Question

Discuss the underlying rationale for regulating banks and examine the potential costs associated with regulations.

Answer 1

The underlying rationale for regulating banks

Banks in countries around the world contribute immensely to the economic growth and development. They do so by contributing to a country’s payments mechanism and credit system. For this reason banks are among the most regulated firms in countries everywhere including United States.Yet, the US subprime mortgage market meltdown and the associated credit crunch that emerged in 2007 showed more the need to reform the current banking regulatory system.
Bank regulation is concerned primarily with ensuring that banks are financially sound and well managed. In the United States, this concept is referred to as safety and soundness regulation and in most of the rest of the world as prudential regulation. Banks are also subject to many other forms of regulation, including consumer and investor protection requirements.

• Banking regulation originates from microeconomic concerns over the ability of bank creditors (depositors) to monitor the risks originating on the lending side and from micro and macroeconomic concerns over the stability of the banking system in the case of a bank crisis.
• In addition to statutory and administrative regulatory provisions, the banking sector has also been subject to other kinds of government regulations, i.e., the government’s use of its discretion, outside formalized legislation, to influence banking sector outcomes (for example, to bail out insolvent banks, decide on bank mergers or maintain significant State ownership).

• When a bank fails, it can create problems for the wider economy. People and businesses can lose money they have placed with the bank. This can mean they also lose confidence in the banks so are unwilling to bank with them again. It can also disrupt the services that banks provide to customers. For example, payments systems – one might not be able to use his/her account for a while if the bank failed.

• Banks can fail for a number of reasons, for example: 1) If they make poor investment decisions and not enough profits and become insolvent.
  2) If people and companies who have put their money in a bank account take it out quicker than the bank can manage which is reffered to as bank run.
  When banks fail, they can also make it more likely that other banks will fail alongwith them, too. The 2007-2009 financial crisis showed that problems can spread from one bank to another, like a fire spreading.

• Altough, banks’ managers and owners understand these risks, but as businesses they also need to make profit. When trying to make profit they have sometimes not acted as safely as depositors or investors would like them to resulting in financial crises at different times. When banks are doing well and making money they might take too many risks by getting overconfident.

• When trying to make money banks have sometimes sold products that aren’t suitable for their customers. For example, some banks made billions of pounds from miss-selling PPI (payment protection insurance) to their customers. Regulation and strong supervision can help stop banks making similar mistakes in the future.

• Individual banks also won’t think about how their actions could affect other banks, the whole financial system and even the wider economy.

• Financial crises created by bank fails can cause people to lose their jobs, or face pay cuts, and to suffer from a higher cost of living. On their own, banks don’t take this into account when making the financing decisions – banking regulation ensures that they do take care while conducting their banking business.
  Regulation helps to reduce many of the problems that could get a bank into financial difficulty. This will mean there will be fewer bank failures in the future.

• Regulation helps make sure that banks have good management so they don’t make bad investments that are too risky. Regulation also makes banks hold shock absorbers to help deal with bad investments/ bad loans. These shock absorbers are referred to as adequate capital reserve requirements.
  Regulation is used to make it less likely people will take out their money unexpectedly. There is a deposit guarantee insurance scheme that ensures that even if a bank fails all deposits under a certain amount will be protected. For example, the Federal Deposit Insurance Corporation (FDIC) insures depositors of banks, and savings and loans up to US$250,000, and regulates state-chartered banks that are not Federal Reserve members.
  Banks also have to hold cash (or assets that can be sold very quickly) to cover unexpected withdrawals. This should help make bank runs less likely.

• Another justification for regulation arises from the existence of information imbalances (“asymmetries”). In a well-functioning financial market, buyers and sellers possess all the information needed to evaluate competing financial products or services offered. Buyers and sellers must be able to identify the alternatives available and understand the characteristics of those products/ services. Yet, information is a commodity like any other, and markets for information can fail like any other. For example, one of the parties to a transaction may deliberately seek to mislead the other, by conveying false information or failing to disclose key facts (e.g. disclosures in securities offerings).

• A key part of bank regulation is to make sure that banks hold enough capital to ensure continuation of a safe and efficient marke. The principal international effort to establish global capital requirements has been the Basel Committee on Banking Supervision, which published the Basel Accords. Their purpose is to impose a framework on banks for holding and calculating adequate capital. Based on the Accords, banks must determine capital ratios and capital adequacy.
  In 1988, the Committee introduced a capital measurement system commonly referred to as Basel I, which was replaced in 2004 by Basel II,which was again followed after the 2008 global financial crisis by Basel III, which is phased in through 2019.
  One of the key bank ratios is the capital ratio, which represents the ratio of a bank’s capital to its risk weighted assets.  

• The Basel Accords, especially the Basel III accord which came into effect in the wake of the financial crisis of 2007-2008, ensure capital adequacy of financial institutions.
  “Basel III” is a comprehensive set of reform measures developed to improve the banking sector’s ability to absorb shocks arising from financial and economic stress; improve risk management and governance; and strengthen banks’ transparency and disclosures.

• In recent years regulation in banking has shifted from structural regulation to more market oriented forms of regulation. As a consequence competition for the banks has come to play a very important role in the allocation of credit and in the improvement of financial services. The capital requirements framework created by the Basel committee led to the development of stronger competition in banking. All over the world, banks now face greater competition both from new entrants in the banking sector and from other financial companies.

• Since the creation of the Federal Trade Commission in 1914, the federal government has had a formal obligation to protect consumers across industries. Since then, numerous laws and regulations have been crafted by various agencies to protect bank customers and promote fair and equal access to credit.
  Banks conduct financial transactions with consumers either directly (lending to consumers and taking consumer deposits) or indirectly (through financial technology on the front end, for example). Banking regulators enforce consumer protection regulations by conducting comprehensive reviews of bank lending and deposit operations and investigating consumer complaints.

• Since a competitive banking system is a healthy banking system, banking regulators actively monitor U.S. banking markets for competitiveness and can deny bank mergers & acquisitions that would negatively affect the availability and pricing of banking services.

• The Federal Reserve is a lender of last resort to the U.S.banking system. Regulation protects the Fed and the FDIC against losses that might occur to them when the Fed lends to banks that later fail.

• The Fed, through the Federal Reserve Banks, operates the payment system in which banks transfer funds among themselves. In the process, the Fed takes the risk of transferring good funds intra-day on behalf of a bank that may fail before final settlement occurs at day’s end. Regulation of banks protects against that risk also.

Potential costs associated with Banking Regulations

Regulation appears to account for a small share of banks' costs. Studies have shown that total cost of all bank regulations in 1991 (the year for which most of the studies were conducted) may have been about 12 percent to 13 percent of banks' noninterest expenses.

The total cost of a regulation is the cost of performing all the activities that it requires.
Incremental costs--the costs of those required activities that are undertakenby the banks only because they are required for the regulatins --may have been about half of the total regulation cost.

The finding suggests that smaller banks, relative to larger banks, have a cost disadvantage that may discourage the entry of new firms into banking, may stimulate consolidation of the industry into larger banks, and may hinder competition among institutions in markets for specific financial products. It also suggests the possibility that regulation in the early stages of the product life cycle i.e. when output is low and average regulatory cost would be high, regulations will discourage the introduction of new financial services.
One survey found that the start-up costs of complying with a new regulation were not affected by the number of changes required to bring a bank's practices and policies into compliance with the regulation. This would mean that applying regulations generally to address the practices of a few institutions would impose costs on all institutions.
The finding also suggests that a regulatory policy of making frequent minor revisions to regulations might be more costly to banks than one of making infrequent major revisions.

When banking regulations restricts entry of new banks into the market, cost of credit becomes higher and chance of getting access to credit becomes lower. The only benefit of these restrictions is a lower proportion of bad loans.

The cost of regulation consists of opportunity and operating costs that arise from activities or changes in activities that are required by the regulation.

Opportunity costs occur when a regulation prevents the bank from engaging in profitable activities. An example is the cost resulting when branching restrictions prevent a bank from taking advantage of profitable lending opportunities outside its local area and possibly making it vulnerable to any downturns in local business conditions. Another opportunity cost is the interest forgone as a result of the prohibition on investing reserves in interest-bearing assets.

Operating costs arise from requirements that banks perform certain actions, for example, reporting to government agencies (Call Reports, currency transaction reports), providing disclosures to customers and meeting certain operating standards. In each case, employee time, material, and equipment must be devoted; and managerial effort must be devoted in understanding the regulation’s requirements, implementing required actions, and ensuring compliance with the regulations.

There are two types of operating costs incurred for banking regulation—start-up and ongoing.

• Start-up costs are the one-time costs of implementing changes to conform to the requirements of a regulation. They include:-

1. legal expenses for interpreting the regulation, advising managers, and reviewing procedures and forms;
2. managerial expenses for reviewing and revising procedures and forms, coordinating compliance activities, and designing internal audit programs;
3. training expenses; costs for modifying information systems and storing records;
4. expenses for programming and testing of software; and
5. costs for designing new forms and destroying obsolete forms.

• Ongoing costs are the recurring costs of performing the activities required by a regulation. They include :-

1. managerial expenses for monitoring employee compliance and for coordinating compliance examinations with regulatory agencies;
2. labor expenses for preparing reports and disclosure statements and responding to customer queries;
3. legal expenses for reviewing complaints;
4. printing and postage expenses to provide written disclosures to customers.