Why are Banks Closely Regulated?

The banking system forms the bedrock of any financial system and even the entire economy. This is because the banking system channels the savings of individuals to the industrious. If there is a problem with this system, both the individuals and the business class are likely to be seriously affected. Therefore, maintaining the health of the banking system is not something in which most countries are comfortable, leaving up to the free market. Instead, there is a regulator assigned who closely monitors the activities of the banks. This is because even though banks are a part of the financial system, they are not allowed to undertake many activities that other participants are allowed to.

In this article, we will enumerate the various restrictions which are placed on the banks as well as the rationale behind those restrictions.

Common Restrictions Placed on Banks Worldwide

• In many countries, banks are not allowed to set up their own investment banking divisions. This is because the regulators want to ensure that banks are not using their money to underwrite risky assets such as corporate equities

• Similarly, banks are not allowed to underwrite other assets, such as life and casualty insurance. These types of insurance also pose a significant risk. Therefore, regulators are not comfortable with allowing the banks to take on these risks with money obtained from small depositors

• Banks are not allowed to invest large sums of money in the securities market. They do provide services related to the securities market. However, these services are for their clients. Several restrictions are placed on proprietary trading for banks. This is because it is a known fact that securities markets are risky as well as volatile. Since banks have large amounts of money, they could end up creating asset bubbles if they are allowed to invest in the market without any restrictions. This will not be beneficial either for the retail investor in the stock market or for the bank’s depositors

• Banks are not allowed to become a counterparty to derivatives trade. In some jurisdictions, they may be allowed to become a broker in a derivative transaction if they are not taking any risk and are being remunerated only with a fee.

Why do Banks Need to be Regulated?

• Banking is already a very risky business. This is because banks use short term demand deposits in order to fund long term loans. Every bank, therefore, has a certain amount of rolling risk i.e., the risk of not being able to roll over short term liabilities. As such, there is always a risk that depositors will ask for funds faster than banks can liquidate them. To make depositors comfortable with this risk, central banks provide a guarantee that funds up to a certain amount per account are insured. However, in order to provide such insurance, central banks have to be sure that the funds are not deployed in risky assets. This is because if the banks fail to make good on their promise, the central bank will become liable to pay back depositors.

• Banks also face a wide variety of other risks, such as operational risks related to banking and credit risks, when they give out loans to third parties.

• Therefore, if banks are allowed to deploy the funds in extremely risky asset classes, the well-being of the whole system is likely to become jeopardized. Products like equity and derivatives have counterparty risks and market risk. Regulators want to prevent banks from taking over excessive risks.

• Also, banks have the power to create money. Under the fractional reserve system, banks create money when they make loans. Therefore, if they make loans to people in the stock market, they create an additional money supply. This money supply inflates the economy in general and can also create an asset bubble in the markets since excessive money flow will be channeled, thereby artificially raising the prices.

What Happens if Banks are Allowed to Take Excessive Risks?

The classic example of what happens when banks are allowed to take on excessive risks is seen in the Great Recession of 2008 in the United States. Banks were involved in the sale of risky mortgage securities, and during the time of crisis, they were not able to obtain funding. As such, the credit markets froze, and the banks' supply to interbank credit was cut off. This was an emergency situation, and the whole financial system was endangered.

The situation was finally resolved after the government stepped in and provided emergency funding. This emergency funding stopped the crisis but was considered to be a wrong policy decision. This is because if banks are not held responsible for their excessive risk-taking, it promotes moral hazard. The United States government ensures that banks had to pay fees and dividends wherever the taxpayer funds were used. However, the moral hazard is still present. There are many critics who still believe that banks take excessive risks since they know that they are too big to fail and that governments will eventually be forced to bail them out.

The bottom line is that banks are not like other institutions. Their well-being is central to other industries and to the economy as a whole. This is the reason why banks need to be monitored more closely as compared to other industries.

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