Regulation Of The Financial Sector Flashcards
(15 cards)
Why is regulation important?
Preventing systemic risk
- Financial regulation helps to reduce the risk of a major financial crisis by requiring financial institutions to maintain adequate capital and liquidity, and by limiting risky activities.
Protecting consumers
- Financial regulation protects consumers from
fraud, predatory lending, and other harmful practices.
Ensuring fair competition
- Financial regulation promotes fair competition in the financial industry by preventing anticompetitive behaviour and unfair pricing practices.
Promoting financial stability
- Financial regulation helps to prevent the kind of market instability that can lead to economic downturns and recessions.
Who are the Financial Regulation Bodies in the UK?
The Bank of England
The Prudential Regulation Authority (PRA)
The Financial Policy Committee (FPC)
The Financial Conduct Authority (FCA)
What does the Financial Policy Committee do? (FPC)
• Identifying systemic risks
The FPC assesses the financial system to identify potential risks that could threaten its stability.
• Setting policy tools
Once systemic risks are identified, the FPC has the authority to recommend or set specific policy tools to address these risks. These tools can include capital requirements for banks, leverage ratios, liquidity requirements, and more.
• Stress testing
The FPC conducts stress tests to assess how well the financial system and individual institutions can withstand adverse economic conditions and shocks.
What does the Financial Conduct Authority do? (FCA)
•Regulation and supervision
The FCA is responsible for regulating financial institutions. It sets regulatory rules and standards for these firms, conducts prudential supervision, and ensures that they comply with applicable regulations.
• Consumer protection
The FCA ensures that financial products and services are fair, transparent, and not misleading.
• Market supervision
The FCA actively monitors financial markets to identify risks and emerging issues
What does the Prudential Regulation Authority do? (PRA)
• Prudential supervision
- The PRA is responsible for prudential supervision involves assessing and ensuring the financial soundness of financial institutions to prevent financial instability.
• Setting and enforcing prudential standards
- The PRA enforces standards to ensure that financial firms can withstand economic and financial shocks.
Arguments for allowing bank failure?
• Encourage market
discipline
• Promote competition
• Avoid moral hazard
• Protect taxpayers
Arguments against allowing bank failure?
• Prevent systemic risk
• Protect depositors
• Prevent the negative externalities from financial market failure
What are liquidity and capital ratios in banking?
Liquidity Ratios
- Assess a bank’s ability to meet short-term financial obligations and maintain sufficient liquid assets for withdrawals and unexpected needs.
Cash Reserve Ratio (CRR)
- Requires banks to hold a certain percentage of total deposits as cash or deposits with the central bank.
Capital Adequacy Ratio(CAR)
- Measures the proportion of risk-weighted assets (RWA) to total capital, ensuring sufficient capital relative to risk exposure.
What is asymmetrical information?
One party in a transaction has more information than the other
Can lead to:
• Adverse selection
- occurs when individuals with hidden information about their riskiness (e.g., borrowers with poor credit history) are more
likely to seek financial products (e.g., loans), leading to higher default
rates for lenders.
• Moral hazard
- arises when one party, typically after a transaction, has an incentive to behave differently because of incomplete information e.g. borrowers may take on excessive risks if they believe they won’t bear the full consequences of their actions.
What is speculation?
Buying assets (e.g. stocks or real estate) with the expectation of profiting from price increases, rather than from the asset’s intrinsic value.
What are Market Bubbles?
When asset prices rise significantly above their fundamental values
- Due to speculation and irrational exuberance
• Bubbles often burst, leading to market crashes and financial instability.
What is Market Rigging?
The manipulation of financial markets to gain unfair
advantages.
• Examples include insider trading (trading based on non-public,
material information), market manipulation (e.g., pump-and-dump
schemes), and collusive behaviour among market participants to
distort prices.
• Monopoly power is usually assumed to damage consumer and social welfare.
• Market rigging undermines market integrity and can lead to investor
losses.
What can Lack of Regulation lead to?
• Fraud
• Excessive risk-taking
& Other forms of misconduct
What is a Financial Crisis?
A major shock to financial markets
• Associated typically with
falling asset prices
What is a Moral Hazard?
A moral hazard refers to the risk that one party may take on excessive risks because they believe they are protected from the full consequences of their
actions
