Financial Regulation in the United Kingdom - Essay Example

FINANCIAL REGLATION IN UK Financial Regulation in UK Introduction The regulation of financial markets and its implications have been a topic of considerable interest among researchers and policy makers for a long time. On the one hand, it is argued that the regulation of financial markets has welfare benefits due to the existence of market imperfections (Llewelleyn, 1999). On the other hand, it is argued that financial market regulation imposes significant costs to an economy that outweighs the benefits (Benston, 1998).The debate remains unsettled. In this essay, the failure of financial regulation in UK in the light of the recent financial crisis is discussed. This essay is organized as follows. Section 2 discusses the origin of global financial crisis and its cases in general as well as in the case of UK in particular. Sections 3 and 4 discuss the different dimensions of financial regulation in UK and the reasons for their failure. Section 5 concludes the report. 2. Global Financial Crisis and Causes The financial crisis had its origin in USA with the sudden boom in housing prices creating high optimism among investors and lenders between 1990 to 2006.This resulted in the creation of many mortgages and finally as the hosing price boom came to an end in 2006, subprime1 defaults started rising. Since the households became unable to repay their debts, the leading financial institutions worldwide had to write off their investments since August 2007. This deteriorated their balance sheet positions, which ultimately resulted in a tightening of supply of credit to households and firms to finance their consumption. Thus, the financial crisis led to economic crisis which spreaded all over the world (Agarwal et al, 2008; Vyuev, 2008; Gwimmer and Sanders, 2008). Financial market regulation is mainly aimed at correcting market imperfection and ensuring allocative efficiency of resources (Giorgio et al, 2000). However, one major reason for financial crisis has been cited as the failure of regulatory system to cop up with the financial innovation that resulted in the crisis (Pan, 2009). The rising indebtedness of the US households and financial institutions during the years before the financial crisis increased their vulnerability to crisis. The complexity of highly sophisticated financial instruments like derivatives helped in spreading the financial crisis to countries all over the world. The inaccurate measurement of risk associated with the financial innovation also resulted in creating the financial crisis. The other main reasons for the financial crisis are identified in the literature as weakened lending practices, deregulation, increase debt burden, complex and innovative financial instruments, and incorrect pricing of risk (Carmassi etal, 2009). Reports show that the banks in UK were very much involved in the trading of securitized financial instruments (Financial Services Authority, 2009). The regulatory system in UK failed to cope up with the complexity of these instruments and the risks associated with them were underestimated there. This resulted in the liquidity problem, which ultimately resulted in financial crisis in UK also (House of Lords, 2009). The housing price cycle and the property cycle in UK also have been identified to have played important role in creating the crisis in UK (Financial Services Authority, 2009). The next sections discuss the failure of different dimensions of financial regulation leading to the crisis in UK. 3. Capital Adequacy Requirements The introduction of minimum capital requirements in banks have been aimed at protecting against unexpected losses (Basle Committee on Banking Supervision, 1999). The evidence from the recent financial crisis however shows that these pressures on banks to maintain minimum capital requirements have resulted in weakened bank lending and to the economic weakening (Hall, 1993). This arises mainly due to two reasons. They are (1)the pressure for banks to switch away from high risk weighted assets to low risk weighted assets due to the differential risk weights for different risk categories and (2)The pressure imposed on the banks to meet minim capital standards might result in reducing bank’s total assets for a given capital base. The result will be reduced credit intermediation (Furfine, 2000). This has resulted in a phenomenon called credit crunch in the context of the global financial crisis. Credit crunch consists of a decline in saving types deposits in banks and a decline in savings and loans that will ultimately result in a decline in bank and capital market lending (UK Economic Outlook, 2008). In UK, Northern Rock, the leading mortgage provider was the first one to be announced affected by the credit crunch. Rather than getting direct exposure to US subprime assets, through the wholesale money markets using complex securitisation instruments ,covered bonds etc , it has been funding UK mortgage lending. The credit crunch problem had its impact on Northern Rock in August 2007 following the unanticipated congestion in these instruments. Northern Rock was prevented from being bankrupt due to the intervention of Bank of England (UK Economic Outlook, 2008).This had a spill over effect to the other mortgage lenders in UK and they restricted the availability of credit to firms and households.UK economic outlook (2008) has shown that the funding needs of the majority of UK firms can be met by retained earnings due to their healthy financial positions and hence the expensive external financing may not create problems to them. However, KPMG (2007) has shown that this dependence on retained earnings is limited, when the external financing is restricted and hence cannot be relied upon for a long period. During the credit crunch of the 1980s the bond markets served the economies well as an alternative source of financing during the periods of loss of bank financial intermediation (UK Economic Outlook, 2008). However, whether bond markets constitute an effective source of alternative financing depends on the absence of co movements of bank and bond markets, and also the absence of contagion in the international capital markets. Credit crunch is likely to affect Euro bond markets, domestic bond markets and foreign bond markets in there different ways. One is by the reduction of liquidity, other is through leverage and the final one is through the cost of funds (KPMG, 2007). Based on its linkages to the issue of new equity and capital structure, the credit crunch will have possible effects on both of these. Tier 1 capital ratio of 8% (6% on a core Tier 1 basis) is increasingly seen as the comfort level for European banks. Recent statistics have shown that in UK,Tier1 capital ratio has become 5.1% for Barclays and 4.5 percent for Royal Bank of Scotland(Bank of England,2008).The data on corporate and bond prices also show that these form of external financing has become expensive and hence firms were finding it difficult through equity or bond issuance. The Bank of England’s Financial Stability Review uses three measures to evaluate the risks to financial stability in the UK banking and corporate sectors and internationally. Two of the methods use market based measures of credit risk, as embodied in equity prices, bond prices and agencies’ credit ratings. The third uses individual company account data to look at the cross-sectional distribution of credit risk. Using these three measures, the efficiency of international financial markets is evaluated here. Table 1 Major UK banks’ and LCFIs’ structured credit and monoline-related write-downs and exposures(a)(b)US$ billions Major UKbanks European US Security US LCFIs houses banks Total write-downs(c) 2007 H2 14 32 39 30 2008 Q1 –(d) 5(d) 13 17 Of which: US sub-prime 11 26 33 33 Other US MBS and ABS(e) 1 2 4 2 CMBS(f) 0 2 1 1 Leveraged loans 1 4 7 8 Monoline guarantees 1 3 7 3 Remaining exposures(g) 192 232 295 195 Memo item Total assets 11,215 11,748 4,086 5,579 Source: Bank of England (2008) The table shows that though the losses in subprime markets have been comparatively negligible, the Large Complex Financial Institutions have shown considerable write downs. Chart 1 Sources of tail risk in the period ahead: change in assessment since October 2007 Source: Bank of England (2008) The above chart shows that since October 2007, the probabibility and impact of household debt has increased only slightly in U.K. At the same time, the impact of high risk premia and institutional distress has increased significantly since October 2007 following credit crunch. The probability and impact of global corporate debt has increased significantly. The probability and impact of global imbalances has remained broadly unchanged since October 2007. Chart 2: Moody’s speculative-grade corporate bond default rate and forecast (a) Source: Bank of England (2008) Bank of England (2008) based on this chart has reported vulnerability in leveraged non financial companies whose default probabilities are expected to rise in the coming years. The chart below has shown that the liquidity in many financial markets has reduced tremendously particularly following the crisis of 2007.The liquidity index has been constructed as an weighted average of nine liquidity measures. Chart 3 Financial Market Liquidity Index Source: Bank of England(2008) Chart 4 shows that the issuance of many asset backed securities have been reduced and many of them have been closed recently. This shows the impact of credit crunch on Commercial paper market Chart 4 Global Issuance of Asset Backed Securities Source: Bank of England(2008) 4. Deposit Insurance Another major issue created by the financial crisis has been the rise in moral hazard on the assets and liabilities of banks’ balance sheets created by the deposit insurance. Explicit deposit insurance has been aimed at reducing the incidence of bank runs in countries with strong institutions and proper safeguards through 100 percent insurance and rapidly. Another major aim of deposit insurance has been identified as helping an insured institution to be closed at the time of crisis through 100 percent insurance or partial coinsurance up to a limit (Goodhart, 2008). In UK, the deposit insurance system has been aimed at closing the insured bank through 100 percent insurance or partial coinsurance up to a limit (Goodhart, 2008). However, in the light of the crisis, this scheme has been dismissed and there has been a plan to shift to the other type of insurance, which is preventing the bank run through 100 percent insurance(Goodhart, 2008). However, the experience with recent financial crisis shows that this can fuel bank crises by giving banks perverse incentives to take unnecessary risks .This phenomenon is known as moral hazard (Coy, 2007). In general, Moral Hazard is an important feature of insurance arrangements because the increased incentives for taking risks that might result in an insurance payoff are provided by the existence insurance. if a bank fails, insured depositors know that they will not suffer losses, so when they suspect that the bank is taking on too much risk they do not impose the discipline of the marketplace on banks by withdrawing deposits. Consequently, banks with deposit insurance can take on greater risks than they otherwise would (Diamond and Philip, 1983; Talley and Ignacio, 1990). In the case of moral hazard, each insurer will try to get cheaper premium and an outcome without having any expenditure on care. This results in a higher probability of loss after the contract than the time of initiation of the contract. This will result in a loss to the insurer and such contracts will not represent a competitive equilibrium (Hiller, 1997). In many studies, solutions have been discussed for moral hazard through the observation by the insurer of the care taken to prevent the loss (Shavell, 1979; Gropp and Vesala, 2004). Here, the insured one will be motivated to prevent loss since due to the monitoring the insurer can link the perceived care in two alternative ways .One is through the insurance premium or through the amount of coverage paid in the event of a claim (Shavell, 1979). In the case of observation by the insurer, the solution to moral hazard depends on the accuracy of the observations of the insurer and the timing of observations. In the case of completely accurate observations by the insurer, full coverage can be considered as desirable as argued in many studies irrespective of the timing of observations whether they are made at the time of policy purchase or at the time of presenting a claim. In case of inaccurate observations, however, an additional risk is imposed on the insured persons .This is because there will be many random factors influencing the observations of the insurers which will be reflected in the premium. In such cases, this risk factor can create an incentive for the insured one to take adequate care to prevent loss if the information about the changes in the level of care is reflected in the observations .Policy can be designed to create the optimal outcome in this case(Shavell,1979;Harris and Raviv,1992). 5. Conclusion In this essay, the failure of financial regulation in UK in the light of the recent financial crisis has been discussed. The regulations in financial market are supposed to correct the imperfections and externalities existing in the market. Based on this, the objectives of financial market regulation include the stability in terms of micro and macro perspectives, equitable distribution of resources as well as the rise in the efficient allocation of resources. Financial market regulations are supposed to ensure these objectives through correcting market failures. However, the recent financial crisis shows that the costs of financial regulation have exceeded the benefits due to the inefficient design of the regulatory system. The recent events in UK showed that the regulatory regime was not capable enough to cope up with the complexity of the highly sophisticated financial instruments like the derivatives. Moreover, the recent crisis showed that the capital adequacy requirements of the banks have been one of the major reasons for felling the crisis rather than preventing it. The system of deposit insurance also has resulted in the phenomenon called moral hazard, which has been aggravating the crisis. This has serious implications regarding the future of the existing regulatory mechanisms. The regulatory mechanisms have to be reframed in the light of the recent financial crisis. Hence, it can be argued that the regulatory regime in the future needs to be designed in such a way that the costs of the financial regulation need not exceed the costs of the original problem. References Barrell,R, Weale, M and Young, G(1998) Commentary: “The UK and the World Liquidity Crisis” ,National Institute Economic Review,No166. Bank of England (2008): “Financial Stability Review”, Issue 23,May. Basle Committee on Banking Supervision (1999): “Capital Requirement and Bank Behaviour: Impact of the Basle Accord”, BIS Working Papers, No.1, July. Benston, G.J. (1998) “Regulating Financial Markets: A Critique and Some Proposals”, Hobart Paper No. 135, London, Institute of Economic Affairs. 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