12.4 Regulation of the Financial System

What is the purpose of financial regulation in the UK

To ensure financial firms are honest, protect institutions, consumers and the wider economy

What is the role of the Financial Conduct Authority (FCA)

To ensure financial firms are honest, protect consumer interests, and promote competition

What is the role of Prudential Regulation Authority (PRA)

To promote safety and stability of financial firms like banks and credit unions, and to protect

What is the role of the Financial Policy Committee (FPC)

To monitor and regulate systemic risk and ensure financial system stability, including clamping down on unregulated activity and loose credit

What triggered the Global Financial Crisis in 2007-2008

The collapse of US housing prices, defaults on subprime mortgages and banks’ exposure to risky assets

How do lending long-term and borrowing short-term contribute to bank failures

If investments fail and liquidity is low, banks may not meet withdrawal demands, leading to failure

Why did banks need bailouts during the financial crisis

They suffered massive losses on bad loans and lacked funds to stay solvent

What is a liquidity ratio

A measure of a firm’s ability to meet short-term obligations; higher ratios mean great financial safety

What is capital ratio

The ratio of a bank’s equity capital to its risk-weighted assets, indicating financial strength and risk exposure

Why are strong capital and liquidity ratios important for financial stability

They reduce the risk of collapse and maintain market confidence, especially during financial crises

What is moral hazard in banking

When banks take greater risks because they expect government or central bank support if things go wrong

Example of Moral Hazard in banking

During the GFC of 2007-08, banks acted recklessly, by giving risky loans, lending too much, borrowing short-term, lending long-term, believing they'd be bailed out, which encouraged risk taking behaviour

What is systemic risk in financial markets

The risk that a failure in one part of the system (like a major banks) causes widespread economic damage

Why is systemic risk considered a negative externality

Because the consequences affect not just the bank but also consumers, firms, and the whole economy

What can be the real economy impact of problems in financial markets

• Loss of confidence

• Reduced lending

• Recession

• Higher unemployment

• Decline in output