8.4 regulation of the financial system

regulation is

imposing rules or laws which limit the freedom of individuals and businesses to make decisions of their own free will

financial regulation involves

limiting the freedom of banks and other financial institutions and of the people they employ

recent history of UKs financial regulation is

in 1997, the Financial Services Authority (FSA) became an external regulator with a range of regulatory powers, the 1998 bank of england act transferred supervision of deposit taking institutions from the bank to the FSA, due to perceived regulatory failure in 2007-8 FSA was abolished and from april 2013 their responsibilites were given to the financial policy committee

the financial policy committee (FPC)

is part of the bank of england with the primary objective of identifying, monitoring and taking action to reduce systemic risk, protecting and enhancing the resilience of the UK financial system, their secondary objective is to support economic policy of the government

the prudential regulation authority (PRA) is

a part of the bank of england responsible for the regulation and supervision of banks, building societies, credit unions, insurers and major investment firms to ensure safety, stability, and that policyholder are protected

PRA regulate by

stress resting through ratio analysis, tailors supervision and regulation depending on the size of the institution, check firms regulatory reporting, may require institutions to maintain specfiied capitla nad liquidity ratios

the financial conduct authority (FCA) are

an independent conduct regulator which aims to make sure financial markets work well so consumers get a fair deal, protecting consumers, enhancing market integrity, promoting healthy competition

FCA regulate by

setting standards for firms, supervising conduct, investigating misconduct, they set and enforce rules, protect consumers and the wider economy, promote active competition among financial service providers

the FCA set and enforce rules such as

instructions and individuals must be registers or authorised to legally conduct certain activities in banking and accounting

PRA compared to FCA

PRA are part of the BOE, FCA are independant, PRA on behalf of banks, FCA on behalf of consumers, PRA regulated individual deposit takers, insurers and major investment banks (1500 financial institutions), FCA regulate asset managers, hedge funds, smaller broker dealers, independant financial adivsers to ensure market functions well (42,000 financial services firms)

reasons for bank failure are

moral hazard, financial ratios, systemic risk,

moral hazard in terms of banking is

pursuing profit and taking on too much risk in the knowledge that, if things go wrong someone else will bear a significant portion of the cost, since the government will bail them out as they are ‘too important to fail’

an example of moral hazard is

in 2008 banks investing in high risk assets which can lead to high profits as before the crash asset prices were high and rises and there was a boom in economic demand, risk bank loans and mortgages were given out meaning that borrowers who has poor credit histories were allowed to take out mortgages etc. when they defaulted on these loans once house prices crashed they defaulted on loans and banks lost huge funds, requiring assistance from the government in form of bailouts of from the bank of england as the lender of last resort

the recognition of moral hazard after 2008 has

meant that measures have been introduced, such as ring fencing or firewalls between retail and investment banking activities, aswell as more regulation

financial ratios include

cash ratio, liquidity ratio, capital ratio, leverage ratio, reserve requirements

cash ratio is

the ratio of banks cash to its current liabilities and is a liquidity measure that shows a companies ability to cover its short term obligations

cash ratio is calculated using

current cash assets/ current liabilities

financial regulation recommendations for the cash ratio are

implement a minimum or raise the minimum, prevents runs on bank and other liquidity based issues, there is no requirement by basel recommendation

liquidity ratio is

the ratio of a banks cash and other liquid assets to its deposits, measuring companies ability to meet its short term financial obligation

liquidity ratio is calculated using

current short term assets/current liabilities

financial regulation recommendations for liquidity ratios are

implement a min or raise the min, prevent run on bank and liquidity based issue, Basel recommendation is bank should have 100% liquidity to cover liabilities that are owed in 30 days or less

a liquidity ratio can be used to see if a bank can cover its short term financial obligations as

if the ratio is greater than 1 then it can

reserve requirements are

the fraction of deposits that must be held at the bank of england

reserve requirement calculated using

RR x liabilities = cash assets held at BoE

financial regulation recommendations for reserve requirement are

implement a min or raise the min, prevents run on bank and other liquidity based issues, no basel recommendation, USA has 10% reserve requirement, UK has 12%

capital ratio is

the amount of capital on a banks balance sheet as a proportion of its loans, measures financial leverage and stability by comparing amount of debt to total capital ensuring they maintain sufficient capital to absorb potential losses

capital ratio is calculated using

capital/ loans, capital being equity and retained earning or shareholder funds

financial regulation recommendations for capital ratio are

implement a min or raise the min, prevent insolvency and thus bank failure or systemic risk, no basel rec

leverage ratio is

an indicator of the level of debt a company uses to finance its assets and operations, which can be risky for investors but ccan amplify profits

leverage ratio is calculated using

capital/ loans and long term investment (advances)

financial regulation recommendations for leverage ratio is

implement a min or raise the min, prevent insolvency and thus bank failure or systemic risk, basel rec 3% as a minimum

systemic risk can cause bank failure since

the breakdown of one bank can risk the breakdown of the entire financial system, caused by interlinkages

examples of systemic risk are

2007-2009 credit crunch, silicon valley bank, credit suisse

problems with regulation are

moral hazard, regulatory capture, asymmetric information and failure within market, unintended consequences, administrative and enforcement costs, difficukt balance between efficiency and equity, higher rewards or greater risk, anks must be internationally competitive

regulatory capture is

when a regulator created to protect instead advances in the interests of the industry it regulates

regulatory capture is a problem with regulation in banking since

people often become too closely associated with the industry and allow riskier behaviour to take place, moreover people often tend to switch from regulators to workers in the industry and firms are happy to employ them since they know what to look out for

asymmetric information and failure within in a market is a problem with regulation because

often regulators don’t have as much information about the market as participants meaning they are unable to regulate it effectively

unintended consequences is a problem with regulation as

pros of deregulation, the shadow banking sector, maximum interest rates

the shadow banking sector is

a consequence of regulation as it operates outside the traditional banking system, lacking the same level of oversight and deposit insurance