Transcript Shadow Banking - LPS Business Department

2.4.4 The regulation of the financial system
Ex-Goldman Sachs trader barred from industry.
AQA 2.4 F INANCIAL
MARKETS AND MONETARY
POLICY
2.4.4 W HAT
YOU NEED TO KNOW

Regulation of the financial system in the UK, e.g. the
role of the Bank of England, the Prudential Regulation
Authority (PRA), the Financial Policy Committee (FPC)
and the Financial Conduct Authority (FCA)

Why a bank might fail, including the risks involved in
lending long term and borrowing short term

Liquidity ratios and capital ratios and how they affect
the stability of a financial institution

Moral hazard

Systemic risk and the impact of problems that arise in
financial markets upon the real economy
R EGULATION

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IN THE
UK
Financial regulation is the laws and rules that govern what financial
institutions such as banks, brokers and investment companies can do
These rules are designed to protect investors, maintain orderly markets and
promote financial stability
Before we look at the current regulatory framework in operation, here is a
brief history of financial regulation in the UK

1985 – Securities and Investment Board (SIB) established with the aim
of preventing fraud and insider dealing, the SIB was largely selfregulatory

1997 – The functions of the SIB were transferred to the Financial
Services Authority (FSA) which became an external regulator with a
broader range of powers although its statutory powers weren’t
established until the Financial Services and Markets Act in 2000

2013 – Following the financial crises of 2008 and the partial failure of
the FSA, the FSA is abolished and replaced with the Prudential
Regulation Authority (PRA) and the Financial Policy Committee (FPC),
as well as establishing the Financial Conduct Authority (FCA)
C URRENT UK F INANCIAL R EGULATORY
F RAMEWORK
The UK now has three
regulatory bodies that
oversee financial
markets and the wider
financial system.
The PRA.
The FPC.
1.
Prudential Regulation Authority (PRA)

The PRA was created as a part of the Bank of England by the Financial Services Act
2012 and is responsible for the prudential regulation and supervision of around 1,700
banks, building societies, credit unions, insurers and major investment firms

The PRA ensures banks hold enough capital and liquidity to withstand shocks without
the need for central bank or government intervention

The PRA ultimately sets standards that banks have to meet and assesses risks that
each firm has and seeks to ensure these are minimised so that if an individual firm
does fail it avoids the significant disruption to the wider financial services system
2.
Financial Policy Committee (FPC)

The FPC is charged with a primary objective of identifying, monitoring and taking
action to remove or reduce systemic risks with a view to protecting and enhancing
the resilience of the UK financial system

The FPC has a secondary objective to support the economic policy of the Government

In other words, the FPC takes a macro over-sight of the financial system, rather than a
micro overview, which is covered by the PRA

For example, in 2013 the FPC recommended regular stress-testing of the UK banking
system to continually assess the resilience of UK banks under deteriorating global
economic conditions
Why did RBS perform poorly in stress test?
C URRENT UK F INANCIAL R EGULATORY
F RAMEWORK
Whilst an in-depth
knowledge of each
regulator is NOT
required, you should
appreciate the role of
each one in
maintaining financial
stability.
3.
Financial Conduct Authority (FCA)

The FCA is a body which aims to improve the workings of financial
markets and ensure consumers get a fair deal. In essence, to act as a
consumer champion

This involves ensuring that consumers are protected, the integrity of
the financial system is enhanced and there is effective competition in
the financial marketplace

For example, the FCA can oversee the design of financial products, ban
certain products if necessary or have them withdrawn from the
market, ensure firms cannot exploit difficulties consumers have with
complex financial products and change misleading promotions
The FCA.
Q&A: Banking reforms.
W HY B ANKS M IGHT FAIL
Despite wide-ranging regulation of the financial
services industry and financial markets, it is still
possible for banks to fail. The primary reasons for this
are:
1.
It suffers a fall in the value of assets so that its
capital liabilities supporting them are
unmatched. If a bank does not have enough
capital to support its assets, the bank is insolvent
2.
It does not have sufficient liquidity to meet the
demands of its depositors. This can occur even if
assets are greater than liabilities
N ORTHERN R OCK C ASE S TUDY: L ENDING L ONG
T ERM & B ORROWING S HORT T ERM
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What happened at
Northern rock?
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One of the main ways a bank can get into difficulty, as Northern Rock did in 2007,
is through an expansion strategy that seeks to enhance its long term asset base
via short term liabilities
In the first 6 months of 2007, Northern Rock expanded its mortgage portfolio
(assets) by 12% - extremely fast. These assets are profitable, but only over a 25
year period – the standard mortgage term
Assets must be matched by liabilities, and Northern Rock funded these
mortgages by borrowing short term i.e. overnight or a few months at most
Around 70% if its funding came from this source, with only 27% coming from
savers deposits. Compare this 70% figure with Nationwide c.30%
This is highly profitable because short term borrowing is much cheaper than long
term borrowing, but this approach is only viable if Northern Rock could access
money market funds and remain creditworthy
This approach also carries a liquidity risk because its assets are long term in
nature, but its liabilities short term in nature
As funds became scarce in the global market, Northern Rock became exposed
because it was unable to fund its mortgages and loans from money markets, and
therefore sought an emergency loan from the BoE
When news of this broke, it was enough to create a run on the bank, a severe
liquidity crisis and ultimate failure

What can Mary Poppins teach us about banking?
L IQUIDITY
AND
C APITAL R ATIOS
Banks typically fail through a lack of either liquidity or sufficient capital
or both
Liquidity Ratios

Liquidity ratios measure a company’s liquid assets against its shortterm liabilities and as such are a gauge of a banks ability to meet
its short-term liabilities

In general, the more liquid assets you have to cover short-term
liabilities, the more likely it is that you’ll be able to pay debts as
they become due without running out of funds to support ongoing
operations

Banks with low liquidity ratios have a higher risk of encountering
difficulty meeting obligations

If a bank does not hold sufficient cash or enough assets that can
easily be turned into cash, depositors may lose confidence in the
bank for fear of it becoming insolvent, which can lead to a run on
the bank
L IQUIDITY
You will NOT be
required to calculate
liquidity or capital
ratios.
AND
C APITAL R ATIOS
Capital Ratios

Capital in a financial sense is best thought of as the difference between a
banks assets and its liabilities, in other words its net worth to shareholders
who have a stake in the bank
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A capital ratio is the amount of capital on a banks balance sheet as a
proportion of its loans

A bank with a low capital ratio can be potentially exposed if the quality of its
assets falls

For example, if a bank lends money to a number of customers who fail to
repay, the value of these advances as assets to the bank reduces

If this reduces below the level of its liabilities, the bank is insolvent and may
fail without intervention

The extensive growth of credit through the early 2000s meant that banks
were able to expand their assets significantly. However, many of these
“assets” have transpired to be very poor as banks chased more lucrative
business and credit standards were compromised. For many banks this led to
the capital ratios becoming severely weakened

As a consequence, in 2013 the PRA set out its expectation that Tier 1 capital
ratios of the largest 8 banks in the UK cannot fall below 7%
M ORAL H AZARD
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Moral hazard can be defined as
“any situation in which one person makes the decision about how much risk to
take, while someone else bears the cost if things go badly.” Paul Krugman
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This is most often applied to the insurance industry. For example, if you had no car
insurance, you might be more eager to drive more safely and ensure it was locked and
parked safely as the cost to you of an accident or theft is so large. However, if you are fully
insured, you might behave in a more reckless or careless way because the financial risk of
accident or theft is borne by somebody else i.e. the insurer
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Moral hazard can be equally applied to financial markets during the crises of 2008
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Because of the importance of banks to individuals and firms, an individual banks failure
can be devastating to those customers involved. However, if the bank knows that either
the Bank of England in its capacity as lender of last resort or Government will intervene
and save the bank from collapse they may change their behaviour and engage in more
risky, but profitable, activities or advance loans to customers with poor credit history

The existence of moral hazard and a weak regulatory framework was one of the underlying
causes of the sub-prime mortgage crises which triggered the financial crises of 2008
S YSTEMIC R ISK
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What is shadow
banking?
Systemic risk refers to the risk of a breakdown of an entire financial
system rather than simply the failure of individual parts within the system
Systemic risk can be exacerbated by:

Insufficient separation between a banks commercial and investment
banking activities

The Vickers Report 2011 recommends that the core functions
of the commercial arm of a bank are ring-fenced from its riskier
investment banking activities. These firewalls must be in place
by 2019 to reduce systemic risk
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The growth of the shadow banking system

Shadow banking is a term used to describe borrowing and
lending outside the regulated banking sector e.g. hedge funds,
private equity funds, crowdfunding, derivatives trading
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However, none of these activities are regulated and because of
the interconnectedness of financial markets there is concern
that if a shadow bank fails, it can bring down a “safe” bank
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These shadow markets have expanded in recent years and have
increased systemic risk in the system
S YSTEMIC R ISK
Shadow Banking:
Lending and other
financial activities
conducted by
unregulated
institutions or under
unregulated
conditions
It was a term first
coined by economist
Paul McCulley in
2007 to describe an
institution that looks
like a bank and acts
like a bank but often
it is not a bank—it is
a shadow bank.
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AND THE
R EAL E CONOMY
The global financial crisis of 2008, the so-called Credit-Crunch, is strong
evidence of the need to manage systemic risk within financial markets
This is highly challenging for regulators, who have sought in recent years to
strengthen regulatory systems and controls
However, as banks’ balance sheets have reduced, this has led to a shift towards
some shadow banking activities which are unregulated, thus moving the
influences on systemic risk to new financial markets
The failure of a number of US and UK banks who saw liquidity and capital ratios
fall so low they were unable to meet their obligations created a global collapse
of aggregate demand, a deep recession and large rise in unemployment
According to the National Audit Office, the UK government has spent around
£124bn in bank bailouts but at different times has faced risk exposures up to
10 times greater than this figure
The cost of systemic failure is extremely large and that is before considering
the cost of the loss of output and impact of unemployment on the economy
S YSTEMIC R ISK
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AND THE
R EAL E CONOMY
The likelihood that financial instability will lead to economic instability is the
fundamental reason why governments around the world have sought to tighten
regulatory controls on financial institutions
If bank activities are not carefully monitored and consumers sufficiently
protected then a desire to chase high profits through riskier lending and
associated activities drives up asset prices through a combination of easy credit
and herding behaviour
However, for many households this increases debt levels. If any instability in
financial markets occurs, coupled with speculation, can mean asset prices might
fall dramatically
If they do, a bank’s capital base can be eroded and liquidity problems may set in
If so, it is likely that commercial banks will restrict their lending activities, which
feeds through to weaker aggregate demand and a contracting economy
Ultimately, the high importance of the financial sector in the efficient functioning
of the economy means that any problems in financial markets are felt widely and
deeply across much of the UK economy
S YSTEMIC R ISK
AND THE
R EAL E CONOMY
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If banks have to be bailed out by the government, the cost
to the taxpayer can be very high
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Moreover, by the central bank acting as a lender of last
resort to provide liquidity assurance, moral hazard can be
enhanced unless sufficient regulation is in place to offset it
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It should be noted however, that regulation can also create
issues of its own:

regulatory capture

additional costs to banks that can be passed on to
customers

the stifling of product innovation or the restriction of
supply of credit
D EBATE
Consider carefully the importance of financial markets and financial
institutions on the UK macroeconomy against the backdrop of the
current economic climate and recent financial crisis.
To what extent do you agree that financial institutions and markets
should be regulated by central banks and government? Or should they
be left to the free market?
Split the class into 2 teams to prepare a motion:
Regulation
v.
Free market