A LevelEconomicsAQARevision NotesThe National & International Economy12. Financial Markets & Monetary PolicyRegulating the Financial System

Regulating the Financial System (AQA A Level Economics)

Revision Note

Test Yourself
Lorraine Clancy

Expertise

Economics Content Creator

Regulation of the UK Financial System

  • Historically, a lack of regulation of financial activities has led to risky loans, poor investments, and banking losses
  • In response, the Bank of England has increased its supervision and regulation of financial institutions to provide financial stability and a degree of protection for depositors and borrowers
  • The following regulatory bodies were set up to oversee the financial system in the UK:
    • The Prudential Regulation Authority (PRA)
    • The Financial Policy Committee (FPC)
    • The Financial Conduct Authority (FCA)

Role of Regulatory Bodies in the UK


Regulatory body
 
Explanation
 

The Prudential Regulation Authority (PRA)

  • The PRA creates regulations for banks, insurers and co-operative institutions. It also helps to avoid insolvency of bank
  • They achieve this by monitoring adherence to rules and regulations
    • E.g The PRA worked with the Royal Bank of Scotland after the 2008 economic crash. To reduce effects from risky loans and poor investments, they advised them to sell parts of the bank, cut costs, and manage risks

The Financial Policy Committee (FPC)

  • The FPC was established after the 2008 recession to create financial stability
  • They aim to identify, track, and address risks to the financial system in the UK
    • To do this, they created a stress test for banks to help them withstand future economic shocks. This requires banks to be able to cover potential losses using a capital buffer 
    • Tighter regulations on the amount individuals were able to borrow were set based on incomes. This avoids excessive lending and aims to prevent another housing bubble

The Financial Conduct Authority (FCA)

  • The FCA regulates financial services firms and financial markets in the UK. This ensures that they are operating fairly and in the best interest of consumers
    • E.g, In 2023, the FCA reviewed NatWest Group after potential data protection breaches and their management of account closures

Reasons why Banks Fail

  • The Financial Crisis of 2008 highlighted fragility of the financial system
    • Governments had to step in to save individual banks from failure (e.g. RBS)

Reasons that Banks Fail


Reasons
Explanation

High-risk loans 

  • When a bank lends too many risky loans it can result in bad debt for banks
  • E.g Northern Rock, a mortgage lender that was unable to manage its debts due to reckless lending practices
    • This resulted in a run on the bank as long queues formed outside branches when depositors tried to access their savings

Regulation violation

  • Banks can fail if they do not follow regulatory requirements or operate within the recommended guidelines
  • This may be as a result of inadequate anti-money laundering controls or interest rate manipulation
    • E.g, HSCB were accused of facilitating money laundering activities and failed to put in controls to monitor activities

Speculation & market bubbles 

  • The higher the money supply in an economy, the greater the speculation & potential for market bubbles
  • Significant amounts of quantitative easing since 2008 have increased the money supply & created potential bubbles in different markets (e.g. property, cryptocurrency, shares)

Asymmetric information

  • Many financial products are complex and difficult for consumers to understand
  • The sellers often have a significant information advantage over the buyers
    • E.g. During the financial crisis, financial institutions bundled thousands of mortgages together and sold them on to investors. The sellers had more information on the risk profile of each bundle than the buyers
    • E.g. Mortgage sellers often understand the implications of interest rate changes to repayments much better than the average consumer
  • The Global Financial Crisis demonstrated that asymmetric information exists between financial markets and the regulators set up to monitor them

Liquidity & Capital Ratio

  • The financial crisis of 2007, highlighted the need to regulate excessive risk-taking by financial institutions and banks
  • Banks are now required to meet capital and liquidity ratios to evaluate their capacity to manage unexpected shocks

Liquidity ratio 

  • The liquidity ratio is the ratio of a bank’s cash and other liquid assets to its deposits
  • This ratio measures a bank's ability to meet its short-term obligations and cash needs. It assesses a a bank's liquidity by comparing liquid assets to its short-term liabilities 

Capital ratio

  • The capital ratio is the amount of capital on a bank’s balance sheet as a proportion of its loans
  • It measures the funds it holds from profits and issuing shares
  • The aim is to identify the level of risk associated with lending 

Moral Hazard

  • Moral Hazard has increased in the financial sector since 2008 as Governments have stepped in to save individual banks from failure (e.g. RBS)
    • Banks seem to be considered 'too big to fail' and governments bear the consequences of their risky behaviour
    • The financial sector returned to questionable practices within two years: The China Hustle documents how investment funds and stockbrokers played up obscure Chinese companies who presented fake financial data
    • This stimulated investor demand, temporarily pushing up prices. Many investors lost a lot of money

Systemic Risk in Financial Markets

  • Systematic failure is when a minor local problem in one country’s financial sector has international consequences 
    • A single bank can trigger the breakdown of an entire market or even the entire financial system
       
  • Banks may collapse following periods of low interest rates, accessible credit, and excessive speculation
    • This may cause a sudden and steep decline in asset prices (e.g., shares or housing) leading to a default on loans
    • This could rapidly escalate into a much more severe international situation 

  • In 2007, French bank BNP Paribas informed depositors that they could not withdraw from two of their funds. The value of the assets in those fund could not be determined 
    • Banks then stopped transactions with each other as they could not trust that borrowing could be returned. This caused a freeze in liquidity and led to a sudden increase in interest rates
    • As a result of this and other causes of the credit crunch, banks collapsed. This triggered a global financial crisis and recession
    • In some cases, the government and central bank intervened. This helped avert an overall systemic failure, but significant economic harm occurred

You've read 0 of your 0 free revision notes

Get unlimited access

to absolutely everything:

  • Downloadable PDFs
  • Unlimited Revision Notes
  • Topic Questions
  • Past Papers
  • Model Answers
  • Videos (Maths and Science)

Join the 100,000+ Students that ❤️ Save My Exams

the (exam) results speak for themselves:

    Test yourselfNext topic

    Did this page help you?

    Lorraine Clancy

    Author: Lorraine Clancy

    Lorraine brings over 12 years of dedicated teaching experience to the realm of Leaving Cert and IBDP Economics. Having served as the Head of Department in both Dublin and Milan, Lorraine has demonstrated exceptional leadership skills and a commitment to academic excellence. Lorraine has extended her expertise to private tuition, positively impacting students across Ireland. Lorraine stands out for her innovative teaching methods, often incorporating graphic organisers and technology to create dynamic and engaging classroom environments.