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LM03 Economics of Regulation 2023 Level II Notes © IFT. All rights reserved 1 LM03 Economics of Regulation 1. Introduction ...................................................................................................................................................... 2 2. Economic Rationale for Regulation .......................................................................................................... 2 2.1 Rationale for the Regulation of Financial Markets ...................................................................... 2 3. Regulation of Commerce .............................................................................................................................. 3 4. Antitrust Regulation and Framework ..................................................................................................... 4 5. Classification of Regulations and Regulators ....................................................................................... 4 6. Regulatory Interdependencies ................................................................................................................... 6 7. Regulatory Tools.............................................................................................................................................. 7 8. Cost-Benefit Analysis ..................................................................................................................................... 8 8.1 Basic Concepts of Cost–Benefit Analysis ......................................................................................... 8 9. Analysis of Regulation ................................................................................................................................... 9 Summary ..............................................................................................................................................................11 This document should be read in conjunction with the corresponding reading in the 2023 Level II CFA® Program curriculum. Some of the graphs, charts, tables, examples, and figures are copyright 2022, CFA Institute. Reproduced and republished with permission from CFA Institute. All rights reserved. Required disclaimer: CFA Institute does not endorse, promote, or warrant the accuracy or quality of the products or services offered by IFT. CFA Institute, CFA®, and Chartered Financial Analyst® are trademarks owned by CFA Institute. Version 1.0
LM03 Economics of Regulation 2023 Level II Notes © IFT. All rights reserved 2 1. Introduction Regulation is an important topic to understand because it has potential effects at both the macro level and micro level of an economy. Regulation may be developed either proactively in anticipation of certain events or reactively in response to certain events. Changes in regulatory structure can have significant effects on business decisions. A major challenge faced by professionals in the finance industry is to anticipate and understand the consequences of potential changes in the regulatory environment. 2. Economic Rationale for Regulation The economic rationale for regulation can be understood using the fundamental theorem of welfare economics. According to this theorem, if we have constant returns to scale, no frictions, and no externalities, then a competitive market will reach equilibrium and resource allocation will be efficient. However, in the real world, information frictions and externalities are present and resource allocation will not be efficient. Therefore, regulatory intervention is required to push an economy towards equilibrium. Informational frictions result in a variety of issues that regulators try to address. These issues include:  Adverse selection: private information in the hands of some market participants which affects the consumption of goods and services.  Moral hazard: incentive conflicts that arise from the delegation of decision-making to agents or from contracts which will affect the behavior of one party to the detriment of the counterparty. Externalities are spillover effects of production and consumption activities onto others who are not directly involved in that activity. Externalities can be:  Positive: produces a spillover benefit. Example: home improvements in a locality.  Negative: produces a spillover cost. Example: environmental pollution. Regulatory intervention may be required to address weak competition. Weak competition is bad for consumers because the prices of goods and services go up and choices come down. Similarly, regulators also try to address the social objectives or public goods problem. Since there are shared benefits from consuming the public good, markets would not produce the optimal amount of these goods. Through regulatory intervention, governments try to ensure that the optimal amount of a public good is produced. Classic examples of public goods include national defense, public parks, and standard setting. 2.1 Rationale for the Regulation of Financial Markets Major objectives of financial market regulation include:  maintaining financial stability and promoting economic growth  maintaining the integrity of markets and acting as a referee to ensure fairness  mitigating agency problems (many financial transactions are executed through agents
LM03 Economics of Regulation 2023 Level II Notes © IFT. All rights reserved 3 which leads to potential agency conflicts) Historically, regulators have tended to focus more directly on protecting retail investors than institutional investors. More recently, regulators have been paying particular attention to prudential supervision, which focuses on promoting financial stability and reducing system-wide risks. Example: Rationale for Regulation (This is Example 1 from the curriculum.) 1. Which of the following is least likely to be a reason for the use of regulation? A. Systemic risk posed by the financial services industry B. Informational frictions in the form of private information C. Extensive disclosure of operating and financial information by companies seeking to attract investors’ attention 2. Prudential supervision is primarily concerned with: A. treatment of inducements in the provision of investment advice. B. provision of information about financial products to retail investors. C. safety and soundness of the financial system. Solution to 1: C is correct. Extensive disclosures are not a reason for the use of regulation. They may be the result of regulation or a reflection of good business practices. Solution to 2: C is correct. 3. Regulation of Commerce The role of government regulation is to set out an underlying framework for the operation of private markets and the facilitation of business decisions. If rules and regulations are well- defined and well-enforced, it becomes easier for companies to make business decisions. Some issues related to regulation include:  Environmental issues: Environmental issues such as pollution tend to be both at a regional level as well as a global level. International mechanisms are required to facilitate the coordination and acceptance of responsibilities among national governments.  Intellectual property: Through R&D, companies often produce intellectual property, such as patents and copyrights. Regulations are required to protect this intellectual property, otherwise the incentive for R&D will be diminished.  Privacy: Several internet companies get private and personal information. Regulations are required to safeguard this data and prevent its misuse. Analysts should understand relevant laws and their impact. For example, if an analyst is focused on distressed securities, then he should understand the laws related to bankruptcy proceedings.
LM03 Economics of Regulation 2023 Level II Notes © IFT. All rights reserved 4 4. Antitrust Regulation and Framework Regulatory decisions can be taken at many levels. For example, regulation around pollution would involve both local and international considerations. Another factor to consider is that governments may want to encourage competition within the country but limit competition from other countries. Competition and antitrust laws prohibit abusive and anticompetitive behavior. Examples of such behavior include:  mergers that create monopoly power with the objective to get more pricing power  exclusive dealings and refusals to deal  price discrimination and engaging in predatory pricing There is an increasing application of the antitrust laws to the technology sector. Large tech companies such as Google, Microsoft, Intel, and Apple have all been dealing with antirust issues over the last decade. In response to antitrust issues, regulators may not only impose monetary sanctions but may require companies to modify their business. Specifically, companies engaging in antitrust behavior might be asked to divest portions, change operating practices or change marketing practices. Also, with increasing globalization, companies may need to satisfy multiple regulators. Example: Antitrust Regulation (This is Example 2 form the curriculum.) 1. Which of the following issues is least likely to be the subject of antitrust rules? A. Privacy and data protection B. Anticompetitive behavior by dominant companies in a market C. Mergers and acquisitions by major companies Solution: A is correct. 5. Classification of Regulations and Regulators Regulators can be classified into: 1. Legislative bodies: They enact a statute at a broad level, leaving it to regulators to fill in the implementation details. For example, US Congress. 2. Government-backed regulatory bodies: They operate under the framework of the statutes to come up with detailed laws such as administrative regulations or administrative laws. They can be further classified into: a. Government departments and agencies b. Independent regulators The major distinction between government agencies and independent regulators is