Financial Regulation Flashcards
The roles of the financial sector
1. Facilitating saving
- people may want to save when they are not confident in the economy and don’t want to consume
- save to smooth consumption over time
- target savers
- some countries may have no welfare state
2. Facilitating borrowing
- firms borrow to invest into research and development
- consumer borrow to buy luxury items
3. Facilitating the exchange of goods and services
- helps Borrowers buy goods
- helps connect borrowers/consumers with producers
- in developing countries transactions don’t rely on the financial sector as tend to be cash in hand
4. Equity market
- people want to invest in the equity market as they expect the equities to appreciate and gain value over time
- invest in a boom as the share prices are going to be very high as firms are doing well and making a lot of profit
- if IR low, this accelerates the equity market as people are going to get reduced rewards from saving so they divert their money to the stock exchange as cost of borrowing is low
- high share prices offsets the likelihood of a hostile takeover
5. Forward/ future market
- when firms buy a commodity at an agreed price in the present but it is delivered in the future
- a lot of companies do this as prices are slowly increasing so buy future contracts
- commodity prices are also very volatile and prices may also become very expensive
- allows firms to acertain profit and revenue, keep their costs the same so are more confident to invest
Reasons why financial institutions need to be regulated
- some people lack financial knowledge so there is asymmetric information which leads to them being exploited
- educational curriculum does not really cover basic financial knowledge
- there are negative externalities of overproduction
- if banks taking a lot of risks people could lose their savings, causing the bank to collapse as no liquidity so entire economy would crumble
- gov would have to bail out banks which is an external cost
- the lack of regulation could lead to moral hazards as banks will never learn their lesson and won’t be responsible
Universal Banks
Banks which operate in both retail and wholesale market
- both day-to-day banking and big corporations
What is the problem of moving from retail to investment banking?
If these banks fail then consumer savings are lost
Factors that contributed to the failure of banks during the financial crisis
1. Savings glut
- as people in emerging countries were saving more in developed countries banks as they are more credible and stable
- these banks became more capitalized and have more liquidity so became more confident
- started to invest into riskier less credible investment projects
2. Deregulation
- there was very low regulation in developed countries as they have a comparative advantage in the financial sector
- when commercial banks receive lots of savings due to the lack of regulation they invested into very risky projects
- banks couldnt make a lot of returns so couldn’t absorb losses as they don’t have a lot of liquidity
3. Securitisation
- turning an iliquid asset into a liquid asset so more easier to turn into cash
- the asset becomes liable to be bought and sold as it is secured
- investment bankers secured mortgages as they thought it was a good idea as house prices tend to increase and people are more likely to repay their mortgages
4. Credit rating agencies
- exists to rate financial products in accordance to risk
- in the financial crisis credit rating agencies were paid by banks to give high ratings so that the banks would make a lot of money
- this led to people and firms making Investments they thought were good but were actually bad
How did the financial crisis start?
- defaults in the subprime housing markets
- people with poor credit ratings were giving mortgages who couldn’t keep up with repayments once interest rates increased due to deregulation
The Prudential Regulation Authority (PRA)
- part of the Bank of England
- operates at the microprudential level
- they supervise individual firms such as insurance banks, and major investment firms
- promote the safeness of financial systems
The Financial Conduct Authority (FCA)
- separate to the Bank of England
- ensures consumers are treated with integrity and fairness in finance as there is a lot of asymmetric information causing consumers to be exploited
- pick up the firms that the PRA don’t supervise such as hedge funds, asset managers and independent financial advisors
The Financial Policy Committee (FPC)
- part of the Bank of England
- operates at the macroprudential level
- it’s role is to identify and eliminate risks in the financial system
- makes recommendations to the FCA and PRA
- often conduct stress tests by stimulating a recession to see which banks can survive in the downturn
- banks which are seen red are told to increase thei liquidity ratio
Capital adequacy ratios
Measures the amount of a bank’s capital expressed as a percentage of its risk weighted credit exposures
- the riskier the Investment the more liquidity and capital the bank should keep in reserve, to absorb loss if investment fails
Evaluating financial regulations
1. Can lose comparative advantage if too much regulation
2. Costs of production increases for banks
- need more compliance officers to ensure following regulation
- costs increase, charge higher interest rates so borrowing decreases
3. Neoclassical school of thought believe in no intervention and regulation
- if gov decide mortgage payments should be cut, more people can afford so demand increases causing prices to increase which leads to asset price bubbles
- wealth effect means that people begin to sell their homes so supply increases and asset price bubble pops
- needs to house prices falling and a negative wealth effect
4. Not effective if only in one country
- firms will leave the UK to other countries which leads to a weaker financial account which is not good as it is often used to finance the current account
5. There is always some time lag
- time for regulations to be passed
- takes time for the government to find out enough information on how to regulate
- takes time to research and understand financial complexities
- investment bankers can easily invest into another risky project which requires the government to research again
International monetary fund (IMF)
Promote global financial stability and short-time emergency loans
- these loans are often given to countries facing a budget crisis or balance of payments deficit
When does the IMF step in?
When the country cannot service its debt anymore
- they can’t keep up with interest payments and are on the verge of defaulting
Why can’t the IMF let a country default?
The credit rating score will decrease and so can’t take out loans in the future
- do this to offset a sovereign default or debt crisis as countries are interdependent
- stop the currency from crashing as if there was a default there would be a selling off in the currency
The IMF will only provide assistance on what conditions?
Providing that the country implement austerity and contractionary monetary policy
- to prevent moral hazard
