In the end, whether a promise is kept rests on rules. Financial markets have three kinds of failure that they cannot fully correct on their own: information asymmetry between buyers and sellers, conflicts of interest between agents and principals, and the externality by which one institution's failure spreads to the whole system. Participants also differ in strength, and the weaker party often has no choice. Regulation is aimed at these failures: mandatory disclosure, suitability, conflict-of-interest management and deposit insurance. Regulation has its own costs, and good regulation strikes a balance between protection and cost.
In most settings free exchange leaves both sides better off, and the price mechanism allocates resources efficiently. But in finance there are several situations that exchange alone cannot correct: one side knows far more than the other; the person making decisions on someone else's behalf has interests of their own; and the collapse of one institution harms many people who had nothing to do with the transaction. Participants also differ in strength: the weaker party often lacks information, bargaining power and room to choose. Each class of regulatory tool corresponds to one of these failures.
Tap a failure.
If product quality can be verified accurately, sellers will in fact disclose it voluntarily. Grossman and Milgrom, independently in 1981, described this "unravelling": the sellers with the best quality disclose first to set themselves apart; buyers assume the worst about any seller who stays silent, so the next-best sellers disclose too, and so on step by step until everyone has disclosed. But once the disclosed information cannot be verified, is costly to verify, or is reported on inconsistent bases from firm to firm, the process breaks down. The role of mandatory disclosure is precisely to make information verifiable and comparable.
Disclosure does not fully solve the problem of credence goods: even after reading the prospectus, most individual investors find it hard to judge whether a complex product suits them. Suitability rules therefore require institutions to understand the client's financial situation, investment objectives, experience and risk tolerance, and to recommend only products consistent with them. FINRA Rule 2111, the SEC's Regulation Best Interest issued in 2019, the EU's Markets in Financial Instruments Directive II in force since 2018, and the Code of Conduct of Hong Kong's Securities and Futures Commission all set out such requirements.
Suitability: matching product risk to the client's tolerance
Choose the client's risk tolerance grade and investment experience to see which products may be recommended.
In financial services, the party giving advice or executing trades is often paid according to what it sold and how much was traded, not according to how much the client earned. Bergstresser, Chalmers and Tufano (2009) found that mutual funds sold through brokers performed worse, net of fees, than funds investors bought directly. Mullainathan, Noeth and Schoar (2012) sent "mystery shoppers" to financial advisers and found that advisers tended to reinforce the biases clients already had and to recommend higher-fee active products. Regulation responds to conflicts of interest in three main ways: requiring disclosure, requiring that the client's interest come first, and banning certain forms of compensation outright.
How the fee model changes what gets recommended
The same adviser and the same client. Switch the adviser's fee model to see what he leans toward recommending and where the client ends up after 20 years.
A bank turns short-term deposits into long-term loans. In normal times this works well, but it carries an inherent fragility. Diamond and Dybvig showed in 1983 that once enough depositors believe others will withdraw, each depositor's best choice is to withdraw first, and even a healthy bank will fail as a result. This is a self-fulfilling panic. Deposit insurance breaks the chain: depositors who know their deposits are protected have no reason to rush to withdraw, so the run never starts.
The cost of deposit insurance is moral hazard: depositors stop caring whether the bank is sound, and the bank may take on more risk as a result. That is why deposit insurance always comes together with prudential regulation such as capital adequacy and liquidity requirements.
Regulation is not free. Compliance itself costs money, and the cost is eventually passed on to clients. Excessive protection restricts the supply of products and innovation. Stigler also pointed out in 1971 that regulators can come under the influence of the industries they regulate and end up protecting incumbents, which is known as "regulatory capture". Good regulation is not a matter of more being better; it finds a balance between the benefits of protection and its costs.
Trading off regulatory intensity
The benefits of protection diminish as regulation tightens, while compliance costs and limits on supply increase. Drag the regulatory intensity to see where the net effect is greatest.
Regulatory requirements are not add-on conditions for a product; they are the safeguard that makes its promises hold. Designing them into the product is better than patching them in afterwards.
Show key information on a consistent basis, with its source and time, so users and third parties can check it.
Base recommendations on the user's situation, not on sales targets; when something does not fit, say no clearly.
Explain fees, commissions, payment for order flow and similar arrangements, so users can judge the conflicts of interest.
State clearly how assets are held in custody and the scope and limits of protection, to reduce panic actions driven by uncertainty.