Banks are central to the economy and they provide financial services that help us live our lives. But why is banking and finance regulated? And what is ‘maturity transformation’, ‘open banking’ and the ‘regulatory sandbox’? Find out in this overview of banking.
When the bank robber Willie Sutton was asked why he robbed banks he is supposed to have said, “Because that’s where the money is.”
Mr Sutton was right. Banks are where most people store their salaries and savings.
Banks are also central to payments and enable so-called ‘maturity transformation’ when they offer loans and mortgages.
Why are banks closely regulated?
Keeping money secure, supporting payments and managing the risk of maturity transformation makes banks central to the economy.
That is why banks in the UK have to be licensed and have to pay into the Financial Services Compensation Scheme (FSCS). If a bank fails, the FSCS will cover deposits up to £85,000 per individual account holder, for each separate bank account they hold.
The government tries hard to ensure that banks won’t fail. They are closely regulated by the Prudential Regulation Authority (PRA) and by the Financial Conduct Authority (FCA).
The PRA sets the rules that try to ensure that 1,500 banks and insurers run their businesses in “a safe and sound way”. The PRA wants to make sure that the failure of a bank or insurer would not threaten the UK economy.
The FCA focuses on keeping financial markets “honest, fair and effective”. It protects consumers and businesses.
What is maturity transformation?
If banks have to be licensed and there is a Financial Services Compensation Scheme, why are there so many rules around what banks do?
‘Maturity transformation’ means turning the short-term liabilities of deposits into long-term lending like mortgages and loans.
But because people can withdraw the deposits in a current account any time they want, maturity transformation is a risky business. It is also fundamental to economic growth as it underpins investment.
For example, most people can’t afford to make big purchases like a car or a house without borrowing money and paying it back over an extended period of time.
The average disposable income in the UK – that is the money after taxes and benefits – was £30,800 in 2020, according to the Office for National Statistics.
But the median price paid for a semi-detached house in 2020 was £197,000 in the West Midlands, £548,000 in London and £140,000 in the North-East.
So, the majority of people in the UK would never be able to afford to buy a home without access to a mortgage.
The same principle applies to many businesses: they need to borrow to invest in a future asset.
We’re very used to the idea that loans and mortgages are available, so we can forget how important they are and why regulation is needed.
Open banking and the regulatory sandbox
Regulators have good reason to try to make sure banks are stable and treat their customers fairly. But they don’t want the stability of the graveyard.
To encourage competition, the UK regulators have introduced the regulatory sandbox, where new digital financial services ideas can be tried out without the need to get a full licence and without risk to consumers.
And they have also brought in open banking, which requires banks to enable customers to share their financial data with other service providers. That will make it much easier for, say, innovative payment service providers to enter the market.
Banking is still banking
Although regulators want to see innovation and competition that helps lower costs and improve services, they’re mindful that banking is about managing risk.
That risk, and the regulation that goes with it, are why big tech companies like Apple, Amazon and Google have not – or at least not yet – sought to become banks – even though all of them are increasingly active in financial services.
The rise of banking as a service – where regulated institutions underpin ‘white label’ banking products marketed under another brand – may encourage companies to enter the fray without becoming a bank.
Even so, what banks do will still be important.
Find out more about our Centre for Digital Banking and Finance