How the UK’s rollback of banking regulations could risk another financial crisis

After the global financial crisis of 2007-08^[1], the UK’s banking sector was placed under a much stricter regime. Bonuses were limited, regulations were beefed up and the whole industry scrutinised like never before.

The idea was to make banks safer places for everyone’s money. But regulators are now thinking about easing some of these financial safeguards in a bid to boost economic growth.

One proposal is to change the rules on mortgage affordability. One industry regulator, the Financial Conduct Authority, is considering relaxing the lending restrictions^[2] which were designed to prevent households from building up unsustainable debt.

This includes reviewing affordability tests^[3] and allowing banks to lend more freely^[4] to borrowers with smaller deposits or lower incomes. Some commentators argue^[5] that these changes will help first-time buyers and increase overall mortgage availability.

But the risks of easier mortgage lending cannot be ignored. Before the last crisis, lenders approved loans to borrowers^[6] without verifying income or creditworthiness, assuming that rising property values would provide a safety net.

And when interest rates increased and property values collapsed, many borrowers could not afford their repayments – and lost their homes^[7].

In fact, mortgage repayments are already becoming more difficult. The Bank of England has warned that over 1.5 million UK households^[8] will face significantly higher mortgage costs in 2025 after their current deals expire.

And loosening lending rules could easily push house prices even higher. When more buyers qualify for mortgages, demand for housing increases and prices go up. This makes home ownership even less affordable, especially for those first-time buyers.

Expanding access to debt without fixing underlying issues around housing supply only creates more financial risk^[9]. And it seems to be part of a broader trend towards deregulation.

Internationally agreed banking rules^[10], which require banks to hold more capital as protection against financial shocks, are being delayed in the UK until 2027^[11]. The Bank of England has justified the wait by saying that banks need more flexibility to increase lending and investment without the constraints those rules would bring.

Banks are also challenging regulations^[12] that require them to hold on to a specific type of debt^[13] designed to ensure that failing banks can absorb financial losses without taxpayer bailouts. But if these rules are weakened, the banking system could become more fragile, forcing governments to intervene.

The banking system is showing other signs of fragility too.

One worrying trend^[14] is the increasing use of something called “synthetic risk transfers”^[15]. This is a technique that banks use to reduce the amount of risk on their balance sheets, by transferring it to outside investors – such as hedge funds or insurers – through special financial contracts.

These are sometimes compared^[16] to “collateralised debt obligations” (or CDOs), where a bank bundles multiple loans (such as mortgages, corporate debt or car loans) and sells portions of that bundle to investors. These complex transactions were a key factor^[17] in the global financial crisis because they concealed risky loans, spreading financial instability across global markets.

Then there’s the UK’s motor finance sector^[18], where lenders have been accused of charging excessive interest rates^[19] on car loans. This could lead to compensation claims of up to £44 billion^[20], making it potentially one of the biggest consumer finance scandals^[21] since payment protection insurance (PPI)^[22].

On that occasion, banks and lenders wrongly sold PPI to millions of customers, leading to a record £50 billion^[23] in compensation payouts.

With the ongoing case of motor finance, the British government wanted regulators^[24] to limit compensation payouts to avoid disrupting financial markets, but this was rejected by the supreme court^[25].

Yet despite these problems, some still claim that deregulation will do wonders for the sector’s financial flexibility. The British chancellor Rachel Reeves has argued^[26] that relaxing some regulations and reducing red tape will encourage growth and increase the UK’s competitiveness in global financial markets.

Perhaps she agrees with Donald Trump, whose aggressive financial agenda^[28] includes relaxed capital requirements and weakened regulatory oversight.

But past experience suggests that weakening financial safeguards and encouraging more debt in pursuit of short term growth can have severe long-term consequences^[29].

Research shows that financial deregulation often leads to financial instability and economic crises^[30]. It also suggests that expanding credit does not fix housing affordability^[31], and that reducing capital requirements does not make banks safer^[32].

The global financial crisis was a direct result of excessive risk-taking in an underregulated system. Governments had to bail out banks with taxpayer money, leading to more than a decade of austerity.

The same mistakes could happen again^[33]. For now though, it looks like some of those hard lessons have been forgotten.

References

1. ^{^} financial crisis of 2007-08 (theconversation.com)
2. ^{^} relaxing the lending restrictions (www.bbc.co.uk)
3. ^{^} affordability tests (www.onlinemortgageadvisor.co.uk)
4. ^{^} lend more freely (www.bbc.co.uk)
5. ^{^} Some commentators argue (www.express.co.uk)
6. ^{^} lenders approved loans to borrowers (academic.oup.com)
7. ^{^} lost their homes (www.thisismoney.co.uk)
8. ^{^} 1.5 million UK households (www.independent.co.uk)
9. ^{^} more financial risk (academic.oup.com)
10. ^{^} Internationally agreed banking rules (www.investopedia.com)
11. ^{^} until 2027 (www.bankofengland.co.uk)
12. ^{^} challenging regulations (skynews.icu)
13. ^{^} type of debt (www.risk.net)
14. ^{^} worrying trend (www.imf.org)
15. ^{^} “synthetic risk transfers” (www.daytrading.com)
16. ^{^} sometimes compared (papers.ssrn.com)
17. ^{^} key factor (www.sciencedirect.com)
18. ^{^} motor finance sector (www.which.co.uk)
19. ^{^} charging excessive interest rates (theconversation.com)
20. ^{^} up to £44 billion (www.theguardian.com)
21. ^{^} consumer finance scandals (www.theguardian.com)
22. ^{^} payment protection insurance (PPI) (www.bbc.co.uk)
23. ^{^} record £50 billion (www.ftadviser.com)
24. ^{^} wanted regulators (www.ft.com)
25. ^{^} rejected by the supreme court (www.reuters.com)
26. ^{^} has argued (www.gov.uk)
27. ^{^} Oksana Valiukevic/Shutterstock (www.shutterstock.com)
28. ^{^} agenda (www.ft.com)
29. ^{^} severe long-term consequences (www.imf.org)
30. ^{^} financial instability and economic crises (www.sciencedirect.com)
31. ^{^} does not fix housing affordability (www.jstor.org)
32. ^{^} does not make banks safer (academic.oup.com)
33. ^{^} happen again (obr.uk)