2.4.4 The Regulation of the Financial System

Role of the Bank of England

Central banks are responsible for regulating the banking system to ensure that banks operate safely and soundly.

The Bank of England has two regulatory roles:

• Prudential Regulation Authority (PRA) - setting rules and standards for banks to ensure they have sufficient capital and liquidity to withstand shocks. For example, the PRA sets minimum capital requirements and conducts stress tests to assess banks' resilience to adverse economic conditions.
• Financial Policy Committee (FPC) - monitoring the financial system as a whole to identify and mitigate risks that could threaten financial stability. For example, the FPC may recommend macroprudential measures such as loan-to-value limits to prevent excessive credit growth and asset bubbles.

Role of the Financial Conduct Authority (FCA)

The Financial Conduct Authority (FCA) is responsible for regulating the conduct of financial institutions to ensure they treat customers fairly and operate with integrity.

The FCA has several key responsibilities, including:

• Protecting consumers by ensuring that financial products and services are safe, transparent, and suitable for their needs.
• Promoting competition in financial markets to ensure that consumers have access to a wide range of products and services at competitive prices.
• Regulating financial institutions to ensure they comply with rules and standards, including those related to conduct, disclosure, and reporting.

Liquidity and Capital Ratios

Regulators require banks to hold minimum levels of liquidity and capital. These two ratios are the main measures of a bank's stability, because each protects against one of the two distinct ways in which a bank can fail.

The Liquidity Ratio

Liquidity ratio: The proportion of a bank's assets that are held in liquid form, such as cash, reserves at the central bank and easily marketable securities.

This measures a bank's ability to meet its short-term obligations, principally depositors' withdrawals. A bank with a low liquidity ratio has committed most of its funds to illiquid but profitable assets such as mortgages, so it cannot raise cash quickly if withdrawals are unusually high or if it is unable to renew its wholesale borrowing.

The Capital Ratio

Capital ratio: The ratio of a bank's capital - shareholders' funds and retained profit - to its risk-weighted assets.

Assets are risk-weighted so that riskier lending counts for more in the denominator. A bank that lends to less creditworthy borrowers must therefore hold more capital against that lending.

Capital measures a bank's ability to absorb losses. When borrowers default, the losses are written off against capital rather than against depositors' money. A bank with a high capital ratio can survive a large rise in bad debts; a bank with a low one cannot. Once losses exceed capital, liabilities exceed assets and the bank is insolvent.

Systemic Risk and Moral Hazard

Systemic Risk

Systemic risk: The risk that the failure of one financial institution triggers the failure of others and a wider financial crisis.

Systemic risk arises because banks are interconnected:

• Banks lend to one another on the interbank market, so one bank's failure immediately becomes another bank's bad debt.
• Banks hold similar assets, so a fall in the value of one asset class damages many balance sheets at once.
• Banking depends on confidence, so a single failure causes depositors and lenders to doubt the safety of every other bank.

Failure then spreads by contagion. As confidence falls, banks stop lending to each other and liquidity dries up, forcing banks to sell assets quickly. These fire sales depress asset prices further, causing more losses and pushing other banks into illiquidity or insolvency. Lending to households and firms collapses in a credit crunch, which reduces aggregate demand and deepens the recession - in turn raising bad debts and weakening banks further. The collapse of Lehman Brothers in 2008 set off exactly this sequence across the global financial system.

Moral Hazard

Moral hazard: The risk that banks take excessive risks because they do not bear the full cost of failure, believing they will be bailed out.

Moral hazard arises because:

• Large banks are too big to fail. Their collapse would impose such large costs on the wider economy that they expect to be rescued by the government or central bank.
• Deposit insurance and the central bank's role as lender of last resort remove much of the penalty for risky behaviour.
• Executives are paid bonuses linked to short-term profit but do not personally bear the losses if the risks go wrong.

The result is that banks pursue profitability at the expense of liquidity and security. They hold lower liquidity and capital ratios, lend to less creditworthy borrowers and take larger trading positions. Risk is underpriced, so the bank appears highly profitable until conditions turn. When defaults rise, the thin capital buffer is wiped out and the bank becomes insolvent. In 2008 the UK government had to rescue RBS and Lloyds at a cost of tens of billions of pounds - and by confirming that rescue was available, the bailout made the moral hazard problem worse.

How Regulators Try to Prevent These Problems

Regulation since the 2008 crisis has aimed both to make individual banks harder to break and to stop failure spreading through the system:

• Higher capital and liquidity requirements, backed by regular stress tests, so that banks can absorb losses and meet withdrawals without assistance.
• Ring-fencing - since 2019 large UK banks have had to separate their retail operations from riskier investment banking, so losses on trading cannot destroy ordinary depositors' money.
• Macroprudential measures such as loan-to-value and loan-to-income limits, which restrain the credit booms that leave the whole system exposed to the same assets.
• Bail-in rules, which require a failing bank's shareholders and bondholders rather than taxpayers to absorb the losses. This targets moral hazard directly by restoring the cost of failure.
• Deposit insurance, which guarantees deposits up to a set limit and so removes the incentive for depositors to start a bank run.