The historical context of financial market regulation

Financial markets have undergone significant changes in regulation, particularly following major economic events.

From the mid-1980s to the 2008 financial crisis, many global financial markets operated with minimal restrictions. This period included a major deregulation event in the 1980s called the Big Bang, which reduced controls to boost profitability. While this approach made markets more dynamic and helped places like London become leading financial hubs, it also contributed to vulnerabilities that led to widespread instability.

The 2008 crisis highlighted the dangers of lax oversight, often described as a combination of market failures. In response, governments worldwide strengthened rules to prevent similar issues, aiming to create more secure and fair systems.

Problems caused by insufficient regulation

A lack of strict rules in financial markets can lead to various issues that undermine economic stability. These problems were evident before and during the 2008 crisis, showing how unregulated practices can escalate into broader failures.

Issues arising from weak financial oversight:

• Excessive risk-taking - Financial institutions, such as investment banks, pursued high-risk investments to chase profits.
• Blurring of banking roles - Deregulation allowed commercial banks to engage in investment banking, meaning losses in speculative activities could harm everyday banking operations.
• Illegal practices - Activities like fraud and market manipulation occurred more easily, with examples including banks fixing prices or rates unfairly.
• Formation of market bubbles - Speculative growth, such as in housing, was fuelled by easy credit, leading to unsustainable booms that eventually collapsed.

Key focuses and types of financial regulation

Modern regulation aims to address the root causes of market failures by targeting specific areas. This includes both national and international efforts to ensure markets operate fairly and sustainably.

Main areas targeted by financial regulation

• Promoting competition - Rules encourage rivalry among firms to provide better options and prices for consumers.
• Firm structure and risk control - Regulations require banks to maintain stability through measures like capital and liquidity ratios, limiting risky behaviour and holding senior staff accountable for breaches.
• Strengthening compliance - Institutions must follow enhanced guidelines, with severe penalties for violations to deter misconduct.
• Managing systemic risks - Strategies identify and mitigate threats that could affect the entire financial system, such as plans for safely handling bank failures without bailouts, encouraging responsible practices.

Capital and liquidity ratios

Capital and liquidity ratios are tools used to assess and ensure a bank's stability:

• Capital ratio - Measures a bank's capital (from profits and shares) against its loans, indicating lending risks and overall security.
• Liquidity ratio - Compares highly liquid assets to short-term cash needs, showing the bank's ability to cover immediate obligations.

Using these ratios together provides a comprehensive view of a bank's health.

Types of financial regulation

There are two primary approaches to regulation, each addressing different scales of risk:

• Microprudential regulation - Focuses on individual firms, ensuring they treat customers fairly, avoid excessive risks, and comply with laws.
• Macroprudential regulation - Targets broader systemic threats to prevent large-scale crises that could damage national economies.

International efforts, such as recommendations from the Basel Committee, set global standards for minimum capital and liquidity levels to buffer against asset value drops or sudden withdrawals. Many countries, including the UK since 2019, have implemented 'ring-fencing' to separate commercial banking (e.g., customer deposits) from riskier investment activities, protecting everyday users.

Roles of UK regulators in financial markets

In the UK, oversight of financial markets is handled by key bodies that collaborate to maintain stability, fairness, and confidence. The Bank of England oversees two main entities, while the Financial Conduct Authority handles consumer protection.

The Bank of England

The Bank of England regulates the financial markets through the work of two bodies under its control — the Financial Policy Committee (FPC) and the Prudential Regulation Authority (PRA). The FPC is a macroprudential regulator and the PRA is a microprudential regulator, but they work together to ensure the stability of financial markets.

Functions of the Financial Policy Committee (FPC):

• Identifying and monitoring risks that could destabilise the entire financial system.
• Directing other regulators like the PRA and FCA to address systemic issues.
• Providing guidance to the government on effective market management.

Functions of the Prudential Regulation Authority (PRA):

• Overseeing financial institutions to ensure proper risk management.
• Establishing and enforcing standards for operations and conduct.
• Defining required capital and liquidity ratios to promote stability and competition.

The Financial Conduct Authority (FCA)

The FCA is a microprudential regulator which aims to protect consumers and increase confidence in financial institutions and products.

Functions of the FCA:

• Supervising the conduct of firms and markets to ensure that things are done legally and fairly.
• Promoting competition in financial markets so that better deals are provided for consumers.
• Banning financial products that don't benefit consumers.
• Banning, or forcing firms to change, misleading adverts for financial products and services.