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Why Banking Regulation Should Be Made

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The Justification for Banking Regulation


Over the past few centuries banking regulation has become increasingly complex. That is because the banking sector has faced numerous changes and regulators have had to adapt to those changes, setting more ambitious goals that would ensure prudence whilst solving specific problems related to banks.

Asymmetric information and externalities are among the main issues that regulators have had to address, in light of the potential impact that could have on the banking industry. In fact, it is crucial that regulatory instruments should be developed in order to minimise the risks associated with them, considering that they could lead to market failures.

Although all market failures justify banking regulation, there are two specific issues that make regulation absolutely necessary, these being banks’ fragility and depositors’ inability to control banks’ management.

Banks’ fragility

The fragility of the banking system stems from the fact that banks hold mainly illiquid assets and liquid liabilities, which can cause bank panics, especially when banks do not provide consumers with suitable alternatives. For instance, Calomiris and Gorton(1991) observed that although several American banks failed between 1863 and 1913, their failure did not lead to particularly deep bank panics because currency was temporarily replaced by bank notes. Solutions like this were not developed in the 1930’s, which caused numerous bank failures. Although banks’ fragility is the main cause of bank failures, it is difficult to minimise and control, as it is their very structure that makes them vulnerable to runs.

As Freixas and Rochet (2008) pointed out, not only do bank failures have very negative effects on both creditors and borrowers, they can also damage the entire banking industry as interbank loans represent an important part of banks’ financial statements. Moreover, they may affect businesses’ solvency and endanger the whole payments system. Therefore, considering the significant impact that bank failures can have on both consumers, especially depositors, and the payments system, it is evident that banking regulation plays a key role in protecting the public.

In this regard, it could be argued that banks are not that different from nonfinancial businesses, seeing as when a nonfinancial business fails, it can damage its shareholders and other creditors just as significantly as a financial institution. Furthermore, similarly to nonfinancial businesses’ managers, banks’ managers do not want their banks to fail, unless they are suspected of unethical behaviour.

However, as Fama (1980) observed, there is a fundamental difference that distinguishes banks from nonfinancial businesses: while the latter are financed by voluntary creditors who are usually experienced and/or informed investors, the former’ credit providers are also their customers.

It should also be noted that even though nonfinancial businesses’ debt can be held by the public through bonds and shares, these are not used as payment methods and nonfinancial businesses’ debt-to-asset ratio is usually much lower than that of financial institutions.

Another issue that makes regulatory instruments necessary is the conflicts of interest that could arise within banks and insurance firms. For example, a bank could be managed by a number of shareholders who will obviously want to maximise their profits. They could do that by opting for risky investment policies which depositors would not probably accept, if they had a say in that matter. Therefore, it is important that a regulator limits banks’ managers decisional power, in order to protect depositors’ interests.

However, conflicts of interest are not only associated with banks whose capital is held by its own managers. In fact, large banks with external investors can face even more complex issues, as debtors, investors and managers’ interests tend to be very different, not to say incompatible. That is the case of managers who are solely interested in managerial incentives, which may encourage them to make imprudent decisions. As Freixas and Rochet (2008) observed, situations like this require the intervention of external regulators to threaten managers and discourage them from ignoring other stakeholders’ interests.

Dewatripont and Tirole (1993) devised a solution to resolve problems related to conflicts of interest. Considering that equity holders tend to be more risk-orientated, whereas debt-providers are more risk-averse, the former should be given control rights when banks perform well and the latter should be given control rights during critical times.

Liquidity risk and the 2007 Financial Crisis

The fragility of the banking sector described by Freixas and Rochet (2008) can certainly be considered to be one of the main causes of the 2007 Financial Crisis, which has led to a deep economic recession that has damaged not only the US economy, but also Europe and other countries across the world. (Baily, M. N. and Elliott , D. J., 2009)

Dowd (2009) argued that bonuses and other incentives combined with poor banking regulation are among the factors that have caused numerous brokers and bankers to make “unethical” decisions, without taking into considerations the needs and interests of depositors. In fact, moral hazards arise when someone representing a financial institution convinces someone to buy a financial product, although they know that it is not in their interests to choose that product. (Dowd, K., 2009) Also, a party may manage another party’s funds in an inappropriate way, just to be awarded significant bonuses. (Dowd, K., 2009)

Simkovic (2011) reported that during the early 2000’s, lenders became increasingly flexible about borrowers’ credentials, which led to numerous high-risk borrowers to be offered loans and mortgages.

In this regard, the Financial Crisis Inquiry Commission (2011) reported that decaying lending standards are among the main cause of the significant losses incurred by financial institutions between the late 1990’s and the early 2000’s.


Considering the weaknesses associated with the very structure of the banking system, the 2007-2008 financial crisis has revealed how fragile banks’ equilibrium can be. As Strahan (2012) observed, increasing precautionary demand for liquid assets (cash) from different sources has caused banks to encounter serious liquidity problems, to the extent that central banks have had to develop emergency lending programmes aimed at saving financial institutions. That clearly shows how deep an impact liquidity risk can have not only on the banking sector, but also on governments and the public, seeing as many governments have had to implement austerity measures in order to meet the requirements set by central banks in exchange for their financial support. (Lapavitsas, C., 2012)

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