The regulation of the financial system

Question 1

Summary

Answer 1

1. Regulation of the Financial System in the UK
2. Why a Bank Might Fail?
3. Moral Hazards
4. Systemic Risks
5. Liquidity Ratios and Capital Ratios

Question 2

2. Why a Bank Might Fail

Answer 2

• The Global Financial Crisis 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 were risky bank loans and mortgages, especially in the US where government securities were backed by subprime mortgages.
• This means the borrowers had poor credit histories, and after house prices crashed in the US in 2006, several homeowners defaulted on their mortgages in 2007.
• Banks had lost huge funds and required assistance from government in the form of bailouts.

• 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 3

3. Moral Hazards

Answer 3

• A moral hazard is a situation where there is a risk that t the borrower does things that the lender would not deem desirable, because it makes the borrower less likely to repay a loan.
- Usually occurs when there is some form of insurance for the mistake. For example, if a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else.

• 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 4

4. Systemic Risks

Answer 4

• Systematic risk in financial markets refers to the risk of a breakdown of the entire financial system
• Most dramatic example: ‘credit crunch’ (2007-09)
• Credit Crunch: was defined as a ‘severe shortage of money or credit’
• Started with French Bank BNP Paribas telling their depositors that they could not take money out of two of the bank’s funds.
• This failure to honour it’s financial obligations started the financial crash
• (Financial crash shows the severity of systematic failure in financial system)

Question 5

5. Liquidity Ratios and Capital Ratios

Answer 5

• Liquidity Ratio: ratio of bank’s liquid assets to its deposits

• The higher the ratio, the greater the safety margin of the bank.
• Liquidity problems arise when a bank does not hold sufficient cash to repay depositors.

• Capital Ratio: Amount of capital on a bank’s balance sheet as a portion of its loans

• A bank’s financial strength is determined using this.
• If Bank does not have sufficient capital, they’re at risk if the value of their assets falls
• A reduction of the value of a bank’s assets can be so large that it wipes out the whole of the bank’s capital (bank is bankrupt = can no longer trade)

• Insufficient liquidity: vulnerable to a ‘run on the bank, insufficient capital: risk of a fall in the value of its assets.

• 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.