Financial market regulation – A-level Economics AQA notes

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Contents

Regulation of the financial system in the UK

The Bank of England:

• The Prudential Regulation Authority (PRA) supervises individual firms offering financial services such as banks and insurers.

• This is also known as “microprudential regulation”. This focuses on the financial stability of individual firms.

• The Financial Policy Committee (FPC) engages in “macroprudential regulation” – the financial stability of the whole financial system.

• Track and prevent “systemic risk” – the risk of a collapse of the entire financial system.

• Supervise “financial market infrastructure”. This refers to the systems that allow payment and recording of transactions.

• If a bank fails, the FPC ensures the bank fails in an orderly way, minimising disruption to the rest of the economy.

The Financial Conduct Authority:

• Ensures fairness for consumers. For example making sure there are fair terms for loans to consumers.

Why a bank might fail, including the risks involved in lending long term and borrowing short term.

Banks make money by “borrowing short and lending long”:

• Borrowing short term (for example deposits in the bank are usually short term)

• Lending long term (for example longer term building projects).

• Long-term interest rates are usually higher than short-term interest rates. [Long-term loans are subject to more risk. So lenders usually demand higher interest rates as compensation for the extra risk.]

• Suppose the bank makes more from lending long than it loses from short-term borrowing. Then it makes a profit.

A bank can fail if it makes poor investments.

But a bank can also fail because of speculation. This is a “bank run”. Suppose bank customers become convinced that the bank may fail. They may rush to the bank to withdraw their money. But the bank does not keep all the customers’ deposits. In fact, banks lend out most of the deposits to fund long-term investments.

This is the risk in “borrowing short and lending long”. Suppose consumers all want to withdraw their deposits from the bank at once. Then the bank cannot convert long-term investments cannot into cash quickly. So not all depositors receive their deposits back.

If a bank cannot meet all its obligations, such as paying depositors, the bank can fail.

The above example is an “illiquid” bank. It has more assets than liabilities. But its liabilities are long-term and the bank cannot convert these assets into cash. So the bank may not have funds to cover many customers withdrawing their deposits at once.

Banks can also fail because they are “insolvent”. This means the bank has more liabilities than assets. For example, suppose asset prices fall in value, because of a recession. Then a bank may suddenly find themselves illiquid or even insolvent.

Liquidity ratios and capital ratios and how they affect the stability of a financial institution

The liquidity ratio measures the ability of a company to turn its assets into cash. In other words, how “liquid” the company’s assets are. A simple liquidity ratio is:

Liquid assets ÷ Total liabilities

A liquidity ratio at 1 or above means a bank can pay off all its liabilities if it needed to. So a higher number indicates a more financially stable bank.

The capital ratio measures the funds the bank holds in reserve, relative to its riskier assets. An example capital ratio is:

Reserves ÷ Riskier assets

The more reserves the bank has, relative to its assets, the more financially stable the bank. So a higher capital ratio is preferable from the point of view of financial stability.

A high capital ratio means, if the bank sees a fall in value of its riskier assets, the bank can cover those losses with its reserves. So the bank will continue to have assets exceeding liabilities. In other words, the bank remains solvent and less likely to fail.

To keep banks stable, one option is to regulate. For example, regulators can require minimum capital or liquidity ratios.

Systemic risk and the impact of problems that arise in financial markets upon the real economy

Systemic risk – problems at an individual financial institution can trigger macroeconomic effects.

Banks can fail because of a lack of liquidity or insolvency. We discussed this above.

But these problems don’t just affect the banks. There are several impacts of financial market problems on the real economy.

• Investment. Banks give out fewer loans. They may need funds in reserve to cover liabilities (deposit withdrawal). As banks give out fewer loans, firms cannot get funding for investment. So investment falls.

• Reduced business confidence due to risk of bank failure. This leads to lower investment.

• Consumption. The risk to deposits from bank failure may reduce consumer confidence, reducing consumption. Suppose consumers lose their deposits or part of their deposits. Then they experience a negative wealth effect, reducing consumption.

• Altogether, this means a significant fall in aggregate demand. So lower real GDP, higher unemployment and lower inflation occur.

• Negative multiplier effects would make aggregate demand shift further left.

Other problems in financial markets can also affect the wider economy.

• Speculation on asset prices. If asset prices suddenly fall, this can reduce the value of wealth. A negative wealth effect can then occur, reducing consumption and AD.

• Examples of speculation include the 2008 financial crisis. Financial institutions speculated on the prices of mortgage-backed assets.

• The Bank of England has more recently argued there are risks from high consumer debt. The Bank of England also monitors cryptocurrency, given cryptocurrency prices are very volatile.

• Consumers not being able to repay loans in larger numbers. This occurred with subprime mortgage lending. Subprime lending means loans to customers who may find it more difficult to pay back. This contributed to the 2008 financial crisis.

• The Bank of England recently had to intervene to prevent failure of some pension funds. They used temporary quantitative easing to do so. [Some pension funds had been using a strategy called “liability driven investment” (LDI). But some pension funds did not have enough collateral (guarantees). So they could not pay the LDI managers as interest rates rose.]

• There have been warnings that the next financial crisis could come from the non-bank sector or “shadow banking”. This includes pension funds, hedge funds and asset management.

Moral hazard

Banks know that, if they fail, there is systemic risk and consumer deposits may be at risk.

So governments or central banks are likely to intervene if the bank fails to save the bank.

Suppose banks think they are insured by government against failure. Then they may engage in riskier behaviour. For example banks could invest in riskier assets. This is moral hazard.

This is one argument for why banks engaged in riskier behaviour leading up to 2008. Financial institutions invested in risky mortgage-backed assets. These banks were “too big to fail”. So there was little downside to risky investments. But only the upside of positive returns.

Governments did have to bail out banks in the end. Northern Rock was nationalised. Other banks were partly nationalised or saw government support. While the initial cost reached over £137 billion, this eventually fell to around £33 billion. This was due to the sale of nationalised banks back to the private sector.

Current examples and extra exam points

Since 2008, there are new policies to prevent moral hazard concerns. Banks can be allowed to fail without bail out. Possible mechanisms include:

• Bail-in: writing down (reduce the amount or value of) the shares of certain investors. This is to give the bank enough capital to function, by reducing liabilities. This makes sure shareholders and lenders to the bank incur the losses when a bank fails. At the same time, it protects taxpayers.

• Transfer of the bank to the ownership of another company.

• A modified insolvency procedure.

• (Partial) nationalisation as a last resort.

The process of allowing banks to fail in an orderly way is called “resolution”. For more on resolution, check out this from the Bank of England.

These interventions are only likely to take place for large banks. In this case, bank failure can have a wider impact on the real economy.

Banks also face stress tests. These tests look at the performance of banks if it faced a shock, such as a recession or a fall in the value of its assets. Banks have broadly performed well on these tests, including during the Covid-19 pandemic.

Major banks in the UK must have a capital ratio of at least 7%. The capital ratio used is the common equity tier 1 (CET1) capital ratio. This gives banks more protection against the risk of a sudden fall in asset values.

Those who deposit money at banks now have less to fear from bank failure. The “FSCS” protects up to £85,000 of deposits per bank. The FSCS is a scheme where financial institutions like banks are taxed. This raises funds to pay off depositors in case a bank fails. This reduces the risk of a bank run.

Information provision may prevent speculation. Trading websites have to state disclaimers. They may state that most traders lose money. Or provide other warnings about risks traders may be taking on, for example.

UK banks had to split up investment banking and commercial banking activities. They had to form separate subsidiaries for each activity. If the investment banking arm fails, it is easier to rescue that part of the firm separately. Then consumer deposits remain protected. This is also known as “ringfencing”.

However some think restrictions on banking activity have gone too far. Restrictions on banking activity can increase costs to banks. Hence this reduces the number of loans banks give out. This may reduce firm investment, as it is more difficult to borrow funds.

Indeed the current UK Government is looking into financial market deregulation. These are the so-called “Edinburgh Reforms”. Possible relaxations include reducing regulation around “ringfencing”. The UK Government may also relax penalties for CEOs for decision making.

Evaluation points for financial market regulation

Other evaluation points for financial market regulation are:

• Whether further regulation is needed depends on the extent of existing regulation. Some have argued the UK’s financial market regulation has become too strict since 2008. Also banks have broadly performed quite well during the Covid-19 pandemic.

• The 2008 financial crisis was global, with some of the key shocks originating in the US. Suppose some causes of financial panics are global in nature. Then it may be difficult to maintain financial stability and prevent systemic risk.

• The FSCS deposit protection scheme protects bank deposits up to £85,000. This makes bank runs less likely. But it may not fully protect those with high wealth.

• New tools, such as bail-in, can save banks wtihout taxpayer money. They punish shareholders for poor bank performance or investment decisions. This reduces the extent of moral hazard.

• Regulation faces the risk of regulatory capture – a form of government failure. Firms can lobby the government to water down regulations. This makes such regulations less effective.

• Regulators may face the accusation of “paternalism”. Private agents may be behaving rationally, so there is no need for intervention. Also, how can a regulator know the right level of regulation to set? Regulators may set too strict or too lenient rules. They do not have the information necessary to judge how much to regulate.

• Can free market forces solve problems themselves? Suppose the Government and Bank of England allowed banks to fail. This may incentivise banks to behave in a less risky way, reducing moral hazard. Greater information provision may help prevent speculation instead, while letting financial markets function.

• May be difficult to predict the next source of financial market failure. This makes it difficult to regulate financial markets. Regulations for some financial institutions are stricter following the 2008 financial crisis. But what about the “shadow banking” sector? This includes companies like asset managers and pension funds. These can engage in risky maturity transformation (such as borrowing short, lending long), like banks.

Essay plan for financial market regulation

Evaluate the view that there should be regulations for financial markets (25 marks)

Introduction:

• Define key terms such as systemic risk and types of financial markets.

KAA1 – Moral hazard and systemic risk

• Asymmetric information – moral hazard. Government does not know that the financial institutions are buying risky assets. Also the government is indirectly insuring the banks. The banks know taxpayers will bail them out if they fail. This encourages riskier behaviour.

• If the banks do fail, would affect the macroeconomy – systemic risk. Significant fall in confidence (bank runs), so lower consumer and firm spending.

• Diagram to show the effect on AD of lower consumer and firm spending.

• Evaluation: depends on the MPC/confidence.

• Alternative evaluation: level of reserves that banks have/banks may not want to fail as it would look bad. Reserve levels have generally improved since 2008, making banks less vulnerable to shocks.

KAA2 – Imperfect information:

• Define speculation in financial markets.

• Imperfect information. If consumers do not know the risks they are taking, then demand for assets would be too high.

• Explain the effect of regulation on market outcomes. This could include requirements for disclaimers on trading platforms.

• Evaluation: regulation could be paternalistic. Regulators cannot see if consumers are weighing up the risks. Indeed they may already be taking into account these risks. Consumers can be acting rationally. Do not know the size of welfare loss/how much consumers are overestimating benefits.

KAA3 – Increases costs for firms.

• Regulations, such as stress tests, capital requirements and information provision, increase firm costs.

• Regulations incur costs for firms. Firms have to spend money updating adverts, websites with information provision. So this leads to inflation at macro level (or price rising for micro diagram), with AS shifting left.

• So consumers face higher prices and workers may be laid off. Less profits, so less investment.

• Evaluation: making bank failure less likely may reduce risk for firms borrowing and lending. This may reduce costs for some firms. [Or regulation may be a small percentage of costs for some firms].

Conclusion:

• Should regulate financial markets.

• Large effect on consumers and preventing excessive risk-taking. Regulations may be a small % of costs.

• Regulations are part of the reason why banks have more reserves and a bank run is less likely.

• It depends on how strict the regulation is and the degree of enforcement.

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