5.3 Financial regulation

• Governments might regulate banks with regulations and guidelines. This helps to ensure the behaviour of banks is clear to institutions and individuals who conduct business with the bank
• Some economists argue that the banks have a huge influence in the economy; if they failed it would have huge consequences.

  Therefore, it is important to regulate the banking industry.
• The Prudential Regulation Authority (PRA) was set up by the UK Government in April 2013. It has responsibility for ensuring that all firms authorised by the FCA are being honest to consumers.
• The PRA ensures that banks hold enough capital so that they could continue operating even during times of economic stress or crisis. They also make sure that banks do not take too much risk when lending money.
• Moral Hazards

  Where there is a risk that the borrower does things that the lender would not deem desirable because it makes the borrower less likely to repay the loan.

  If a house is insured, a borrower might be less careful because they know any damage caused will be paid for by someone else.
• Moral Hazards

  Banks might take more risks if they know the Bank of England or the government can help them if things go wrong.

  e.g. The financial crisis has been regarded as a moral hazard due to the degree of risk-taking
• Systematic risks:

  In the financial markets, systematic risks are seen as a negative externality. Systematic risks are the risk of damage of the economy or the financial market.

  e.g. it could be the risk of the collapse of a bank. Since this costs firms, consumers, the economy and the market, it is called a negative externality.
• A liquidity ratio is used to determine how able a company is to pay off short-term obligations. The higher the ratio, the greater the safety margin of the bank. When creditors want payment, they look at liquidity ratios to decide whether the bank is a concern.
• A capital ratio is a comparison between the equity capital and risk-weighted assets of a bank. A bank's financial strength is determined using this. Assets have different weightings, where physical cash has zero risk and credit carries more risk.
• The role of a central bank:

  The central bank manages the currency, money supply and interest rates in an economy. For example, the European Central Bank (ECB), the Bank of England and the People's Bank of China are central banks.
• Implementation of Monetary policy:

  The central bank controls the base rates, which ultimately controls the interest rates across the economy.
• Implementation of Monetary policy:

  The Monetary Policy Committee (MPC) alters interest rates to control the supply of money.

  Interest rates are used to help meet the government target of price stability, since it alters the cost of borrowing and reward for saving.
• Central Banks- Banker to the government:

  The central bank provides services to the Central Government. It collects payments to the government and makes payments on behalf of the government. It maintains and operates deposit accounts of the government.

  The central bank also manages public debt and issues loans.

  The Bank can also advise the government on finance, including the timing and terms of new loans.
• Central Banks- Banker to the banks:

  The Bank of England is considered to be a lender of last resort. If there is no other method to increase the supply of liquidity when it is low, the Bank of England will lend money to increase the supply.

  If an institution is risky or is close to collapsing, the Bank might lend to them. This is when they have no other way to borrow money.
• Central Banks- Banker to the banks:

  It can protect individuals who deposit funds in a bank and might otherwise lose them. It also aims to prevent a run on the bank', which is when consumers withdraw their bank deposits in a panic, because they believe the bank will fail.
• The role of the IMF + World Bank evaluation:

  Institutions. They aim to provide structure and stability to the world's economic and financial systems.

  Almost every country is a member of both institutions. The governments of each member nation own and direct the institutions.

  The World Bank mainly focuses on development. The IMF tries to keep payments and receipts between countries logical and ordered.
• The World Bank:

  The World Bank can loan funds to member countries, and its aim is to promote economic and social progress by raising productivity and reducing poverty. The assistance is usually long term.

  The World Bank is involved in several projects globally, such as providing microcredit, supporting education, and helping the rebuilding of countries after earthquakes.
• The IMF aims to promote monetary cooperation between nations, and monetary problems can be consulted in the institution.
• The IMF aims to help free trade globally, so jobs are supported.
• The IMF promotes exchange rate stability and tries to avoid competitive depreciations in the currency.
• Members can also borrow from the IMF, such as if they need to correct an imbalance in the balance of payments. However, the loans are loaded with conditions and so results in the country repaying the loan at rather hefty interest rates.
• External debt is the amount of money owed to foreign lenders.
• Money is owed to commercial banks, governments and international institutions, such as the IMF and World Bank.