Objectives of the Legal and Regulatory Framework for OFIs2
Against this background, the assessment of the regulation and supervision of OFIs should not only account for their effectiveness in meeting the traditional objectives of financial supervision, but should also consider whether the regulatory framework helps build a sound environment that fosters the development of those institutions. For instance, an inadequate regulatory framework that promotes regulatory arbitrage in the OFI sector could restrict the potential developmental role of OFIs and at the same time could lead to the buildup of substantial undetected vulnerabilities and risks.
While both competition regulation and conduct of business (including market integrity) regulation apply to all sectors and institutions in the financial system, assessing which type of OFIs warrants prudential regulation is, in practice, a difficult exercise. Three characteristics of financial institutions are critical in judging the scope of prudential regulation: (a) the difficulty of honoring the contractual obligations, (b) the difficulty faced by the consumer in assessing the creditworthiness or soundness of the institution, and (c) the adversity caused by a breach of contractual obligations (see Carmichael and Pomerleano 2002). For instance, banks are subject to systemic liquidity risks that may lead to the breach of obligations, financial conglomerates have complex structures whose soundness and creditworthiness are difficult to assess, and the failure of a large bank or insurance company is likely to generate great adversity. Each group of institutions could be ranked using those characteristics to judge the desirability and scope of prudential oversight.
An appropriate regulatory environment is required to foster the development of OFIs as recognized legal entities that are well integrated with the rest of the financial system. In many emerging economies, the legal and regulatory framework for finance, leasing, and other specialized financial institutions is ambiguous, fragmented, and incomplete. Assembling and analyzing the laws and regulations governing the operations of each group of institutions to ensure clarity and completeness is an important step in the assessment of OFIs. While repressive regulation can retard the growth of OFIs, an inappropriate and poorly designed regulatory structure can create incentives for regulatory arbitrage. However, even when high-quality legislation exists, enforcement is sometimes poor. Those factors are all impediments to the development of the financial system in general, but the impediments become more pronounced in the case of OFIs that, in many emerging economies, are often not supported by a clear legal framework.
Legislation should permit effective enforcement. The legal framework for financial system supervision could be somewhat prescriptive, spelling out specific prudential rules within the scope of the governing law, or could be general, thereby providing guidelines and principles while conferring broad regulatory powers on the regulator. The guidelines approach could provide more discretion and flexibility to the regulator, which may be particularly important for OFIs, because separate laws governing specific types of OFIs and markets often overlap, which gives rise to conflicts and ambiguity regarding the applicable rules. If, however, the regulator’s lack of operational independence hampers the effective use of discretion, a more-prescriptive law, if well designed, could provide a workable alternative.
