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Unit 14: Regulatory Environment

Introduction Notes

At the centre of any economy, it is the process of financial intermediation and disintermediation
that helps the economy to grow and function smoothly. For instance, the credit creation function
of banking institutions allows the economy to expand more than what it could do without
banking institutions. Financial services industry not only channels savings into productive
investments, it also helps the economic activities to take place without much difficulties. For
example, the cheque facility and clearing service provided by the banks help several million
people to perform economic activities. Similarly, stock brokers help investors to sell and buy
shares which is critical for development of financial services and financial markets. Insurance
companies give protection against the risk of many unknown events like fire, flood etc., that
affect the business and allow the firms to perform their activities with confidence. The financial
services have thus become indispensable in running the economy. Such an important system
faces two problems – cheating an instability. During the stock market scams, many investors
were cheated. Recently, internet bubble attracted several investors, who lost their wealth. While
such losses are partially on account of investors overvaluing the securities, it is also on account
of many firms providing misleading information. Financial markets are also highly volatile
and show instability in that process. In view of its importance in the economy, this sector is
governed by strict regulations. Though regulations per se may not remove cheating and reduce
volatility, it would certainly help to reduce its occurrence and minimize the length of volatile
period.

14.1 Financial System, Markets and Services

A financial service cannot generally be tested at the time of purchase since there is a time-lag
between the purchase of service and its actual effect. For example, when you buy a share through
a member of stock exchange, the service completes only at the time of physical delivery of
shares. Similarly, when you buy units of mutual fund and take its expert service of investment,
the results of this service is known only in the future. In case of dealings in cheques, the service
concludes only when the cheque amount is credited or debited in your account but the time-lag
is short. The need for regulation stems from the problems of failure of the firms which provide
financial services in the meantime and thus causing hardship to the purchaser. Since financial
system is closely integrated and inter-linked, failure of one firm often affects other firms and
thus the entire financial system is affected. Further, in a competitive market for borrowing and
lending where the spread is thin, financial services firms often take high risk to maximize the
return and thus are more susceptible to default. There are several other events that can imperil
the interest of investors and others who avail the services. The list includes fraud, misfeasance
and collapse of an institution due to mismanagement. Regulations are thus in place to safeguard
the interests of the participants of the system and prevent economic instability. The second
aspect assumes more relevance recently after several East-Asian economies have suffered due to
the failure of the financial system.

14.2 Types of Regulations

The regulatory framework relating to financial services can be broadly classified into three
main types. One set of regulations determine the types of activities that different forms of
institution are permitted to engage in. These regulations can be called as structural regulations.
For example, the Securities and Exchange Board of India (SEBI) insists that merchant bankers
and stock broking institutions, to separate all their fund-based activities. Similarly, the Reserve
Bank of India (RBI) has prescribed the activities that commercial banks can provide to the
investors. Structural regulation thus involves demarcation lines between the activities of financial
institutions but many of them have in fact been eroding in recent years. Banks are now providing

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