Question

What is the reason for banks needing to be regulated? Show how the current regulation tempers bank risks.

Answer 1

The most important reason for banking regulation is to address concerns regarding financial institutions ' security and stability, the financial sector as a whole, and the payment system. To stop bank runs, compulsory deposit insurance policies are implemented. Requirements for capital adequacy ensure banks are not exposed to too much. Lender measures of last resort relieve temporary illiquidity.

In banking, household deposits are considered to be liabilities, while provided loans constitute their assets. So the bank's balance sheet consists largely of liquid liabilities and illiquid assets. In any situation where the public was going to lose trust in the banking system, there would be a bank run. Knowing that a bank offers loans pooled from many small deposits, the liquidity is locked in long-term investments (loans). As a result, the bank will likely collapse due to its inability to account for the sudden increase in cash demand as a result of a bank run.

In general, the depositors, being a bank's investors, are not well informed about the investment activities of the bank. Moral hazard may arise when banks invest too risky at the expense of their depositors. Using a regulator on behalf of depositors to track banks offers confidence and retains their faith in the financial system. In fact, with government deposit insurance, it covers depositors and decreases the likelihood of a bank run that may result in the financial system collapse.

Governments, however, exert administrative pressure in other respects. Banks are increasingly being asked to assist in crackdowns on illegal and unethical financial transactions by identifying signs of money laundering, busting sanctions, bribery, and terrorist financing, and promoting tax collection. Governments also demand that their banks abide by national regulatory standards wherever they are operating in the world. For example, banks operating abroad must already comply with US rules on bribery, fraud, and tax collection. Regulations covering employment practices, environmental standards and financial inclusion will potentially be enforced in the same way