Regulating the Financial System (AQA A Level Economics)

Regulation of the UK Financial System

• Historically, a lack of regulation of financial activities has led to risky loans, poor investments, and banking losses

• In response, the Bank of England has increased its supervision and regulation of financial institutions to provide financial stability and a degree of protection for depositors and borrowers

• The following regulatory bodies were set up to oversee the financial system in the UK:

  • The Prudential Regulation Authority (PRA)

  • The Financial Policy Committee (FPC)

  • The Financial Conduct Authority (FCA)

Role of Regulatory Bodies in the UK

Reasons why Banks Fail

• The Financial Crisis of 2008 highlighted fragility of the financial system

  • Governments had to step in to save individual banks from failure (e.g. RBS)

Reasons that Banks Fail

Liquidity & Capital Ratio

• The financial crisis of 2007, highlighted the need to regulate excessive risk-taking by financial institutions and banks

• Banks are now required to meet capital and liquidity ratios to evaluate their capacity to manage unexpected shocks

Liquidity ratio 

• The liquidity ratio is the ratio of a bank’s cash and other liquid assets to its deposits

• This ratio measures a bank's ability to meet its short-term obligations and cash needs. It assesses a a bank's liquidity by comparing liquid assets to its short-term liabilities 

Capital ratio

• The capital ratio is the amount of capital on a bank’s balance sheet as a proportion of its loans

• It measures the funds it holds from profits and issuing shares

• The aim is to identify the level of risk associated with lending 

Moral Hazard

• Moral Hazard has increased in the financial sector since 2008 as Governments have stepped in to save individual banks from failure (e.g. RBS)

  • Banks seem to be considered 'too big to fail' and governments bear the consequences of their risky behaviour

  • The financial sector returned to questionable practices within two years: The China Hustle documents how investment funds and stockbrokers played up obscure Chinese companies who presented fake financial data

  • This stimulated investor demand, temporarily pushing up prices. Many investors lost a lot of money

Systemic Risk in Financial Markets

• Systematic failure is when a minor local problem in one country’s financial sector has international consequences 

  • A single bank can trigger the breakdown of an entire market or even the entire financial system 

• Banks may collapse following periods of low interest rates, accessible credit, and excessive speculation

  • This may cause a sudden and steep decline in asset prices (e.g., shares or housing) leading to a default on loans

  • This could rapidly escalate into a much more severe international situation 

• In 2007, French bank BNP Paribas informed depositors that they could not withdraw from two of their funds. The value of the assets in those fund could not be determined 

  • Banks then stopped transactions with each other as they could not trust that borrowing could be returned. This caused a freeze in liquidity and led to a sudden increase in interest rates

  • As a result of this and other causes of the credit crunch, banks collapsed. This triggered a global financial crisis and recession

  • In some cases, the government and central bank intervened. This helped avert an overall systemic failure, but significant economic harm occurred