Regulating the financial system

Overview

Financial sector regulated more heavily than most other industries, why the failure of a bank is a negative externality and systemic risk.

What you need to know

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Questions from this subtopic

Each one with the model answer underneath.

1. 1

   Why is the financial sector regulated more heavily than most other industries?

   Model answer

   Because the consequences of failure fall largely on people who were not party to the transaction. When a manufacturer fails, its owners and creditors lose; when a bank fails, the payments system is disrupted, depositors lose access to money they need for ordinary life, other banks suffer losses on their claims and confidence in banks generally is damaged, so credit to firms and households contracts and output falls. Finance is also unusually dependent on confidence, which makes it liable to sudden collective withdrawal, and its products are complex and long-lived, so ordinary customers cannot judge quality before or often even after purchase. Add to that the state guarantees that stability requires, which themselves create an incentive to take risk, and the case for regulating what regulated institutions may do becomes very strong.

2. 2

   Explain why the failure of a bank is a negative externality.

   Model answer

   The private cost of failure is borne by the bank's shareholders and creditors, and it is that private cost the bank weighs when choosing how much risk to take. The social cost is much larger: it includes losses to other institutions exposed to it, the collapse in confidence that leads depositors elsewhere to withdraw, the forced asset sales that depress prices for everyone holding similar assets, the loss of lending to firms that had done nothing wrong, and the wider recession that follows. Because the bank does not bear those additional costs, it takes more risk than is socially optimal, exactly as a factory not charged for its pollution produces too much of it. Regulation, and in particular capital requirements, is the instrument that forces the bank to internalise part of that external cost.

3. 3

   What is systemic risk, and why can a system be fragile even when every individual institution appears sound?

   Model answer

   Systemic risk is the risk that the failure or distress of one part of the financial system triggers failure across the rest of it, rather than remaining contained. A system can be fragile even when each institution is individually prudent, because prudence at the level of the institution can be destabilising in aggregate: if all banks hold the same assets and all respond to a fall in price by selling to restore their ratios, their collective selling drives the price down further and imposes losses on all of them. Similarly, if every institution relies on being able to obtain short-term funding, the system depends on that funding always being available even though no single institution has promised to provide it. Interconnection through lending, derivatives and shared exposures means the failure of one node propagates, so the safety of the whole is not the sum of the safety of the parts.

4. 4

   Why does asymmetric information justify regulating how financial products are sold?

   Model answer

   A financial product such as a pension, a mortgage or an investment fund is complex, its value depends on events far in the future, and the seller knows far more about its charges, its risks and its suitability than the buyer. The buyer often cannot judge quality even after purchase, because a poor outcome may be indistinguishable from bad luck, and most people buy such products only a handful of times in a lifetime, so they never learn by repetition. Ordinary competition, which relies on informed buyers switching away from poor products, therefore works weakly, and sellers paid by commission have a direct incentive to sell the wrong product. Requiring disclosure of charges and risks in comparable form, restricting commission-driven selling, imposing suitability duties and providing redress substitute for the information the buyer cannot obtain.

5. 5

   Distinguish prudential regulation from conduct regulation.

   Model answer

   Prudential regulation is concerned with the safety and soundness of financial institutions: whether a bank holds enough capital to absorb losses, enough liquidity to meet withdrawals, and manages its risks competently, so that it does not fail and impose costs on depositors and the wider system. Conduct regulation is concerned with how firms treat their customers and behave in markets: whether products are sold honestly and suitably, charges are disclosed, complaints are handled and markets are free from manipulation and insider dealing. A firm can be perfectly sound prudentially while treating its customers badly, and can treat its customers well while being dangerously undercapitalised, so the two require different rules and, in many countries, different regulators.

6. 6

   Distinguish microprudential from macroprudential regulation.

   Model answer

   Microprudential regulation looks at each institution separately and asks whether it holds enough capital and liquidity for the risks on its own balance sheet, the aim being to reduce the chance that this particular firm fails. Macroprudential regulation looks at the system as a whole and at the way institutions interact, recognising that risks build up collectively during a credit boom and that actions which are individually sensible can be collectively destabilising. Its instruments therefore vary with the cycle and target aggregates: capital buffers that rise when credit is growing rapidly and can be released in a downturn, limits on loan-to-value and loan-to-income ratios in mortgage lending, and extra requirements on institutions whose failure would be systemically damaging.

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