How Banks Are Regulated

Imagine that you had a good amount of money that you wanted to invest in a business. There are many options that would be available to you, and normally you would freely choose whatever you liked, provided you had the means to at least attempt to get it off the ground.

About 80% of new businesses fail in the first year though, but the hit is generally limited to the investors and the creditors, parties who knew or should have known the risk. People may have lost their jobs but this isn’t a loss per se, some other potential future benefits were lost, but this is just the way it often goes in business.

Banks are quite different though. The repercussions of bank failure are far more significant. First off, depositors lose money, and it’s only due to regulation that they may have all or part of their deposits covered by government sponsored insurance schemes, if one is in place in the regulating country that is.

At various times we have seen lesser to far lesser degrees of regulation than we typically see today. For instance during the early years of the United States, the new country felt that a more free market approach was at least worth trying out with banks, and this led to a very high number of bank failures and a rethinking of this philosophy.

All these years later, banking in the U.S. is still more fragmented than in many other countries, with a lot more banks in the marketplace. There are presently 6799 FDIC insured banks in the country, which is well over half the banks in the world.

During the mortgage crisis of 2007, there were criticisms that a lack of proper regulation caused a lot of the financial turmoil that ensued, and it certainly was true that American banks as well as banks in other countries were excessively exposed to risk from holding such large amounts of mortgaged backed securities, and when these securities went bust, this served to increase bank losses significantly.

Why Not Be More Lax With Banking Regulations?

Banking, left unregulated, is a hugely risky proposition, due to the way banks operate. So we have a few million to start a business for example and we decide to open a bank, and just get a normal business license which just means we pay a fee, rent a building, hire some staff, and open up shop.

Sure, we can lend out our capital, and maybe make a go of it that way, but banks are in the business of being financial intermediaries, so we’re going to want to take deposits as well, to borrow from the public to lend this money out.

There’s going to be some business risks involved with this, for instance if our default rate is high enough we may lose money and lose some of the borrowed money as well, and our depositors are of course going to be upset.

This is one of the two big reasons why financial institutions who take deposits are more tightly regulated than just lenders, who may get their capital from other means, and especially not from demand deposits, which involve a lot more risk.

This is because when you lend out money with longer terms than you borrow it, this involves liquidity risk, the risk that your borrowers will come calling for their money and you don’t have it because their money is loaned out and won’t be available to repay your loan to them for up to several years from now.

This is the biggest risk with unregulated banking, and this is what has brought down many banks in the past, so called bank runs. The reason why some banks have such huge lobbies is that they want to minimize the appearance of long lines, which at one time used to spill over into the street at some banks, and this itself has caused panic and had people joining the line in fear of it being a bank run.

The truth is, banks simply cannot satisfy this demand if it is sufficient enough, and while today they can rely on the central bank to cover their liquidity risk, this still needs to be minimized. The mismatch in terms between deposits and loans is potentially a huge issue for banks if it is not managed properly, so we simply make sure that it is, including having the government stand behind the banks fully, which is necessary to preserve public confidence.

So if we could just run banks without any regulation, we would quickly get to the point where people would see bank failures and would lose their confidence in banks, withdrawing what deposits they have made, and this would serve to easily bring down the banking industry in a country.

There are other reasons for regulation other than to protect against bank failure, for instance to ensure that the operations of banks are transparent enough to ensure that those who both deposit and invest are acting out of informed consent, to prevent abuses by bank officials and to keep them in compliance with the laws, to keep them from exposing the public to excessive risk which may need to be bailed out, and so on, and all of it is set up to preserve the institutions and public confidence.

Why The Banking Industry Is So Important to Preserve

There are certain business sectors that are important to the economy, larger sectors for instance that may provide a lot of jobs and a strong economic base, and governments will act in various ways and means to help preserve them.

The banking sector is uniquely important though in that it is fundamental to the entire economy. Take away the banking sector and the whole economy collapses, all the other industries, and the economy itself even.

Banks control the money supply itself, and the government may institute policies to expand or contract it, but it’s banks that are the engine behind the money supply. Without banks, the money supply would simply dry up.

Many people do not properly understand this and think that the money supply is how much money that the government prints but currency is actually only a small percentage of the money supply, about 10%. The rest is bank credit. This credit must keep flowing or the money supply will dry upĀ  It doesn’t have to dry up by that much to thrust us into a recession or even a depression,

During the 2007 recession, bank credit dried up for just a single day and this was enough to send governments panicking and over a trillion dollars were spent to fight this fire, and it wasn’t even a big fire compared to what could happen if they did not work so hard on keeping this all together.

It was only the expectation that the government would step in to help that kept things from getting a lot worse, and it still took several years to recover from this rather minor contraction in the money supply. So while many people complain when these things happen and may think that the government is coming to the aid of the fat cats so to speak, they are coming to the aid of everyone..

Regulations Are Far More Preferable Than Bailouts

If businesses can’t borrow enough, they will fail, and when they fail, people will lose their jobs, and this whole thing can have a domino effect, with disastrous consequences. So while there is a lot of money spent on this each year by governments, far more than most people realize because this is kept out of the public eye pretty much, it’s far better to look to reduce the amount of government intervention by using regulation.

So we look to do things like set minimum capital requirements, and this is the cornerstone of banking regulation actually. People think reserve requirements are, since they think that’s what protects against runs on banks and bank failures, but central banks cover liquidity issues these days so that’s not really a matter of safety anymore, although banks are expected to nonetheless pull their weight here.

Reserve requirements are more a tool for managing the money supply actually. Capital requirements do deal with a bank’s overall health though, their safety, so this is obviously a big concern. What is sought here is basically to ensure that a bank’s net worth is sufficient to support the risks it takes, so that it is not overly exposed to risk and business failure.

Some countries have actually done away with reserve requirements and just want to make sure that a bank can stay in business on the basis of its long term financial health, and this is certainly the most important thing to regulate by far.

As important as regulation is, you don’t want excessive regulation either, as this can restrain the market too much, making it too inefficient. For instance this may raise the costs of doing business as well as limit its growth, effecting the economy in such a way as the costs may outweigh the benefits.

So there is pressure on both sides in play, from those who want to see more protection and from those who want more freedom, and we hammer out compromises that both protect the industry and the public while at the same time not restraining things too much.

While banking regulation does not achieve this perfectly, it is there to ensure that things will run as smoothly as possible, which is important indeed with this vital industry that affects all of our lives so much, in ways far greater than most people imagine.