The regulation of the financial system

Question 1

What are the regulation of the financial system in the UK

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.
• 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.
• The UK banking industry is regulated by the Prudential Regulation Authority (PRA)
  and the Financial Conduct Authority (FCA). 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. The PRA promotes the safety and stability of banks, building societies,
  investment firms and credit unions, and ensures policyholders are protected.
• The Financial Policy Committee (FPC) regulates risk in banking and ensures the financial system is stable. It clamps down on unregulated parts and loses credit. The committee monitors overall risks to the financial system as well as regulating
  individual groups.

Question 2

Why might the bank fail?

Answer 2

• Doesn’t have sufficient liquidity- Insufficient liquidity makes a bank vulnerable to run on the bank which can cause the bank to fail even if its assets are greater than its liabilities
• As the 2007-08 financial crises showed banks are sometimes tempted to take too many risk in pursuing huge profits that lending long allows. They do this because they believe that the BOE in its role as lender of last resort and the government through its bailout , will not allow banks to fail

Question 3

Why might bank fail?

Answer 3

Moral hazard- This is when a frim or individual pursues profit and takes on too much risk in the knowledge that if things go wrong, someone else will bear a significant portion of the cost. Investing in high risk asset can lead to high profits but unless there is the possibility that financial institution will be allowed to fail, there is insufficient incentive to act prudently. 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 5

What is capital ratio?

Answer 5

The amount of capital on a bank balance sheet as proportional of its loans. 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 6

What are systematic risk

Answer 6

Systematic risk in financial markets can be seen as negative externality. Systematic risks are the risk of damage to the economy and the financial market. The risk that a problem in one part can lead to breakdown of the whole market or perhaps even the whole financial system.