The regulation of the financial system

• What is a moral hazard?

  A situation where a borrower takes undesirable actions because they are less likely to repay a loan.
• Why does moral hazard usually occur?

  It usually occurs when there is some form of insurance for the mistake.
• How might an insured house affect a borrower's behavior?

  A borrower might be less careful because they know damages will be covered by insurance.
• How can banks exhibit moral hazard?

  Banks might take more risks if they know they can receive help from the Bank of England or the government.
• What financial event is regarded as a moral hazard due to risk-taking?

  The financial crisis.
• What is systematic risk in financial markets?

  The risk of damage to the economy or financial market.
• How is systematic risk similar to a negative externality?

  It costs firms, consumers, the economy, and the market.
• What does a liquidity ratio measure?

  How able a company is to pay off short-term obligations.
• What does a higher liquidity ratio indicate?

  A greater safety margin for the bank.
• Why do creditors look at liquidity ratios?

  To decide whether the bank is a concern for repayment.
• What is a capital ratio?

  A comparison between equity capital and risk-weighted assets of a bank.
• How are assets weighted in a capital ratio?

  Physical cash has zero risk, while credit carries more risk.
• What did the recent financial crisis demonstrate about capital and liquidity?

  Insufficient finance in either can be dangerous for banks.
• What can happen if investors assume other banks will fail?

  It reduces confidence in the banking system.
• Who regulates the UK banking industry?

  The Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA).
• What is the role of the FCA?

  To ensure financial firms are honest to consumers and protect consumer interests.
• What does the PRA promote?

  The safety and stability of banks, building societies, investment firms, and credit unions.
• What is the function of the Financial Policy Committee (FPC)?

  To regulate risk in banking and ensure the financial system is stable.
• What is the Global Financial Crisis also known as?

  The Great Recession.
• What characterized the economy before the Global Financial Crisis?

  High and rising asset prices with a boom in economic demand.
• What were risky bank loans and mortgages backed by during the crisis?

  Subprime mortgages.
• What happened to homeowners after house prices crashed in the US in 2006?

  Several homeowners defaulted on their mortgages in 2007.
• What assistance did banks require after losing huge funds?

  Assistance from the government in the form of bailouts.
• What risks are involved with lending long term and borrowing short term?

  They might lose money on investments and may not provide depositors with money when demanded.
• What are the key roles of the Prudential Regulation Authority (PRA) and the Financial Conduct Authority (FCA)?

  • PRA: Promotes safety and stability of banks and protects policyholders.
  • FCA: Ensures honesty in financial firms and protects consumer interests, promoting competition.
• What are the consequences of insufficient capital or liquidity for banks during a financial crisis?

  • Increased risk of bank failure.
  • Loss of confidence from investors.
  • Potential for widespread economic damage.
• What factors contributed to the Global Financial Crisis?

  • High asset prices and economic demand.
  • Risky loans backed by subprime mortgages.
  • Homeowners defaulting on mortgages after price crashes.
• The Basel Accounts refer to a series of international banking regulatory meetings that established capital requirements and risk measurement for global banks.
• The Basel Accounts were designed to ensure that banks have enough capital to fulfill their obligations and to absorb unexpected losses.