4.4.4 Regulation of financial markets

Question 1

History of the regulation of financial markets

Answer 1

From the mid-1980s until the 2008 financial crisis, regulation in many financial markets across the world wasn’t very strict. This was partly due to a process of deregulating financial markets in the 1980s, known as the Big Bang.

Less regulation in the financial markets helped them to be more profitable.

Question 2

How did a lack of regulation in the financal sector lead to market failure and instability?

Answer 2

• Excessive risk taking by financial institutions – e.g. many financial institutions, especially investment banks made very risky investments in the hope of making large profits.
• Commercial banks acting as investment banks – the deregulation of investment banking in the 1980s led to many commercial banks getting involved in investment banking activities. When some of those banks made massive losses in their investment banking activities during the 2008 financial crisis, it also affected their commercial banking.
• Fraud and other illegal activity – e.g. several major banks have been involved in market rigging.
• The growth of market bubbles – speculative bubbles, e.g. in the housing market, were allowed to develop, and were made worse by the over-provision of credit.

Question 3

Two types of financial regulation

Answer 3

• Microprudential regulation
• Macroprudential regulation

Question 4

Microprudential regulation

Answer 4

To ensure that individual firms act fairly towards their customers and don’t take excessive risks or break the law.

Question 5

Macroprudential regulation

Answer 5

To tackle systemic risks in financial markets and avoid large-scale financial crises that can hurt the country’s economy.

Question 6

What does regulation usually focus on?

Answer 6

• Competition – making financial markets competitive to benefit consumers.
• The structure of firms and risk management – ensuring firms are stable. This might be achieved by requiring banks to meet capital and liquidity ratios, or by preventing them from taking excessive risks (and making senior individuals within the bank personally accountable if they do).
• Strengthening rules and principles that financial institutions must abide by, or face tough punishments if they don’t.
• Systemic risks – identifying systemic risks in the financial markets and finding ways to manage or remove them.

Question 7

How can a bank’s stability be assessed?

Answer 7

Using capital and liqudity ratios.

Question 8

Issues with regulation

Answer 8

• It may be vulnerable to regulatory capture.
• If the regulation of the financial market is too strict, it can harm economic growth.
• It may lead to the growth of the shadow banking system (which isn’t regulated).

Question 9

International agreements to regulate financial markets.

Answer 9

As well as regulation introduced by individual governments, there have been international agreements to regulate financial markets.

• For example, the Basel Committee (a committee of global banking authorities), have made recommendations on minimum liquidity and capital levels for banks. These should help to increase the financial stability of bank by making sure they have a buffer in case of a fall in asset values or a bank run.

Question 10

How does the Bank of England regulate financial markets in the UK?

Answer 10

The Bank of England regulates the financial markets through the work of two bodies under its control – the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).

The FPC is a macroprudential regulator and the PRA is a microprudential regulatory, but they work together to ensure the stability of financial markets.

Question 11

Financial Policy Committee (FPC)

Answer 11

The work of the FPC involves:
- Identifying, monitoring and protecting against systemic risks in the financial system.
- Issuing instructions to the PRA and FCA to tackle problems that threaten the financial system.
- Advising the government on managing financial matters.

Question 12

Prudential Regulation Authority (PRA)

Answer 12

The work of the PRA involves maintaining the stability of banks and promoting effective competition by:
* Supervising firms and financial institutions to ensure that they successfully manage risk.
* Setting industry standards for conduct and management and making sure they’re followed.
* Specifying capital and liquidity ratios for financial institutions.

Question 13

Financial Conduct Authority (FCA)

Answer 13

The FCA is a microprudential regulator which aims to protect consumers and increase confidence in financial institutions and products.

It does this by:
* Supervising the conduct of firms and markets to ensure that things are done legally and fairly.
* Promoting competition in financial markets so that better deals are provided for consumers.
* Banning financial products that don’t benefit consumers.
* Banning, or forcing firms to change, misleading adverts for financial products and services.