Abstract
In any working economy, financial regulation is essential. First, financial regulation is the imposed restrictions, control, and mandatory measures put in place (especially by the central government) to regulate the financial markets and the financial institutions such as the banking industry. Financial regulation requires these industries (the financial institutions) to adhere to some rules, restrictions, requirements, and guidelines to operating in the given economy. The measures are necessary for an economy for financial stability and the efficient working of the financial institutions, that is, to restrain financial institutions from exploiting their consumers (HM-Treasury, 2019). The central government also uses financial regulation to ensure favorable economic conditions, that is, as a monetary tool to control macroeconomic instability such as inflation. In addition, financial regulation is essential to prevent money laundering and other illegal markets such as drug smuggling in an economy (Llewellyn,2009).
In the UK, financial regulation is carried out by various bodies that work to realize the goals of favorable economic conditions for the consumers. To achieve their numerous objectives, including securing consumer confidence, limiting the extent of uncertainties, eliminating money laundering cases, establishing a reliable baking sector, maintaining economic stability, and achieving macroeconomic goals such as competitive advantage, the UK has split the regulatory authority into different sub-sectors. So, the government uses specific tools, for example, reserve requirements interest regulations, among other measures, to ensure that the financial system is working effectively. Further, we will discuss Brexit, a historical move that saw the UK exit from the European Union. Brexit had many impacts on the regulation of the financial system, including; taxation, data protection, mortgage and personal payments, anti-money laundering, security enforcement, dealing with counterparties, among others (Ashurts, 2020). This paper will discuss financial regulation, the rationale for financial regulation in the UK, and the impacts of Brexit in the UK.
Economic Rationale for Financial Regulation
In this sector, I will discuss why consumers depend on or require the government to regulate the financial institutions and financial services, that is, the benefits of having financial institutions and banking services regulated. First, we need to understand that there is a difference between monitoring, supervision, and regulation of the financial sector; where monitoring refers to ensuring that rules are followed, and supervision refers to observing their conduct, regulation means imposing specific restrictions or behaviors to be followed by the financial institutions. Unlike other sectors of the economy where the market forces work to determine the equilibrium price and quantities, the financial industry depends on the regulatory agencies to determine the operating conditions (Llewellyn, 2009). Thus, because the financial sector does not operate in a free market, there are uncertainties created by the regulators. For instance, the consumers do not have sufficient information to allow them to make important decisions before major financial moves. However, the primary function or aim of the regulatory agencies is to change the behaviors of the financial institutions, for example, reduce lending to consumers in case of persistent inflation. To ensure that the financial institutions adhere to the regulatory requirements, the agencies use incentives, laws, supervisory, and regulatory actions. In brief, the effectiveness of financial regulation depends on designed incentive contracts.
The financial system is constantly faced with periods of economic upheavals; these include financial instabilities and bank failures (Llewellyn,2009). To mitigate these upheavals, which are speculated to be caused by poor regulation, the role of an effective financial regulation comes into work. There are three major financial crises: bad incentive structures, poor regulation, monitoring, supervision, and weak management and control systems. The central argument on the need or rationale of financial regulation is that it aims to serve the government’s interests (HM-Treasury, 2019). However, despite the rules being put in place to benefit the government, the regulated financial institutions and markets also benefit from the move, especially from reduced competition. Other objectives of financial regulation include; sustenance of system stability, protection of the consumer, and maintenance of financial systems’ soundness (Llewellyn,2009). The economic rationale can further be distinguished into several reasons:
- To curb market externalities.
- To correct market failure, such as imperfections.
- To increase consumer confidence.
- To monitor financial transactions and economies of scale
- To control moral hazard and adverse selection scenarios in the financial sector
There are two major types of financial regulation; prudential and business conduct. Prudential regulation assumes that the consumers do not have perfect information adequate to make decisions regarding the financial systems. Therefore, prudential regulation aims to protect the consumers from imprudent behaviors of financial institutions. Imprudent behaviors include; unsound purchases, devalued contracts, inadequate compensation schemes, and liquidity risks. On the other hand, the conduct of business regulation takes an interest in how the financial institutions carry out their day-to-day business, that is, how they relate to their consumers. In essence, this regulation determines the honesty and integrity of financial organizations, including disclosing information. In simple terms, business conduct aims to regulate the working relationship and establish rules and guidelines while dealing with the consumers. For example, a consumer is bound to protection to avoid failed contracts which may arise from:
- A consumer being advised wrongly
- Fraud and misinterpretation of information
- Change in contract terms
- Incompetent financial institution
- Insolvency of the institutions before contract maturity
Therefore, the critical concern of financial regulation is to reduce the chances of failed contracts.
We can see how the regulatory agencies get to regulate and thereby control the significant issues in the banking and financial systems. One to control externalities, which arise from having the social costs exceed the private benefits, mainly due to the effects of moral hazard and adverse selection. A moral hazard is defined as a situation in which one party takes risky measures because they are protected by the other party (HM-Treasury, 2019). For example, the case is rampant in the insurance industries where the insured fail to take protective measures to prevent some incidents because they will get compensated (they are insured). On the contrary, adverse selection refers to a situation where one party uses their awareness (complete information) to make informed choices at the expense of the other party (HM-Treasury, 2019). For example, a banking agent might be aware of possible fluctuations in the interest rates, possibly arise, and use the information to convince consumers to borrow more without informing them of the fluctuations. So, there is a need to regulate the financial sectors to reduce the externalities to avoid jeopardy. For instance, the banking system’s insolvency can cause financial disruptions across the whole economy. The regulatory agencies, mainly the central government, use deposit insurances and lending as a last resort to reduce jeopardy cases in the banking systems.
Another major rationale for regulating the financial systems is to correct market failure and market externalities that impact the level of consumer welfare. Market externalities in the financial system are caused by; imperfect/inadequate information for the consumer, asymmetric information (the institutions are more informed than the consumers), difficulties in assessing the quality of purchase, and conflicts of interest (possible principal-agent issues). Maybe if the financial market were perfectly competitive, the consumer would have to incur the cost of regulation because there would be no financial regulation in the regulation-free environment. Regulatory agencies aim to monitor the institutions’ behaviors concerning the economics of scale to ascertain the contract’s economic terms act. In the absence of regulations, consumers are forced to spend time, resources, and effort investigating financial firms. Also, the consumers do not have the authority to demand requirements or call for corrective actions for the institutions, thereby necessitating regulatory services. Financial regulation is all about trade-offs and making judgments concerning costs and benefits and, of course, has limitations. The limitations in its functionality include; not covering all costs and not influencing the consumer in decision making.
The Effectiveness of the Regulatory Structure of the UK Financial Sector
The Financial Services Regulatory and Markets Act (FSMA) is obligated to set the standards. FSMA will always be remembered for coming with Financial Service Authority (FSA) for regulating the UK’s Financial Services Act (FSA). The financial regulation is further categorized into Financial Conduct Authority (FCA), which is mandated with protecting consumers, enhancing market integrity, and promoting fair competition. The FCA controls over 59,000 financial services and is governed by the Treasury and the UK Parliament (Six Degrees, 2020). Before setting up a business in the UK, firms need to register all the financial services through the FCA. The registration process takes 6-12 months to meet the regulatory standards, taking a fee for the approval. Second is Prudential Regulation Authority (PRA), which is mandated to regulate the banking system. The 3rd is the Financial Policy Committee (FPC) which mitigates the risks within the system and supports economic policies from the government. The roles of FPC can integrate to implement guidelines for testing the economic viability of firms. Financial regulation is continuous and dynamic as it challenges the law and the policies as the services diverge (Six Degrees, 2020). Therefore, financial institutions need a resilient and evolved regulatory framework (HM-Treasury, 2019). The FSMA act of 2000 is the foundation of the UK’s present regulatory framework. From the 2007-2008 financial crisis, the UK’s regulation system was found to be incoherent and unaccountable for their doings. An additional sector, Payment Systems Regulator (PSR), to regulate the payments systems in the UK, of the financial regulation was added in 2013.
With the development of the EU’s single market overtime for financial services, the application of the EU legislation has expanded. The expansion of the EU legislation came as a need to address the regulatory failure exposed after the financial crisis. The EU legislation comes as directives or regulations. Even after the EU legislation is in force, the member states should follow the EU law requirements. The UK financial regulation is faced with several challenges, which require the sector to grow and adapt to fit future goals. One of the critical challenges is operating outside the EU; the UK financial regulation is set in line with the EU’s level, and so there is a need for the framework to make new regulatory arrangements that fit outside the EU guidelines (Six Degrees, 2020). Another critical issue is new relationships; as the regulatory framework integrates beyond the EU requirements, the government hopes for a maintained UK-EU relationship in financial services, especially while trading. In addition, technical change also poses a significant area of concern with the race to use the most efficient or latest technological advances. The advances bring about consumers’ satisfaction as opposed to the outdated frameworks. Last but not least, the issue that reflects broader global challenges; the regulatory authority is supposed to carry out their duties while adhering to the international requirements.
The roles of the regulators in the UK regulatory framework include developing a policy with the HM-Treasury, research and evaluation, guiding the consumers and the firms and carrying out enforcement and supervision. The five central financial regulators in the UK are; the FCA, the PRA, the Bank of England, the PSR, and the Competitions and Market Authority (CMA) (Six Degrees, 2020). The financial sector is additionally subject to both sector-specific and cross-boundary regulations. The HM Treasury maintains and enhances the government requirements in the financial services legislation. The HM Treasury follows Cabinet Office Consultation Principles and the Better Regulation Framework requirements to make new legislation. FSA and PRA have the full responsibility of creating and amending rules under FSMA. The financial service regulators can act independently of the HM Treasury or the parliament, especially in rule changes, as long as they present a cost-benefit analysis (Buckle & Thompson, 2020). However, there are constraints to the free working of the regulatory services; for example, EU directives impact the new or proposed changes.
The Impacts of Brexit on UK Financial Regulation
Brexit is a combination of two words, Britain and exit, referring to the exit of the UK from the European Union (EU) (Noonan, 2022). The effects of the withdrawal large depended on the withdrawal terms, that is, the agreements placed. The EU has some laid down rules and regulations that must be adhered to by any of its members. Therefore, by the UK exiting from the union, the authority partially changes to adapt to the new or free state. Moreover, certain functionalities had been instilled in the UK through the EU, which cannot be easily abandoned. So, in as much as is longer answerable to the EU, the UK will continue to behave as a member of the EU before it fully integrates to other regulations. The financial sector is a crucial component in the economy; it fully determines the functioning of different sectors of the economy. The EU has a regulatory base for financial markets and transactions that its members must obey. Having withdrawn from the union, the UK will enjoy a lack of restraint from the EU and freedom in policymaking (Noonan, 2022). First, the UK has continuously integrated cross-border regulations in the financial systems; this has been made feasible by the good relations by the UK being a member of the EU. To assess the impact, we should first look at how much reliant UK was on the EU.
Although the UK exits the EU, the EU allows some free interactions with non-members but with a level of imposed restrictions. We are confident that the impact will be significantly felt on cross-border transactions such as deposit-taking, investment services, and payment services. Also, the UK has to suffer from loss of access to EU financial markets, which demands more regulations from the agencies. In addition, the transactional value changes brought about by the exit will impact financial regulation (Noonan, 2022). For example, the English law, which has a stable basis for EU members, reduced its rationale in the UK after Brexit. Moreover, Brexit allows the UK to develop the taxation system away from the EU’s principles of free movement.
As much as the UK expected some consequences from the exit, there are more than the intended consequences that have been felt. First, the rules and regulations, that is, the regulatory framework, protect EU members from the unfair competition (Ashurts, 2020). Therefore, Brexit allowed UK’s rivals to have a more considerable competitive advantage; only one year was enough for the UK to feel the pain of the exit; Britain’s big banks were already losing their competitive base to EU’s banks who were able to lend more cheaply to British corporates. UK banks are bracing for more impacts in the second half of 2022, notably tougher treatments in the business lending function. In addition, both the EU and UK have advanced in new financial regulations faster than ever experienced. The UK plans to overhaul the financial regulations to implement the latest Basel recordings of banking systems and create digitalized anti-money laundering regimes (Ashurts, 2020).
Also, because the UK experiences freedom of change from the culture of the EU, there are administrative costs associated with the UK using a different approach to regulations. Moreover, the UK experiences the need to increase regulations in their financial markets, especially concerning the increased potential of EU lenders doing more business in the UK (Buckle & Thompson, 2020). Another impact is seen in the need for a national regulator, rather than the refined standard rules; the UK feels uncertain of their competitiveness with their financial rivals. Furthermore, by creating the single anti-money-laundering Authority (AMLA), the regulations have taken a huger base in which the banks will have to deal with; the UK has increased the regulators such as the FCA, HMRC, the Serious Fraud Office, and the National Crime Agency, to curb money laundering (Ashurts, 2020).
Conclusion
In conclusion, financial regulation is essential for efficient and favorable economic conditions. Financial regulations are used to ensure that the financial systems do not take advantage of the consumer, who in most cases is uninformed; that is where we apply the theory of adverse selection. From the essay, it is clear that the financial systems will hide vital information from their consumers to benefit from the financial moves without financial regulations. Also, unregulated financial markets affect the financial suppliers because consumers would, in some cases, take risky and avoidable moves to benefit from the insurances or compensations (moral hazard)—moreover, the essay analyses the UK financial regulation and the rationale behind it. In the UK, for instance, the financial sector is significant and affects almost every other sector in the economy. For example, money laundering is rampant and needs regulators to ensure that the economy is void of such (Buckle & Thompson, 2020). Also, the banking system needs continuous monitoring and regulation to prevent jeopardy, that is, the banking crisis experienced in 2008-2009.
The financial regulators in the UK include the FCA, the PRA, the Bank of England, the PSR, and the Competitions and Market Authority (CMA); all these work together or independently, but to ensure a competitive base and for consumer protection (Buckle & Thompson, 2020). Finally, the essay tackles issues regarding Brexit and how it impacted the financial regulation in the UK. Brexit is a move made by Britain withdrawing from the EU. EU had progressively affected the functioning of the financial sector in the UK. That is to say, because the UK was part of the EU, most regulation in UK’s financial systems came directly from the EU. So, Britain withdrawing from the EU meant the creation of its regulation, as the UK saw them fit to adapt to the new changes and increase the regulatory base. In summary, the financial sector requires continuous regulation, especially in major political moves, such as Brexit; the UK gives us a general perspective of how financial regulation happens, including the benefits of such regulations.
References
Llewellyn, D. (2009). Occasional Paper Series x 1 The Economic Rationale for Financial Regulation. https://www.fep.up.pt/disciplinas/pgaf924/PGAF/Texto_2_David_Llewellyn.pdf
HM-Treasury. (2019). Financial Services Future Regulatory Framework Review Call for Evidence: Regulatory Coordination. https://assets.publishing.service.gov.uk/government/uploads/system/uploads/attachment_data/file/819025/Future_Regulatory_Framework_Review_Call_for_Evidence.pdf
Six Degrees. (2020, December 3). A Crash Course on UK Financial Regulatory Authorities. Six Degrees. https://www.6dg.co.uk/blog/uk-financial-regulatory-authorities/
Noonan, L. (2022, January 26). The UK faces unintended consequences of post-Brexit financial regulation. Financial Times. https://www.ft.com/content/bebc1162-55f5-4be8-af8b-4c66d422510e
Ashurts. (2020). Brexit: the potential impact on the UK’s banking industry. Ashurst.com. https://www.ashurst.com/en/news-and-insights/insights/brexit-potential-impact-on-the-uk-banking-industry/
Buckle, M., & Thompson, J. (2020). The UK financial system: Theory and Practice. Manchester University Press.
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