The financial sector, which includes financial institutions (FIs), people, systems and services, is an important part of any nation’s economy. It includes banks, investment funds, insurance companies, etc. (wise geek 2011). All these financial activities need to be regulated and supervised in one way or another and financial regulations play a vital role in any financial services market. These regulations are basically the rules or guidelines that help the financial institutions to perform their operations as per defined parameters. They not only provide guidance to the overall banking sector but also minimize the exploitation of retail consumers by FIs. According to Investopedia, retail consumers deal with banks directly for services like cheques, deposits, mortgages, personal loans, credit/debit cards, etc. Devlin et al (2003) argue that these consumers are normally less informed about financial services and perhaps do not evaluate alternatives available to them. While constituting a large volume of any bank’s consumer base, most retail consumers’ understanding of financial markets is very limited and, to a great extent, they require the monitoring and supervision of the banks (FSA 2008).
FIs provide consumers with a wide range of financial products and services like credit cards, personal loans, and overdrafts, etc. but consumers can easily be exploited due to the complex nature of these products. It is very important that consumers get the correct outcomes of their financial decisions (Hoban & Davey 2010). Both Bazley and Haynes (2007) argue that it is not necessary for everyone to be aware of all the complexities of the financial products. Most of the time, consumers cannot decide whether or not they have been given proper financial services or advice before they make an investment. Globalisation and the competitive business world have also increased the risks for consumers. The movement of labour, capital and technology has increased the number of financial institutions across the world. Financial transactions have begun to take place on a large scale and the complexity of the FIs has increased. (IMF Staff 2008).
The question arises about the extent to which regulations are needed for the retail consumers. The answer could give the objectives of financial regulations and cover different issues such as systemic stability, market dependability/confidence, information asymmetries, consumer protection, frauds/misrepresentations (Benston et al 1999).
1) Asymmetric Information:
The financial market has two major parties: buyers (borrowers) and sellers (banks). Information asymmetry lies with both banks and consumers. The market has imperfections and a large number of customers with different needs. The consumer may not be sure about his or her actual financial needs (Alfon 2004) and choosing among various products is not an easy task. White (1999) explains that consumers do not necessarily have knowledge of financial products and services; thus, they can make wrong choices and be unable to fulfil their actual financial needs. On the other hand, the bank’s credit risk increases if it does not evaluate the risk associated with the borrower.
Information asymmetry affects both banks and consumers; the bank’s profitability is affected and the financial needs of the customer are not satisfied. It leads to the concept of ‘mis-buying’ and ‘mis-selling’. The consumers will get financial services irrelevant to their requirements and the bank will not get the real benefit of its lending. In this case, the regulations can play an effective role in protecting the retail customer and the bank (Patrick 2011).
2) Consumer Protection:
The regulator has a relationship with the customer in terms of the customer’s protection and capability. Llewellyn et al (2003) state that there are two main reasons for why the customer needs protection. First, the institution does not have public funds. Second, the poor conduct of business with the consumers. Under these circumstances, the customer feels uncertain about his or her financial matters and needs protection. Similarly, according to Bazley and Haynes (2007), retail customers undergo a number of financial interactions with FIs. All consumers will not be able to understand the complexities of financial products. Consumers are responsible for choosing financial services. They may not be able to assess the risk and protect their interests. It all has to do with customer capability. The incapacity of consumers can expose them to various risks.
FSA (1998) mentions principal risks: prudential, bad faith, complexity and performance risks. Incompetence in meeting regulatory requirements creates prudential risk. It not only weakens the bank’s position but also increases the danger for the consumer in case of loss. The banks should be regulated to ensure that they do not use fraud or misrepresentation to capture market profit. This would constitute a risk of bad faith. The financial regulations can deal with the risk of complexity; this refers to the difficulty in understanding the nature of financial contracts. The regulations cannot protect consumers from performance risk because such risk is linked to the performance of the investment market and may be inherited. Therefore, the regulations should mitigate these principal risks that consumers face in their affairs.
If the capability of consumers is not improved, there would be some unproductive consequences, as identified by Llewellyn (1999), such as the market being misled, infrequent purchases and lack of transparency.
3) Systemic Stability:
Systemic risk refers to the collapse of the entire financial system due to the failure of a single institution, thus leading to the failure of other organisations. It is very important that regulations take systemic stability seriously because systemic risk can arise from any risk, whether at a lower level or a higher level. Avgouleas (2008) claims that the basic rationale of the financial regulation is to protect the consumer/investor and to keep the financial system stable. He argues that the lack of appropriate structures and rules can make the regulations weak; this was the reason for the global credit crisis. The ultimate protection of the consumer is, to a large extent, correlated with systemic stability.
Systemic stability does not only ensure the soundness of the FI but also protects the interests of the consumers. Therefore, regulators should take a macro-prudential approach prior to dealing with the crisis. According to Kawai and Pomerleano (2010), the regulators must have complete access to the information and respective knowledge and expertise to assess the financial firm’s capability. Further, it should include all methods and techniques to implement a macro-prudential supervisory approach for gaining systemic stability. Therefore, the systemic stability is not only important for the consumers but also for FIs. There needs to be clear focus as, if neglected, there could be another global crisis.
Various approaches have been adopted by regulatory authorities in the UK to give protection to the retail consumers. Bearing all the issues in mind, consumers cannot be left unguided or self-regulated due to insufficient knowledge (Finansinspektionen 2009:10). The effectiveness of each approach varies at different levels. Some of the important regulatory approaches are discussed as below:
1) Consumer Empowerment:
Consumer protection is a serious concern for regulating bodies. FSA (Sept, 2003) argues that consumers cannot be protected from all the facilities of firms but they can be protected up to a certain degree. However, consumer capability can be improved. Financial literacy is very important for the basic understanding of financial products and services. It has become one of the major purposes of regulatory authorities. As the FSA (2003) has suggested: ‘national strategy for financial capability’ consisting of:
i) Financial Education
iii) Generic Advice
An independent financial body established by the FSA, Consumer Financial Education Body (CFEB) has started work to educate consumers. Its sole responsibility is to advice, inform and educate consumer in financial matters. It is funded by public funds, dormant accounts and consumer credit firms (CFEB 2011).
Information plays an important role in financial markets. Besides regulatory bodies, it is also the responsibility of financial providers to give correct information to their consumers. Smith (2011:5) states:
Financial service providers should be required to take more responsibility for ensuring that consumers receive clear, sufficient, reliable, comparable and timely information about financial service products.
He further states that consumers remain mostly unclear about understanding the contracts with banks; this causes ‘mis-selling’ of the products. Therefore, banks should find out how much customers understand about their products.
In the UK’s financial system, appropriate efforts have been made to provide relevant financial information to the consumers. The FSA introduced ‘Comparative Tables’ in 2001 under its ‘Comparative Information Scheme’, 1999. These tables (FSA 2001) provide information about similar financial products being offered by different institutions. This helps consumers to make less risky decisions as they can make comparisons and information asymmetry decreases.
The FSA (2005: 6) defines generic financial advice: ‘Generic financial advice is a set of services and tools that use information about individuals’. Financial advice is provided to consumers after their financial positions have been analysed. However, there are some concerns about generic advice: advisors should be authorised by the FSA and clear standards must be in place. In some cases, consumers may not be able to understand how to make the right use of generic advice (FSA 2005).
This approach would have many benefits for the financial system. First, it would enhance the competition for financial entities and they would become more compliant in their services. Second, the cost of wrong choices by consumers could be minimised as their money would be correctly placed from the start. Third, the information asymmetry would be reduced. The correct information would help consumers to self-regulate. Ultimately, the burden on the regulator would be reduced due to fewer consumer complaints. The CFEB Consumer Research Report (2011) reveals that the improvement in financial capability improves lifestyles, saving patterns, household income and psychological well being.
2) Deposit Insurance:
Deposits form a major portion of bank’s liabilities and should be protected by the banks. Arner and Lin (2003) argue that if consumers believe that the bank is unable to return their money on demand, the bank can have run on it and, therefore, liquidity risks arise.
The regulatory approach is of ‘Deposit Insurance’. This is the assurance of payment to the depositors that may suffer loss. Arner and Lin (2003) suggest that they can be protected by either explicit or implicit deposit insurance. Explicit deposit insurance secures a limited number of depositors. Payment is guaranteed to the insured depositors only on the closure of the bank’s operations. Payment is not guaranteed to creditors, shareholders and managers. Arner and Lin (2003) explain that the benefit of excluding them from deposit insurance is to make them take responsibility for their activities. The assurance of being compensated can make management less effective in carrying out its role prudently.
This approach can be considered to be successful on the basis of a report (Financial Stability Forum 2001) that deposit insurance helps to maintain the soundness and stability of a country’s financial system. Similarly, ‘implicit insurance’ (Arner & Lin 2003) can be defined as a ‘blanket guarantee’ of payment to all depositors, creditors, shareholders and managers.
Implicit insurance may seem to be beneficial but there are some moral hazards as well. Benston (1998) highlights the negative effects of implicit insurance; it may not be an effective approach because it makes all these stakeholders less efficient. Banks will take aggressive risks and will hold less capital because of the compensation given if any loss occurs.
It seems reasonable that regulations should secure insured depositors only; by guaranteeing insurance for the managers or creditors, the ratio of risks would increase which would be a threat to consumer protection.
3) Product Regulation:
In addition to giving information and offering generic advice, the regulating authorities in the UK felt the need for something further to make the consumers safer. Therefore, they planned to introduce ‘Regulated Products’. This refers to financial products that are safe and meet the standards approved by the regulating authorities. According to the Sandler Review (2002), it is better to make a collection of simple products with certain regulatory parameters. It would minimise the need of generic advice for the consumers. He further suggests that this set of products must be defined to the consumer in simpler terms so that there is no complexity. Further, there should be a warning system at the time of selling these products. It would ultimately protect consumers from various risks. The Review further highlights the benefits of product regulation so that those consumers who are not able to pay for financial advice can still be protected by the regulated products.
In 1999, the UK Government introduced CAT (Charges, Access & Terms) standards to be followed for ISA (Individual Saving Accounts) products. The Government supported this product on the understanding that consumers with CAT based ISAs will, at the very least, not have bad transactions and information asymmetry between consumer and FIs will be tackled. However, there are some counter-arguments; there are those who believe that product regulation is not the ultimate solution for consumer regulation.
Johnson (2000) argues that the Government’s notion is based on the assumption that all customers have the same needs. A consumer with less knowledge cannot differentiate between non-regulated and CAT-standard products. Therefore, the need for information and financial education is far important than introducing only regulated products. It would enable the customer to more clearly understand the standards. Hence, the successful implication of the regulated products depends on other issues that cannot be left unaddressed.
4) The Financial Ombudsman Service :
In the presence of the regulations, there is still the chance that retail consumers will find their matters unresolved. To deal with this situation, the regulating authorities took a step forward to secure the consumer’s interest. The UK Government established an independent organisation that deals with the complaints made by consumers and institutions about the financial market. It offers free services for the complainant. Some of the sectors covered are banks, insurance companies, mortgages, money transfers, savings and investments. (FOS 2011)
If a complaint to an FI remains unaddressed or the consumer is dissatisfied with the response, the consumer can go to the FOS. It will look into the matter and judgment will be made accordingly. The FOS has come up with positive results; in 2009–10 it resolved 38 per cent of cases within three months, 67 per cent within six months, and 89 per cent within a year (ADRnow 2011).
According to its ‘fact sheet’, the FOS does not use any funds from its sources to compensate the consumers; rather it directs the institutions to do the things in the right way. Despite this, in 2010, Sinclair, the director of AIFA (Association of Independent Financial Advisors), asked for a complete review of the FOS’s responsibilities. He was concerned that the FOS had moved beyond its statutory powers and it needed to be accountable for its acts. He further added that the FOS was supposed to perform the role of arbitration but it had taken the form of quasi-judicial institution.
However, the role of ombudsman service seems more beneficial and helpful for financial consumers as it appears to minimise their exploitation. The FOS has been quite successful in dealing with consumer complaints if the statistical data discussed above is considered. Therefore, this regulatory approach seems to be quite effective in its responsibilities.
5) The Financial Services Compensation Scheme (FSCS) :
FSCS is another regulatory effort for the protection of the retail consumer protection that seems to be effective. In the absence of this independent body, consumers may lose hope of being compensated by the FIs. According to FSCS (2011), if any institution fails to meet its obligations in the case of insolvency or claims against it, the FSCS is the compensation fund of last resort. The FSCS deals with deposits, insurance policies, investment businesses, etc. It is also known as the ‘final safety net’. The FSCS is entirely different from the FOS but the two cooperate with each other to work for the efficient protection of consumers.
Any approach followed by the regulating body can secure the consumer to a certain extent (FSA 1998). Such approaches can be effective, but cannot totally eliminate risks; complete protection of the financial consumer is impossible. If complete protection is ensured, there would be accompanying ethical issues. Consumers tend to rely too much on the guarantees given by the regulator and they either go for extreme risks or choose a bank without any analysis or judgement. This could cause a rising threat to the financial structures and could ultimately bring loss to the financial parties.
However, the FIs are facing challenges due to the diversity of their customers. Cross-border transactions have broadened the operations of FIs. In order to maximise the profits, banks may engage in such activities that could be harmful to the entire banking sector. The need for monitoring banking activities has been enhanced because of the competition among the banks. Therefore, the importance of financial regulations cannot be denied in any financial system because they are vital for the protection of the retail consumers who are associated with financial markets in one way or another. The financial regulations should be in place to safeguard the interests of the customers to avoid any financial collapse.