Financial Regulation

What is the role of the financial sector?

What is the role of the financial sector?

→ Facilitate savings

→ Equity markets

→ Forward markets

→ Facilitating borrowing

→ Facilitating the exchange of goods and services

Explain facilitating savings:

Enables individuals to save

→ Target savers → save for big ticket items

→ Savings have interest → generates income

→ Precautionary savings ( if on transitory not permanent income)

→ Saving to smooth future consumption e.g. after retirement

Explain equity markets:

Grow wealth through purchasing equities

→ Buy shares at a low price and sell at a high price

→ Pension funds tend to invest into equities

→ Companies sell themselves on the stock market to raise finance

Explain forward markets:

When economic agents agree prices today, but deliver them in the future

→ Most likely commodities (volatile → susceptible to exogenous shocks)

→ Done to minimise costs

→ Manufacturing → Use future contracts → lack certainty

Explain facilitating borrowing:

Both firms and households borrow

→ Fund investment for capital (R&D)

→ Borrowing to buy capital/big ticket items

Explain facilitating the exchange of goods and services:

Financial sector needed for g&s to be exchanged through the use of money

→ Allowing transactions to take place

→ Depends on inflation

Why do financial institutions need to be regulated?

→ Negative externalities

→ Many banks engage in excessive risk taking

→ Left with little liquidity → closer to collapsing → leads to a loss of jobs

What are universal banks?

Operate in both retail and wholesale markets

→ Retail: Everyday banks

→ Wholesale: Big institutions

What is the world bank?

A multinational organisation that provides financing for long term development projects

e.g. infrastructure

→ They perceive developing countries to be risky

What is the IMF?

Promotes global and financial stability

→ Provides short term emergency loans to avoid budget crisis

When does the IMF step in?

→ When the government can’t pay interest on national debt

→ Prevents sovereign defaults

→ Maintains financial stability

→ Prevents currency from crashing

→ Conditionality attached: Must use demand side policy

What is the capital adequacy ratio?

A measure of the amount of banks liquidity as a (%) if its risk weighted credit exposure

→ The riskier the loans, the more capital they need to hold

What are the factors leading to bank failure during a crisis?

→ Savings gluts

→ Deregulation

→ Securitisation

→ Credit rating agencies

Explain savings gluts:

Savings are high due to a high RDY {Developed}

→ Leads to more risk taking → loans given out at a low interest rate

→ Encourages borrowing and lending → unsustainable

Explain deregulation:

Before 2007, there was low regulation → banks didn’t need to hold up liquidity

→ Meant they were unable to react to emergencies

→ Banks invested deposits into risky businesses

→ Deposits could be lost

→ Government didn’t want to regulate finances so that London’s reputation wasn’t harmed

Explain securitisation:

Also known as CDO (Collateral Debt Obligations)

→ Transformation of illiquid and liquid assets → easy to take out

→ Takes place so that an asset can be bought and sold within the financial market

BEFORE 2007:

→ FC → weren’t mortgaged → became securitised into a financial asset

→ Securitised due to high volatility of prices

→ Now MBS (Mortgaged Backed Security)

→ Can be sold to financial institutions

e.g. hedge funds once securitised

→ Investors bought MBS → Thought they’d get healthy returns from mortgage payments

→ Problem : Mortgages were given to risky people due to deregulation → no payments

→ If mortgage payments weren’t given → asses would be taken

Explain credit rating agencies?

Subprime mortgage crisis → giving MBS to those unworthy

→ Rating A: Safe/ Rating C,D: Risky

→ Before 2007, mortgages were give to CDOs with AAA ratings

→ CDOs weren’t factually safe → perverse relationship between banks and CRA

→ Banks used to pay them

What is a stress test?

A test on banks to observe the resilience of firms during an emergency

What is a systematic risk?

The interdependence of financial instituitions

What are the types of regulatory bodies to lower systematic risk?

→ PRA (part of the BofE)

→ FCA (seperate from the BofE)

→ FPC

Explain PRA:

→ Its their job to create a stable financial system at a micro-prudential level

{supervised single firms}

→ Promotes the safety of deposits → no risky investments

Explain FCA:

Ensures customers are given services that aren’t too risky

→ Ensures firms act with integrity

→ They oversee conduct of firms → PRA don’t look at that

e.g. asset managers and hedge funds

Explain FPC:

→ Identify and eliminate risks → within the system

→ Make direct recommendations to FCA AND PRA

→ Conduct random and occasional stress tests to banks

→ Part of the BofE → Prevents future financial crisis

→ Tightens liquidity regulation

What are the criticisms of financial regulations?

→ Harms of globalisation worsens

→ IMF intervention are short term in nature

→ Imposition of Washington consensus

Explain harms of globalisation worsens:

With a increase in globalisation:

→ Trading increases → Interdependence → contagion

→ More natural resource depletion → negative externalities

→ Illicit lending → all contaminated

Explain IMF intervention are short term in nature:

IMF may never have control over the budget deficit

→ IMF only focuses on DSP → not long term

→ The world bank does more for development than the IMF has ever done

Explain the imposition of the Washington Consensus:

The IMF implement regulation and privatisation

TRADE LIBERISATION IMPOSED:

→ Sunrise firms → Bad capital/labour

WANTED TO IMPOSE FISCAL DISCIPLINE ON COUNTRIES:

→ Spending on infrastructure → VAT increases (regressive)

→ Must have competition → Floating ER

DEREGULATION:

→ Lack of control → Bad for consumers welfare

→ Workers rights decreased

→ China shows a different path

Negatives of financial regulations:

→ Neoclassical: laissez faire

→ When regulation imposed → COP increased

→ Regulation time lag

→ Banks should lower interest rate

Financial regulations are neoclassical:

Laissez faire → free markets should be left to S&D

→ Excessive meddling → Market failure → FDI decreases

→ Government failure → Unemployment → EG increases

→ PPF inwards → Costs increases → Interest rate

→ Can’t take loans → consumption decreases → savings decreases

When more regulation is imposed…

COP increases → Demand for high wages

→ May need to employ oversight team

→ Profits decrease

There is a regulation time lag:

IB may create risky financial assets

→ May delude to securitise other assets

→ Banks develop higher risk → higher reward?

Banks should lower Interest rate

Asset price bubble → Burst → House price crash created

→ Supply for homes inelastic

→ Value of homes not equal value they sell it at

→ Negative wealth affect