Why Banks should be Regulated - Research Paper Example

Why Banks should be Regulated Introduction Regulations are established to avert abuses such as monopoly, corruption, and fraud among others. With regards to banks, some people advocate for their regulation while others are opposed to the idea. I am a strong believer of a free-market economy, who does not support the red tape of the government choking the life out of businesses. However, I believe banks should be regulated for the good of various nations as well as for their own good. According to Dow (1996), the regulation of the banking sector is vital because of its role within the economy, as well as, the insecurity associated bank failures. Banks fuel economy of various nations via provision of credits and money circulation. People trust that banks will keep their monies safe, and it is from the deposits that banks find capital to operate; therefore it can be said that banks symbolize trust of the people. What happens when that trust is broken, and bank runs occur? The failure of a leading bank causes a public panic, which spread all through the entire banking industry and the economy. In addition, the panic contagion may also spread overseas, consequently engulfing the entire globe. The fall of Lehman Brothers and Bear Stearns in 2008 is evidence to the panic contagion (Stockfessor, 2012). For instance, the United States suffered a key bank run in 1929, after which the Great Depression took place. Another example is the 2008 economic meltdown that nearly toppled the key players in the banking industry, and as a result, a significant recession occurred, whose impacts are still being felt to date. This paper discusses the reasons why the banking system should be regulated. Before looking at regulation of the banking system, let us examine the kinds of banks existing in the banking sector. According to Stockfessor (2012), there are two types of banks i.e. commercial and investment banks. Examples of commercial banks include JPMorgan Chase, Citibank, and Bank of America among others. Investment banks include Morgan Stanley, Goldman Sachs etc. Commercial banks receive deposits from the public in the form of saving, retirement and checking accounts. In case of bank failure, the United States government assures every account holder an amount permitted by the law via Federal Deposit Insurance. However, the government necessitates commercial banks to conform to the set rules and practices in the banking sector i.e. their sole purpose is to receive deposits and give loans. The government expects Commercial banks to earn their profit via the interest they charge on loans, and are forbidden from engaging in risky businesses such as trading stocks or underwriting to make extra profit. Investment banks, on the other hand, have more autonomy for operation. Their clients are mainly investors who are willing to take high risks in financial products, stocks, as well as underwriting new companies. Incase of failure of these banks, the government does not provide them with any Federal deposit insurance owing to the high risk of their ventures (Stockfessor, 2012). The Reasons Why the Banks Should Be Regulated History of Economic Failure It is vivid from the American history that a majority of the economic problems experienced in the last two centuries were caused majorly by speculators and banks. The bank panics experienced in the 1800s and the Great Depression are examples of how the banking system contributed to the financial difficulty of numerous hard-working American citizens. Following the Great Depression, the Glass-Steagall Banking Act was enacted in 1933, to avert public panics in the case of bank runs. The Act prohibited commercial banks from engaging in speculative and risky ventures and transferring their losses to the government via the deposit insurance scheme. Consequently, economic prosperity and stability reigned in the US for more than seventy years. However, the reforms brought about by the Act were destroyed quietly, and what followed was the unprecedented act by the US Congress in 1999 to vote against the Glass-Steagall Act with an intention of adopting the Gramm-Leach-Bliley Act (Stockfessor, 2012). I am of the opinion that the banking sector either through bribery, or intense lobbying, influenced the Congress to oppose the Act. As a result, commercial banks have been able to utilize people’s money (deposits) to engage in risky ventures like trading securities and derivatives. Additionally, investment banks, in conjunction with brokerage firms have also been able to receive deposits from the public through opening retirement and checking accounts. The results have been enormous: the banks have wildly pursued risky ventures with the public’s money, and when they fail, it is the government to foot the bill. For instance, AIG lost $750 billion in the 2008 financial meltdown, and the American government fully bailed them out (Hope to Prosper, 2012). I am of the opinion that banks will continue to ignore and undermine reforms aimed at bringing sanity in the banking sector, and still do risky businesses that put the public’s money and the entire economy at stake. Therefore, regulation of banks either by the government, or other nongovernment bodies is vital, to prevent the occurrence of similar economic problems in the future. Those opposed to the regulation of banks should learn from the 2008 financial crisis, which pushed the economy of the world to the brink of collapse, and led to million of jobs being lost, and see sense in advocating for the regulation of the banking system. Excessive Leverage is Legal According to Hope to Prosper (2012), financial institutions utilize considerably high leverage in order to maximize profits. An example is the MF Global collapse that took place recently, where customers’ deposits worth $1.6 billion went missing. Forbes reported the leverage ratio of the company to be 80:1 in 2007, but by the time of its collapse, the ratio was 40:1. By regulating the banking system, such enormous leverages and risks will be made illegal. Too Big To Abide By the Law Large financial institutions have strongly resisted financial reforms, prior to and following their enactment. They have stifled modifications of loans and re-ordered transactions so as to collect from customers billions of dollars in overdraft fees (Hope to Prosper, 2012). In essence, they act as if they are above the law. Till the executives of such banks are imprisoned for going against the law, they will always continue to do so, and that is why regulations of banks are vital to bring the necessary reforms within the banking sector. Bailouts are Unavoidable A majority of significant political positions within Treasury and Fed are held by bankers, who have strong attachments with the banking community (Hope to Prosper, 2012). It is likely that when there is another pressure of economic crisis, President Obama and the Congress will be forced to give in to bailouts in order to save the American economy. Therefore, evading future bailouts necessitates that solid regulations be established, that will prohibit banks from taking extreme risks that put the country’s economy at stake. Conclusion The series of financial crises that have happened in the past such as the Great Depression and the 2008 economic meltdown, coupled with the lack of free market forces, to regulate banks is a reason enough not to trust banks to regulate themselves. With the current freedom at their disposal, banks will continue to engage in risky businesses due to the excessively high profits they attain from them, all at the expense of the public’s money and the whole economy. Therefore, in order to prevent future financial crisis, governments have a moral responsibility to step in and regulate the operations and activities of banks in an attempt to protect the interests of their economies and people. References Dow, S. C. (1996). Why the banking system should be regulated. The Economic Journal, 106 (436), 698-707. Hope to Prosper (2012). “10 reasons why banks must be closely regulated.” Retrieved 12 Nov. 2012, from http://hopetoprosper.com/10-reasons-why-banks-must-be-closely-regulated/ Stockfessor (2012). “How should banks be regulated?” Retrieved 12 Nov. 2012, from http://stockfessor.wordpress.com/2012/05/21/how-should-banks-be-regulated/ Read More