Regulation of Financial System: Role & Importance (2024)

When a bank fails, it can create problems in the economy. Regulations and laws help prevent banks from self-destructing and ensure better management for a smooth and efficient economy. This explanation introduces the concept of regulations in the finance world, the history of regulations and why they’re needed.

Why is it important to regulate the financial system?

Regulation means imposing rules and laws which limit the freedom of individuals and businesses to make decisions.

Financial regulation involves limiting the freedom of banks and financial institutions to follow certain policies and procedures. Regulations ensure banks have relatively good risk management so they don’t make bad investments. Bank capital acts as a shock absorber to help deal with bad investments.

Regulations are also used so that people are less likely to withdraw a lot of money unexpectedly. Moreover, there are deposit guarantee schemes that ensure the protection of banks if they fall short of a certain deposit level. Banks also have to hold cash or quick assets to cover any unexpected withdrawals.

The objectives of baking regulation emphasize the following points:

• Prudency: this is to reduce the level of risk to which bank creditors are exposed. This regulation aims to protect the depositors.

• Systemic risk reduction: this is to reduce the risk of disruption resulting from adverse trading conditions. It basically aims to avoid multiple bank failures.

• Misuse of banks: this is to reduce the risk of banks being used for criminal purposes, for example, for money laundering.

• Credit allocation: this directs credit to favoured sectors of the economy.

• Corporate social responsibility: aims to direct companies to make an effort to contribute towards the needs of society at large.

History of the regulations of the financial system

Banks’ managers and owners understand the risks associated with the banking system better than outsiders. However, as businesses try to make a profit, they may sometimes not act as safely as depositors or investors would want them to. When banks want to be profitable, they might take too many risks assuming the result will be favourable for them. For instance, when trying to make money, banks sometimes sell products such as PPI (payment protection insurance) that aren't suitable for their customers. This, for example, resulted in the Global Financial Crisis during 2007 and 2008.

Fig. 1 - Picture of London around 1880 with the Bank of England on the left and the Royal Exchange of London on the right

Before 2001, the Bank of England largely controlled the financial regulation in the UK. In 1985, a self-regulatory board - Securities and Investments Board- was created to regulate all financial matters in the UK. After a series of scandals with the Barings Bank in the 1990s, this self-regulatory organ was dissolved.

In 1997, this same board was changed to the Financial Services Authority (FSA), which acted as an external regulator with a range of regulatory powers. This was established in the 1998 Bank of England Act, which radically changed the role of the Central Bank, thereby transferring all responsibility and supervisory authority to the FSA.

However, the FSA did not exercise this power until 2001. That’s when the Bank of England was instructed to concentrate on the banking responsibilities while the FSA’s task was to focus on the financial system regulations.

During the Global Financial Crisis, multiple regulatory failures forced the Treasury to abolish the FSA. This governing body was mostly criticised for failing to spot the lending boom before 2007, which subsequently resulted in the bust and collapse of the Northern Rock bank and the Royal Bank of Scotland.

From 1 April 2013, the FSA was divided into three new committees: the Financial Policy Committee (FPC), the Prudential Regulation Authority (PRA) within the Bank of England, and the Financial Conduct Authority (FCA) as an external agency.

Through the FPC, the Bank of England regained its responsibility for maintaining financial stability. The FPC is primarily responsible for macroprudential regulations, whereas the other two agencies handle microprudential regulations.

The UK’s financial regulators

Let’s study these financial regulating committees in more detail.

The Financial Policy Committee (FPC)

The independent FPC was formally established on 1 April 2013. Systemic risks could trigger the collapse of the whole or a significant part of the financial system (like in 2007–08, the collapse of one bank could affect other banks as well and have devastating consequences). That is why the FPC’ws main role is to identify the risks and take appropriate action to make the system more resilient to shocks.

Its secondary objective is to support the economic policy of the government.

The Prudential Regulation Authority (PRA)

The Prudential Regulation Authority’s (PRA) main function is to oversee different types of financial institutions such as banks, credit unions, etc. It does so by assessing the risks and ensuring that they are managed according to the regulations set in place. This enables the PRA to build and maintain a stable financial system in the UK.

Although the PRA limits the number of liabilities a financial institution has, it doesn’t aim for ‘zero-failure’. In case a firm experiences bankruptcy, the PRA quickly addresses it to prevent it from impacting the rest of the financial system.

The Financial Conduct Authority (FCA)

The FCA aims to protect consumers by promoting competition between providers of financial services. This regulatory body makes rules, enforces them, and investigates financial service providers.

Types of financial system regulations

• The microprudential regulation of UK financial services is the regulation and oversight of individual financial institutions to ensure that they remain solvent and act in the best interests of their customers. In essence, this implies ensuring that each bank’s balance sheet is resilient to economic and financial shocks.

• Macroprudential regulation, on the other hand, is concerned with the entire financial system. The ultimate goal of macroprudential regulation, according to the IMF, is to prevent long-term wealth losses by minimising the accumulation of system-wide financial risk.

The need for financial system regulations

Bank failures, liquidity assurance, and moral hazard

Banks are required to maintain certain liquidity and capital ratios. Having too much liquidity exposes banks to risks that become increasingly hard to manage. This then sends waves to other parts of the financial system, leading to a financial crisis. To avoid such a crisis from emerging, the Central Bank steps in. It acts as a lender of last resort and provides liquidity insurance to the banks.

However, support from the central bank and government bailouts can result in banks taking too many risks as they believe the authorities will always be there to help. This raises concerns for moral hazard.

Moral hazard occurs when someone enters a risky agreement because they know that they won’t have to bear the consequences.

Investing in high-risk assets can lead to high profits unless there is a possibility that financial institutions will be allowed to fail. Bank regulations are intended to limit the banks’ capacity to act dangerously by putting up barriers between their commercial and investment activities. This means that banks can allow riskier aspects of their businesses to fail without jeopardising the provision of critical financial services.

Liquidity and capital ratios affect a financial institution’s stability.

The liquidity ratio is used to assess a company’s ability to meet short-term obligations. The higher the ratio, the better the bank’s safety margin. When creditors demand payment, liquidity ratios are used to determine whether the bank is risky.

Finally, the capital ratio is a calculation that compares a bank’s equity capital to risk-weighted assets. This is used to assess a bank’s financial strength. Various assets have different risk weightings, with actual cash having no risk and credit having a higher risk.

The recent financial crisis has shown how having little capital or liquidity can be hazardous.

Finally, another risk is that investors would believe that other banks may fail as well, which would further lower investor confidence.

Systemic risks and the impact on the real economy

Systemic risks in the financial markets are negative externalities.

The possibility of economic or financial market damage is known as systemic risk.

Systemic risk, for example, could be the risk of a bank failing. This is related to a negative externality, because it damages businesses, consumers, the economy, and the market.

A good example would be the systemic failure that resulted in the ‘credit crunch’ between 2007 and 2009. There was a severe shortage of money or credit when a French bank, BNP Paribas, had not evaluated their assets, which led to complete evaporation of liquidity in the market. This eventually led to the credit crunch that destabilised the economies of various countries. The financial crisis caused the collapse of aggregate demand which in turn led to rising unemployment and recession.

Prudential regulations and consumer protection

There are two facets to financial regulation:

• Prudential regulation
• Consumer protection

Prudential regulation ensures that firms have the funds they need to trade securely, as well as the right risk controls and oversight.

Consumer protection entails ensuring that businesses treat customers fairly throughout the sales process and in the handling of complaints.

Authorization is an essential element of prudential regulation. This means that only organizations that have met certain conditions are able to operate in the financial system. Consumer protection rules are also established, which advise businesses on how they should handle their customers.

Firms must be supervised to ensure that they follow the laws of regulation. Supervision is frequently stringent and intrusive in order to ensure that financial service providers follow the rules.

Risk-based supervision refers to the degree to which enterprises are monitored based on the level of risk they pose to the financial system. In the financial services industry, enforcement attempts to reduce undesirable behaviour. When a company does not follow the regulations, efforts are made to ensure that the rules are enforced.