Regulation of Securities Markets Andrew Sheng Chairman Securities - - PowerPoint PPT Presentation

HKU International MBA Programme

Regulation of Securities Markets

Andrew Sheng Chairman Securities and Futures Commission Hong Kong 16 July 2002

P.2

Global Backdrop

• Since Asian financial crisis, there is better

understanding of the causes of crisis, the need for financial system resilience, and higher international accounting and regulatory standards.

• Regulators need to enhance surveillance, share

information on emerging risks and make contingency plans for crisis management.

• Regulatory environment is changing rapidly due

to globalization, technology, competition and restructuring.

P.3

The Changing Financial Landscape

• All financial markets are networks - Metcalfe’s Law
• On-line trading and globalization enable 7x24 hours

markets - contagion can be global

• Technology & Globalization changing market structure &

nature of competition

• Financial regulation needs to encompass changing

environment - this means that regulatory policies and processes need to change

• How do we build a flexible regulatory structure that

responds to such dramatic changes?

P.4

Environmental Impact

• Technology - regulators need to understand technology &

its impact on risks

– How to define property rights & risks in online environment? e.g.

• perational risks post 9.11
• Globalization - jurisdictional lines are blurred, both within

domestic markets and cross-border

– How do regulators co-operate cross-jurisdictionally along functional and geographic lines?

• Competition - intensive competition through innovation &

consolidation

– Complex financial groups emerging - markets structure changing

• Restructuring - As old franchises erode, losses in

financial system occur, eg NPLs and intermediary failure

– Who bears loss in such transition - investor or state?

P.5

Objectives of Financial Regulation

• The goal of financial regulation is to influence

the behaviour of intermediaries so that the policy objectives are achieved. Regulatory Cycle

• Policy Objectives ⇒ Processes ⇒ Policy

Outcomes ⇒ Policy Review

• Ability to clearly define objectives, lay down

effective processes and achieve desired policy

• utcome critical to credibility of regulator.

P.6

Malcolm Sparrow - the Regulatory Craft

“Pick important problems, fix them and then tell everybody.” “The essence of the [regulatory] craft lies in picking the right tools for the job, knowing when to use them in combination, and having a system for recognizing when the tools are inadequate so that new ones can be invented.”

Professor Malcolm Sparrow, The Regulatory Craft, Harvard University

P.7

Regulations as Contracts

• Goodhart views laws and regulations as

contracts between regulators and regulatees that carry important incentive structures

– if badly-designed, moral hazard behaviour increases systemic risk (e.g. open-ended deposit insurance, policy lending directives, market intervention) – if well-designed and enforced, financial managers behave in ways that avoid systemic risk, without unintended side effects

• Incentive Structure Key to Market Stability

P.8

Regulatory Objectives

• IOSCO’s objectives

– Protection of investors (+ consumers of financial services) – Ensuring fair, efficient and transparent markets – Reduction of systemic risk

• UK FSA’s objectives in Financial Services &

Markets Act 2001

– Market confidence – public awareness – the protection of consumers – the reduction of financial crime

• SEC - “We are the Investor’s Advocate”
• Regulators job is “to make the market work

better”

P.9

• Price discovery - are prices reflecting risks?
• Resource allocation - is there market

distortion?

• Risk management - are there products to

hedge risks and are intermediaries managing risks well?

• Corporate governance - Are markets playing

role to improve corporate governance?

Four Functions of Capital Markets

P.10

Quality of Markets

Seven “I’s” of market quality:

• information
• incentives
• issuers
• intermediaries
• infrastructure
• investors
• I- the regulator

P.11

Information and Markets

• Timely and accessible information is a market

fundamental

• Markets cannot function well without reliable information
• Inaccurate, untimely or misleading information

undermines fairness, integrity and level playing field

• Information important for sound regulation
• IAS and good auditing standards important for good

information

• Bad accounting = bad information = bad risk

management = financial crisis

• Markets punish brutally when information on financial

position is opaque or doubtful

• International pressure to strengthen accounting, auditing

and disclosure standards

P.12

Incentives

• If a market manipulator thinks he won’t be caught, he

will rob the market blind

• What deters manipulation is whether we can catch the

perpetrators

• Co-operation with other agencies in enforcement field

needed to minimise financial misconduct and crime

• Incentives must be balanced between risks and

rewards; otherwise markets would be distorted by greed without fear of being caught

• Pay structures affect competitiveness, innovativeness,

ability to attract talent, and risk appetite of staff

• Incentives also important for regulators, who tend to be

underpaid relative to market, while powers to enforce and coordination between regulators may not be well developed

Lawrence Liu: “Asian regulators tend to over-regulate and under-enforce”

P.13

Issuers

• Quality of market determined by quality of listed

companies

• Ultimately responsibility for quality rests with

management and controlling shareholders

• Good companies attract more investors, enhance

liquidity of stocks

• Liquidity begets liquidity, attracting quality issuers,

financial intermediaries and investors in virtuous circle that improves market quality

• Quality of companies determined by quality of

governance

• Good corporate governance is about self-discipline,

regulatory discipline and market discipline

P.14

Using Different Levels of Discipline

• Self Discipline - self regulation, using standards and

codes

• Regulatory Discipline - can be imposed by SROs or by

statutory regulator - with civil or criminal sanctions

• Market Discipline - contractual discipline through courts,
• peness to market competition and clear exit mechanisms
• All three disciplines are necessary to achieve good

corporate governance and efficient markets Increasing calls for more regulation to strengthen governance of issuers and intermediaries, in order to restore faith of investors in markets

P.15

Intermediaries

• Perform front-line regulatory work in capital markets

– Investment banks advise and underwrite IPOs – Accountants and lawyers ensure due diligence of information disclosure

• The higher the quality of intermediaries, the more they

can exercise market discipline on issuers and market participants

• If quality of intermediaries poor, greater burden falls on

securities regulators

• Excessive protection of domestic intermediaries and

barriers to foreign entry could retard market development

• Large complex financial institutions make regulation
• difficult. Standards, and regulatory cooperation

important

P.16

Infrastructure

• Trading, clearing, settlement and payment processes

transact across networks

• Quality of infrastructure determines size of operational risks

arising from human error, hardware or software failure, or terrorist attacks

• Good Infrastructure builds in checks and balances
• Infrastructure comprises platforms, processes, legal

framework and efficient and fair judiciary that protects property rights or market participants

• IOSCO and CPSS stress need for robust systems in

managing market risks, post 9.11

• Building robust infrastructure to global standards part and

parcel of sectoral and national risk management

• Balanced and complete markets, with adequate product

choice important for risk management

P.17

Investors

• Quality of markets depends on quality of investors
• Uneducated investors chase rumours and if served by

poor quality intermediaries, investors and market lose

• Investor education is an important supervisory tool to

promote investor protection

• Investors need to understand concept of risk and return,

know their rights, ask the right questions of their brokers and financial sales persons, and where to verify information

• Shareholder activism imposes market discipline
• HKeRIC provides essential ABCs of investment, games to

test knowledge, and 550 links to over 400 websites around the world

P.18

I, the Regulator

OECD - “Too often, legislators issue laws as symbolic public action, rather than as practical solutions to real problems. Regulatory inflation erodes the effectiveness of all regulations, disproportionately hurts small and medium businesses, and expands scope for misuse of administrative discretion and corruption.”

• All financial regulations have a cost, which creates incentives

for regulatory arbitrage

• Goodhart points out danger that regulators could over-regulate,

as public perceive regulation as a free good and regulators supply more regulation after crisis to minimise future failure and avoid blame

• Regulators have to balance between investor protection and

the need to not stifle competition and innovation

• Public support of regulatory action critical, and this demands

fairness, integrity, transparency and public trust

P.19

Tools of Regulation How to regulate? - Rules vs Enforcement

• Prescriptive vs Differentiated Rules

(depending on risk profile)

• Entry - Licensing rules and conditions, eg

capital & liquidity requirements

• Conduct - surveillance, monitoring and

discipline

• Exit - failure management, investor

compensation schemes and insolvency

• Rules are only as good as Enforcement

– Regulators have to be seen to act in order to deter misconduct

P.20

Craft and Tools of Regulation

“The essence of the [regulatory] craft lies in picking the right tools for the job, knowing when to use them in combination, and having a system for recognizing when the tools are inadequate so that new ones can be invented.”

Professor Malcolm Sparrow, The Regulatory Craft, Harvard University

• Given scarce resources and wide array of problems,

focus on where the risks are greatest

• As different tools have conflicting objectives, choose right

combination to achieve objectives

• Given trade-off of objectives and tools, exercise judgment
• n effectiveness of regulation and policy outcomes

P.21

Sparrow‘s Six Themes of Regulatory Practice

• Cut obsolete regulations
• Reward results, not red tape
• Get out of your office and create regulator-

regulatee partnerships

• Negotiate, do not dictate
• Reduce regulatory reporting burdens
• Search for results that count

P.22

… Pick Important Problems

• Daily process tendency to focus on the

urgent rather than the important

• “In a crisis, don’t pick all problems, pick the

top three” - Dr Nordin Sopiee, ISIS Malaysia

• Take care of big problems, the small will take

care of themselves - go for results

P.23

Pick Important Problems ...

Hong Kong Three-pronged securities reform programme introduced in 1999 to address structural issues

• Market reform: demutalization, merger and listing of

stock market, futures exchange and clearing house to align institutions with market

• Infrastructure reform: fully electronic web-friendly

world-class high-tech infrastructure blueprint under implementation - enhance efficiency, reduce costs and risks

• Legislative reform: Securities and Futures Bill tabled

at Legislative Council in November 2000, expected to pass in March 2002

P.24

Managing for Results

Now in Phase II of reforms

• Market and product development

– Develop new market products in conjunction with market experts – Accelerate market infrastructure development

• Strengthening and monitoring the institutional structure

– Improve surveillance and dialogue with industry to monitor pressure from competition and consolidation – Dual filing to enhance quality of corporate information disclosure through enforcement

• Building a transparent and accountable SFC

– Streamline regulatory processes e.g. licensing & investigation with e-workflow – Upgrade staff skills through training, exposure – Build a knowledge sharing culture for better risk management; coordination and coherence in policy

P.25

… Fix Them and Tell Everybody

• Analysing technical problems and finding technical

solutions is easy part

• Challenge is to convince everyone that reform package

is a win-win situation

• Stakeholders view change with suspicion and resistance
• Must have a good story to tell
• Be clear on objectives of measures, what the processes

are and how to manage for concrete results

• Public must understand why strict enforcement is

needed so that we get the desired mandate to act

• Ownership of all stakeholders, including staff, is key

P.26

Tell Everyone: Our Experience

• Identify the problem

Investor and independent stakeholder survey to assess perception of our effectiveness

• Working with stakeholders

Media - quarterly and regular media briefings; first to publish quarterly financial reports Legislature - Quarterly reports to Financial Affairs Panel

• spent 150 hours with Bills Committee, and

presented 150 separate papers on policy justifications Intermediaries - stepped up dialogues with stockbroker associations, revamped Advisory and specialist Committees Market Consultations - published 15 market consultations

• n policy initiatives and rule changes in 2001, and first

to post public responses on website

P.27

Establishing Credibility

• Securities and Futures Bill - engaged community leaders

to build ownership and consensus for change

• We have to demonstrate transparency, accountability and

credibility - demonstrate no agenda except public interest

• Stepped up investor education, published quarterly

reports and newsletters to tell everyone what we do and what we are trying to achieve

• Established independent Process Review Panel to ensure

SFC observes proper procedures and due process and fairness in its work

P.28

Fixing the Problem and Telling everyone

 Old-style regulators:

“Nitpicking, unreasonable, unnecessarily adversarial, rigidly bureaucratic, and incapable of applying discretion sensibly.”

 It is often the obsolete and defective

systems, not the people, that create problems.

 Change is the constant. Be prepared to

change.

 Regulators need to be tough - get the public

behind you to take action

P.29

Supervision, Crisis and Restructuring

• Financial crisis is an event, financial supervision

and restructuring is a Process of:

• Diagnosis
• Damage Control
• Loss Allocation
• Getting the Incentives Right

P.30

Diagnosis: Ask the Right Questions

• What are the risk implications of market and macro

economic developments?

• Are there emerging gaps between regulations and market

developments?

• Have you stress-tested the markets and infrastructure

relative to the risks?

• Are current incentive structures reducing or magnifying

risks?

• Are there patterns of risk concentration?
• Are markets and investors aware of emerging risks?
• Have you double-checked your analysis and solutions with

market practitioners?

P.31

Damage Control

• Take supervisory action before the problem worsens
• No decision is also a decision
• Regulatory forbearance doesn’t solve problems
• Better quick pain than pain forever
• Have you thought through the implications of your

solutions, their proper sequencing and co-ordination with

• ther parties?
• Have you got political and public backing for your action?

Keep decision-makers informed, prepare public for emerging problems

• Have you adequate resources and skills to undertake

damage control?

P.32

Loss Allocation

• There is no free lunch - someone always pays
• Excessive competition and structural changes may

cause some intermediaries to take excessive risks

• Financial intermediaries could be accounting alive but

economically insolvent [mark to market]

• First line of defence should be intermediary capital
• Second line could be fidelity insurance or investor

compensation funds

• State bailout means taxpayer pays
• The regulator is the convenient party to blame

P.33

Getting the Incentives Right

• The only downside to financial crime is the Enforcement

Process

• Financial crime and bad intermediary conduct thrive

when there is no regulatory credibility that they will be caught

• Regulatory credibility depends on effective surveillance,

speedy investigations, good prosecutions and appropriate sanctions

• Justice must not only be done, but seen to be done -

there must be clear and transparent due process in investigation and the disciplinary process

• The Enforcement action must be visible
• “Kill chickens to scare monkeys” - you cannot totally

eliminate or prevent financial crime, but we can try to minimize it

P.34

Challenges to Regulators

• Cannot prevent all fraud, financial crime and managerial

incompetence

• Cannot prevent ignorant investors from being attracted

to quick gains

• We can only try to minimise financial misconduct and

crime

• We are entering a phase of post-bubble deflation and

structural changes in real economy - not clear how this this will affect financial systems

• Credibility is hard to earn but easily lost

P.35

Conclusions

• Securities regulation is about protecting the investor
• This calls for quality markets which demands the regulator

to ensure quality information disclosure, the right incentives and enforcement to promote good behaviour, sound regulation, robust infrastructure, and investor education

• Rapid market changes imply that regulation is still a craft or

an art, not a science

• Regulators need a range of tools and judgement to use

them effectively

• The regulatory framework must be flexible and responsive

to change, so that regulation is effective

• Regulators need to be independent, but they are not

independent of their environment - their rules & enforcement shape the environment & the environment shapes them

• Credibility is key, and this ultimately is about the regulator

Picking important problems, fixing them and telling everyone!