Chapter 3 – Role of the Government Why Regulate Financial Markets? What should the output of a financial market be? Efficient and Low Cost… What conditions would produce this outcome if left to itself? Competitive Markets The Government should “regulate” when Markets are not competitive Markets can not maintain a competitive state Markets that would become competitive are too slow to reach this state Production Efficiency vs. Information Efficiency

Chapter 3 – Role of the Government Forms of Regulation Disclosure (Information Efficiency) Asymmetric information and agency problems Some argue there is no need for disclosure regulation…the market will do this voluntarily Activity Regulation (Production Efficiency) Rules governing the NYSE, insider trading, etc. Permissible Functions (Production Efficiency) Glass-Steagall Act – Financial Modernization Act Permissible Agents (Information Efficiency) Limit Foreign Participation in Markets

Chapter 3 – Role of the Government U.S. Regulation (After the Fact Reaction) New Securities – 1933 Secondary Markets – 1934 Relationship Regulations – Self Regulating Organizations (SROs)…NASD, NFA (Futures) work with government agencies such as SEC, CFTC, etc. Examples – all futures contracts are “approved” by CFTC for economic rational in hedging NASD sets standards and disciplines equity dealers Market Management Regulation Federal Reserve System (Independent) for currency and money supply

Chapter 3 – Role of the Government Regulation in Japan Power resides with Minister of Finance (MOF) and the Bank of Japan MOF has seven bureaus and the Securities Bureau controls the securities markets Strong central control – very restrictive on foreign participation in markets, especially issuing securities Real Estate Market Crash and Stock Market Plunge – Loosening of Controls and Increase Foreign Participation Foreign Firms trying to participate in pension fund management, securities underwriting, etc.

Chapter 3 – Role of the Government Regulation in Germany Strong Banking State Bundesbank – controlled bond market Eight Regional Stock Markets – Majority of activity and ownership controlled by banks  INTERBANK MARKET  CURRENT PRESSURE ON BANKS TO REDUCE EQUITY POSITIONS Deutsche Terminborse – Derivatives Market European Central Bank now controls monetary policy and currency (EURO) European Economic and Monetary Union (1/4/99)

Chapter 3 – Role of the Government Regulations in the United Kingdom Following Big Bang of mid 80s – UK now has large commitment to disclosure for regulation Parallel to U.S. in many ways… SIB (Securities Investment Board) and SEC Bank of England and Federal Reserve Bank Financial Services Act of 1986 and Securities Act of 1933 Insider Trading banned in 1985 and extended in 1994 Allows strongest foreign participation in financial Markets – underwriting and listing

Chapter 3 – Role of the Government Three Reasons for Market Regulation and Reform Financial Crisis SOX Meltdown of 2008 Innovation Keeping a level playing field Foreign Competition – Flow of business out Globalization Technologies have “shrunk” the world

Chapter 3 – Role of the Government Question 2 “The Securities and Exchange Commission ensures that securities issued in the United States are not risky and therefore are acceptable investments for the general public” Agree or Disagree? Disagree – The SEC sets standards for disclosure and approval of sale implies that sufficient information has been supplied for investors to reach their own conclusions on the risk level of the equity offering

Chapter 3 – Role of the Government Question 3 Why do countries regulate their money supply? Control Economic Activity This activity is viewed as the main instrument of the government to control economic activity The regulation of money supply impacts the ability (supply) to borrow and thus can “stimulate” or “slow-down” business investment activity The control of economic activity indirectly impacts inflation and deflation

Chapter 3 – Role of the Government Question 5 Identify two key elements in the United Kingdom’s Big Bang of the mid-1980s? First Element – Movement to Disclosure Regulation Prior to this point in time disclosure regulation was minimal – insider trading prominent and accepted Second Element – Open up financial markets to foreign investment firms Underwriting and Listing