Plain and simple, banks are important because they introduce efficiencies to the local as well as the global economy. Regulation and supervision of conduct has become an important component of doing business as a bank.
Reasons why banks are important
There are 3 reasons why banks are important to society.
- Banks act as intermediaries through which surplus funds can be made available to finance productive activities in the economy.
- Banks offer a range of needed financial services to the public such as payment services and the storage of wealth for safekeeping.
- Banks are also able to increase the supply of money through credit extension.
All three of these reasons create efficiencies in the economy. It’s therefore in societies interest that somebody ensures that these efficiencies are not diminished and stay in place to help society. Effective regulation can play a role in achieving this aim.
Why banks must submit to regulation
As an example, the efficiencies that are created by banks in the economic system enable monetary authorities to reach better decisions that will affect all of us. The efficiencies banks create therefore become a ‘public good’ because everyone benefits from better monetary policy decisions. Efficiencies become a public good because they do not reduce in availability as benefits are derived by society, nor is it possible for anyone to be excluded from deriving the benefit. Regulation can make sure that these efficiencies are protected so that society can continue to derive benefits from the efficiencies created.
A more practical reason banks should be subjected to regulation relates to the unique nature of the business of a bank. Taking a simple approach to the business model of a bank, it can be reduced to the taking of deposits and the lending of these deposits to other parties at a profit. The liabilities of a bank or its deposits are generally short-term in nature and certain in amount. The public makes a deposit and withdraws it when needed and banks repay these deposits when they are required to do so. Banks know with relative certainty the amount they must at some future date repay to depositors. On the other hand, the assets of a bank or the loans that it makes, are generally long-term in nature and uncertain in value. The assets are uncertain in value because a bank can never be certain that the loan it grants will be paid in full over the specified period.
A banks business is therefore inherently risky, and poor loan decisions can result in the loss of depositors funds causing the failure of a bank when it is unable to repay its depositors. Ensuing loss of confidence in the banking system by the public will impact upon all the efficiencies enumerated above. The recent financial crisis has shown that this loss of confidence in the banking system brought into being by either bank failure or the treat of bank failure, has a high cost on society. This cost far exceeds the cost of intervention through regulation when saving systemically important financial institutions. Intervention to save banks when they are in financial trouble, is a compelling reason banks should be subject to stringent regulation and that they are prudently managed by competent, experienced and ethical people.
Another reason banks should be regulated is because depositors do not have enough information about the true risks that a bank is exposed to. Depositors earn interest from the bank for the funds they place with them. The interest rate they receive is proportional to the extent of the risk their funds are exposed to. The higher the risk, the higher the interest rate they would expect to receive. Interest rates are therefore a good indicator of the extent of risk the deposit is exposed to. This information should be communicated transparently by banks and not be masked by keeping deposit interest rates low to boost their margins. Depositors have a right to know how their funds are being applied so that if they are not comfortable with the risk exposure, they may move their finds to a less risky investment. Regulation is an ideal mechanism to set minimum standards of disclosure to the public and in this way make sure that relevant information is communicated and not withheld from the public.
What is regulation and supervision about?
Regulation is about the creation and maintenance of a legal framework within which a bank is licensed to operate. Banks become subject to prudential rules and practises through regulation once they are licensed to receive deposits from the public.
Supervision on the other hand is about the process of monitoring the control systems, activities and financial condition of banks to make sure that they are within the limits of prudent banking practise that are set out in the legal framework established by regulation.
Objectives of regulation and supervision
There are three main objectives.
- Ensuring systemic stability
- Enhancing efficiency
- Investor and depositor protection
There is a tight interrelationship between these objectives and for this reason the same authority should perform both regulation and supervision.
Because banks play a pivotal role in the economy and monetary system and due to the risk of banks causing systemic failure, the most obvious candidate for this role of regulation and supervision is a central bank. This role can be enhanced if a central bank is legislated as independent from the state. This arrangement affords central banks the right under the law to act independently from the state facilitating independent regulation without political influence. Many jurisdictions have adopted this model for their central banks such as Switzerland, United Kingdom, United States, South Africa, Australia and others.
Regulation and the regulatory landscape has shifted toward being composed of two main dimensions namely micro and macro-prudential regulation. Micro-prudential regulation focuses on oversight of individual financial institutions while macro-prudential regulation attempts to address systemic risks.
Clearly the goal of maintaining “safe and sound” institutions individually does not guarantee overall financial stability and central banks are well positioned to take account of this in their existing framework. Enhanced oversight of the financial system by central banks should not overburden it through excessive regulation, but rather facilitate the consolidation of financial regulation.