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	Table of Contents
p. 28 of 58 BACK | NEXT Purpose and Structure of the Toolkit Part One: Introduction and Overview Part Two: Preconditions and Infrastructure for Financial Sector Development Part Three: Financial Regulation and Supervision I. Financial Stability, Development and Institutional Design II. Financial Regulation: General Principles III. Financial Regulatory Structure IV. Banking Regulation V. Bank Insolvency and Depositor Protection VI. Securities and Derivatives Regulation VII. Insurance and Pensions Regulation VIII. Regulation of Financial Conglomerates Part Four: Regional Financial Integration Part Five: ADB's Intervention in the Financial Sector Bibliography Glossary and List of Abbreviations Acknowledgements

Financial Sector Legal and Regulatory Toolkit : Part Three: Financial Regulation and Supervision

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II. Financial Regulation: General Principles

1. International Standards
2. Guidance and Recommendations

Effective prudential regulation and supervision of financial markets and intermediaries (including banks, insurance companies, securities firms, and pension funds) are essential to the financial stability and efficient functioning of any economy because of the central role of the financial system in allocating savings and investment. Regulation and supervision play an essential role in fostering stable and robust financial systems and should seek to support and enhance market functioning, rather than to displace it, by establishing basic "rules of the game" and seeing that they are observed.

Official oversight of the financial system encompasses financial regulation, including the formulation and enforcement of rules and standards governing financial behavior as well as the ongoing supervision of individual institutions. At the most basic level, prudential regulation and supervision serve to promote the public confidence on which market-based financial systems are based. Further, supervision and regulation are essential complements to effective management and market discipline. Effective regulation and supervision should ensure that financial institutions operate in a prudent manner and that they hold capital and reserves sufficient to support the risks that arise in their business. However, regulations can themselves be a source of vulnerability if they are too lax, too intrusive, poorly designed, outdated, or inadequately implemented, as highlighted by the current global financial crisis.

Financial crises that have affected emerging, transition, developed, and developing economies emphasize the very real dangers of lack of financial regulation and supervision, not only to economic transition and development, but to political stability and public order.

International Standards

At present, international standards deal with regulation and supervision issues in the context of individual sector standards, i.e., banking, securities, insurance, and conglomerates.

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Guidance and Recommendations

Regulatory and supervisory authorities collectively have three broad objectives that can also serve as a road-map for reform:

• clearly define the types of intermediaries subject to regulation and oversight along with the jurisdiction of each regulatory or supervisory agency for those institutions;
• promote the reliability, effectiveness, and integrity of market infrastructure; and
• foster efficient operation and competition in the financial system.

These objectives can be achieved through the following actions:

• The establishment of a regulator with its authority clearly defined. This can be done through e.g., a central bank law, banking law, or law establishing an individual regulatory authority.
• The awareness of the regulator about the nature and function of a financial market in order to support the needs of the market and protect the public from risks.
• Adoption of rules governing the participants in the financial system and their relationships with one another, with the regulator and the public, in order to foster the operation of and competition in the system.

In the context of this broad framework, the following core aspects of regulation and supervision should be highlighted:

• Supervisory and regulatory authorities need to be both independent and accountable. This also applies to central banks, regardless of their supervisory responsibilities. This means that ideally, the law establishing the regulator and/or central bank should provide for such independence and accountability. As such, central banks should be free from political interference from the executive branch.
• Authorities need to have powers of licensing, prudential regulation, and consolidated supervision. They should also have access to accurate and timely information as well as the ability to engage in remedial action. Again, this should be in the law establishing the regulator or in the legislation governing specific financial markets (e.g., the banking law).
• Authorities must have adequate powers and resources to cooperate and exchange information with other authorities within and outside their own jurisdiction about the status of financial institutions or financial intermediaries.

Financial regulation itself generally seeks to promote financial market efficiency, protect consumers, and prevent instability in the financial system through institutions and systems designed to address market failures. Therefore, financial regulation must address a variety of problems that occur when financial transactions are left solely to market forces ("market failures").

On this basis, financial regulation should seek to address four specific issues:

• anti-competitive behavior (competition regulation)
• market misconduct (market integrity regulation)
• information asymmetries and safety and soundness of individual financial institutions (referred to as "prudential concerns" - prudential regulation)
• systemic instability (financial stability regulation)

Market integrity, prudential and financial stability regulation are at the centre of current international efforts of the G-20 and FSF to improve international financial regulatory standards as a result of the global financial crisis.

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