Model Essay: Financial Objectives
Objective 1: Market Efficiency
The effectiveness of financial systems is often measured through the metric of “efficiency”,
which is taken to ideally mean the Pareto optimal, where welfare is maximised without making
any other person worse off.
Regulation often aims to promote efficiency or reduce inefficiencies that would otherwise arise
from market failures in a laissez-faire market, adopting an approach that transplants economic
concepts as the basis of regulatory design (Lagenbucher).
Common sources of market failure
(1) Asymmetrical information: Information asymmetry can result in market failure as a lack of
optimal information results in mispricing and misallocation that can be exploited by fundraisers
to issue goods of a lower quality that cannot be discerned, resulting in a ‘lemons’ market. In
capital markets, the primary regulatory tool to address information asymmetry is mandatory
disclosure. This increases access to comparable information for investors and ensures all
information is factored into the price of the security, per the Efficient Capital Markets Hypothesis.
It thereby reduces price dispersion, thereby enhancing efficiency for the securities market
(Coffee).
Limitation 1: The question of what information should be disclosed may not always be correctly
answered. Regulators mey get it wrong, as seen in the lack of disclosures for asset-backed
securities prior to the 2008 GFC. The ex ante approach to disclosure may thus still be ineffective
to correct market failure if the quality of disclosure has not caught up to the sophistication of
new investment products.
Limitation 2: Behavioral biases means that a purely rational approach to regulation may not
always work. For example, the market of 2001 still believed heavily in Enron’s stock despite
major accounting errors being publicly identifiable by the market. Providing more information
through mandatory disclosure may thus be ineffective in correcting market failure, especially for
investors that may not even use that information in their decisions. Regulation should thus pay
more attention to the systemic behavioural biases that may render a fully rational approach
ineffective (Langevoort).
Should regulation play a part in more ‘paternalistic’ actions e.g. warn investors of their own
biases, protect them from herding?
(2) Negative externalities: Negative externalities are a form of market failure that results from
costs that are not included in the price of the good, resulting in a third party suffering the
unaccounted for cost. For instance, a bank that lends to a company that engages in activity
producing significant carbon emissions does not internalise the costs of climate change into its
lending. Regulation forces this cost to be internalised by requiring climate-related financial
disclosures.
,Model Essay: Financial Objectives
Objective 2: Consumer Protection
Accessing financial intermediation services are often done through an agent (such as a broker
or investment advisor) and may result in an agency problem where the agent does not pursue
the best interest of his principal and may abuse their client with their superior financial
knowledge. As such, regulation is often presumed to take on a more paternalistic role in
consumer protection as consumers are presumed not to have as much bargaining power or
evaluative capacities to defend their own interests, especially since the value of financial
products only really materialises much further down the line.
Examples:
● £85k FSCS for consumers
● Occupational Pension Scheme
● FCA proposals to ban retail investors from borrowing to invest in crypto assets like
Bitcoin
There are two views on consumer protection. On one end, the neo-liberal view sees the aim of
consumer protection as being to push consumers into market participation. This can be seen in
mandatory disclosure being the regulatory tool meant to encourage freedom of choice in
purchasing financial products. The ‘moral paternalistic’ view goes beyond this, and espouses
that consumer protection should be based on promoting well-being outcomes. For instance,
access to investing on online crowdfunding platforms is restricted through investor frictions such
as warnings and assessments. Mass marketing on mini-bonds was also banned following the
London and Capital Finance blow-up, demonstrating a paternalistic view that aims to protect
consumers from riskier investments. As McVea argues, regulatory policy is not merely a
technocratic exercise and requires “political judgement” on the part of the regulators, seen
especially as Rathi, FCA head, asking what the appetite for consumer harm is in response to
Keir Starmer’s demands to slash regulation in Jan 2025.
The FCA has trended towards a moral paternalistic approach, and has re-orientated from a
more neo-liberal view of consumer protection, especially as the regulator (FSA at that time)
believed part of the cause of the GFC was irresponsible mortgage borrowing on the part of
consumers. As such, the FSA described a need to help “protect consumers from themselves” in
a 2009 mortgage market review discussion paper, adopting what Sustein and Thaler call a
“libertarian paternalism” that deems it right and proper for the state to act in this manner.
The paternalism of the FCA can also be seen in the relatively new guidance on (1) vulnerable
customers and (2) the new consumer duty, though also with some neo-liberal slants, such as
the FCA generally promoting investment in innovative products.
(1) Vulnerable Consumers: In 2021, the FCA published guidance on the fair treatment of
vulnerable consumers, referring to customers that are susceptible to an increased risk of harm
due to their vulnerable characteristics, such as physical or mental health conditions, challenging
personal life events, or limited financial capabilities. Are these sufficient or too limited?
,Model Essay: Financial Objectives
Firms are to take appropriate care depending on the characteristics of their customers in terms
of product design, marketing, communications, including telling customers to obtain third party
or specialist support, but does not impose any new legal duties on firms, though actionable by
the regulator.
(2) The New Consumer Duty: In 2022, the FCA introduced a new consumer duty which requires
firms to act to deliver good outcomes for retail customers. This supersedes the former duty to
treat customers fairly, which only provided for procedural fairness. For instance, consumers may
be provided with information due to mandatory disclosure, but are overloaded with information
and thus not meaningfully protected by the procedural requirements. Instead, the
outcome-focused duty, underpinned by moral paternalism, seeks to achieve empowered
consumers that are confident in the service they receive and outcomes hoped for. However,
considering that financial products are credence goods, this may be challenging to apply with
regards to financial products.
The new duty is also underpinned by three cross-cutting rules and four outcomes.
● Three cross-cutting rules
○ act in good faith
○ avoid causing foreseeable harm
○ enable and support retail customers to pursue their financial objectives
● Four outcomes relating to
○ products and services (suitably designed for customers)
○ price and value (fair value)
○ consumer understanding (timely and effective communication)
○ consumer support (available and accessible customer service, especially
post-sale)
It is likely that a breach of the new duty will be enforced when there is an outcome failure
accompanied by breach of one of the cross-cutting rules. It is worth noting that there is no right
of private action, though cases can be brought to the Financial Ombudsman. While one may
argue there should be a right to private action, this seems unnecessary in light of the aim of the
duty to provide more accessible aid to consumers, especially given the time and costs of
litigation are likely not affordable for the average consumer.
Should we regulate financial products like medicine?
Warren argues that financial products should be regulated for safety and advocate heavily for
moral paternalism. However, this is not a proposal that can be supported as financial products
are credence goods that cannot guarantee a certain outcome. It would not be practical for
regulators to grant a stamp of approval on every financial product, and this may even be more
misleading than helpful to consumers if the regulator’s approval is relied on without discretion,
resulting in the moral hazard problem. As Llewellyn argues, the regulator should not be subject
to excessive demands to protect consumers and occasional regulatory lapses and failures
, Model Essay: Financial Objectives
inevitable and signal that consumers cannot be complacent. Instead, consumer protection can
be achieved in a two-pronged approach, both imposing duties on providers to act in line with
their fiduciary duties and in the best interest of the customer (as the new consumer duty
requires), and putting the onus on consumers to make responsible decisions through providing
information to them.
Objective 3: Financial Stability
Financial stability can be seen as a public good that everyone desires and refers to a state of
stability where one’s expectations for financial needs can be predictably met. Key indicators of
financial stability include liquidity (as illiquidity can cause panic and price swings), and access to
firms and financial services. The most salient example of financial instability was the GFC,
where risky borrowing on a large scale led to banks on multiple levels failing, for instance with
the Northern Rock bank run in 2007. At the same time, however, it is difficult to tell when there is
a financial “bubble” (Trichet), and regulators will hesitate to intervene in the market but
simultaneously worry about allowing a market crash to occur that they will have to support the
economy out of. The solution has been macroprudential regulators that monitor the market and
put out educational material in attempts to maintain financial stability.
To achieve financial stability, regulators have powers to halt trading in certain financial
instruments that may cause prices to spiral and depress out of control.
Regulators also seek to prevent bank runs by providing deposit insurance of up to £85,000 per
person per bank under the Financial Services Compensation Scheme. However, this only
covers consumers, although sophisticated investors are just as capable of engaging in ‘run’-like
behaviour (Armour). As Schwarcz argues, individual private sector parties do not have the
collective good in mind and prioritise self-preservation, sometimes leading to destructive
collective action (as seen in the GFC), which should be prevented top-down by a regulator as a
means of managing systemic risk.
Other than being top-down, financial stability powers are also supported by regimes of
accountability of regulators, and regulators’ actions generally try to return conditions back to
market rather than supplant markets.
Basel: Following the GFC, international regulations have imposed stricter capital adequacy
requirements on banks, requiring banks to have more capital to cushion potential losses and to
disincentivise excessive risk-taking.
● Basel III, learning from Basel II, restricted debt capital and required a higher percentage
of equity financing so that debt holders are not converted into equity holders. It also
introduced a fundamental backstop of a 3% of capital requirement floor based on
balance sheets.
Objective 1: Market Efficiency
The effectiveness of financial systems is often measured through the metric of “efficiency”,
which is taken to ideally mean the Pareto optimal, where welfare is maximised without making
any other person worse off.
Regulation often aims to promote efficiency or reduce inefficiencies that would otherwise arise
from market failures in a laissez-faire market, adopting an approach that transplants economic
concepts as the basis of regulatory design (Lagenbucher).
Common sources of market failure
(1) Asymmetrical information: Information asymmetry can result in market failure as a lack of
optimal information results in mispricing and misallocation that can be exploited by fundraisers
to issue goods of a lower quality that cannot be discerned, resulting in a ‘lemons’ market. In
capital markets, the primary regulatory tool to address information asymmetry is mandatory
disclosure. This increases access to comparable information for investors and ensures all
information is factored into the price of the security, per the Efficient Capital Markets Hypothesis.
It thereby reduces price dispersion, thereby enhancing efficiency for the securities market
(Coffee).
Limitation 1: The question of what information should be disclosed may not always be correctly
answered. Regulators mey get it wrong, as seen in the lack of disclosures for asset-backed
securities prior to the 2008 GFC. The ex ante approach to disclosure may thus still be ineffective
to correct market failure if the quality of disclosure has not caught up to the sophistication of
new investment products.
Limitation 2: Behavioral biases means that a purely rational approach to regulation may not
always work. For example, the market of 2001 still believed heavily in Enron’s stock despite
major accounting errors being publicly identifiable by the market. Providing more information
through mandatory disclosure may thus be ineffective in correcting market failure, especially for
investors that may not even use that information in their decisions. Regulation should thus pay
more attention to the systemic behavioural biases that may render a fully rational approach
ineffective (Langevoort).
Should regulation play a part in more ‘paternalistic’ actions e.g. warn investors of their own
biases, protect them from herding?
(2) Negative externalities: Negative externalities are a form of market failure that results from
costs that are not included in the price of the good, resulting in a third party suffering the
unaccounted for cost. For instance, a bank that lends to a company that engages in activity
producing significant carbon emissions does not internalise the costs of climate change into its
lending. Regulation forces this cost to be internalised by requiring climate-related financial
disclosures.
,Model Essay: Financial Objectives
Objective 2: Consumer Protection
Accessing financial intermediation services are often done through an agent (such as a broker
or investment advisor) and may result in an agency problem where the agent does not pursue
the best interest of his principal and may abuse their client with their superior financial
knowledge. As such, regulation is often presumed to take on a more paternalistic role in
consumer protection as consumers are presumed not to have as much bargaining power or
evaluative capacities to defend their own interests, especially since the value of financial
products only really materialises much further down the line.
Examples:
● £85k FSCS for consumers
● Occupational Pension Scheme
● FCA proposals to ban retail investors from borrowing to invest in crypto assets like
Bitcoin
There are two views on consumer protection. On one end, the neo-liberal view sees the aim of
consumer protection as being to push consumers into market participation. This can be seen in
mandatory disclosure being the regulatory tool meant to encourage freedom of choice in
purchasing financial products. The ‘moral paternalistic’ view goes beyond this, and espouses
that consumer protection should be based on promoting well-being outcomes. For instance,
access to investing on online crowdfunding platforms is restricted through investor frictions such
as warnings and assessments. Mass marketing on mini-bonds was also banned following the
London and Capital Finance blow-up, demonstrating a paternalistic view that aims to protect
consumers from riskier investments. As McVea argues, regulatory policy is not merely a
technocratic exercise and requires “political judgement” on the part of the regulators, seen
especially as Rathi, FCA head, asking what the appetite for consumer harm is in response to
Keir Starmer’s demands to slash regulation in Jan 2025.
The FCA has trended towards a moral paternalistic approach, and has re-orientated from a
more neo-liberal view of consumer protection, especially as the regulator (FSA at that time)
believed part of the cause of the GFC was irresponsible mortgage borrowing on the part of
consumers. As such, the FSA described a need to help “protect consumers from themselves” in
a 2009 mortgage market review discussion paper, adopting what Sustein and Thaler call a
“libertarian paternalism” that deems it right and proper for the state to act in this manner.
The paternalism of the FCA can also be seen in the relatively new guidance on (1) vulnerable
customers and (2) the new consumer duty, though also with some neo-liberal slants, such as
the FCA generally promoting investment in innovative products.
(1) Vulnerable Consumers: In 2021, the FCA published guidance on the fair treatment of
vulnerable consumers, referring to customers that are susceptible to an increased risk of harm
due to their vulnerable characteristics, such as physical or mental health conditions, challenging
personal life events, or limited financial capabilities. Are these sufficient or too limited?
,Model Essay: Financial Objectives
Firms are to take appropriate care depending on the characteristics of their customers in terms
of product design, marketing, communications, including telling customers to obtain third party
or specialist support, but does not impose any new legal duties on firms, though actionable by
the regulator.
(2) The New Consumer Duty: In 2022, the FCA introduced a new consumer duty which requires
firms to act to deliver good outcomes for retail customers. This supersedes the former duty to
treat customers fairly, which only provided for procedural fairness. For instance, consumers may
be provided with information due to mandatory disclosure, but are overloaded with information
and thus not meaningfully protected by the procedural requirements. Instead, the
outcome-focused duty, underpinned by moral paternalism, seeks to achieve empowered
consumers that are confident in the service they receive and outcomes hoped for. However,
considering that financial products are credence goods, this may be challenging to apply with
regards to financial products.
The new duty is also underpinned by three cross-cutting rules and four outcomes.
● Three cross-cutting rules
○ act in good faith
○ avoid causing foreseeable harm
○ enable and support retail customers to pursue their financial objectives
● Four outcomes relating to
○ products and services (suitably designed for customers)
○ price and value (fair value)
○ consumer understanding (timely and effective communication)
○ consumer support (available and accessible customer service, especially
post-sale)
It is likely that a breach of the new duty will be enforced when there is an outcome failure
accompanied by breach of one of the cross-cutting rules. It is worth noting that there is no right
of private action, though cases can be brought to the Financial Ombudsman. While one may
argue there should be a right to private action, this seems unnecessary in light of the aim of the
duty to provide more accessible aid to consumers, especially given the time and costs of
litigation are likely not affordable for the average consumer.
Should we regulate financial products like medicine?
Warren argues that financial products should be regulated for safety and advocate heavily for
moral paternalism. However, this is not a proposal that can be supported as financial products
are credence goods that cannot guarantee a certain outcome. It would not be practical for
regulators to grant a stamp of approval on every financial product, and this may even be more
misleading than helpful to consumers if the regulator’s approval is relied on without discretion,
resulting in the moral hazard problem. As Llewellyn argues, the regulator should not be subject
to excessive demands to protect consumers and occasional regulatory lapses and failures
, Model Essay: Financial Objectives
inevitable and signal that consumers cannot be complacent. Instead, consumer protection can
be achieved in a two-pronged approach, both imposing duties on providers to act in line with
their fiduciary duties and in the best interest of the customer (as the new consumer duty
requires), and putting the onus on consumers to make responsible decisions through providing
information to them.
Objective 3: Financial Stability
Financial stability can be seen as a public good that everyone desires and refers to a state of
stability where one’s expectations for financial needs can be predictably met. Key indicators of
financial stability include liquidity (as illiquidity can cause panic and price swings), and access to
firms and financial services. The most salient example of financial instability was the GFC,
where risky borrowing on a large scale led to banks on multiple levels failing, for instance with
the Northern Rock bank run in 2007. At the same time, however, it is difficult to tell when there is
a financial “bubble” (Trichet), and regulators will hesitate to intervene in the market but
simultaneously worry about allowing a market crash to occur that they will have to support the
economy out of. The solution has been macroprudential regulators that monitor the market and
put out educational material in attempts to maintain financial stability.
To achieve financial stability, regulators have powers to halt trading in certain financial
instruments that may cause prices to spiral and depress out of control.
Regulators also seek to prevent bank runs by providing deposit insurance of up to £85,000 per
person per bank under the Financial Services Compensation Scheme. However, this only
covers consumers, although sophisticated investors are just as capable of engaging in ‘run’-like
behaviour (Armour). As Schwarcz argues, individual private sector parties do not have the
collective good in mind and prioritise self-preservation, sometimes leading to destructive
collective action (as seen in the GFC), which should be prevented top-down by a regulator as a
means of managing systemic risk.
Other than being top-down, financial stability powers are also supported by regimes of
accountability of regulators, and regulators’ actions generally try to return conditions back to
market rather than supplant markets.
Basel: Following the GFC, international regulations have imposed stricter capital adequacy
requirements on banks, requiring banks to have more capital to cushion potential losses and to
disincentivise excessive risk-taking.
● Basel III, learning from Basel II, restricted debt capital and required a higher percentage
of equity financing so that debt holders are not converted into equity holders. It also
introduced a fundamental backstop of a 3% of capital requirement floor based on
balance sheets.
