INTRODUCTION TO FINANCIAL LAW

Learning Objectives
By the end of this chapter the learner should be able to:
i). Define Financial Law
ii). Discuss the importance of financial law in the creation and development of strong financial
markets
iii). Analyze the institutional framework that is necessary for the provision of credit and the operation
of financial markets
iv). Explain the role of Financial Law
v). Explain the Legal Preconditions for Efficient Financial Laws in the Financial Markets
vii) Discuss the institutional preconditions for Efficient Financial Laws in the Financial Markets
.

INTRODUCTION

1.1 NATURE AND SCOPE OF FINANCIAL LAW

 There is no generally accepted definition of financial law. Generally, the concept relates
to the legal rules relating to finance, finances and financiers – in other words, the rules
relating to the process of raising or providing funds or capital or furnishing credit to
another person. Financial law is therefore a broad concept, which may include the legal
framework applicable to investors, depositors or lenders, financial intermediaries,
borrowers and issuers, financial instruments, transactions and contracts, markets and
exchanges, or even public authorities overseeing that process.
 Financial law is the branch of law that regulates social relationships arising from the financial
activities. Financial law applies only to those financial relationships that are of an
organizational nature; those based on contracts are regulated by civil law. For example,
financial law covers questions of the organization of banking and the system of accounts but does
not apply to relationships between bank institutions and recipients of credit or between clients
settling accounts.
 Public finance law refers to legislation and regulations relating to the financial
activities of government or public sector organizations. Public finance laws govern the

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 funding and administration of specific governmental activities including the sale and
purchase of various types of bonds.
1.2 ROLE OF FINANCIAL LAW
 Financial law is important in the creation and development of strong financial markets
 Financial markets rely on legal institutions. Law and regulation ensure that financial transactions
are carried out within a clear, predictable and enforceable legal framework.
 Financial law provides the institutional framework that is necessary for the provision of
credit and the operation of financial markets
 Financial law critically discusses the basic legal components of the financial system
 Financial law examines and discusses the key legal problems that relate to the provision
of finance and the ways in which financial institutions address such problems
 Financial law discusses the legal principles and rules applicable to bank deposits and the
relationship between the banker and the customer
 Financial law discusses and analyses the basic legal principles underpinning commercial
and international banking transactions
 Financial law identifies and critically evaluates the legal risks involved in the process of
agreeing and documenting the most basic financial agreement
 Financial law analyses and discusses the basic legal components of the payment systems
of key jurisdictions of the world
 Financial law critically evaluates the nature, scope, economic function of security in the
provision of finance

1.3 COMPONENTS OF THE ESSENTIAL LEGAL FRAMEWORK UNDERPINNING MODERN

FINANCIAL SYSTEMS

 Generally, financial markets and financial institutions comprise a country’s financial

system. The financial system is broadly the set of markets and institutions that are
involved in moving savings from savers (households and firms) to borrowers, and in
transferring, sharing and insuring risks. The financial system consists of several
components, which include the banking system, the primary and secondary securities
markets, insurance markets, the central bank and other financial supervisory authorities

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 and the underlying infrastructure for the clearing and settlement of payments and trades
in financial instruments.
1.3.1 The Banking System
 Banks play a special and crucial role in all market economies and the banking system is
probably the most important component of the financial system, whether national or
international.
 The banking system comprises the network of institutions responsible for providing
banking services. This consists of two parts. First, there are the actual banks providing
services to the general public; these may be universal banks, or specialist institutions
dealing with particular types of banking business. These range from ‘high street’ banks,
with numerous branches dealing with many small clients, to merchant banks specializing
in financing capital market transactions or foreign trade. Second, there are higher-level
institutions, which are not involved in direct contact with the general public. These are,
first, the central banks, which act as bankers for other banks and the government, and are
responsible for monetary policy and macroeconomic management of the monetary
system; and second the supervisory authorities which supervise other banks and check
their probity, liquidity and solvency. Banks are special because banking is crucial for the
functioning of market economies. The activity of banking includes the provision of
payments facilities, credit and capital to individuals, firms and the government.
 There are many different types of firms that may be described as banks. For example; a
country would have a central bank like the Central Bank of Kenya, Federal Reserve in
the US or the Bank of England in the UK. Commercial banks, on the other hand, are in
the classic business of banking in the sense outlined above. Commercial banks primarily
accept the customers’ deposits and lend money for their own account in view of profit.
There are two other terms here – retail banking and wholesale banking. Retail banking
refers to small-value banking services offered to the general public. Retail banks collect
deposits from individuals and small businesses, and make loans to them. In both cases the
sums concerned may be small. Retail banking is distinguished from wholesale banking,
which concentrates on large-scale transactions with other financial institutions.
Wholesale banking involves low volume and high value. It covers transactions between
two banks in the inter-bank market or between banks and the central bank, other

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 corporations, pension funds and other investment institutions. Merchant banking is a
classic UK term while investment banking is the US equivalent. Investment banks play a
different role from commercial banks. They do not normally lend money directly but they
assist their clients to find the necessary funds by organising securities offerings. They
also deal for their own account or for the account of the customer in financial and
derivative instruments in capital markets and provide investment advice for a fee. It used
to be the case that investment banking and commercial banking were separate lines of
business, each carried out by different institutions. Institutions authorized to accept
deposits were prohibited by law from engaging in investment banking activities.
Similarly, investment bankers were prohibited by law from accepting deposits from the
public. More recently, these rules have been relaxed in most countries of the world and
the result has been the emergence of powerful all-encompassing financial institutions that
engage in the full range of banking and financial activities – the so-called universal
banks.
 In a narrow sense, however, the banking system would be considered to comprise those
financial firms whose main or principal line of business is to accept deposits from the
public. Commercial banks are the main types of depository institutions that further
encompass the deposit-taking institutions outside the commercial banking sector, such as
saving banks and cooperative banks. Deposit-taking institutions such as commercial
banks accept deposits and, with the funds raised through deposits and other funding
sources, both types make direct loans to various entities and invest in securities in the
capital markets.
1.3.2 Capital Markets
 Capital markets are markets in which long-term funds are raised by industry and
commerce, the government and local authorities. The money comes from private
investors, insurance companies, pension funds and banks, and its administration is
usually arranged by issuing houses and by merchant or investment banks. Organised
stock exchanges such as the New York Stock Exchange or the London Stock Exchange
and other alternative trading systems are also part of the capital market in that they
provide a market for the shares and loan stocks that represent the capital once it has been
raised. It is the presence and sophistication of their capital markets that distinguishes the

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 industrial countries from developing countries, in that this facility for raising industrial
and commercial capital is either absent or rudimentary in the latter.
 The securities issued, sold and bought include both shares in companies and various
forms of private and public debt. The capital market allows firms, governments and
countries to finance spending in excess of their current incomes. It also enables
individuals, firms and countries to lend to others savings they cannot employ as
profitably themselves. Some transactions in capital markets involve the sale of newly
issued shares and debt instruments, but the vast majority occur in secondary markets
(organised stock exchanges and other trading systems) where existing shares and debt
instruments change ownership.

1.2.3 Financial securities

 Capital can be classified in various ways but the most important legal distinction is between

equity and debt capital and, accordingly, equity and debt securities. Equity capital represents the

sharing of the commercial risk. Contributors of equity capital (i.e. the company’s shareholders)

have rights and obligations as the company’s members. The most common form of equity

securities is common shares or stock, but there are many different types depending on the rights

and obligations attached to different kinds of instrument.

 The commonest form of debt is, of course, a bank loan. Debt finance in general involves a

promise on the part of the company to repay the money plus interest in the future in exchange for

the release of the funds. Debt capital is used to finance an organisation that is subject to payment

of interest over the life of the loan, at the end of which the loan is normally repaid.

 The legal implications of debt and equity finance are strikingly different. The shareholder is part

owner of the company along with the other shareholders. He or she makes money by selling the

shares at a higher price than the price originally paid for them. As the owner of the company, the

shareholder is set to gain from future profits in the form of dividends but he or she is the ultimate

bearer of commercial risk. Should the company fail, shareholders are the last in the long queue of

those waiting to be paid from the company’s assets. In the event of insolvency, they normally

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 receive nothing. Debt holders, on the other hand, are mere creditors. Their expectations are

normally fixed. They will receive the original capital plus interest but they will not enjoy the huge

benefits of exceptional corporate performance in the future.

 In capital markets, debt capital can take a number of forms. A company may issue debt securities

such as bonds, notes, certificates of deposit, debentures, commercial paper and so on. Despite the

variations, the fundamental legal character of a debt instrument represents the simplest form of

obligation in English financial law (i.e. debt, or the promise of the issuer to repay the amount of

the instrument with interest).

1.4 The Legal Preconditions for Efficient Financial Markets Law

This section examines the essential components of a sound financial architecture – in other

words, the required ingredients for the development of strong, vibrant and successful banking

and capital markets law. In short, modern financial systems rely on the following seven

conditions:

 legally binding rules ensuring that promises must be kept and fulfilled, either voluntarily
or by compulsion of law
 impartial courts and lawyers
 clearly defined property rights, certainty and predictability in the obligations and rights
attached to financial instruments and assets
 the ability to provide security by mortgaging land or other forms of personal wealth
 clearly defined instances of liability for lies, cheating and fraud
 sound mechanisms of investigation and punishment of financial crimes
 Political institutions that ensure the openness of competition.

 Law underpins stable financial markets and is an important source of their vitality. It

provides both the rules by which firms and investors in the market must play and a vital

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 part of the environment in which savings and investment are encouraged. Legal rules

enable financial commitments to be created and honoured. They also govern the conduct

of the market in which the underlying transactions are carried out.

 Strong financial markets require not only that these legal rules exist, but that they operate

in an environment where they are effective. However, in the absence of adequate

foundations for sound finance, the trust and confidence of savers and investors can easily

be misplaced, particularly when they are inexperienced. There have been high-profile

examples of misplaced confidence in transition economies – such as pyramid schemes

that promise high returns which can only be met by attracting new investors. Perhaps the

most extreme examples of misplaced confidence were the Albanian pyramid schemes of

the 1990s. These promised returns as high as 100 per cent in sixmonths, sold claims to

half the population of Albania, and attracted sums equivalent to the total GDP. Their

collapse contributed to civil unrest and a change of government

 In times of market euphoria and increased market activity, the challenge for the legal

systems is to keep abreast of the market developments. With regard to the causes of the

damaging financial crises in Asia, Latin America and Russia of the mid and late 1990s,

the jury is still out, but there is broad consensus that those crises tended to occur when

financial markets were liberalised from the earlier suffocating state control but when

supervision and regulation (in other words, the government oversight of the system)were

not upgraded to cope with expanded activity. Supervision of markets and financial

institutions is a core element of a sound financial system. While the regulation and

supervision of markets and firms are central to a sound and stable financial system, they

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 come into play only if savers and investors have the confidence and means to engage in

financial activity.

 Creating confidence in this activity requires the intensive use of legal and accounting

services. Law serves to establish and enforce property rights and contracts, as well as

creditor and shareholder rights. Accounting and auditing practices generate the reliable

financial information required by savers and investors to ensure their rights are being

respected and to perform an active corporate governance role.

 The availability and quality of these services are thus crucial factors in determining how

well a financial system performs. The absolutely essential rules and institutions required

for the functioning of robust and market-based financial systems are well documented

and defined.

The essential legal framework comprises the following:

 Laws that clearly define and protect private property rights: finance is predominantly concerned

with promises to pay money made by borrowers, investors, intermediaries or lenders. Contractual

claims are the foundations of finance and the law of financial contracts fulfils the function of

enabling financial exchanges and protecting property rights and expectations. Financial markets

absolutely rely on efficient contract laws that protect the rights and enforce the obligations of

counterparties, including lenders and borrowers.

 A framework for creating and enforcing collateral and security interests which protects the rights

of lenders through obtaining a pledge of assets, including real property (mortgages).

 Laws and regulations which govern the non-cash payments system and the clearance and

settlement systems for the transfer of funds between lenders, borrowers and intermediaries and

the completion of securities transactions in organised stock exchanges or alternative markets,

including depository and custodian facilities for securities.

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  Laws which support and organise governance standards and protect shareholders’ rights; the

roles, rights, and responsibilities of directors, managers, and shareholders must be legally defined

 A legal framework for the establishment and operations of a central bank with responsibility for

overseeing the liquidity and stability of the financial system; the central banking law should

establish a politically independent but accountable central bank that is mandated with the

responsibility to maintain price stability and to act as the ‘lender of last resort’.

 Laws that provide for a transparent, fair, and effective legal and regulatory environment for

capital markets, including laws to protect investors and regulate the issuance of securities, broker,

dealers and stock exchanges, and laws that provide for financial transparency through adequate

disclosure, accounting and auditing. Laws and regulations governing collective investment

vehicles (for example, investment companies) are an important component of capital market

regulation.

 All markets, including financial markets, cannot achieve their full potential without laws and

institutions which encourage the creation of competent, ethical, politically independent judiciary.

Such a judiciary must be supported by a sufficient number of lawyers with appropriate legal

training and by credible and honest law enforcement authorities.

1.5 The Institutional Preconditions for Efficient Financial Markets Laws

 A sound framework of financial law is not sufficient. The importance of a general political and

institutional framework subject to the rule of law should not be underestimated.

 The rule-of-law provides an essential framework for investment and financial activity. Without a

certain and enforceable set of rules and standards, economic activity is distorted by the lack of a

climate conducive to individual planning and lack of predictability. Without transparent legal

rules enforced by a competent and honest judiciary, the cost of investment goes up and the

prospects of economic growth go down. Investors require higher returns on their investments,

raising capital becomes more expensive, and debtors may not repay debts knowing that laws and

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 contracts are not consistently enforced. Lack of confidence in law enforcement and fair, effective

dispute resolution supervised by the courts also leads to the creation of alternative institutions,

opens the door to criminal elements, and creates a fertile breeding ground for corruption and

money laundering.

An effective and well-functioning legal system based upon the rule-of-law underlies a sound financial

system. The rule-of-law encompasses:

 A system of government where institutions and officials are guided by and constrained by the

law – that is, a government accountable to, not above, the law.

 A body of laws that is transparent, reasonably predictable, validly derived, and fairly and

equitably applied laws, principles and procedures that protect those civil, political and economic

rights that have become enshrined as universal human rights

 A fair and effective legal system led by an independent and professionally competent judiciary

that acts as the final arbiter of the law.

1.6 Conclusions
 It is now established that financial systems cannot operate in a legal vacuum. The
importance of legal rules and institutions for the creation of financial markets cannot be
underestimated. A legal system defines property rights, allows for exchange of property
rights, and protects property rights.
 Countries with a rule of law and well established property rights are more prosperous and
grow more quickly than countries lacking such a system. An important function of the
rule of law is to protect property rights from governments and market participants who
fail to keep their promises and participate in markets in bad faith. Rules also facilitate
private exchange through contract. Financial markets are particularly vulnerable to
abuses and contractual failures which puts further emphasis on the importance of
enforceable rules, government supervision and the rule of law for the creation and well-
functioning of financial systems

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