10.6 Financial Market Regulation

Question 1

1. What is the role of the Financial Policy Committee (FPC)?

Answer 1

The Financial Policy Committee (FPC) is a macroprudential regulator within the Bank of England. Its main objective is to monitor and protect against systemic risk in the financial sector. The FPC has the authority to instruct the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA) on how to address systemic risk concerns. It also advises the government on potential state intervention. The FPC plays a crucial role in conducting annual stress tests to assess the health and functionality of banks, identifying potential shocks in the financial sector. Additionally, it can provide emergency liquidity using the lender of last resort function of the Bank of England.

Question 2

2. What is the role of the Prudential Regulation Authority (PRA)?

Answer 2

The Prudential Regulation Authority (PRA) is a microprudential regulator within the Bank of England. Its primary role is to maintain the stability of banks and the banking sector as a whole, aiming to prevent bank failure and systemic risk. The PRA supervises the management of risk and sets industry standards for management and conduct within the banking industry. It possesses the power to enact and enforce banking regulations, such as reserve requirements, capital ratios, and liquidity ratios. By fulfilling its regulatory functions, the PRA aims to ensure the soundness and stability of the banking sector.

Question 3

3. What is the role of the Financial Conduct Authority (FCA)?

Answer 3

The Financial Conduct Authority (FCA) is a government regulatory body that reports to the Treasury. Its main role is to protect the public interest and consumers, promoting confidence in financial products and institutions. The FCA supervises the conduct of firms in the financial sector, ensuring that their activities are legal and that market rigging does not occur. It can incentivize competition by deregulating and reducing production costs for banks, making it easier to set up and sell various financial products. Additionally, the FCA has a regulatory role in protecting consumers and the public interest. It can ban the misselling of financial products, such as life insurance schemes that do not benefit consumers without dependents, or products sold without consumer knowledge, such as payment protection insurance (PPI). The FCA also has the authority to ban or enforce changes in misleading advertising and the selling of financial products that may not be in the public interest, ensuring clear and transparent information for consumers.

Question 4

1. What is the purpose of banning market rigging in financial markets?

Answer 4

Banning market rigging aims to monitor and strictly enforce regulations that prevent collusion and fixing of interest rates and/or exchange rates in the financial markets. By doing so, interest rates and exchange rates can be determined based on market forces, ensuring fair and transparent outcomes that do not harm consumers, businesses, or other financial institutions. This regulation promotes market integrity and prevents manipulative practices that can distort market outcomes.

Question 5

2. Why is it important to prevent the sale of unsuitable financial products?

Answer 5

Preventing the sale of unsuitable financial products involves banning the sale of products where consumers lack information or where the information provided is unclear. Examples include payment protection insurance (PPI) and selling life insurance to individuals without dependents who cannot benefit from the scheme. By implementing such regulations, consumers are protected from purchasing financial products that do not meet their needs or increase their overall welfare. This helps ensure fair treatment of consumers and promotes trust in the financial sector.

Question 6

3. What is the rationale behind imposing maximum interest rates in capital markets?

Answer 6

Imposing maximum interest rates in capital markets serves a dual function. Firstly, it protects borrowers, such as households with mortgages or car loans, from excessively high interest rates that can become a burden. Secondly, it reduces the incentive for banks to issue loans and make investments with excessive risk. By limiting interest rates, the chance of bank failure is reduced, contributing to the stability of the financial system. This regulation is intended to balance the interests of borrowers and the overall health of the financial sector.

Question 7

4. How does deregulating the financial markets benefit consumers?

Answer 7

Deregulating the financial markets involves reducing paperwork, red tape, and limitations on bank lending, such as capital controls, liquidity constraints, and reserve requirements. This promotes competition in the banking sector, making it easier for new banks to enter the market and for existing banks to exit. The increased competition can lead to lower interest rates on borrowing and higher interest rates for savings, benefiting consumers. Deregulation aims to create a more efficient and competitive financial sector that works in the best interest of consumers.

Question 8

5. What is the purpose of deposit insurance schemes?

Answer 8

Deposit insurance schemes, imposed as regulations, aim to protect individual savings in times of bank failure. These government-backed schemes, like those seen in the UK, provide confidence to depositors that their savings are protected, even if a bank fails. By providing this safety net, deposit insurance schemes help prevent bank runs and maintain stability in the banking system. This regulation helps promote trust in the banking sector and ensures the safety of individual deposits.

Question 9

6. Why is it important to ring fence commercial banking from investment banking?

Answer 9

Ring-fencing commercial banking from investment banking reduces the risk of commercial bank failure. By separating the two activities, the funds held within commercial banking remain within a safer and more regulated environment, reducing the likelihood of losses and collapse. This helps mitigate systemic risk in the financial sector. The regulation aims to protect household funds by ensuring that commercial banks, which hold their deposits, operate within a lower-risk framework, reducing the potential impact on overall financial stability.

Question 10

7) What is the lender of last resort function of the Bank of England?

Answer 10

The lender of last resort function of the Bank of England is the provision of emergency liquidity to prevent a liquidity crisis from leading to bank failure, thereby preventing systemic risk and the potential collapse of the entire financial sector. This function instills confidence in individual savers that their money is safe and prevents panic from sinking in. This is crucial for maintaining confidence in the banking sector, as without it, the economy would experience a deep recession, affecting growth and living standards. The liquidity provision comes with strict regulatory conditions from the Bank of England and repayments with interest rates above market levels, which helps limit the likelihood of such a crisis happening again in theory.

Question 11

7) What is the importance of the lender of last resort function of the Bank of England?

Answer 11

The lender of last resort function of the Bank of England is crucial for maintaining confidence in the banking sector. It prevents a liquidity crisis from resulting in bank failure and systemic risk, which could lead to the collapse of the entire financial sector. This function assures individual savers that their money is safe and prevents panic from spreading. Without this confidence, the economy would experience a deep recession, negatively impacting growth and living standards. The provision of emergency liquidity by the Bank of England is subject to strict regulatory conditions and repayment with interest rates above market levels, limiting the likelihood of a similar crisis occurring in the future.

Question 12

7) What are the regulatory conditions associated with the provision of emergency liquidity by the Bank of England?

Answer 12

The provision of emergency liquidity by the Bank of England comes with strict regulatory conditions. Repayment of the liquidity is required, and the interest rates charged on the repayment are set above market levels. These conditions are imposed to ensure that the liquidity provided is repaid and to discourage banks from relying on emergency liquidity as a long-term solution. By setting higher interest rates, the Bank of England aims to incentivize banks to find alternative sources of funding and to limit the likelihood of a similar liquidity crisis occurring in the future.

Question 13

g) What are Basel III recommendations for limiting bank lending?

Answer 13

Basel III recommendations are regulatory measures agreed upon by industry experts to reduce the risk of bank failure and systemic risk globally. The recommendations include imposing limits on bank lending to prevent bank runs (liquidity crises) and insolvency. These limits can be achieved through various means, such as tightening cash ratios, liquidity ratios, reserve requirements, capital ratios, and leverage ratios. However, it is important to note that these recommendations are not binding, and individual governments can choose to ignore them, implement them as law, or even tighten them further.

Question 14

i) How is the cash ratio calculated, and how does it help prevent bank runs?

Answer 14

The cash ratio is calculated by dividing total cash assets (cash and reserves) by current liabilities (deposits and short-term borrowing) on a bank’s balance sheet. Increasing the cash assets required as a proportion of current liabilities through the imposition or tightening of this ratio reduces the chance of a bank run. By ensuring that banks have enough cash liquidity to meet their short-term liabilities, the risk of a liquidity crisis and subsequent bank failure is minimized. It is worth noting that there are currently no Basel recommendations specifically regarding cash ratios.

Question 15

li) How is the liquidity ratio calculated, and what does Basel III recommend regarding this ratio?

Answer 15

The liquidity ratio is calculated by dividing current assets (cash, reserves, money at short notice, and short-term investments) by current liabilities (deposits and short-term borrowing) on a bank’s balance sheet. Increasing the required proportion of short-term, liquid assets as part of current liabilities through the imposition or tightening of this ratio reduces the chance of a bank run. Basel III recommends that this ratio reach 100% coverage by 2019. Additionally, until then, banks are expected to adhere to the liquidity coverage ratio (LCR), which requires them to hold 100% liquidity to cover liabilities due within 30 days or less.

Question 16

ili) What is the reserve requirement, and how does increasing it help prevent bank runs?

Answer 16

The reserve requirement refers to the fraction of savings deposits that banks must hold as reserves at the Bank of England. Increasing this requirement by raising the fraction of deposits that must be held as reserves reduces the chance of a bank run. By ensuring that banks have enough reserves to meet their short-term liabilities, the risk of a liquidity crisis and subsequent bank failure is minimized. However, it is important to note that there are currently no Basel recommendations specifically regarding reserve requirements.

Question 17

iv) How is the capital ratio calculated, and what is its purpose?

Answer 17

The capital ratio is calculated by dividing total capital (shareholders’ funds and retained profit) by advances (loans issued) on a bank’s balance sheet. However, this ratio only includes loans that are at the greatest risk of default, excluding safer loans such as mortgages. By increasing the level of capital required as a proportion of risky loans issued through the imposition or tightening of this ratio, the chances of bank insolvency are reduced. Banks are required to have enough capital to offset losses from defaulting loans. Basel III recommendations state that this ratio should be at least 0.08 or 8% to mitigate insolvency risks.

Question 18

v) How is the leverage ratio calculated, and how does it differ from the capital ratio?

Answer 18

The leverage ratio is calculated by dividing total capital (shareholders’ funds and retained profit) by total loans and long-term investments on a bank’s balance sheet. Unlike the capital ratio, the leverage ratio includes all loans and long-term investments, not just risky ones. By increasing the level of capital required as a proportion of loans issued and long-term investments held through the imposition or tightening of this ratio, the chances of bank insolvency are reduced. Basel III recommends a leverage ratio of 0.03 or 3%, which is lower than the capital ratio, as it takes into account that not all assets are at risk of default or becoming worthless.

Question 19

1) What is moral hazard in the context of financial market regulation?

Answer 19

Moral hazard in the context of financial market regulation refers to the situation where commercial banks take excessive risks because they know that if they face failure, the savings of customers will be largely protected and the central bank or government will provide emergency funds or bailouts. This knowledge creates a sense of security for banks, leading them to engage in riskier behavior, as they do not bear the full consequences of their decisions. Despite regulatory intervention and the ability of the central bank and government to regulate banks after a crisis, the risk of excessive risk-taking in the future remains.

Question 20

2) What is regulatory capture and how does it affect financial market regulation?

Answer 20

Regulatory capture refers to a situation where managers of commercial banks develop close relationships with regulators, influencing the decision-making process of regulatory bodies. This influence can lead to regulatory decisions favoring the interests of commercial banks rather than what is in the best interests of society. Regulatory capture can result in significant government failure, with bank failure and systemic risk still remaining as potential outcomes. The likelihood of regulatory capture is increased by the fact that regulators often have prior experience as managers or CEOs of banks, leading to existing relationships with those still in the sector.

Question 21

3) How does asymmetric information impact the effectiveness of financial market regulation?

Answer 21

Asymmetric information refers to a situation where banks possess more information than regulators, making it challenging for regulators to impose the appropriate level of regulation. Banks may hide information or present it in a way that favors their own interests, rather than the interests of society. This leads to lax regulation, which fails to sufficiently reduce the risk of bank failure and systemic risk in the banking sector. The imbalance of information between banks and regulators hampers the effectiveness of financial market regulation.

Question 22

4) What is information failure, and how does it affect financial market regulation?

Answer 22

Information failure in the context of financial market regulation refers to the inability of regulators to have full awareness of bank operations once regulations are in place. Regulators may implement bans or regulations targeting specific practices, but banks can quickly adapt and find new ways to exploit consumers or engage in risky behavior that regulators are not aware of. This lag in regulatory response means that regulators may always be one step behind banks, rendering the regulation less effective in protecting the public interest.

Question 23

5) What are some unintended consequences of financial market regulation?

Answer 23

Financial market regulation can lead to significant unintended consequences. Deregulation of bank lending limits to promote competition, for example, can actually increase the risk of bank failure and systemic risk. Deregulation may also fail to promote competition if incumbent firms react and increase barriers to entry, leading to the consolidation of market power and limited competition. Additionally, regulation in one area can lead banks to shift their operations to less regulated sectors such as the shadow banking sector, limiting competition in the commercial banking industry. Maximum interest rates imposed as part of regulation can create an excess demand for loans, attract riskier borrowers, and discourage innovation and profitability for commercial banks. These unintended consequences contribute to government failure, where the costs of intervention outweigh the benefits.

Question 24

6) Why is regulation considered costly, and how does it impact financial market regulation?

Answer 24

Regulation is considered costly due to the administrative expenses of establishing and maintaining regulatory bodies, as well as the costs associated with enforcing the regulations. The costs of regulation need to be justified by significant and tangible benefits in order to prevent government failure. When regulatory capture occurs, combined with the high costs of regulation, the likelihood of government failure increases. The high costs of regulation should be carefully weighed against its benefits to ensure that the intervention is effective and efficient.

Question 25

Evaluation: 1) What is the balance that needs to be struck in financial market regulation?

Answer 25

The balance that needs to be struck in financial market regulation is between preventing bank failure, systemic risk, and protecting the public interest on one hand, and maintaining bank profitability on the other hand. Overly strict regulation can discourage commercial banking activity and lead to unintended consequences and government failure. It is important for banks to have healthy balance sheets in terms of liquidity and capital, but they should also be profitable to incentivize innovation and provide products that enhance living standards and support investment by firms. Striking this balance ensures that regulation is effective and beneficial for both banks and society.

Question 26

Evaluation: 2) What should effective financial market regulation prioritize?

Answer 26

Effective financial market regulation should prioritize equity without damaging efficiency. It is crucial to protect consumers from misleading advertising and misselling without undermining the efficiency of free markets. Regulations, such as maximum interest rates, that restrict the functioning of free markets should be carefully evaluated for their potential harm. The focus should be on utilizing the benefits of free markets while implementing regulations that prevent exploitation and promote fairness. By achieving this balance, regulation can avoid unintended consequences and government failure.

Question 27

Evaluation: 3) Is regulation on bank lending necessary, and why do banks themselves have an incentive to avoid failure?

Answer 27

The necessity of regulation on bank lending can be debated. Banks themselves have an inherent incentive to avoid failure because it threatens their survival and profitability. Some argue that if governments did not bail out banks and central banks allowed banks to fail safely, banks would impose their own limits on lending effectively, reducing the need for controversial and uncertain regulation. However, it is important to consider that the role of regulation is to mitigate systemic risk and prevent crises that could have far-reaching consequences. While banks may have self-preservation incentives, regulation acts as a safeguard to protect the stability of the financial system and the broader economy. Basel recommendations provide guidelines to ensure appropriate limits on bank lending are set, reducing the likelihood of regulatory errors and unintended consequences.