4.2.4.4 The regulation of the financial system

Question 1

Three regulator bodies of the financial system

Answer 1

• Prudential Regulation Authority (PRA)
• Financial Policy Committee (FPC)
• Financial Conduct Authority (FCA) - unlike the other 2, independent of the BoE

Question 2

Macroprudential regulation

Answer 2

• Identifying, monitoring and acting on risks that threat the whole financial system of an economy

Question 3

Microprudential regulation

Answer 3

• Identifying, monitoring and acting on risks to individual banks and firms

Question 4

Role of the Prudential Regulation Authority (PRA)

Answer 4

• Supervises banks, building societies, credit unions, insurers and major investment firms
• Supervises individual financial institutions and sets standards for the organisations to follow

Aims to improve financial stability - takes action to ensure they are managed properly

• Can specify that individual institutions maintain certain capital and liquidity ratios
• Will allow banks and other financial institutions to fail as businesses, but only if their failures doesn’t disrupt the overall financial system

Question 5

Role of the Financial Policy Committee (FPC)

Answer 5

• To identify, monitor and take action to remove systematic risks to the whole financial system
• Take action to make the system more robust
• E.g. - where a collapse in one bank could led to a ‘run’ on other ones, triggering a collapse of the system

Can make recommendations to banks and other institutions if it feels they are at risk - risks judged by stress tests

Question 6

Systematic risks

Answer 6

• Risks that could lead to a collapse in the whole or a significant part of the financial system

Question 7

Stress tests

Answer 7

• Hypothetical exercises that see how banks and other institutions would be affected by various economic shocks

Question 8

Role of the Financial Conduct Authority (FCA)

Answer 8

• Separate from govt - funded by charging fees to financial institutions
• Aim: to protect consumers and ensure healthy competition between financial institutions
• If its felt they aren’t acting appropriately it has the power to regulate and set standards and rules for behaviour - can also order investigations into the industry if it’s felt that behaviour isn’t acceptable

Question 9

Why may banks fail

Answer 9

• If they don’t have sufficient capital - at risk from a fall in the value of their assets - may occur if they experience defaults on what they’re owed (e.g., due to housing market collapse)
• Insufficient liquid assets
• BoE acting as lender of last resort could create culture of taking unnecessary risks
• Moral hazard

Question 10

Insufficient liquid assets

Answer 10

• Make a bank vulnerable to a run on the bank - customers rush to withdraw deposits before bank runs out of cash
• Leads to panic - each customer fights to ensure they get their money back

Question 11

Bank of England acting as lender of last resort

Answer 11

• Provides liquidity insurance - should miniseries likelihood of banking collapse
• However - if the banking sector is backed by the BoE (and govt) may create culture in which banks take unnecessary risks knowing they will always be supported if they run short of cash

Question 12

Define moral hazard

Answer 12

When one institution takes on too much risk knowing that if the risk fails, someone else will cover the costs of the failed risk.

Question 13

Issue of moral hazard

Answer 13

• Present in run-up to banking crisis - some banks took too many high risks
• High-risk investments and the high-risk lending undertaken had potential to generate significant profits for banks
• But - if the risks failed - the cost of failure would be covered by the govt (wouldn’t allow significant parts of the banking industry to fail)
• Came from banks engaging in both commercial and investment bank activities (using funds from commercial activities to fund risky investment banking activities)