughout the EU, without the imposition by other Member States of any
additional regulatory burdens. This freedom is premised upon equivalence of domestic
regulatory safeguards. In order to guarantee this, the associated second regulatory step
has been to agree on minimum standards that have then been harmonized throughout
the EU by European legislation.
There are also a number of instances where competition has actively been promoted
within a jurisdiction or series of jurisdictions other than by the development of cross-
border markets. For example, in the field of banking, competition can be promoted by
the relaxation of prudential regulation, which effectively creates a barrier to entry, or by
permitting mutual societies to convert to shareholder ownership in order to raise
greater capital. Similarly, in the field of securities trading, the abolition of ties between
brokers, dealers, and exchanges creates greater possibilities for competition between
venues for trading securities. Each of these initiatives is motivated by the desire to
increase the penetration of the relevant financial services through removing anti-
competitive practices. One of the most striking examples of where deregulation was
used to promote competition was ‘Big Bang’ in the UK in 1986, which removed the
prohibitions to the free entry of new participants and the restrictive practices that
previously existed in UK financial markets. Similarly, in the US, fixed commissions for

40
JC Coffee, Jr, ‘Market Failure and the Economic Case for a Mandatory Disclosure System’ (1984) 70
Virginia Law Review 717.
41
MB Fox, R Morck, B Yeung, and A Durnev, ‘Law, Share Price Accuracy, and Economic Performance:
The New Evidence’ (2003) 102 Michigan Law Review 331.
42
This is recognized in legislative measures: see eg Prospectus Directive, n 17, recital 41; Transparency
Directive, n 17, recital 36; UCITS V Directive, n 22, recital 3; see also National Securities Market
Improvement Act 1996 (US) §106, requiring the SEC, when exercising rulemaking powers under US
securities legislation, to consider, ‘in addition to the protection of investors, whether the action will promote
efficiency, competition, and capital formation’ (emphasis added).
 The Goals and Strategies of Financial Regulation 69

stock trading were eliminated on 1 May 1975, ‘May Day’, and in 2000 the SEC ended a
market rule that confined trading of securities listed on the New York Stock Exchange
(‘NYSE’) to the NYSE itself. Thus, the way was opened for new entrants and new forms
of stock market trading.

3.4.6 Preventing financial crime

The prevention of financial crime is a primary goal of financial regulation in many
countries. It is mentioned explicitly, for example, as a matter to which the UK’s
Financial Conduct Authority must have regard in performing its general functions.43
This goal is also implemented elsewhere by specific legislation.44 However, there is a
question mark as to the extent to which this is genuinely an independent goal of
financial regulation or merely a means of achieving other goals.
In a loose sense, ‘financial crime’ might be understood as any criminal act associated
with the financial system.45 This would then encompass many instances of criminal
liability imposed in order to further the goals of financial regulation we have already
considered—for example, liability for insider trading or fraudulent misstatements in
disclosures to investors. Preventing crimes of this type is not an independent goal of
financial regulation; rather, it is simply an instrument for achieving the regulatory goals
that criminal sanctions support.
However, we can distinguish a particular sense of ‘financial crime’, the prevention
of which is not parasitic on other goals of the financial system. Such prohibitions are
concerned with preventing the financial system from being used for ends judged to
be socially harmful, namely public bads (negative externalities)—the opposite of
public goods. It includes: (i) the use of financial services by criminal and terrorist
organizations, justifying prohibitions on money laundering and terrorist financing;
(ii) the making of payments designed to influence a decision-maker improperly—that
is, bribery and corruption; (iii) the making of payments associated with trade which is
in prohibited goods (such as slavery, weapons, endangered species) or with countries
on which economic sanctions have been imposed; and (iv) the use of the financial
system to hide assets from tax authorities and creditors.

3.4.7 Other goals of financial regulation?

Financial regulators cite a number of other goals, some of which are simply restate-
ments of the foregoing. For example, a number of regulatory pronouncements speak of
the desirability of ‘lowering the cost of capital’ for firms,46 or of promoting ‘capital

43
Financial Services and Markets Act 2000 (as amended by the Financial Services Act 2012), s 1B(5)(b).
44
In the EU, the Anti-Money Laundering Directive 2005/60/EC [2005] OJ L309/15, and the US, the
Bank Secrecy Act (Currency and Foreign Transactions Reporting Act of 1970) and the Patriot Act (Uniting
and Strengthening America by Providing Appropriate Tools Required to Intercept and Obstruct Terrorism
(USA PATRIOT) Act of 2001).
45
See eg Financial Services and Markets Act 2000 (‘FSMA’) (UK), s 1H(3) (‘financial crime’ defined as
including fraud or dishonesty, misconduct in, or misuse of information relating to, a financial market,
handling the proceeds of crime, or the financing of terrorism).
46
See eg Prospectus Directive, n 17, recital 41; Transparency Directive, n 17, recital 36.
70 Principles of Financial Regulation

formation’.47 These may be expected to flow from the achievement of the goals of
investor protection and enhancement of market efficiency we have described.
Others are implicit in the way in which an economic case for regulation is framed.
For example, the recitals to a number of the relevant EU Directives speak of the need to
‘balance costs and benefits’, and the need to ‘encourage innovation in financial mar-
kets’.48 Making an economic case for regulatory intervention presupposes not only that
there is in principle a failure in the market, but also that regulatory intervention can put
it right (or at least improve on the status quo).
In assessing this question, the fact that regulation brings with it costs must be taken
into account, so that the case for regulation focuses on establishing the existence of net
benefits where the benefits to society from intervention exceed the costs. This is not so
much an independent goal of financial regulation, as a statement of the appropriate
process to be followed in reaching the goals.49 One important challenge is that
assessing the costs and benefits of a financial regulatory change is often very difficult
in practice,50 particularly because important rule changes may result in considerable
change to the financial system itself, in ways that are not readily predictable.51 But cost-
benefit analysis can still provide a valuable check on the rationality of policymaking, if
applied insofar as the quantitative evidence will permit. Thus, a modest enquiry in the
face of pervasive uncertainty might simply seek to articulate what sorts of benefits and
costs a proposed rule might have (without necessarily quantifying them).52 Or, if a
range of possible estimates can be produced, policymakers can seek to satisfy them-
selves that the benefits of a measure are at least likely to exceed the costs (a ‘breakeven’
test).53 The extent to which these sorts of refinements can be deployed may depend on
whether cost-benefit analysis is seen simply as a tool for good policymaking,54 or
whether—as is sometimes the case in the US—it is subject to scrutiny in judicial review
of the authority of regulatory action.55
Throughout this book we will often argue for the importance, indeed priority, of
financial stability as a regulatory goal. Pursuit of this goal raises particular challenges
for a decision procedure like cost-benefit analysis. The sums involved are vast—tens of
billions, even trillions. In a thoughtful recent critique of the use of cost-benefit analysis

47
National Securities Market Improvement Act 1996 (US) §106.
48
See sources cited in n 42.
49
See eg Financial Services Authority (UK), Practical Cost-Benefit Analysis for Financial Regulators
Version 1.1 (2000), 5–6.
50
JC Coates IV, ‘Cost-Benefit Analysis of Financial Regulation: Case Studies and Implications’ (2015)
124 Yale Law Journal 882; cf EA Posner and EG Weyl, ‘Benefit-Cost Analysis for Financial Regulation’
(2013) 103 American Economic Review 393.
51
JN Gordon, ‘The Empty Call for Benefit-Cost Analysis for Financial Regulation’ (2014) 43 Journal of
Legal Studies 351. A classic example is Glass–Steagall’s divorce of commercial banking from investing
banking.
52
See Coates, n 50, 891–8 (distinguishing ‘conceptual’ from ‘quantified’ cost-benefit analysis).
53
CR Sunstein, ‘Financial Regulation and Cost-Benefit Analysis’ (2015) Yale Law Journal Forum 263.
54
For example, in the UK, financial regulators are required to produce a ‘detailed cost-benefit analysis’
as part of their consultation process over new rules, but in order to exercise their powers validly are held
only to the lesser standard of ‘hav[ing] regard to’ the principle that ‘burdens’ should be ‘proportionate’ to
their expected benefits: FSMA 2000, ss 3B(1)(b), 138I, 138J.
55
See Business Roundtable v SEC 647 F.3d 1144 (CADC, 2011); SEC Memo, Current Guidance on
Economic Analysis in SEC Rulemakings, 16 March 2012.
 The Goals and Strategies of Financial Regulation 71

in financial regulation, John Coates argues that the regulators’ efforts to quantify in this
domain are inevitably based on arbitrary choices and do not serve as an independent
check on the regulators’ decision-making.56 The regulators need decision tools, how-
ever, and framing policy choices as regards financial stability in terms of trade-offs and
immediate and foreseeable consequences, while marshalling whatever quantitative or
qualitative evidence is available, may be the most that our limited foresight will permit.
The justifications we have discussed all have in mind the over-arching goal of
enhancing efficiency. A final category of policy goals, which are based on distributional
outcomes, stands distinct from this. It is not uncommon for policymakers to seek to
further distributional goals through the financial system. For example, during the
opening years of the twenty-first century, policymakers in the US sought to facilitate
house purchases by large numbers of Americans who previously would not have been
considered wealthy enough to do so. This was associated with an increase in the
extension of mortgage credit. Similarly, in many developing countries, the extension
of the availability of credit to citizens is viewed as a goal in its own right, regardless of
their quality as borrowers. And we shall see in Chapter 10 that the regulation of
consumer financial services may also be understood as furthering distributional, as
well as efficiency-related, goals.

3.4.8 The regulatory objective function

We have articulated six goals of financial regulation that respond to distinct market
failures and which regulators are tasked with implementing. A key challenge they pose
is that the goals are often in tension and sometimes in conflict with one another. It is
necessary to understand how the goals may conflict and to develop a framework for
resolving such conflicts to arrive at an ‘objective function’ for regulators.
Investor and consumer protection may conflict with financial stability by reducing
diversity in the financial system. Microprudential rules designed to reduce agency costs
in financial institutions may have the effect of channelling large pools of capital into a
restricted number of investment types and strategies. The application of restrictions on
the types of investment in which consumers may participate increases the correlation
of investment strategies at the level of the system as a whole, and reduces its resilience
to systemic shocks.
Such restrictions may also have implications for informational efficiency. Restric-
tions on the ways in which institutional investors can trade in the market may increase
the possibility of herding, which makes it more difficult for arbitrageurs to act to
correct pricing anomalies and distortions.57
The promotion of competition amongst providers of financial services may also be
in tension with other goals. Most obviously, excessive competition amongst financial

56
See Coates, n 50.
57
There may also be a tension with financial stability. In times of crisis, the short selling of financial
institution shares may contribute to so-called ‘equity runs’. If creditors of these institutions look to the share
price for an indication of expectations, then this may become self-fulfilling. Consequently, a number of
jurisdictions saw fit to impose restrictions on the short selling of financial institution stock during the
financial crisis. This, however, makes it harder to control any upward price pressure.
72 Principles of Financial Regulation

institutions results in lower profitability and consequently an urge to engage in more

risky activities.58 This is inimical to financial stability. Eliminating interest rate caps on
consumer savings accounts encourages a competition for deposits that benefits con-
sumers, but it may also lead banks to favour riskier loans with high yields. This too can
threaten financial stability. Competition also encourages firms to focus on the dimen-
sions of their products most salient to consumers, cutting costs along other dimen-
sions. If consumers cannot assess those other dimensions, inferior products may
result.59
In thinking about how the pursuit of these goals should be prioritized, regulators
need to think about the corpus of financial regulation in the round, and whether the
various aspects combine to maximize overall efficiency of the financial system without
undercutting one another. This has two important implications. The first relates to the
relative size of the stakes as among different regulatory goals. The Sarbanes–Oxley Act
of 2002, which targeted investor protection, is estimated to have had an impact ranging
somewhere between a net cost of $289 billion and a net benefit of $317 billion.60 The
UK FSA’s introduction of ‘affordability’ checks for mortgage borrowers in the UK,
intended as a consumer protection measure, was associated with a net benefit estimated
by the FSA at around $9 billion.61 These are all large numbers. Yet the introduction of
Basel III, a measure primarily seeking to further financial stability, has cost estimates in
trillions, and benefit estimates in tens of trillions, of dollars:62 orders of magnitude
larger than the numbers discussed in relation to any of the other measures. This implies
that the amounts at stake in relation to financial stability, at least for mature financial
systems, significantly outweigh the amounts at stake as regards other regulatory goals.
The second implication is for the design of regulatory institutions: at least one
agency needs to be tasked with thinking about these issues and determining a regula-
tory objective function. This agency should have access to information on a system-
wide basis and the power to tell other agencies when to rein in (or expand) their
activities in accordance with the regulatory objective function. In our view, the agency
best placed to perform this function is the one tasked with macroprudential oversight
of the system as a whole.63

3.5 The Strategies of Financial Regulation

Financial regulation around the world employs a discrete number of techniques to
achieve the goals we have outlined. We group these into seven ‘strategies’, which are set

58
X Vives, ‘Competition and Stability in Banking: A New World for Competition Policy?’, Working
Paper (2009), IESE Business School.
59
Competition amongst trading platforms can also undermine the goal of promoting informational
efficiency. This is because price formation only operates on the basis of trades actually occurring and
announced in a given marketplace. Trading in smaller venues may result in lower costs for participants, but
will make price aggregation less effective: see RA Schwartz and R Francioni, Equity Markets in Action
(2004), 318–28.
60
Coates, n 50, 946.
61
Ibid, 989 (citing FSA, Mortgage Market Review: Proposed Package of Reforms, Consultation Paper
11/31, 2011).
62 63
Ibid, 959–74. See further Chapters 19 and 27.
 The Goals and Strategies of Financial Regulation 73

Table 3.1 Strategies of Financial Regulation

Scope of obligations: User Firm Sectoral

Regulatory strategy

Ex ante strategies
Entry regulation Participation Licensing Market power
Profiling Qualification requirements
Product regulation
Structural restrictions
Conduct regulation Trading rules Trading restrictions
Conduct of business
Information regulation Education Disclosure
Prudential regulation Balance sheet Macroprudential
Governance regulation Board structure
Compensation regulation
Risk management
Ownership restrictions
Ex post strategies
Insurance Insurance Lender of last resort Lender of last resort
Bail-outs Bail-outs
Resolution Resolution procedures

out in Table 3.1.64 The exercise of grouping is undertaken so as to facilitate an

overview, from a high level, of the different mechanisms employed in financial
regulation. This enables us to think about their interrelationships with each other,
and with the financial system. In particular, it helps us to escape from the ‘silos’
approach that afflicts many other treatments of financial regulation. The classification
is therefore not intended to be definitive: it is offered simply as a heuristic device rather
than a traditional legal taxonomy.65
We categorize these seven core strategies of financial regulation in two ways. First,
we classify the strategies according to the timing of their application. Ex ante strategies
apply from the moment at which the investment is made or the activity carried out.
There are five ex ante strategies described in this section: entry, conduct, information,
prudential, and governance regulation. Ex post strategies apply only if something goes
wrong. Insurance and resolution are examples of ex post strategies. This division is set
out in the rows of Table 3.1.
Second, we classify the strategies by the scope of the obligations they impose.
This is shown in the columns in Table 3.1. ‘User’-based obligations restrict the
actions of investors, consumers, and customers of financial products or services.

64
Analysing regulatory techniques in terms of generic strategies has an influential pedigree within legal
scholarship: see eg RC Clark, ‘The Soundness of Financial Intermediaries’ (1976) 86 Yale Law Journal 1;
R Kraakman, J Armour, P Davies, L Enriques, H Hansmann, G Hertig, K Hopt, H Kanda, M Pargendler,
WG Ringe, and E Rock, The Anatomy of Corporate Law, 3rd ed (Oxford: OUP, 2016), Ch 2.
65
Questions of taxonomy are traditionally very important for legal scholars because the categorization
of an obligation can affect the chances of a successful claim, through the application of defences, procedure,
limitations, etc. None of these consequences flows from the classification offered here. It is simply offered as
an expository device. This means that the test of its utility is whether it helps you to understand the field.
74 Principles of Financial Regulation

Firm-based obligations apply to firms offering, or advising upon, financial prod-

ucts. Sector-based obligations apply to firms offering, or advising upon, financial
products conditional on the behaviour of other firms in the sector.

3.5.1 Entry
Entry regulation affects the ability of (would-be) participants in the financial system to
engage in financial transactions with other participants. From the user’s perspective,
this means participation restrictions.66 These inhibit the ability of market players to
engage in particular sorts of financial transaction. For example, many types of security
and investment product may only be offered to ‘sophisticated’ investors. Formally, the
legal obligation to abstain from offering is imposed on the putative offeror, but the
effect is primarily felt by the unsophisticated investor, who consequently may not
participate in markets for securities of this type.67
The entry of financial firms is subject to licensing requirements: regulators must
grant approval to the firm prior to it opening its doors for business. To a large degree,
licensing regimes are simply a means of enforcing the other firm-based regulatory
techniques. Initial and continuing compliance is made a condition of the grant of a
licence, with the consequence that the sanction for non-compliance could be the
cessation of the firm’s business. However, licensing also entails independent require-
ments, especially depending on the identity and character of the owners and managers
of the firm. In particular, this seeks to weed out those with a history of having
committed fraud or other serious violations of financial regulations.
Another version of entry regulation affects the ability of firms to offer particular
types of product to (particular types of) investors.68 We term this ‘product regulation’,
although in the US it is often referred to as ‘merit regulation’. Because the ‘products’
offered by financial services firms are in fact contracts, this type of regulation is really
the substantive regulation of the relevant contractual terms.
Structural restrictions, which impose limitations on the nature or scope of the
business that may be carried on by certain types of financial firm, are another form
of entry regulation: policymakers segment the financial sector to reduce systemic risk,
conflicts of interest, or both. Examples of structural restrictions are the separation
between commercial and investment banking, in force for decades in the US during the
twentieth century, the distinction between brokers and jobbers in force for centuries in
the UK, and the US Volcker Rule precluding banks from engaging in proprietary
trading, which came into force in 2015.69
Finally, at the level of the sector, regulators are concerned with whether the market
power of particular players creates a barrier to entry by other firms who might wish to
offer similar products. In contrast to the individual and firm-level application of entry
regulation, at the sector level, this strategy applies not to restrict entry, but to foster
it. While the explicit goal of each of the other examples of entry regulation so far

66
See Chapter 8, section 8.4.2.
67
The offeror remains free to market such securities to ‘sophisticated’ investors.
68 69
See Chapters 12, section 12.3.2. See Chapter 23.
 The Goals and Strategies of Financial Regulation 75

considered is geared towards protecting users, such as investors and consumers, entry
regulation based on market power is concerned with fostering competition.
Clearly, there may be tension between the different types of entry regulation: licensing
requirements create barriers to entry, whereas the regulation of market power seeks to
overcome barriers. Entry regulation can also have unintended implications for the other
regulatory goals. Encouraging entry into the banking sector will reduce the extent to
which banks can earn supracompetitive profits (‘rents’) from their activities. This in turn
may stimulate them to engage in more risky activities, as the consequences of failure—loss
of the ability to participate in their current market—will be less costly to their owners.70
And encouraging entry into the provision of financial market services can result in the
fragmentation of trading venues with less effective information aggregation. Conversely,
restricting the entry of financial products reduces the diversity of financial contracts
deployed and may thereby have adverse implications for financial stability.71

3.5.2 Conduct
Conduct regulation dictates appropriate standards of conduct to participants in the
financial system. From the perspective of both users and firms, there are trading
restrictions, which affect the way in which trades in securities may be conducted.72
Specifically, actions taken to manipulate market prices are generally prohibited, as is
trading on the basis of inside information. These restrictions are geared towards
promoting market liquidity.
For financial firms, the most extensive category of conduct regulation comprises
conduct of business rules.73 These direct the way in which firms are expected to carry
on their businesses. Three sets of issues are particularly important: first, the ways in
which firms deal with clients and/or customers, focusing on marketing, advertising,
and sales techniques; second, the handling of client assets, focusing on custody and
segregation requirements; and third, the management of conflicts of interest by
financial firms. These restrictions are most clearly concerned with the protection of
users such as clients, customers, and consumers.
Regulators are also concerned with financial firms’ conduct from the perspective of
competition. In particular, collusion between firms so as to support prices or restrict
supply is universally prohibited as a matter of antitrust law, which also applies to the
financial sector. The regulation of collusive behaviour is concerned with the promotion
of competition in the financial sector.

3.5.3 Information
This category of regulation comprises rules intended to secure the dissemination and
comprehension of information about financial firms and products. From the user’s

70
See Vives, n 58.
71
Roberta Romano, ‘For Diversity in International Regulation of Financial Institutions: Critiquing and
Recalibrating the Basel Architecture’ (2014) 31 Yale Journal on Regulation 1.
72 73
See Chapter 9. See Chapter 11; see also section 12.3.3.
76 Principles of Financial Regulation

perspective, an important technique is education.74 Strictly speaking, this does not

impose any legal obligation on users—rather, legal obligations to provide education are
imposed on public bodies.75 However, if education is provided, the onus is upon users
to make use of it to improve their understanding. Consequently, users of the financial
system who do not make use of educational provision are likely to find themselves at a
disadvantage. In this sense, they are subject to practical obligations by the provision of
education.
From the standpoint of firms, the principal technique of information regulation is
disclosure.76 This compels the provision of information to customers, investors, and
regulators about financial products and firms’ investment strategies. Specifically, it
comprises: first, mandatory pre-contractual disclosure as a means of informing invest-
ors and consumers about financial products and securities; second, the imposition of
initial, periodic, and event-driven disclosure requirements on issuers of securities so as
to promote the informational efficiency of markets for securities; and third, obligations
on financial firms to report details of their balance sheets and investment strategies to
regulators charged with maintaining an overview of risk in the financial system as a
whole.
Information regulation, especially disclosure, serves a number of goals. Disclosure to
contractual counterparties can be understood in terms of investor or consumer pro-
tection; public disclosure can be understood as seeking to enhance the informational
efficiency of financial markets, and reporting to regulators can be seen as assisting in
their task of maintaining financial stability.

3.5.4 Prudence
The fourth form of regulation comprises rules that direct how financial firms shall
manage their assets and liabilities.77 It includes: first, rules on capital adequacy which
require banks and other financial institutions to maintain a minimum level of net assets
and to ensure a certain proportion of their liabilities are subordinated;78 second, rules
on assets requiring a certain proportion of asset holdings to be of a liquid character;79
and third, rules restricting the riskiness of investment and insurance firms’ asset
portfolios, including prohibitions on the purchase of particular asset classes and
procedural obligations regarding portfolio management and risk allocation.80
Prudential regulation has principally been understood as imposing obligations on
individual firms with the goal of ensuring their safety and soundness, independently of

74
See Chapter 10, section 10.4.1.
75
See eg FSMA 2000 (UK) s 3S (obligation on FCA to establish a ‘consumer financial education body’ to
educate members of the public about financial matters and how to manage their financial affairs); Dodd–
Frank Act of 2010 (US), §1021(c)(1) (one of the functions of the newly established Consumer Financial
Protection Bureau is ‘conducting financial education programs’). See also European Commission Com-
munication on Financial Education, COM(2007) 808 final, 8 (exhorting Member States to ensure financial
education is ‘actively promoted’).
76
See Chapter 8 and Chapter 12, section 12.3.1.
77
Clark terms this ‘portfolio regulation’ (Clark, n 64, 44), but ‘prudential’ is much more a part of the
regulatory lexicon.
78 79 80
Chapter 14. Chapter 15. See Chapter 12, section 12.4 and Chapter 22.
 The Goals and Strategies of Financial Regulation 77

the actions of other firms. Such firm-level or ‘microprudential’ rules are best under-
stood as being concerned with the protection of users, such as investors and consumers.
However, since the financial crisis, it has become clear that this approach is not itself
sufficient to ensure stability of the financial system as a whole. Prudential regulation
may in fact have unintended consequences for financial stability. By imposing sub-
stantive restrictions on which types of asset may be purchased, and/or procedural
obligations regarding the ways in which risks must be managed, rules of this kind may
artificially stimulate demand for particular types of asset class and increase the overall
correlation of investment strategies.
Interconnectedness of firms’ assets and liabilities, and correlations in their invest-
ment strategies, significantly affect the stability of the system as a whole. Consequently,
the new technique of ‘macroprudential’ regulation imposes portfolio restrictions on
firms, classes of firm, or whole sectors, according to how investment strategies inter-
relate.81

3.5.5 Governance
This strategy is exclusively focused on financial firms. It relates to the way in which
such firms are organized and managed.82 Most obviously, this strategy includes rules
about executive compensation, board structure, and directors’ duties for certain finan-
cial firms. These sorts of rules comprise the traditional domain of ‘corporate governance’.
Governance requirements have traditionally been understood as investor protection
measures. However, the negative externalities associated with risk-taking by large finan-
cial institutions mean that their governance has implications for the stability of the
financial system as a whole. There may also be unintended consequences. The regulation
of the compensation of money managers, for example, affects their incentives regarding
trading behaviour, and consequently may have implications for the effectiveness of financial
markets—where trading is dominated by such money managers—at aggregating new
information.
Governance also relates to combination restrictions, which deal with mergers and
acquisitions by financial firms of one another. Such restrictions are concerned both
with the promotion of competition in financial services and with financial stability.

3.5.6 Insurance
Each of the foregoing five strategies can be understood as operating ex ante; that is, at
the time that an investor parts with her money (or a consumer borrows it), regulation is
already shaping the investor’s relationship with the financial firm and how that firm
may deal with the funds. The penultimate strategy we identify, which we term
‘insurance’, operates ex post. It is triggered by the failure, or financial distress, of a
financial firm. The strategy operates to provide a backup provision of liquidity at this
point.

81 82
See Chapter 19. See Chapter 17.
78 Principles of Financial Regulation

From the user’s standpoint, the insurance strategy is implemented through investor
and depositor insurance regimes. The most obvious example of these is deposit
insurance schemes, which provide (retail) depositors in failed banks with compensa-
tion.83 However, there are other insurance schemes. Best known of these is the lender
of last resort (‘LOLR’) function played by the central bank. Traditionally, this was seen
as a way of providing emergency liquidity assistance—or ‘liquidity insurance’—to a
temporarily troubled financial institution.84 However, in recent years LOLR has
evolved into a way in which the central bank can assist in restructuring the balance
sheets of troubled entities, through lending against inferior collateral. This might be
characterized as a type of ‘asset insurance’.
Another form of ‘insurance’ for financial institutions tends to be offered through
the provision of state bail-outs. These have been characterized as ‘capital insurance’
for financial firms, because, through such schemes, the taxpayer effectively insures
investors in the troubled firm against loss of their capital through its failure.85 Both
the extension of LOLR and the provision of bail-outs create problems of moral hazard
for individual firms. Consequently, the deployment of these techniques is only justified
by reference to the adverse impact of the failure of financial firms on the economy
at large.

3.5.7 Resolution
Finally, the post-financial crisis environment has seen much interest in resolution
mechanisms, designed to operate more quickly and effectively than ordinary insolv-
ency law so as to avoid the destructive loss of value associated with a bank failure.86
These seek to introduce private capital to troubled financial institutions, rather than
rely on state support. One version involves the sale of the troubled entity to a
competitor; another anticipates an automatic reduction of its liabilities. In the former
case, the purchaser effectively becomes guarantor for the troubled firm’s liabilities; in
the latter case, the existing creditors are forced to take a haircut and thereby insure
protected creditors who do not participate in the restructuring.
Each of these examples of insurance and resolution strategies in financial regulation
is usually understood in terms of promoting financial stability: reducing the probability
of bank runs and bank failure, or the severity of the consequences of bank failure.
However, they could also be understood in terms of user protection, as each one—most
clearly deposit insurance—has the effect of protecting a particular class of user against
loss. The provision of insurance for troubled financial firms also has competition-
related implications where public support provided to an institution enables it to
continue in business where others, without support, would not. This could constitute
illegitimate state aid under EU competition law rules.

83
See Chapter 15, sections 15.4–15.5 and Chapter 16, section 16.2.
84
P Alessandri and AG Haldane, ‘Banking on the State’, Bank of England (2009) (speech given at 12th
Annual Federal Reserve Bank of Chicago International Banking Conference, September 2009), 4.
85 86
Ibid, 6. See Chapter 16.
 The Goals and Strategies of Financial Regulation 79

3.6 Conclusion
This chapter has provided an economic analysis for financial regulation. It has started
from the efficiency properties of markets and the allocative, productive, and dynamic
efficiency of competitive markets. It has then considered the market failures that may
undermine the achievement of these properties of markets and the adverse distribu-
tional as well as efficiency consequences that may result.
The chapter then discussed the goals of regulation and argued that each of the goals
can be related to a particular type of market failure. It considered the potential conflicts
that can arise in pursuit of different goals and the way in which these should addressed
through the derivation of a regulatory objective function. Finally, the chapter has
examined seven strategies that are available to regulators and related these to the
attainment of the goals of regulation.
You should come away from this chapter with an understanding of the economic
basis of financial regulation and how it can help guide the formulation of regulatory
policy. This will provide the underpinnings for the discussion of regulation of different
parts of the financial system in the remainder of the book.