This is a study presentation on different causes of financial market failure and also policies introduced designed better to regulate the activities of the financial sector.

1. Financial Market Failure and Regulation of
the Financial System
Financial Economics

2. Financial Policy Committee of the Bank of England
• FPC’s main role is to identify, monitor, and take action to
remove or reduce risks that threaten the resilience of the
UK financial system as a whole
• FPC publishes a Financial Stability Report identifying key
threats to the stability of the UK financial system
• The FPC has the power to instruct commercial banks to
change their capital buffers
• When the FPC decide that the risks to the financial system
are growing, they may tell the commercial banks and
other lenders to increase their capital buffers to help
absorb unexpected losses on their assets (bad debts etc.)
• These capital buffers are part of “macro-prudential policy”
- prudent means being careful at times of uncertainty.

3. UK Prudential Regulation Authority (PRA)
• PRA is part of the Bank of England and is responsible for
the prudential regulation and supervision of around 1,700
banks, building societies, credit unions, insurers and major
investment firms
• Particular focus on the solvency of specific financial
markets such as:
1. Insurance providers
2. Buy-to-let mortgage lenders
3. Credit unions
4. Other specialist lenders

4. Financial Conduct Authority (FCA)
• The Financial Conduct Authority (FCA) replaced the
Financial Services Authority (FSA) on 1 April 2013.
• It is funded entirely by the firms it regulates
• FCA has three main objectives:
1. Secure an appropriate degree of protection for
consumers
2. Protect and enhance the integrity of the UK financial
system
3. Promote effective competition in the interests of
consumers.

5. Financial Market Failure – Moral Hazard
• Moral hazard exists in a market where an individual or
organisation takes many more risks than they should do
because they know that they are either covered by
insurance, or that the government will protect them from
any damage incurred as a result of those risks.

6. Financial Market Failure – Asymmetric Information
• This type of market failure exists when one individual or
party has much more information than another individual
or party, and uses that advantage to exploit the other
party.
• Finance is a market in information

7. Financial Market Failure – Monopoly / Market Rigging
• This type of market failure is effectively collusion or abuse
of a the power resulting from a concentrated market.
• When there is a small number of firms in a market, they
may choose to work together to increase their joint profits
and exploit consumers.
• The Competition and Markets Authority report on UK
banking in August 2016 said that “the older and larger
banks, which still account for the large majority of the
retail banking market, do not have to work hard enough to
win and retain customers and it is difficult for new and
smaller providers to attract customers.”

8. Financial Market Failure – Speculative Bubbles
• A bubble exists when the price of something is driven well
above what it should be, usually due to the behaviour of
consumers.

9. Financial Market Failure - Externalities
• A negative externality exists when a market transaction
has a negative consequence for a 3rd party.
• A positive externality exists when a market transaction has
a positive consequence for a 3rd party.
• We can also talk about network externalities, whereby
there are knock-on effects of organisations working
together – you could describe this as synergy if the effects
are positive, or discord if the effects are negative.

10. Financial Market Failure – Principal Agent Problem
• This situation exists when one person (i.e. the agent) is
able to make decisions on behalf of another person (i.e.
the principal), but the principal is unable to adequately
supervise the agent. This can result in the agent acting in
his/her own best interests rather than the interests of the
principal.

11. Financial Market Failure – Speculation
• This can be defined as a risky action in which a person or
organisation tries to predict what will happen to the price
of an asset and buys / sells accordingly in order to try and
make a profit. A speculator takes advantage of fluctuations
in market prices.

12. Financial Market Failure – Incomplete Markets
• An incomplete market exists when the available level of
supply is not enough to meet the needs and wants of
consumers i.e. only a proportion of potential demand is
met.
• Around 2 billion adults worldwide without a bank account.
• 10 million US households, and 1.5 million UK adults are
also unbanked

13. Moral Hazard and Banking Instability
• Moral hazard happens when an agent is given an implicit
guarantee of support in the event of making a loss – for
example insurance pay-outs or the guarantee of a bail-out
• In the commercial banking industry, the belief that the
government will absorb the losses that bank creditors would
otherwise bear can lead to moral hazard.
• This may lead banks to take on more risk than is optimal, since
they believe they receive any private benefits from the risk
taking (i.e. higher profits) while the government will bear the
cost of failure (funded eventually by the tax payer)
• Some institutions may be deemed “too big to fail” – leading to
diseconomies of scale and increasing the risk of financial
collapse
• Guaranteeing the deposits of savers might also mean that
banks can attract deposits by offering lower rates of interest

14. Financial Instability and the Real Economy
Why does financial instability matter for the economy? According to the Bank of England,
“Financial stability – public trust and confidence in financial institutions, markets, infrastructure,
and the system as a whole – is critical to a healthy, well-functioning economy.”
• Negative impact on business investment
• Increased precautionary saving lower demand
• High levels of debt and falling asset prices hit consumer wealth and spending
Instability and confidence
• People have less trust in banks and other institutions
• Higher interest rates on loans to businesses
• Credit harder to get for small and medium-sized enterprises and start-ups
Instability and loss of trust
• Evidence that poorer communities and families are more vulnerable during periods of
financial stress/recession
• Policy response of ultra-low interest rates hits real incomes of savers
Instability and inequality

15. What is Systemic Risk?
• Systemic risk became a key concept during the Global
Financial Crisis (GFC)
• Systemic risk is the possibility that an event at the micro
level of an individual bank / insurance company for
example could then trigger severe instability or collapse an
entire industry or economy.
• The GFC illustrated how interconnected the financial
world has become.
• Shocks in one location (e.g. the USA) or asset class (e.g.
sub-prime mortgages) can have a sizable impact on the
stability of institutions and markets around the world.
• Since the crisis, financial regulators have tried to make the
banking system less vulnerable to economic shocks and
create “firewalls” to prevent damage from systemic risk

16. The LIBOR scandal
• The “Libor” is the London Inter-Bank Offered Rate – this is the interest
rate charged by banks in London when they lend to each other in the
short-term. It is calculated every morning by Thompson Reuters, a
company specializing in producing financial data. The calculation is based
on information provided by members of the British Bankers Association.
• The scandal “broke” in early 2012, when a whistleblower from Barclays
Bank went public with the information that banks including Barclays, RBS
and HSBC amongst others had been under-reporting their inter-bank rate
to Thompson Reuters. The bankers had believed that by under-reporting
the rate they would make their banks look stronger, because a low rate
would indicate that they were trustworthy and creditworthy i.e. not risky.
This in turn would boost profits.
• There were a number of losers from the Libor-fixing scandal. One loser
were the many local government organisations around the world who
had bought a financial product called an interest-rate swap to try and
reduce fluctuations in interest payments on the variable-rate bonds they
had issued. Swap-sellers exploited the lack of financial knowledge of local
governments by linking payments to local government to the artificially-
low Libor rate.
• The US government estimates that the extra cost to local governments in
the United States alone was $6bn.

17. The Enron Scandal
• Enron Corporation was a Texas-based US energy company established in 1985.
• By 2001, at the time of its bankruptcy and subsequent downfall, it was America’s 7th
largest company, employing over 21,000 people in over 40 countries. In 2000, Enron had
been awarded the accolade of America’s Most Innovative Company, by Fortune Magazine.
What many people didn’t realise was that Enron’s creativity and innovation extended to its
accounting practices.
• Enron was well known for producing very confusing annual financial statements to its
shareholders. Their statements had, for years, shown volatile cash flow and large debts
under vague headings.
• The most senior managers, Kenneth Lay, Jeffrey Skilling and Andrew Fastow, later said in
court that they were totally focused on meeting Wall Street’s expectations about their
share prices and performance so they developed ways of hiding the huge amounts of debt
that Enron had built up. For example, expectations about future profit were included in
their accounts.
• Enron also established many “special purpose entities”, or “shell companies” – these
companies didn’t really exist, but Enron executives moved Enron’s debt into the accounts
of these shells.
• Most of Enron’s managers were rewarded using “stock options”, so their performance was
directly linked to Enron’s share price – this meant they had an incentive to make Enron
look as profitable as possible all the time.
• Making matters worse, Enron’s accounting auditor, a firm called Arthur Andersen, signed
off Enron’s accounts annually without question, convincing investors that the firm was
financially sound. In 2000, Arthur Andersen received over $50m from Enron in fees; they
faced a conflict of interest because unless Andersen’s confirmed that the accounts were
sound they would lose a significant amount of revenue.

18. The 2010 Wall Street Flash Crash
• On May 6th 2010, the price of shares on the US Dow-Jones Index
plummeted nearly 1000 points in a matter of minutes, before rebounding
within 30 minutes; this was the largest daily drop in the Index’s history.
• This wiped a temporary $1 trillion off the value of shares on the New York
Stock Exchange (NYSE). For years, the cause of the flash crash was
unknown.
• Initially, analysts suggested that the cause could be due to slower IT being
used on the NYSE compared with the IT used by financial firms, allowing
changesin share prices to be exploited in a bear market.
• An alternative suggestion was that the crash was due to over-activity by
High-Frequency Traders (HFT) – these are (usually) computerised trading
programs that buy and sell shares within milliseconds to make a profit.
• However, in April 2015, the US Department for Justice brought charges
against Navinder Singh Sarao, a London-based HFT for his role in the crash.
• The US believed that he used commercially-available computer software
to create large “sell” orders (i.e. instructions to sell shares) which would
cause the price of those shares to fall, but then pull out of the sale at the
very last millisecond in order in order to benefit from buying shares at the
lower price. This practice is known as “spoofing”. The US authorities think
that he earned $40m as a result.

19. The Sub Prime Mortgage Crisis
• This crisis was the main fuel that ignited the 2007/
2008 global financial crisis
• Sub-prime lending is lending money, usually to buy
a house, to people who are risky to lend to.
• To compensate for this risk, commercial banks
charge higher interest rates.
• When house prices were rising in the 2000s, banks
decided that the risk of sub-prime lending had
fallen, as borrowers would be able to sell their
houses for a higher price than they had bought
them at in order to repay their mortgage if they ran
into financial difficulties.
• In the USA, many sub-prime loans were insured by
the firms Fannie-Mae and Freddie-Mac.
• However, when house prices started to fall, sub-
prime homeowners found themselves in negative
equity and unable to repay their loans.
• This meant that commercial banks lost out

20. The Sub Prime Mortgage Crisis
• This crisis spread quickly, because banks had
sold on debt in the form of financial derivatives.
• Effectively, they had ‘chopped up’ the safe loans
and the sub-prime loans and ‘repackaged’ them
in a bundle, selling them for a higher price than
they would have received for merely selling on
the sub-prime loans.
• Financial institutions (such as pension funds)
buying these derivatives didn’t understand the
risk attached to them, because the derivatives
had been given high ratings by the major credit
ratings agencies
• This meant that many financial institutions
owned large amounts of sub-prime debt.
• The USA government ended up bailing out
Fannie-Mae and Freddie Mac, and the UK
government bailed out a number of UK banks
taking some into state ownership.

21. Liquidity Ratios and Capital Ratios
• Liquidity means the ease and cost with which assets can be
turned into cash and used immediately as a means of exchange
• Certain assets are highly liquid
• Notes and coins that are legal tender are perfectly liquid
• Money held in sight-deposit accounts is highly liquid because it
can often be withdrawn immediately without penalty
(although there might be a daily limit)
• Other liquid assets might include treasury bills (short term
government loans) and also stocks held in large listed
companies (because these stocks are traded heavily each day)
• According to the Bank of England (July 2016) UK commercial
banks hold more than £600 billion of high-quality liquid assets,
which is around four times the level they held before the
global financial crisis.

22. What are Liquidity Ratios?
• A liquidity ratio is the ratio of liquid assets held by a bank on
their balance sheet to their overall assets
• Banks need to hold enough to cover expected demands from
depositors
• In the wake of the Global Financial Crisis (GFC) the Basel
Agreement require commercial banks to keep enough liquid
assets, such as cash and government bonds, to get through a
30-day market crisis
• A liquidity ratio may refer to a reserve assets ratio for a bank
which sets the minimum liquid reserves that a bank must
maintain in the event of a sudden increase in withdrawals
• A high liquidity ratio may limit the amount of lending that a
bank is able to do – it must maintain higher amounts of cash

23. What are Capital Ratios?
• Capital ratios have become important as part of attempts
to maintain financial market stability in recent years
• A commercial bank's capital ratio measures the funds it
has in reserve against the riskier assets it holds that could
be vulnerable in the event of a crisis.
• The European Union runs regular “stress tests” to check
whether banks have enough of a capital buffer to weather
difficult economic/financial conditions (known as disaster
scenarios)
• Banks must maintain sufficient capital which includes
money raised from selling new shares to investors and
also their retained earnings (profits)
• Europe’s banks have raised €180bn since the end of 2013
• But the size of “non-performing loans” has also risen

24. Tier One Capital Ratio for Lloyds Banking Group
Tier 1 common capital ratio is a measurement of a commercial bank's equity capital
compared with its total assets. This ratio is used to assess bank's financial strength.
11.6%
12.5%
13.8%
14.5%
16.5% 16.4%
0.0%
2.0%
4.0%
6.0%
8.0%
10.0%
12.0%
14.0%
16.0%
18.0%
20.0%
2010 2011 2012 2013 2014 2015
Tier1capitalratio

25. What are Leverage Ratios?
• The leverage ratio is a simple indicator of the ability of a bank
or building society to absorb losses
• Leverage ratio = Capital / Exposures
• The leverage ratio refers to the share of the total value of a
firm’s assets and its other commitments (referred to as
‘exposures’) that is funded with high-quality capital capable of
absorbing losses while a firm is a ‘going concern’.
• The lower the leverage ratio, the more than a commercial bank
or building society relies on debt to fund their activities
• In June 2015, the FPC directed the Prudential Regulation
Authority (PRA) to require each major UK commercial bank
and building society to meet a leverage ratio requirement and
hold buffers over that requirement

26. Micro and Macro Prudential Policies
• Since the global financial crisis, regulators have placed
increased emphasis on prudential regulation – i.e. putting
in place safeguards for the stability of the financial system
• Micro-prudential involved regulation of individual
financial firms such as commercial banks, payday lenders
and insurance companies
• Macro-prudential regulation is designed to safeguard the
financial system as a whole

27. Peer to Peer Lending

28. Peer to Peer Lending
• Peer-to-peer lending happens when individual savers are able
to lend directly to borrowers, often through online peer-to-
peer lending platforms
• Market participants include Zopa (launched 2005), Crowdcube
(launched 2009), Funding Circle (launched 2010), Rate Setter
(also launched 2010) and Thincats (launched 2011).
• Both the investor and the borrower benefits as the lender
achieves higher interest rates and the borrower lower interest
rates than would be on offer if either had gone through a
commercial bank.
• Lenders are at more risk because loans are generally
unsecured – the risk of borrower default is higher
• Individuals can choose the level of risk they are prepared to
tolerate – the higher risk loans offer a better rate of interest

29. Peer-to-peer lending via the Funding Circle platform
2,195,200
17,397,500
49,239,620
129,217,080
278,573,020
410,927,080
0
50000000
100000000
150000000
200000000
250000000
300000000
350000000
400000000
450000000
2010 2011 2012 2013 2014 2015
AmountofmoneylentinGBP
Funding Circle is a peer-to-peer lending platform that allows investors to lend money
directly to small & medium-sized businesses. Funding Circle is the largest P2P lender in UK

30. Market Share of leading Business P2P Lending Platforms
Peer-to-peer websites connect investors to borrowers online, cutting out the banks.
However savers who lend money are not part of the Deposit Protection Scheme
20.35%
9.97%
3.27%
2.85%
2.1%
1.55%
0.88%
0.71%
0.63%
0.28%
0.17%
0.14%
0.11%
0.1%
0.07%
0.0% 5.0% 10.0% 15.0% 20.0% 25.0%
Funding Circle
LendInvest
Wellesley & Co.
Saving Stream
ThinCats
Folk 2 Folk
Landbay
Assetz Capital
FundingKnight
ArchOver
Rebuildingsociety
UK Bond Network
Money&Co
Abundance Generation
Crowdcube MiniBonds
Market share (%) in October 2015

31. Crowdfunding
• Crowdfunding is a form of
equity finance that has
grown rapidly in the USA
and the UK in particular
• Crowdfunding involves the
collective effort of a large
number of individuals who
network and pool small
amounts of their capital to
finance a new or existing
business venture
• Social causes remain the
most active source of
crowdfunding activity
Crowdfunding market participants
include Indiegogo (launched 2008)
which has funded more than 275,000
campaigns, and Kickstarter (launched
2009) which has funded around 100,000
projects globally

32. Profitability of the UK Commercial Banking Industry
• Major UK commercial banks’ profitability has fallen quite
significantly since the global financial crisis
• Low profitability reduces the ability of commercial banks to
generate fresh capital internally and reduces their resilience to
future domestic and external shocks.
• Key factors:
1. Significant rise in regulatory costs
2. Lower interest rates on loans has reduced trading incomes –
for example, a steep fall in mortgage rates
3. Financial cost of previous misconduct - UK banks put side
another £15 billion relating to past misconduct in their 2015
results, reducing pre-tax profits by around 50%. This includes
the costs of miss-selling PPI
4. Commercial banks are now making less money from
investment banking services such as currency &
commodities trading. Retail banking is traditionally less
profitable than the higher risk investment banking side

33. Regulation of the Financial System
Financial Economics