4.4 The Regulation Of The Financial System

Question 1

Why might governments regulate banks?

Answer 1

• Governments might regulate banks with regulation and guidelines.
• This helps to ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank.

Question 2

Why is it important to regulate the banking industry?

Answer 2

• Some economists argue that the banks have a huge influence in the economy; if they failed it would have huge consequences.
• Therefore, it is important to regulate the banking industry.

Question 3

What is the UK Banking industry regulated by?

Answer 3

• The Prudential Regulation Authority (PRA)
• The Financial Conduct Authority (FCA).
• The Financial Policy Committee (FPC)

Question 4

What is the role of the PRA?

Answer 4

• The PRA promotes the safety and stability of banks, building societies, investment firms and credit unions, and ensures policyholders are protected.

Question 5

What is the role of the FCA?

Answer 5

• The FCA regulates financial firms to ensure they are being honest to consumers and they seek to protect consumer interests.
• The FCA also aims to promote competition which is in the interests of consumers.

Question 6

What is the role of the FPC

Answer 6

• FPC regulates risk in banking and ensures the financial system is stable.
• It clamps down on unregulated parts and loose credit. The committee monitors overall risks to the financial system as well as regulating individual groups.

Question 7

Why might a bank fail?

Answer 7

• The Global Financial Crisis is sometimes called The Great Recession, and it refers to the decline in world GDP in 2008-2009.
• Before the crash, asset prices were high and rising, and there was a boom in economic demand.
• There are risks involved with lending long term and borrowing short term. They might lose money on investments, and if there are insufficient funds in a vault, banks might not be able to provide depositors with money when it is demanded.

Question 8

What are moral hazards?

Answer 8

• A moral hazard is a situation where there is a risk that the borrower does things that the lender would not deem desirable, because it makes the borrower less likely to repay a loan.
• It usually occurs when there is some form of insurance for the mistake.
• Banks might take more risks if they know the Bank of England or the government can
  help them if things go wrong.
• The financial crisis has been regarded as a moral hazard, due to the degree of risk taking.

Question 9

What are systemic risks?

Answer 9

• Systematic risk in financial markets can be seen as a negative externality.
• Systematic risks are the risk of damage of the economy or the financial market.
• For example, it could be the risk of the collapse of a bank. Since this costs firms, consumers, the economy and the market, it is deemed as a negative externality.

Question 10

What is a liquidity ratio?

Answer 10

• A liquidity ratio is used to determine how able a company is to pay off short-term obligations.
• The higher the ratio, the greater the safety margin of the bank.
• When creditors want payment, they look at liquidity ratios to decide whether the bank is a concern.

Question 11

What is a capital ratio?

Answer 11

• A capital ratio is a comparison between the equity capital and risk-weighted assets of a bank.

-A bank’s financial strength is determined using this.

• Assets have different weightings, where physical cash has zero risk and credit carries more risk.

Question 12

How do liquidity and capital ratios affect the stability of a financial institution?

Answer 12

• The recent financial crisis showed how having insufficient finance, in either capital or liquidity, can be dangerous.
• Another risk that comes with this is that investors might assume other banks will fail as well, which reduces confidence.