2.4.4a Financial regulators and bank failure (A-level only)

The Bank of England, PRA, FPC and FCA Together Regulate UK Finance, and Banks Fail When Short-Term Funding Cannot Cover Their Long-Term Loans

1. Financial regulation exists because a bank collapse can wipe out ordinary savers and spread damage through the whole economy.
2. In the UK the task is shared between the central bank, the Bank of England, and three specialist bodies: the FPC, the PRA and the FCA.

Four Bodies Share the Work of Regulating UK Finance

1. The Bank of England is the UK's central bank.
   1. It has overall responsibility for financial stability and acts as lender of last resort, providing emergency funds to a solvent but illiquid bank.
2. The Financial Policy Committee (FPC) sits within the Bank of England.
   1. It takes a system-wide, or macroprudential, view, identifying and acting to reduce risks that threaten the financial system as a whole.
3. The Prudential Regulation Authority (PRA) is also part of the Bank of England.
   1. It carries out microprudential regulation, supervising individual banks, building societies and insurers to make sure each holds enough capital and liquidity to stay safe.
4. The Financial Conduct Authority (FCA) is separate from the Bank of England and regulates how firms behave.
   1. It protects consumers, promotes competition and ensures markets work fairly and honestly.

Banks Can Fail Because They Borrow Short and Lend Long

1. Banks take in deposits that can be withdrawn at short notice but lend for long periods, such as mortgages and business loans.
   1. This gap is called a maturity mismatch.
2. Because most of the money is tied up in long-term loans, a bank holds only a fraction as liquid cash.
3. If many depositors demand their money at once, in a bank run, the bank cannot pay them even though it is solvent.
   1. This is liquidity risk.
4. If borrowers default and loans turn bad, the bank makes losses and can become insolvent, so poor lending is a second route to failure.

Trace Why a Bank Fails and Identify the Right Regulator

2.4.4b Stability, moral hazard and systemic risk (A-level only)

Liquidity and Capital Ratios, Moral Hazard and Systemic Risk Together Decide Whether a Financial Institution and the Wider Economy Stay Stable

Liquidity and Capital Ratios Show How Safely a Bank Can Operate

1. A liquidity ratio measures the proportion of a bank's assets held as cash, or assets that can quickly be turned into cash, relative to its liabilities.
2. A higher liquidity ratio lets a bank meet sudden withdrawals and reduces the risk of a bank run, but holding liquid assets lowers the returns it can earn.
3. A capital ratio compares a bank's capital, such as shareholders' funds and reserves, with its risk-weighted assets.
4. A higher capital ratio gives a larger buffer to absorb losses before a bank becomes insolvent, so both ratios strengthen the stability of the institution.

Moral Hazard Makes Protected Institutions Take Greater Risks

1. Moral hazard is the tendency to take greater risks once protected from the consequences.
2. It arises from asymmetric information after a contract is agreed, for example once a bank expects to be rescued.
3. A bank that believes it is too big to fail may lend recklessly, because the cost of failure falls on taxpayers rather than on itself.

Systemic Risk Can Turn One Failure Into a Crisis for the Real Economy

1. Systemic risk is the risk that the failure of one financial institution triggers the failure of others across the system.
2. Because banks lend to and borrow from one another, one default can spread losses through the system in a process known as contagion.
3. A loss of confidence can cause bank runs and a credit crunch, where lending to households and firms dries up.
4. This spills into the real economy as investment and consumption fall, output declines and unemployment rises.