Why regulation is important in the banking industry

Banks are fundamentally different from other corporations in other industries. Banks lie at the heart of the economy. A large section of the population keeps their money with them. Many businessmen and small entrepreneurs depend heavily on these institutions for their capital requirements. Banks create and sustain markets for financial instruments and help in channelising savings into productive investments. They also facilitate payment flows among customers. It is difficult to conceive of a modern economy working without banks.

When a bank fails, the impact can be disruptive for the economy. For example during a banking crisis, investors may retreat to safe government securities, due to lack of confidence in the financial system. This may lead to a sharp decline in investment spending. Consumers may also postpone purchases. As a result, recessionary pressures will gather strength. Several percentage points of GDP growth may be lost in the process. This is exactly what happened during the recent financial crisis.

Banks are inherently fragile as they use a small amount of capital and leverage it to build huge asset positions. Banks assume that all depositors will not demand their money back at the same time. From time to time, banking crises have been witnessed as panicky depositors have tried to withdraw money in droves.

Since banks are inherently fragile, most countries have a system of deposit insurance, which protects small investors in the event of a bank failure. This guarantee of a “bailout” for small investors helps in maintaining customer confidence and consequently preventing a run on the bank. But deposit insurance can lead to a moral hazard problem. Banks may end up taking more risk than they can handle. Also, because they are protected by insurance, depositors may have little incentive to monitor banks. This is where a strong regulatory framework comes in. Regulation aims at providing a robust risk management framework for financial institutions and checking whether enough capital has been set aside to deal with various eventualities.

In short, the following are the reasons given to justify the existence of banking regulation:

v A bank’s depositors are too small to monitor the performance of the bank.
v Banks facilitate payment against and settlement of transactions. If payment and settlement systems break down, there will be chaos.
v The failure of a bank can have systemic effects because of interlinkages with other financial institutions. The systemic risk must be managed carefully. Otherwise, there will be a crisis in the financial markets.The collapse of a major financial institution can affect industrial investment in the region. Other banks may not be able to step in with substitute offers as they may not have enough information on the clients