4.4 The Regulation Of The Financial System

Question 1

What are the three financial regulators you need to know?

Answer 1

• PRA = prudential regulation authority
• FPC = financial policy committee
• FCA = financial conduct authority

Question 2

What is different about the FCA?

Answer 2

It is independent from the Bank of England

Question 3

What is macroprudnetial regulation?

Answer 3

Identifying, monitoring and acting on risks which threaten the whole financial system of an economy

Question 4

What are microprudential regulation?

Answer 4

Identifying monitoring and acting on risks to individual banks and firms

Question 5

Which bodie(s) are macroprudential regualtion?

Answer 5

FPC

Question 6

Which bodie(s) are microprudential regulation?

Answer 6

PRA and FCA

Question 7

Describe what the PRA does

Answer 7

• supervises individual financial institutions = improve financial stability by taking action to ensure these financial institutions are managed properly
• sets standards for these organisations to follow
• can specify specific institutions maintain certain liquidity and capital ratios
• they will let financial institutions fail if it doesn’t effect the overall financial system

Question 8

Describe what the FPC does

Answer 8

• identify, monitor and take action to remove systemic risks to the whole financial system
• make recommendations to banks and other institutions if it feels that they are at risk of failure
• risks are judged by stress tests

Question 9

Stress test definition

Answer 9

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

Question 10

What is the key aim of the FCA and who runs it?

Answer 10

to protect consumers and ensure healthy competition between financial institutions
- it is a government run authority

Question 11

What are the four ways the FCA protects consumers?

Answer 11

• make sure there is no market rigging (that everything is legal) e.g no collusion on setting interest rates
• promote competition in the financial system e.g Deregulation - reducing ‘red tape’
• banning financial products that are against the interests of consumers - Mis selling e.g PPI insurance (didn’t know they were paying it)
• banning or changing misleading adverts for financial products e.g Loan sharks advertisements fully disclosing the high interest rates

Question 12

Financial market failure definition

Answer 12

When financial markets fail to allocate financial products at the socially optimum level of output, which leads to a misallocation of resources in the financial market

Question 13

Why do banks fail?

Answer 13

• excessive risk, (if goes bad) = high systemic risk = collapse of banks = recession, loss of output + jobs = bailouts by government = negative externality as cost is bared by the taxpayer
• moral hazard
• speculative bubbles
• lack of liquidity + bank run

Question 14

Moral hazard definition

Answer 14

Occurs when a firm, insitution or Individual, knows that their failures or bad actions will be covered by a third party

Question 15

How do market bubbles form?

Answer 15

• assets brought cheap and sold at high prices
• prices can fall below what they were brought at or a leveraged deal (borrowing to amplify the end outcome of a deal)
• at some point future estimates of prices are unrealistic and asset prices get so high that they are no longer worth the price
• lead to a fall in demand for these assets = fall in price
• This leads to debt and banks may fail as individuals can’t pay back their debts

Question 16

How is moral hazard apparent in the banking sector?

Answer 16

• banks take risks on investments e.g subprime mortgages, knowing if they risk fails they are covered by the government (bailed out)

Question 17

How does a bank run form?

Answer 17

• if banks do not have liquid assets, mainly notes and coins and individuals can not withdraw their money = more and more people rush to the banks to withdraw their money before the bank runs out of notes and coins = bank failure

Question 18

Liquid ratio defenition

Answer 18

The requirement of banks and other finacial institutions to hold a proportion of their deposits as cash

Question 19

Capital ratio definition

Answer 19

The ratio of the banks equity to the amount of lending made by the bank

Question 20

How do capital ratios and liquid ratios regulate banks?

Answer 20

• prevents a liquidity crisis = can cause bank runs
• reduces the risk of banks not having enough capital to offset any losses in lending
• prevents insolvency

Question 21

What are Basel recommendations?

Answer 21

• global recommendations set but industry experts to stop financial crisis’ such as the 2008 one occurring
• recommendations on limits, ratios and regulations

Question 22

What regulation was introduced in 2019 in the UK?

Answer 22

• ‘liquidity coverage ratio’
• banks need to hold 7% of their lending in the form of capital
• e.g lends £100 mil, needs to make sure they have £7 mil in capital
• the EU has enforced this

Question 23

Problems with financial market regulation

Answer 23

• moral hazard
• shadow banking sector could form
• banking services move overseas (too strict regulation)
• restricts economic activity (less lending)
• administration + enforcement costs
• regulatory capture