Lesson 6 of 6
Regulation is important because it is too expensive to regulate certain behaviors through market-based mechanisms for people who are unsophisticated and uninformed. Effective regulation of markets facilitates better achievement of people's financial goals. Following points discuss why market regulation is required and what they should achieve.
Financial markets are complex, and customers are often much less sophisticated than the professionals in the market. For this reason, there is unacceptably high probability of potential losses through various frauds.
Customers generally do not have much information about market conditions and they find it extremely difficult to measure the added value they obtain from their agents.
Regulators often act to level the playing field for market participants. For example, in many jurisdictions, insider trading in securities is illegal.
Many situations arise in financial markets in which common standards benefit everyone involved. For example, having all companies report financial results on a common basis allows financial analysts to easily compare companies.
Without a substantial financial interest in the decisions that they make, companies often take too many risks and exercise poor judgment about extending credit to others. Regulators generally require that financial firms maintain minimum levels of capital. These capital requirements serve two purposes. First, they ensure that the companies will be able to honor their contractual commitments when unexpected market movements or poor decisions cause them to lose money. Second, they ensure that the owners of financial firms have substantial interest in the decisions that they make.
Regulators regulate insurance companies and pension funds that make long-term promises to their clients. Such entities need to maintain adequate reserves to ensure that they can fund their liabilities. Unfortunately, their managers have a tendency to underestimate these reserves if they will not be around when the liabilities come due.