Regulation of the Financial System (AQA A-Level Economics): Revision Notes
Regulation of the Financial System
Understanding regulation
Regulation is a way for governments to address market failures and achieve better outcomes for society. When we apply regulation, we create rules and sometimes laws that limit how freely individuals and businesses can make certain decisions.
Financial regulation specifically controls how banks and other financial institutions operate. It restricts the freedom of these organisations and their employees to behave exactly as they might wish, with the aim of protecting the stability of the financial system and the interests of consumers.
Financial regulation acts as a safeguard mechanism, balancing the need for market efficiency with the protection of consumers and the broader economy from excessive risk-taking by financial institutions.
Financial regulation in the UK
The evolution of UK financial regulation
The structure of financial regulation in the UK has changed significantly over the past few decades, particularly in response to financial crises.
Before 2001: The Bank of England was the main regulator of financial services. A self-regulatory board called the Securities and Investments Board was created in 1985, but after a series of scandals in the 1990s and the collapse of Barings Bank, there was a push to reform the system.
1997-2001: The Securities and Investments Board was renamed the Financial Services Authority (FSA), becoming an external regulator with broader powers. The 1998 Bank of England Act formally established the Monetary Policy Committee (MPC) and transferred responsibility for supervising deposit-taking institutions from the Bank of England to the FSA.
The 2007-08 financial crisis: The FSA was heavily criticised for failing to prevent the financial crisis. Regulators had not spotted the lending boom before 2007 or curbed excessive risk-taking by banks. This led to the collapse of banks such as Northern Rock and Royal Bank of Scotland. The Treasury decided to abolish the FSA, which operated from 2001 to 2013.
From April 2013: A new regulatory structure was established with three main bodies:
- Financial Policy Committee (FPC) at the Bank of England
- Prudential Regulation Authority (PRA), part of the Bank of England
- Financial Conduct Authority (FCA), a separate institution
The Financial Policy Committee (FPC)
The FPC has restored the Bank of England's role in maintaining financial stability. This committee focuses on macroprudential regulation, which means looking at risks that affect the entire financial system rather than individual institutions.
FPC Objectives:
Primary objective: Identifying, monitoring and taking action to remove or reduce systemic risks that could threaten the stability of the UK financial system.
Secondary objective: Supporting the government's economic policy, including objectives for growth and employment.
The FPC can reduce threats to financial system resilience by raising awareness of systemic risks among financial market participants. One key tool is the requirement to publish a Financial Stability Report twice yearly, which identifies major threats to UK financial stability.
Sometimes simply warning about risks can prompt the private sector to reduce vulnerabilities. However, the 2007-08 crisis showed that warnings alone are not always sufficient - action is also needed.
The Prudential Regulation Authority (PRA)
The PRA handles microprudential regulation, which focuses on ensuring the stability of individual financial institutions. While the FPC looks at the system as a whole, the PRA examines specific banks, building societies, credit unions, insurers and major investment firms.
The PRA works by:
- Setting standards that financial institutions must follow
- Supervising institutions by assessing their risks
- Taking action to ensure firms are managed properly
The authority aims to promote the soundness of banks and other financial services providers, thereby enhancing the stability of the UK financial system. It may require institutions to maintain specified capital and liquidity ratios to ensure that if a financial firm fails, it does so without causing significant disruption to essential financial services.
The Financial Conduct Authority (FCA)
The FCA is a separate institution responsible for ensuring financial markets work well. Its aims are to:
- Protect consumers by securing appropriate protection for them
- Protect financial markets to enhance the integrity of the UK financial system
- Promote effective competition in the interests of consumers
The FCA ensures the financial industry operates with integrity, that consumers can trust firms to act in their best interests, and that consumers receive appropriate financial products and services.
Bank failures, liquidity and moral hazard
How banks can fail
A bank can fail in two main ways: through insolvency or through liquidity problems.
Bank insolvency: A bank's capital equals the value of its assets minus the value of its liabilities. If the value of assets falls so that it runs out of capital, the bank becomes insolvent or bankrupt.
Liquidity problems: A bank can also fail because it lacks sufficient liquidity. Insufficient liquidity makes a bank vulnerable to a run on the bank, which can cause failure even if its assets are greater than its liabilities.
Banks typically borrow short term (such as overnight money from the interbank market) but lend long term (such as mortgage loans for house purchases). This makes them vulnerable to liquidity shortages.
The lender of last resort
The willingness of the central bank to act as lender of last resort and provide liquidity insurance increases confidence in bank stability. This is necessary because banks must be able to meet their short-term obligations while their assets are tied up in long-term loans.
However, this safety net creates a problem: banks may be tempted to take excessive risks because they believe the Bank of England and the government will not allow them to fail.
Moral hazard
Moral hazard occurs when a firm or individual takes on too much risk because they know that if things go wrong, someone else will bear a significant portion of the cost.
In banking, moral hazard exists when financial institutions pursue profit through high-risk activities because they believe:
- The Bank of England will act as lender of last resort
- The government will bail them out if they face collapse
Without the possibility that institutions will be allowed to fail, there is insufficient incentive for banks to act prudently.
The Northern Rock Example:
When Northern Rock got into financial difficulty in 2007, the Bank of England initially considered letting it fail to teach other banks about the dangers of excessive risk-taking. However, the Bank quickly realised that allowing even a relatively small bank to fail could trigger a crisis throughout the commercial banking system.
The policy changed, and the government began bailing out struggling banks, including RBS in October 2008. This approach of rescuing banks deemed 'too big to fail' replaced the policy of using bank failures as lessons.
Firewalls and other measures
The Bank of England's recognition of moral hazard led to more robust measures, such as imposing 'firewalls' between the retail and investment banking activities of banks. These measures aim to allow the riskier parts of banks to fail without damaging the provision of retail banking services.
Liquidity and capital ratios
Banks have failed or required government assistance either because they lacked liquidity, had inadequate capital, or suffered from both problems. While liquidity and capital are distinct concepts, they are closely related and both play essential roles in a bank's viability.
Understanding liquidity
Liquidity measures the ability and ease with which assets can be converted to cash. A bank's liquidity ratio is the ratio of cash and other liquid assets held by the bank to its deposit liabilities.
Liquid assets can be converted into cash quickly if needed to meet financial obligations. Examples include:
- Cash itself
- Balances held at the central bank
- Holdings of short-dated government debt
To remain viable, a financial institution must hold enough liquid assets to meet its short-term obligations, such as cash withdrawals by depositors. Liquidity problems arise when a bank cannot hold sufficient cash (or assets easily converted to cash) to repay depositors and other creditors.
Understanding capital
A bank's capital is the difference between the value of the bank's assets and its liabilities. This represents the net worth of the bank or its value to those who own it. For a company, the bank's capital represents the shareholders' stake in the bank.
Capital acts as a financial cushion that allows a bank to absorb unexpected losses and protects creditors if the bank's assets fall in value. A bank's capital ratio is the amount of capital on its balance sheet as a proportion of its loans.
Bank regulators typically require the capital ratio to be above a prescribed minimum level. This ensures banks have sufficient buffer to withstand losses without becoming insolvent.
The distinction between liquidity and capital
Understanding the Difference: A Family Finances Analogy
Think of a family's finances to understand the difference:
- Liquidity: Money in the family's bank account and cash on hand that can be used quickly to pay bills
- Capital: All the family's assets (bank account, home, savings accounts, other investments) minus all debts (rent, mortgage, other liabilities)
For banks, insufficient liquidity makes them vulnerable to runs, while insufficient capital exposes them to the risk of insolvency if asset values fall.
Basel III agreement
In 2010 and 2011, members of the Basel Committee on Banking Supervision, including the Bank of England, signed the Basel III agreement. This voluntary agreement aims to strengthen bank capital requirements by:
- Increasing bank liquidity requirements
- Decreasing borrowing by banks
Portions of Basel III have already been implemented, but full compliance is expected by 2028, with implementation beginning in 2023.
Systemic risk and the credit crunch
What is systemic risk?
Systemic risk refers to the risk of a breakdown of the entire financial system, caused by inter-linkages within the financial system, rather than simply the failure of an individual bank or financial institution.
The financial system is highly interconnected, so problems in one part can quickly spread throughout the system, potentially causing widespread failure.
The 2007-09 credit crunch
The most dramatic recent example of systemic risk threatening financial systems was the credit crunch, which began in 2007 and extended into 2009. This event demonstrated how problems in one part of the financial system can cascade throughout the entire economy.
The trigger event: On 9 August 2007, the French bank BNP Paribas told its depositors that they would not be able to withdraw money from two of the bank's funds. BNP Paribas could not value the assets in these funds due to a 'complete evaporation of liquidity' in the market.
This was the clearest sign yet that banks were refusing to do business with each other, triggering a sharp rise in interest rates. However, the roots of the credit crunch were in place several years earlier.
The build-up to the crisis
Normal circumstances: Virtually all firms require a reliable supply of credit or bank lending to remain in business. Historically, the banking system provided this liquidity by borrowing household savings and passing them on through lending to businesses and consumers.
Changes by 2007: Banks throughout the world, particularly in the USA, were raising funds to lend to customers by borrowing from each other on the interbank market rather than from households. Much of this borrowed money was lent as mortgages to low-income customers who were bad credit risks.
Sub-prime mortgages: These loans, known as sub-prime mortgages, were risky assets. From a bank's perspective, a mortgage granted to a customer is an asset, but for the borrower, it is a liability since the loan must be repaid with interest over many years. The danger with sub-prime mortgages is that they may turn into bad debts that cannot be recovered.
How the crisis developed
Banks that created sub-prime mortgages repackaged these risky assets and sold them on to other banks as if they were prime mortgages (secured loans to low-risk home owners). Essentially, banks were buying 'toxic debt' from each other without fully understanding that the repackaged assets were extremely risky.
As banks realised many of their so-called 'assets' were worthless or nearly worthless, the situation quickly deteriorated:
- The supply of liquidity began to freeze
- Banks became unwilling to lend to each other because they distrusted each other's creditworthiness
- This triggered a financial meltdown when banks either collapsed (Lehman Brothers in the USA) or were partly or completely nationalised by governments (Royal Bank of Scotland in the UK)
Impact on the real economy
The financial crisis that followed BNP Paribas's failure eventually destabilised the real economies of many countries, including the USA and UK. The financial crisis caused:
- A collapse of aggregate demand
- Rising unemployment
- Recession
The credit crunch paralysed financial markets, threatening affected countries with systemic failure in their financial systems. Systemic failure was eventually largely averted through government and central bank intervention to rescue financial systems, but by this time much real economic damage had been done.
Remember!
Key Points to Remember:
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Financial regulation limits the freedom of banks and financial institutions to protect the stability of the financial system and consumers.
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The UK has three main regulatory bodies since 2013: the Financial Policy Committee (macroprudential regulation of the whole system), the Prudential Regulation Authority (microprudential regulation of individual firms), and the Financial Conduct Authority (consumer protection and market integrity).
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Moral hazard occurs when banks take excessive risks because they believe they will be bailed out, creating a need for strong regulation and oversight.
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Liquidity (ability to convert assets to cash quickly) and capital (the cushion against losses) are distinct but related concepts crucial to bank stability. Regulators use liquidity ratios and capital ratios to ensure banks remain viable.
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Systemic risk - the risk of the entire financial system collapsing - was dramatically illustrated by the 2007-09 credit crunch, which began with BNP Paribas's announcement and spread throughout the global financial system, causing severe economic damage.