Presentation by R. Shyam Khemani MiCRA ( Microeconomic Consulting & Research A ssociates, Inc)

1. Competition as The Regulator or Regulation of Competition in Financial Markets? Experience and Lessons Presentation by R. ShyamKhemani MiCRA (Microeconomic Consulting & Research Associates, Inc) Washington, D.C. USA Email address: sk@micradc.com

2. COMPETITION, REGULATION & FINANCIAL MARKET STABILITY-1 It’s recognized that a number of ‘market’, ‘regulatory’ and ‘institutional’ factors have contributed to the current financial market crisis. One question posed: To what extent competition positively or negatively impacts on financial market stability? Past episodes of financial market liberalization and deregulation have been followed by financial crisis . An argument advanced favoring less competition is: countries with highly concentrated financial markets (Australia, Canada, Germany, Sweden, …) have fared better in the recent crisis. There are however differences in cross-country and country-specific comparisons. In addition, high/low concentration can not be equated with less/more competition. There are other undesirable consequences of maintaining or promoting high concentration in financial markets including: “Too big to fail”

3. COMPETITION, REGULATION & FINANCIAL MARKET STABILITY-2 Moreover, no unambiguous relationship or causal link can be postulated in economic theory or found in empirical data between competition, concentration and financial market stability. YET: Regulators in several jurisdictions trade-off between CompetitionConcentration in “interests” of promoting financial market (‘systemic’) stability. Arguments can be advanced that regulatory and supervisory failures rather than competition have contributed more financial market fragility. Regulatory and supervisory policies have lagged changes is financial market structure, products and services. Rather than fine tuning competition, focusing regulatory and supervisory policies on promoting competition driven incentives would serve the economy and society better.

4. RATIONALE FOR REGULATING FINANCIAL MARKETS Driven by the role and importance of financial markets in the economy, and inherent nature of money and its functions (medium of exchange, store of value, fungibility…) It is critical to ensure financial markets provide efficient, effective, predictable intermediation between savers and investors to foster economic growth and development through appropriately designed and supervised institutions. Risks of ‘Market Failure’: Asymmetric information between lender-borrower Adverse selection (borrowers at any interest rate even when likely to default) Moral hazard (borrowers/lenders partly insulated from risk)

5. OBEJECTIVES OF REGULATING FINANCIAL MARKETS Ensure Macroeconomic Stability: Controls over financial exchanges, clearing houses and securities settlement systems… Ensure Microeconomic Stability: Controls over financial intermediaries capital ratios, portfolio limits, off-balance sheet activities, capital, borrowing, lending limits and integrity requirements… Transparency in markets, in intermediaries, equity and non-discrimination in activities, investor protection… Foster efficiency and competition Controls over market structure-behavior, entry-exit, cartels, abuse of market dominance, fees……

6. INSTITUTIONAL DESIGN AND APPROACHES TO REGULATING FINANCIAL MARKETS Different supervisory/regulatory models across countries: • Institutional Supervision • Supervision by Objective • Functional Supervision • Supervision by Single-Regulator Different countries, different models Pros/Cons to different models Major challenge to institutional design and supervision: blurring between different markets (domestic-international, products and services, ‘financial innovations’, conglomeration and co-mingling of banking, investment, insurance and real sector activity…..

7. FACTORS CONTRIBUTING TO FINANCIAL CRISIS Multiple factors: Difficult to weight one against other. Factors include: -Easy money, low interest environment fostering excessive borrowing: funds flow into speculative assets: equities, housing, commodities -Distorted incentives, ‘false’ notions of wealth effects led to excessive borrowing, misleading and fraudulent lending practices (especialy sub-prime mortgages), moral hazard -Inadequate controls and regulatory oversight over financial innovations(securitization, derivatives, risk shifting), agency problems, credit ratings, non-banks trading on own accounts…. -Globalization and conglomeration including increased consolidation (M&A activity) in financial markets.

8. FINDINGS ON FINANCIAL MARKET CONSOLIDATION AND CONGLOMERATION-1 • Number of banks have declined in almost all countries. • While US financial market displays low concentration—markets regionally segmented, some products and services dominated by few firms. • Over the counter (OTC) derivatives quadrupled in 1990s alone. • Globally, banks account for 60%+ of all financial sector M&As. • Consolidation driven by various factors: technology, diversification, specialization, outsourcing…risk reduction not assured, nor evidence of cost reduction, efficiency

9. FINDINGS ON FINANCIAL MARKET CONSOLIDATION AND CONGLOMERATION-2 • Post consolidation firms have shown shift towards riskier asset portfolios. Other risks include operating and managerial complexities. • Larger financial institutions tend to be more highly leveraged. Systemic financial risk more likely to be transmitted to the real economy thru’ wholesale activities of financial institutions in markets—including payment and settlement systems Markets in terms of structure, products and services have evolved faster than regulatory supervision institutions.

10. ROLE OF/FOR COMPETITION POLICY? Can protecting and promoting competition provide safeguards? Regulation of financial markets unavoidable. Financial markets ARE different from other markets for goods and services. Competition can play complementary not substitute role. Competition law and policy (CLP) in most jurisdictions extends to financial markets. But exemptions/exceptions exist in respect to structural changes (especially financial institution failures) Competition ‘trumped’ by ‘systemic stability’, ‘public interest’ concerns in many countries (most recently, US, UK…) Untested what consequences of letting financial institutions fail. Why share-and bond holders of financial institutions be treated differently from firms in other sectors not evident. Need re-balancing role of competition and regulatory policies and institutions.

11. DID PAST DE-REGULATION GO TOO FAR?NEED FOR RE-REGULATION? • Some view repeal of Glass-Steagall Act in US (1999) a mistake. • In many countries blurring of boundaries between ‘4-pillars’ (banking, insurance, trust and investment activities) has occurred with few problems (Canada). • Depends on content and quality of regulatory oversight. • Some need for ‘un-bundling’…especially between traditional banking and investment banking (Volcker Proposals). • More intensive ‘antitrust’ scrutiny required.

12. THANK YOU