Regulation of the Financial Sector
As we have discovered in the previous pages on the financial sector, market failure evidently takes place in the financial sector. There is a need for regulation, so we can help prevent systemic risk and market bubbles, internalise externalities and improve information in the financial sector.
Question: How does regulation prevent market failure?
Regulation prevents market failure by targeting the causes. To improve social welfare regulation will aim to:
1. Improve competition within financial markets
2. Improve the risk management of financial institutions so that firms are stable.
[This will help prevent unnecessary risks taking place, helping to counter systemic risk]
3. Strengthen rules within the financial sector and distribute tough punishments to those who break the law
The 2 Kinds of Financial Regulation
Microprudential – aimed at individual firms to ensure they don’t take excessive risks and act fairly towards customers.
Macroprudential – aimed at avoiding a large scale financial crisis. The objective is to prevent systemic risks that can cause the collapse of the financial system and the macro/global economy.
Capital and Liquidity Ratios
A form of financial regulation is to require banks to meet minimum capital and liquidity ratios.
Capital ratio – compares the amount of capital a bank has compared to how much it lends
Liquidity ratio – compares the amount of liquid assets (e.g. cash) a bank has with its need for short term cash.
These two ratios will provide information about a bank’s stability. Higher levels of capital and liquidity will result in increased stability, but if these are too high it will come at the expense of bank profitability. A successful regulation will strike a balance between stability and profitability.
There have been international agreements to regulate the financial markets. One such example is the Basel Committee, who have made recommendations for the minimum liquidity and capital levels for banks.
Ring Fencing PolicIES
A ring fencing policy is to prevent large banks from mixing their commercial activities with their investment banking activities.
This is important because without this regulation, banks can use the deposits of their commercial banking customers and engage in riskier investment activity. This can put customers’ deposits at greater risk.
Question: How are Financial Markets regulated in the UK?
There are two bodies that are responsible for regulating banking activity in the UK:
1. The Bank of England (within this, the FPC and PRA)
2. The FCA
The Bank of England as a Regulator
The Bank of England has two bodies which are under its control – the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA).
The difference between these two bodies is that the FPC is a macroprudential regulator and the PRA is a microprudential regulator.
FPC (macroprudential)
Identifies and monitors risks in the financial sector.
Issues instructions to PRA and FCA to tackle problems that threaten the financial system.
Advises the government on how to manage the financial markets.
PRA (microprudential)
Oversees firms in the industry to ensure they are managing risk appropriately.
Set the standards and conduct in the industry to give banks a platform by which to follow.
Set capital and liquidity ratio requirements.
The FCA as a regulator
The FCA is the other regulatory body in the UK. It is a microprudential regulator, so it aims to protect consumers from individual firms.
Supervises firms to ensure actions are legal and fair
Banning certain products which could cause a decrease in social welfare
Promotes competition within the financial industry
Regulates advertisements, which will prevent misleading customers or misinforming them
Question: How is the Financial Sector Regulated around the World?
There are two main regulators of the global financial system:
1. The IMF (International Monetary Fund)
2. The World Bank
They analyse strengths and weaknesses of a country’s financial system and make recommendations about policies...
...they also step in to help countries in times of need.
For example, the IMF helped Iceland in 2008 to stabilise its banks and currency. The World Bank has provided developing countries $189 billion during the financial crisis.
However, they have been criticised for recommending countries to reduce public spending. This has had negative effects particularly for the poorest in certain countries, so this could worsen inequality.
The World Bank and IMF are also headed by people from developed countries. Some people claim this to be unfair as the people in charge are likely to put developed countries’ needs first.
In summary, we have learned:
Policies used to Regulate the Financial Sector
The Bank of England as a Regulator
The FCA as a Regulator
The IMF and World Bank
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