13.2 Financial regulation in the uk

l	the possibility of contagion as the result of a run on one bank turning into a panicthat might lead to a serious reduction in liquidity for the system as a whole; and

l	the need for consumer protection, given the nature of the banking industry andthe cost and difculty of acquiring knowledge.

We have added to these the need to cause as little moral hazard as possible, to

keep compliance costs low and to interfere as little as possible with competition,

either by creating barriers to entry or exit or by favouring some institutions over

others within the market. A common approach to ensuring the stability of the bank-

ing industry has been to prevent banks from participating in the more risky aspects

of nance by limiting them to deposit creation and lending functions. For example,

in the US, legislation passed during the 1930s rigidly separated commercial banking

from investment banking and other nancial activities. Since banks could provide a

wider range of nancial services not just in their own name but through the acquisi-

tion of other companies, this had to be supported by legislation that restricted the

ability of banks to acquire non-banking rms and vice versa. In the US, for example,

the Bank Holding Act of 1956 sought to prevent companies owning banks from

being allied with insurance companies, securities rms and commercial enterprises.

Such a separation tted well with the British and American model of banking in

which the various kinds of banking business were undertaken typically by different

types of banking organisation. In particular, deposit-taking banks concentrated on

short-term lending. This contrasted with the universal banking model common in

northern Europe.

Other approaches to ensuring the stability of banks have included guaranteeing

the liquidity of the overall banking system by giving the central bank the role of

lender of last resort to the system, seeking to prevent runs on individual banks by

introducing some form of deposit insurance scheme, placing limitations on interest

payments on deposits to prevent competition for deposits, and establishing barriers

to entry also with the intention of limiting competition among banks.

All of these restrictions came under challenge in the 1980s and 1990s. High and

variable ination and interest rates put pressure on traditional specialised savings

institutions. In the US this was magnied by legal restrictions on rates of interest

payable on retail deposits. As nancial services became an increasingly interna-

tional industry, governments became concerned about the competitiveness of their

domestic nancial industries hobbled by tight regulation. In a world of increasingly

mobile capital, rms found their way around existing restrictions and sooner or later

forced legislative changes that gave them greater freedom. Diversication of asset

bases provided benets in an increasingly risky environment and rms sought to

benet from economies of both scale and scope. The nancial conglomerate was

born. All of this was fostered by an anti-government mood in the worlds of both

business and nance.

In such a world, fears of instability increased and the issue of bank supervision

at both national and international levels grew in importance. In supervising banks,

regulatory authorities became concerned particularly with questions of capital ade-

quacy, liquidity, asset quality and the concentration of risks.

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Chapter 13 • The regulation of nancial markets

Capital adequacy is central because a bank’s capital must be sufcient to absorb

losses and to nance the operation of its business. The modern approach to the

assessment of a bank’s capital adequacy is based on a calculation of its risk–asset

ratio. This involves a number of steps:

l	a denition of the elements of capital for supervisory purposes;

l	the allocation of weights to different broad categories of asset (e.g. cash, govern- ment securities, loans to banks, loans to rms and households);

l	the expression of capital as a percentage of total risk-weighted assets.

The weights applied in the second step reect the degrees of risk associated with

the different categories of assets. More risky assets are given higher weights. Thus,

an increase in the proportion of a bank’s assets regarded as risky increases the size of

its risk-weighted assets and lowers the ratio of capital to risk-weighted assets.

Liquidity relates to the ability of a bank to meet its obligations on time, especially

in relation to repayment of interbank borrowings and customer deposits. Since the

survival of a bank depends on the retention of the condence of its depositors, the

maintenance of a reputation for trustworthiness is critical. Thus, banks must actively

manage liquidity. They seek to do this in three ways. Firstly, they hold a stock of

readily marketable liquid assets that can be turned into cash quickly in response to

unforeseen needs. Secondly, they identify mismatches between potential receipts

and payments in future periods. Thirdly, they respond to potential mismatches by

borrowing in the market to smooth out cash ows in particular periods. Regulators

may attempt to ensure the continued liquidity of banks by, for example, imposing a

required minimum liquidity ratio (a ratio of assets of short maturity to total deposits)

and/or by setting limits on mismatches or net positions in particular time bands.

The main issue in relation to the quality of a bank’s assets is the ability of its

borrowers to service and repay loans. The poor quality of the loans of many banks

has been a central element in the problems faced by the Japanese banking system

in recent years. The early identication of problem loans is important if remedial

action is to succeed. To this end, banks may employ a grading system that classies

loans in a range from trouble-free to non-performing. Some countries require such

ratings to be assigned to individual loans in the attempt to evaluate the quality of

banks’ assets on a consistent basis.

Risk concentration becomes a problem when loans to a small number of large

borrowers make up a high proportion of a bank’s assets. Then, default by only one

or two borrowers can cause serious difculties for the bank. The usual regulatory

response is to limit exposure to single borrowers or groups of borrowers to some

proportion of the bank’s capital base. Dangers can also arise for banks if deposits

come from a narrow range of sources, if individual deposits are large and volatile,

if income derives from a small number of transactions or activities, or if a high pro-

portion of loans are made against one particular kind of collateral.

In the UK the Bank of England had, until the 1980s, largely exercised its control

of the banking system indirectly through its close relationships with the clearing

banks, discount houses and accepting houses. However, banking scandals among

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