To what extent can financial regulation correct financial market failure?

One type of regulation that could be used to correct financial market failure would be to impose a cash or liquidity ratio for commercial banks, to solve the issue of excessive and risky bank lending. A cash ratio for commercial banks is the amount of cash assets (so the amount of cash + reserves of the Bank of England) divided by the current liabilities (deposits and short-run borrowing by banks). Similarly, a liquidity ratio refers to current assets (cash, money at short notice, short-term investments and reserves of the bank of England) divided by current liabilities. For example, if a commercial bank had cash assets of £20 million and liabilities of £100 million, the cash ratio would be 0.2 (or 20%). This shows that for every pound worth of liabilities a commercial bank owes, they have 20p worth of cash assets to pay it off. The purpose of imposing or raising a cash ratio as a form of regulation is to reduce the risk of a liquidity crisis – that is, to make sure that banks always have enough cash to pay off short-term liabilities that it owes, even if there is a large number of individuals that wish to withdraw their money from the bank. By raising the cash ratio or liquidity ratio, it inhibits excessive lending by banks and means that they need to hold a larger proportion of the cash that individuals save in their bank accounts. This means that the amount of cash that the bank can use for loans falls, which reduces the risk of excessive spending and over-lending by negligent commercial banks. Therefore, this could be effective in reducing the risk of a similar crisis to the one in 2008.

However, such regulation may not be entirely effective in the UK economy. As mentioned previously, to meet an imposed cash ratio, commercial banks have to limit how much they lend out to retain reasonably large cash holdings. This may lead to a reduction in the money supply. The effect of a reduction in the money supply is to increase the rate of interest (can be shown on a diagram). This increased interest rate increases the opportunity cost of borrowing money, as firms and individual consumers could instead yield a great rate of interest by saving money in large interest-bearing accounts in commercial banks. This could therefore discourage investment and consumption, the 2 largest contributors to aggregate demand in the UK. Therefore, this could lead to a fall in the aggregate demand curve, and due to the multiplier effect, a fall in a component of aggregate demand or a withdrawal from the Circular flow of income leads to a greater than proportional fall in real GDP. The effect of this is that economic decline has occurred and unemployed has increased, with deflation occurring as the price level has fallen (can be shown on a diagram). This completely undermines the UK’s macroeconomic objectives. This is reinforced by the fact that as the rate of interest rises, there is a rise in the cost of mortgages for those on variable rate mortgages or those that wish to renew their fixed rate of mortgage, as this depends on the interest rate. This decreases incentives for house-buyers to buy a new house, whilst current homeowners are more likely to sell their house(s). So as the demand for houses is far outstripped by the supply of houses, it will lead to a decrease in the price of houses. This will lead to a negative wealth effect, which means that the marginal propensity to consume falls even further as consumers feel poorer, reinforcing the reduction in aggregate demand and the negative effects associated with this.