Rationale for Bank Regulation - Essay Example

RATIONALE FOR BANK REGULATION Rationale for Bank regulation Introduction The reason as to why banks are regulated seems to be a perplexing concern from most of the banking industry stakeholders. There seems to be no reasonable policy that can justify regulating banks. Most of bank regulations are enhanced through the central banks, which performs the function of macroeconomic and microeconomic. The two activities are closely related since they are aimed at achieving and maintaining micro-level financial stability in payments and banking systems (Goodhart, 2000). In United Kingdom the two function are don separately, and the authority mandated to supervise financial institutions is the Financial Services Authority (FSA). The conventional explanations that have been used to justify regulation of banks include the inherent bank instability, insurance of the depositors, or the role federal government in making monetary policies. Regulation of banks originated from microeconomic apprehensions in relation to the ability of the banks to monitor the risks originating on the lending side and from macroeconomic and microeconomic apprehensions over the stability of the banking system in case bank crisis occurs. There has been instances where the government has used informal measure to control the outcome of the banking sector. The transformation of banks since they emerged from being mediaeval goldsmith is not significant, this is because their main objective from this time has remained to be borrowing and lending. There are various costs that are met as a result of regulation. It is very ironic that despite the fact that banks are characterized with various regulatory body they are bound to collapse in certain unfavorable economic conditions. The debate of financial systems and banks regulation took a new turn during the financial system that broke in 2008. The symptoms of crisis emerged in the UK and US in 2007, but they became persevere in the year 2007. Rationale for bank regulation One of the reasons as to why banks should be regulated is the fact that they are inherently unstable. There is no doubt that banks in comparison to other forms of business are inherently unstable, this is because the deposits made in the banks are withdrawn upon demand. This will then cause a panic “runs” which ay in turn make the business to become solvent. The basic and most rationale given for regulating banking industry is safety and stability concerns (Baltensperger, 1989). All the banks operate in conditions of fractional liquidity reserve. As stated earlier the greatest majority of banks liability is the issue of liquid deposit that is redeemable on demand. Banks assets are much more in form of illiquid loans. Which now raises the query that if all the depositors decided to as for their deposits at the same time the bank will be at a tight position and it might be unable to meet this obligation. Another major concern is bank run, which is a situation that occurs when depositors rush to the bank to withdraw their deposits since they presume that the bank is in a state of insolvency. The other reason is that banks have the risk of moral hazard. The loans that the banks grant are based on the deposits that these banks receive. It can be said that this is not a prudent way and it is too much risk. Regulation helps to avoid negative outcomes for the economy of widespread bank failures Berger, Kashyap and Scalise, 1995). There are two major assertion that can explain the reason as to why banks should be regulated. The first argument deals on the systematic dangers of failure of bank, and the other assertion is to manage the security and stability in the payments system. From this assertions in this paper it is clear that the bank should be regulated because of banking crises and banking the failure of individual banks. Banking crises are the crises of a banking system, which occur when there is failure or an almost failure of banks that put in risk many of a country’s savers, consumers, business credit, or the payment systems of country’s operation. The banking industry of the banks in today’s world are highly networked, any failure of one individual bank can cause a spill over to the whole industry ether locally or globally. Failure in an individual bank can be experienced as a personal crises for depositors, shareholders, or bond holders but does not constitute to the banking crisis. Prudential regulation is the most prominent form of bank regulation, it is mainly concerned and involved in the regulation of individual banks. Prudential regulations ensures that the individual banks strictly adhere to required balance sheet ratios and other important regulation. Prudential regulation therefore, oversights the risks of individual banking from failing. Banking crises should be avoided at all cost and this is a major rationale for regulating banks (Heller, 1991). Banking crises are prone to have huge economic costs, one of such indicator of such costs is the significant rise in government debt. The government might be forced to increase its borrowing as a response to the crisis, which can be because the government want to bail out the banking system. The crises also cause a decline in tax revenues that will result to an economic recession. Moral hazard The central government has a deposit insurance and it is normally controlled by the government, it will be thus not reasonable to claim that either the taxpayers or the government are at risk of bailing out depositors when the banks fail. Banks are sometimes required to increase bank deposit insurance premiums by the regulators whenever the insurance fund falls below 1.25% of the total insured deposits. The regulators are required to increase premiums on banks from time to time, which is meant of replenish the finances that back the promise of deposit insurance. The regulator is required to tax all the insured institutions anytime it requires to pay off depositors of a failing bank, which means that the capital of insured depository institution has become the key guarantor of the deposit insurance system. The amount is worth billions of euros, and is arguably very sufficient to protect insured depositors under any uncertain economic condition. Realistically the federal government and the taxpayers are not liable in any sense to insure deposits (OECD, 1997b). Therefore, the regulation of insured depository institution is not specifically meant to protect the taxpayers or the government against losses from failed banks. This argument raises some concern, for instance, if all the depository institutions are obligated for the losses suffered by depositors in the few institution that fail, then banks should have more of a say in the regulatory policy as well as the manner in which the insurance funds are administered. It is also a matter of concern to question that if the main government interest is to assure that small depositors have a safe place to deposit their funds, is it not sufficient to require that small deposits have preference over all other creditors when the bank fails? Deposit insurance are definitely very important since they guarantee the depositor’s debt is honored in case the bank is declared bankrupt. The occurrence of incentive to “run” is reduced by deposit insurance when the bank is facing financial difficulty (Baltensperger, 1989). Rumors of insolvency and illiquidity situations are that often lead to bank failure are greatly reduced. One of the major disadvantage of deposit insurance is on the part of the insurer since, since depositors will view all banks equally attractive (Kaufman, 1996). The incentive of the depositor to determine the risk of a bank is eliminated by this regulatory measure. The effectiveness of this form of regulatory measure can be enhanced by incorporating forms of regulation. If deposit insurance are extended to all deposits, done by decreasing the market incentives for cautious management can result to the incentive of making banks riskier. This is a moral hazard that can extend to all financial institution, and the macroeconomics outcomes that can result from this scenario can be very significant. Oral hazard problem and the necessity of additional regulatory measures can be decreased if the insurance problems is related to the risk of the insured bank. Concept of Free banking Free banking is a concept that means a monetary system without a central bank. Issuance of currency and deposit money legally left to unrestricted private banks. This concept was very common in the 19th century especially in Scotland where the notion of unrestricted banking system worked perfectly end effectively. Today the banking industry is characterized by numerous regulation especially the concept of central a regulatory body. But in recent times the central banks have proven not to be so effective in prevention and controlling of inflations, which has made many economists to question the role of the government in issuing money (White, 1984b). Those who argue against the role of the central bank claim that money should be supplied competitively just the same way competition is achieved in supplying other goods. This concept of competitive money supply is what is been referred to as ‘free banking.’ Since the major role that banks played in the future and in present have not changed much, free banking in the present times can mean a banking system with competitive note issue, minimal or no legal barrier to entry, and central control of reserve is absent. The traditional regulation mechanisms and alternative regulation mechanism In the traditional regulation mechanisms, the commercial banks were controlled heavily through imposition of restrictions related to entry into the banking industry, chartering of new banks and other statutory restrictions on the already established banks. Existing banks were limited on how to react to respond to certain types of operations, especially those affecting individual banks. There were also limitations on the extent to which existing banks could expand into the market by establishing more branched throughout the country. The acquisition of funds in bank deposits and the composition and acquisition of investments and loans of the commercial banks were also restricted. The traditional regulation mechanisms had only one purpose in the banking industry, which is to instil public confidence in the banking industry by ensuring sound operations of individual banks (Santos, 2001). Nevertheless, the traditional regulation mechanisms have faded as a practice in most of the banks due to the reforms in the industry. Instead, alternative regulation mechanisms have been introduced to replace them in response to the financial innovations which have transformed the fundamental economic forces towards intense competition in the market. The intense competition has led to the undercutting of the position of the banks in the loan market as well as weakening the cost benefits that the banks derived from acquiring funds. The alternative regulation mechanism are classified into three major categories which are the market-based instruments, information and education schemes and self-regulation and co-regulation approaches. For purposes of this paper, market-based instruments will be analyzed to give a glimpse of the reforms in the banking sector (Beck, Asli & Maria, 2007). The role of the market-based instruments is to modify or change the behavior of the banking trends through the application of economic incentives to businesses and to the public. They seek to fundamentally provide trading and financing opportunities to businesses and citizens in area where such opportunities are non-existent by transformation of the relative prices. An example of such trading schemes can be illustrated by the government’s move to regulate trading activities by issuing permits such as permits allocated to regulate emissions in the production of carbon dioxide. However, the government allows for the banks to trade the permits amongst themselves. In this case, the government has the ability to specify the emissions levels permitted but individual companies are not limited discriminatively. The market - based instruments also use fiscal measures in terms of subsidies and taxes to control the conduct of the firms. Subsidies are used to motivate firms to increase or improve their consumption or production activities if such activities or their products are considered to be desirable by the government. On the other hand, taxes are imposed in order to discourage the consumption or production of products that involves harmful practices. The main aim of taxes is to raise the price so that the products are very expensive for many people to consume them. For instance, tobacco manufacturers face imposition of taxes of the tobacco products which are considered harmful. This makes them expensive, thereby discouraging consumption (Santos, 2001). Empirical evidence showing regulation increase risk-taking incentives of banks There has been lack of clear empirical evidence showing the relationship between regulation and risk-taking incentives of banks. This is because the risk-taking incentive of banks is influenced by the moral hazard problem that is caused by either implicit or explicit government guarantees, such as when shareholders are allowed to increase their stake in the firm. There are several studies that have been conducted to examine the relationship between regulation and risk-taking incentives of banks. An empirical study conducted by Keeley and Furlong (1990) sought to defend the premise that, regulation increases the risk-taking incentives of banks by refuting the Mean-variance framework which had been proposed to examine the relationship between regulation and risk-taking incentives of banks. The mean-variance framework, as proposed by Kim and Santomero (1988), Koehn and Santomero (1980) and Kahane (1977), led to the conclusion that bank regulation had an opposite effect on the risk-taking incentives of the banks thereby resulting in an increase in the overall portfolio risk. In this framework, any changes in the capitals structure of the bank is positively correlated with the portfolio risk. An empirical study by Keeley and Furlong (1990) found the Mean-variance framework inappropriate to study the relationship between bank regulation and the risk-taking incentives of the banks since the framework does not take into account the option value of deposit insurance. These authors examine the relationship in a more comprehensive ways using a contingent claims mode. The results from the study indicate that banks would not be pushed to increase their portfolio risks simply by increasing their capital standards. This is because an increase in the capital structure of the banks have an effect of declining the incentives associated with risk-taking practices (Jeitschko & Jeung, 2004). Conclusion The reason that we regulate banks is very certain that is because of the inherent risk and instability nature of the banking system. There is great importance in regulating and governing banks to ensure that depositors are protected. The problem of bank failure is very realistic and prudential regulation should be used to address this problem. Regulatory intervention is critical since it helps to protect depositors, regulation of bank settlement is done in a coherent manner, and information is made available. The regulation should however recognize the occurrence of moral hazard and make sure that regulation system should promote an open, competitive, banking environment that does not advocate for unjust restriction. The separation between the enforcement of prudential regulation and general competition riles should be well defined in the regulation of the banking sector. It is also very important for the banks to make sure that there is a conducive working environment with regulatory agencies and work closely to effect the efforts of reviewing particulars concerns in banking system. References Baltensperger, E., (1989). "The Economic Theory of Banking Regulation" in Furubotn and Richter, eds, The Economics and Law of Banking Regulation, p 1. Berger, A.N., Kashyap, A.K., and Scalise, J.M., (1995). "The Transformation of the U.S. Banking Industry: What a Long, Strange Trip It’s Been", Brookings Papers on Economic Activity 2:1995, 55-217. Beck, Thorsten, Asli Demirguc Kunt, & Maria Soledad Martinez Peria (2007) “Reaching Out: Access to and use of banking services across countries,” Journal of Financial Economic. Diamond, D. and Dybvig, P.H., (1983)."Bank Runs, Deposit Insurance and Liquidity", Journal of Political Economy, 91, 401-419. Goodhart, S., (1995). “Should the Functions of Monetary Policy and Banking Supervision Be Separated?” Oxford Economic Papers, 47, 539–60 Heller, (1991). “Prudential Supervision and Monetary Policy‟, in J. Frenkel and M. Goldstein, eds, Essays in Honor of Jacques Pollack. Washington, DC: IMF, 269-281 Jeitschko, T.D., and S.D. Jeung, (2004), Incentives for risk-taking in banking- a unified approach, Journal of Banking and Financein press. Kaufman, G., (1996). "Bank Failures, Systemic Risk and Bank Regulation ", Cato Journal, vol 16, no. 1, p 17, OECD, (1997b)"Regulatory Reform in the Financial Services Industry", The OECD Report on Regulatory Reform: Volume I, Santos, J.A., (2001), Bank capital regulation in contemporary banking theory : A review of the literature, Financial Markets, Institutions and Instruments, 10, 41–84 White, L.H. (1984b). Free Banking in Britain: Theory, Experience and Debate, 1800–1845, New York and Cambridge: Cambridge University Press. Read More