Discuss the rationale for regulating financial institutions, particularly in banking institutions (employ arguments from theory to support the discussion).
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Introduction
According to Llewellyn (1999), financial regulation objectives should be clearly defined as it focuses on three parts. Firstly, to sustain confidence in the financial system, the second one is contributing to the protection and enhancement of the financial institution’s stability. Thirdly, to protect the consumer. However, the meaning of protecting consumers should be known. The real regulation case is decided by its purpose, which depends on the financial market defects and failures.
The rationale for financial regulation
Systemic Issues
When the public costs of banks’ failure exceed private costs, and these public costs are not included in the banks’ decision-making, financial regulation for systemic causes is necessary. The following points are considered in Systemic issues:
1 The bank is essential in the financial system, especially in clearing and payments systems;
2 The bank may cause systemic risks;
3 The nature of the bank (debt) contracts on both parts of the balance sheet;
4 Unfavourable selection and moral hazard related to lender-of-last-resort and deposit insurance.
Banks have a crucial position in the economy because they are the only financial origin for many borrowers. Furthermore, they control the payments system. If the bank system is in danger, it may cause more severe problems than other financial institutions. The main systemic point is that the bank is potentially subject to run, which might have contagious effects. The externality is that a bank’s failure can cause depositors of other banks to withdraw deposits (Llewellyn, 1999).
Moral Hazard
According to Llewellyn (1999), moral hazard is also one reason why financial institutions need regulations. Deposit insurance and lender-of-last-resort may create a moral hazard for financial institutions and customers. For example, Dowd (1996) said that the lender-of-last-resort and deposit insurance might have harmful effects. It might encourage banks to take risks. Due to the deposit of being protected, customers may choose the banks and institutions with a high-interest rate. The main reason they choose high-interest rate banks is they can get a high return if the bank does not go bankrupt. If the bank goes bankrupt, the customers will get protect and receive compensation. Also, the bank may hold lower capital levels because of deposit insurance. Overall, the risks can move to others to some degree. Therefore, the moral hazard rationale for regulation is constructing regulations to decrease the probability of moral hazard being exploited.
In the context of the UK financial system, arguments are provided for and against the current institutional set-up for the regulation of the UK financial system. While the rationale of financial regulation is founded, over-regulation appears. It causes avoidable costs on the services and customers of the financial market and the whole financial system. There is almost an inherent tendency to over-regulate because regulation and supervision services are not through the market process but imposed outside. The consumer has no choice about the regulatory amount he/she is prepared to pay. This means that regulation has costs but no price (Llewellyn, 2006).
Over-regulation
According to Booth (2017), the Bank of England’s economist said that the number of financial regulators and banks’ payback has enormous growth. Regulators may create red tape as a purpose in themselves. For example, after the 585 pages Mortgage Market Review published, 312 pages were implemented and got feedback, and the result of it is it does not work well for many people. Now the regulators need review for the mortgage market, but it will not lead to decreased regulation.
Hodge (2020) pointed out, the country’s leading banking lobby group said that the development of the UK’s regulatory framework for the financial market causes several public departments to regulate the financial system, which frequently overlaps. Furthermore, the UK finance pointed out financial firms that often commuted with numerous regulators (including non-financial regulators). These actions cause the growth of economic system operational risk and increase the firm’s cost; therefore, the regulatory costs are crowding out money for innovation. Additionally, UK finance also said that financial regulators push “industry initiatives” to promote “best practice” to increase costs and burdens.
After the 2008 financial crisis, the UK regulators stronger oversight of the financial services sector, especially the regulatory environment, was considered too “light touch” at the time of the financial crash. But UK finance said that the regulatory environment had changed hugely after that time, and the regulatory requirement has become too strict. For example, nowadays, a British bank receives 18 publications per week from regulators. It needs to check whether its compliance or not. Furthermore, a firm said that it needs makes around 25,000 IT changes every month, and regulators request half of the changes. These changes have an extent of operational risk. From 2015 to 2018, some financial companies estimated compliance requirements costs that accounted for around 30 percent (Hodge, 2020).
Financial regulators need to take risks with “under-regulation” rather than maintain control and perfect financial markets. Statutory supervision suppresses institutions that can develop in the market and may be more effective than government regulatory agencies (Booth, 2017),
Discuss the role that macroprudential policy has played in either attenuating or amplifying the impact of Covid19 on the UK financial system?
Aikaman (2020) pointed out that compared with 2008, the Bank of England and financial regulators have spent much time building resilience into economic systems in the name of macroprudential policy in the last ten years. Nowadays, banks have large amounts of capital and liquidity buffers, as many households mortgage borrowing has been curbed. These policies’ objective is to prevent a crash like the 2008 financial crisis—these macroprudential policies attenuating the impact of Covid19 on the UK financial system.
According to the Bank of England (2020), the BoE and other regulators’ interventions helped meet the growth of demand for cash. At the same time, they also adopted a fiscal policy to help calm the financial market. However, the March ‘dash for cash’ episode and liquidity stress might resurface in the future. The central banking system has been resilient to these stresses. This is to no small extent due to the macroprudential policies in the last decade. They significantly improved the resilience of UK banking systems and financial systems. For example, the daily margining of positions and central clearing of derivatives have made sure that great sharp price moves did not cause competitors to pay attention to credit risks.
The BoE ‘s Term Funding plan adds funding for banks that increase lending, incredibly small, and medium-sized firms. Also, the Covid Corporate Financing Facility, which is set up by the Bank of England, provides financing to investment companies directly. Due to capital buffers’ ability to absorb the loss in Covid-19, the government provides guarantees for new lending, the Bank of England funding, and the banking system in the UK can support the UK economy. Sponsored by the government, the banking system is continuously lending. This is important for decreasing long-term loss. If banks stop credit provision, more companies will fail due to cash flow deficits, causing more significant bank loss. Also, the unemployment rate will higher. The FPC will continue to oversee the financial market and the credit situation of the UK’s households and corporates, and the running of the financial system stands ready to take action to maintain UK financial stability (Bank of England, 2020).
In the past decade, regulatory innovations have helped prevent the transmission of market stress to banks. The UK financial system deals with this crash in a much stronger position than the 2008 financial crisis. The UK has taken significant macroprudential actions, taking benefits of the flexibility built into post-crisis regulation to support the real economy. For example, the FPC decreases the UK countercyclical capital buffer (CCyB) rate to 0 and improves its lending capacity (Bank of England, 2020). Overall, macroprudential policies have essential effects on attenuating the impact of COVID-19 on the UK financial system.
Discuss the macroprudential weaknesses in the UK financial system that have been exposed by the Covid-19 pandemic and the effect of the UK’s current financial regulation institutional structure deal with policy conflict within the financial system.
Dash for cash exploit
Due to the Covid-19, the economic activity has fallen, the financial market is full of uncertainty, risk, and large amounts of financial capital have substantial price changes. For example, Brent crude oil prices reduced 75 percent and only＄16 in April as it reflected the decrease in demand. Due to no USD issued between March 4th and March 31st and no GBP published since February 13th. In March, the UK appears to be an extreme dash for cash because of the decrease in the risky assets price and the increase in developing countries’ bond prices. Investors’ demand for money and near-cash capital increased significantly at that time, leveraged investors left government bond markets, dealers left repo market, many investors had to sell assets to seek liquidity. The cash had a shortage, and the liquidity stresses were significantly high.
After the 2008 financial crisis, financial regulation in the UK has tremendously changed. The regulators and Bank of England spent much time on stronger regulation. Banks have enough capital and liquidity buffers. On the one hand, this strict regulation may cause the growth of the financial firms’ costs, and households do not need to borrow money from banks. On the other hand, these policies prevent financial crises from happening again to a certain extent. Overall, due to the macro-prudential policies in the last ten years, the financial system in the UK can face market stress in Covid-19.