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Regulation and Interventionin the Competitive Marketplace
Prices and PoliciesSecond Edition ©2001
Richard M. Levich
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McGraw Hill / Irwin
International Financial Markets
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McGraw Hill / Irwin © 2001 by The McGraw-Hill Companies, Inc. All rights reserved.
Overview
Regulation of Financial Markets in an Open Economy
Financial Market Participants and Competitive BehaviorCompetition among RegulatorsThe Net Regulatory Burden and Structural ArbitrageCoordinated versus Competitive Approaches to International Financial RegulationA New Twist to Financial SupervisionCredit Ratings, Capital Requirements, and the BIS
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Overview
Foreign Exchange Market InterventionIntervention as a Policy InstrumentThe Objectives of Central Bank InterventionThe Mechanics of InterventionEmpirical Evidence on InterventionThe Effectiveness of Central Bank InterventionSecurity Transaction Taxes: Should We Throw Sand in the Gears of Financial Markets?
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Regulation of Financial Marketsin an Open Economy
To analyze the dynamic effects of regulation on financial markets, it is convenient to consider three sets of market participants:
individuals and institutions that demand financial services,firms that supply financial services, andregulatory bodies that set the rules and monitor the various aspects of financial transactions.
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Financial Market Participantsand Competitive Behavior
The Demand SideIndividuals benefit from regulations that
reduce negative externalities (for example, rules concerning minimum capital requirements and lender-of-last-resort responsibilities), andproduce higher quality information than what the competitive market would provide.
However, regulations that restrict the menu of financial products, raise transaction costs, or otherwise reduce financial efficiency or mobility reduce the welfare of individuals.
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Financial Market Participantsand Competitive Behavior
The Supply SideRegulations that benefit private firms
assure the stability and orderliness of the financial system over time and promote public confidence in the financial institutions,restrict entry into the industry and monitor anti-competitive pricing arrangements, andprovide ancillary services (such as deposit insurance) at below private cost.
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Financial Market Participantsand Competitive Behavior
Regulations may also result in revenue-losses for supplier institutions from
forgone interest on required reserves,forgone earnings on excessive capital requirements,cost of regulatory information and compliance, andforgone revenues from limitations on geographic activity or product offerings.
The difference between these costs and benefits defines the net regulatory burden (NRB) placed on private firms.
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Financial Market Participantsand Competitive Behavior
The Regulatory SideMarket regulators are themselves subject to competitive forces.The footloose nature of financial transactions gives users of financial services strong incentives to seek product innovations and new trading locations that legally avoid cumbersome regulations.Note that a single economy may have multiple regulatory authorities.
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Competition among Regulators
The rise of offshore markets underscores the fact that market participants can choose among several financial centers to execute their transactions.Consequently, if domestic regulators desire to have transactions conducted within their respective financial centers, regulatory requirements cannot be set arbitrarily.The interaction between the regulator and the regulated is dynamic.
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The Net Regulatory Burdenand Structural Arbitrage
Structural arbitrage is the transfer of financial activities into another regulatory domain when ceteris paribus, the NRB on these activities can be reduced.In a perfect capital market, all banking and securities activities will migrate to the country with the lowest NRB, inclusive of taxes.In the real world, a variety of imperfections exist such that some dispersion of NRB across countries is permitted.
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Coordinated versus Competitive Approachesto International Financial Regulation
Should international financial market regulation be directed in a coordinated fashion?
Coordination reduces the chance of negative externalities.Harmonization helps to promote a level playing field.Coordination reduces the risk of spillover effects.
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Coordinated versus Competitive Approachesto International Financial Regulation
Is the invisible hand of the competitive approach likely to produce a superior outcome?
Each regulatory body retains the ability to move swiftly in response to new financial products, changes in financial market risks, and new techniques for measuring risk.Healthy competition helps to push the NRB towards the right level.
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A New Twist to Financial Supervision
The capital adequacy rules announced by the Bank for International Settlements (BIS) in 1995 offer a surprising move toward a competitive approach.Previously, banks were required to use standardized measures that banks criticized as crude and inconsistent with market practices.The new BIS proposal allows banks to use their own internal risk measurement systems as the basis for their statutory capital requirements .
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Credit Ratings, Capital Requirements,and the BIS
In 1999, the BIS proposed to incorporate the credit ratings and obligor types of a bank’s financial assets into its capital adequacy requirement.The BIS proposal offers a “three pillar”approach for dealing with credit risk:
minimum regulatory capital requirements,adequate supervisory review of each institution’s capital adequacy and internal assessment process, &the importance of market discipline.
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Foreign Exchange MarketIntervention
Many government actions (such as monetary policy, interest rate policy, fiscal spending, and taxation policies) can have an impact on the foreign exchange rate.The central bank may also intervene officially by directly purchasing or selling currency.Intervention is an essential part of a pegged exchange rate system.
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Foreign Exchange MarketIntervention
The modern experience of floating exchange rates is better described as a period of managed floating exchange rates.Note that acknowledging the importance of exchange rates and the potentially adverse effects of exchange rate misalignments or volatility does not automatically establish a valid case for central bank intervention.
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Foreign Exchange MarketIntervention
Under floating exchange rates, an active intervention policy presumes that:
markets are at times inefficient, thus permitting misaligned or excessively volatile rates,policymakers can identify such market inefficiencies,intervention techniques can correct the misalignments and excess volatility, andthe benefits from the correction exceed the costs of conducting the intervention.
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The Objectives ofCentral Bank Intervention
Shortly after the breakdown of the Bretton Woods Agreement in 1973, the International Monetary Fund (IMF) enacted a set of guidelines designed to limit the use of intervention and the potential for conflicts among nations.
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The Objectives ofCentral Bank Intervention
The guidelines, which are still in effect, specify that member nations of the IMF:
Have an obligation to intervene to prevent “disorderly conditions” in the foreign exchange market.Should avoid manipulating exchange rates to prevent balance of payments adjustment or gain an unfair competitive advantage in trade.Should take into account the interests and policies of other members when setting their own intervention policies.
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The Mechanics of Intervention
Central bank interventions typically occur in the spot foreign exchange market.
If the domestic currency is stronger than desired, the central bank sells domestic currency, and vice versa.
Central bank interventions may generate direct effects associated with the changed quantities of money and/or bonds.
The magnitude of the effects depends on whether the intervention was sterilized or unsterilized.
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The Mechanics of Intervention
An unsterilized intervention is simply a foreign exchange market sale or purchase.
The money supplies in both countries are affected.
A sterilized intervention includes an offsetting transaction in the domestic money market (such as the purchase or sale of government securities) that reverses, or sterilizes, the impact of the initial intervention transaction.
The money supplies remain unchanged, but the bond supplies are affected.
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The Mechanics of Intervention
According to the monetary approach, sterilized interventions have no direct impact on the exchange rate.However, according to the portfolio balance approach, the relative supply of government bonds helps to determine the exchange rate.
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The Mechanics of Intervention
Central bank interventions may also generate indirect effects:
They may signal the market about future monetary and fiscal policies.They may interrupt short-term patterns in rates and reduce the profitability and incidence of noise trading.
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Empirical Evidence on Intervention
From 1982 to 1991, the U.S. Federal Reserve sold $35.8 billions and purchased $15.8 billions.
Note that the interventions were small compared with the daily foreign exchange trading volume.
There was also evidence of coordinated interventions with other central banks, such as the German Bundesbank and the Swiss National Bank.
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The Effectiveness ofCentral Bank Intervention
Does intervention have any effect - beneficial or detrimental - on the course of exchange rates and the ability of policymakers to achieve their larger macroeconomic goals?The debate hinges on whether a market failure has occurred and whether official intervention can correct this failure.
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The Effectiveness ofCentral Bank Intervention
Private Speculation Official InterventionA C
Stabilizing Efficient markets view Official interventionsmoothes the market
Credible signals of futurepolicy remove uncertainty
Encourages stabilizing private speculators
B DDestabilizing Inefficient markets: Stabilization policy gamed
bandwagons, bubbles, by market and becomesnoise traders destabilizing
Intervention is inconsistentwith underlying economicpolicies
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The Effectiveness ofCentral Bank Intervention
Evidence suggests that intervention may stabilize exchange rates by lowering the daily volatility, as well as cause the rates to move in the intended direction.It seems that interventions send the strongest signals and have the highest chance of success when the conditions of surprise, publicity, and coordination with other central banks, are met.
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Security Transaction Taxes
Some economists have proposed securities transaction taxes (STTs) as an indirect technique for calming financial market volatility.
Those in favor of an STT argue that a transaction tax will reduce unwanted, destabilizing speculation without significantly affecting the ability of the market to channel long-term capital flows.
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Security Transaction Taxes
Opponents of STTs argue that:Many fundamental explanations for exchange rate volatility can be offered without appealing to speculative bubbles.Theoretically, an STT will discourage both unwanted destabilizing speculation as well as desirable stabilizing speculation.Without a broad international agreement, there is no incentive for an individual country to implement an STT and watch its financial transactions migrate to another country.
