Need for Banking Regulations

Bank Regulations:

Bank regulations are a form of government regulation which subject banks to certain requirements, restrictions, policies, procedures, standards, disclosures and guidelines. This regulatory structure creates transparency between banking institutions and the individuals & corporations with whom they conduct business.

The fundamental rationale for exercising fairly close regulation and supervision of banking institutions, all over the world, is premised on the notion that the banks are "too big to fail". This originates from the fact that many financial institutions (particularly investment banks with a commercial arm) hold too much influence and control over the economy to fail without enormous consequences. The belief is that if not regulated, there exists a risk of banking institutions being crippled creating rippling effects throughout the economy.

This enormous influence that banks hold over the economy is because banks are special institutions. They accept public deposits without offering any collateral security, run the payment and settlement system, and are an important channel for monetary policy transmission. Through a combination of lending and deposit activities, the banking system can affect the aggregate supply of money and credit, making banks a crucial link in the monetary mechanism and in the overall condition of the economy. Banks are keystone in the edifice of financial stability of the system. Ensuring safety and soundness of the banking system, therefore, becomes a predominant objective of the financial regulators.

Objectives of Bank Regulation:

The objectives of bank regulation, and the emphasis, vary between jurisdictions. The most common objectives are:

Prudential (Protection of Depositors):

The most basic reason for regulation of banking is depositor protection. Pressure for such regulation arose as the public began making financial transactions through banks, and as businesses and individuals began holding a significant portion of their funds in banks. Today most countries adopt fractional reserve system of banking where deposits are only partially backed by the reserves banks hold in the form of cash and balances maintained with the Central Banks of the country. As a result, depositor safety is linked to many other factors as well, including the capital in a bank and the condition and value of its loans, securities, and other assets. Thus one of the key objectives of banking regulations is to reduce the level of risk to which bank creditors are exposed (i.e. to protect depositors).

Systemic Risk Reduction - Monetary and Financial Stability:

In the modern world, vast volume of transactions is conducted every day by individuals and businesses. This multitude of daily transactions needs to be completed with a high degree of certainty and safety and hence a safe and acceptable means of payment is critical to the health of our economy. Absence of an effective payment system would result in serious disruptions in functioning of today’s complex national economies, as hindrance in financial transactions would impact the flow of credit, leading to slippages in the depositor confidence.

Banking regulations are enforced to ensure that fluctuations in business activity and problems at individual banks does not impact the flow of transactions across the country’s economy and shake the public confidence in the banking system. Specific laws and regulations have been enacted by various countries to prescribe which institutions can offer deposit accounts, the level of reserves that must be held against these accounts, and the various deposit reports that must be filed. These regulations reduce the risk of disruption resulting from adverse trading conditions for banks causing multiple or major bank failures

Efficient and Competitive Financial System:

Like any other industry, banking industry must allow for customers getting quality services at competitive prices. Another purpose of bank regulation is to create a regulatory framework that encourages efficiency and competition and ensures an adequate level of banking services throughout the economy. To achieve efficiency banks must utilize their resources wisely, be innovative and design new effective products/services for consumers, and manage their risks effectively. This can be achieved by creating a healthy competitive environment for banking industry. Without such competition, individual banks might attempt to gain higher prices for their services by restricting output or colluding with other banks.

Competition and efficiency depend on the number of banks operating in a market, the freedom of other banks to enter and compete, and the ability of banks to achieve an appropriate size for serving their customers. Regulation should foster a banking system that can create an effective competitive environment, prescribe entry and exit barriers and evolve in response to changing economic conditions and technological advances.

Consumer Protection

Banking Regulation also strives to protect consumer interests in various aspects of a banking relationship. Several examples are; requiring banks to provide their customers with a meaningful disclosure of deposit and credit terms, enforcing equal treatment and equal access to credit among all financial customers, promoting financial privacy and preventing problems and abusive practices during credit transactions or debt collections.

The growing complexity of financial instruments and the uniqueness of individual customers have made consumer protection a very complicated and detailed regulatory process.

Avoiding Money Laundering:

Another aim of banking regulations is to avoid the misuse of banks. Money Laundering involves transactions intended to disguise the true source of funds; disguise the ultimate disposition of the funds; eliminate any audit trail and make it appear as though the funds came through legitimate sources; and evade taxes. Money laundering erodes the integrity of a nation’s financial system by reducing tax revenues through underground economies, restricting fair competition with legitimate businesses, and disrupting economic development. 

Governments and International Bodies undertake efforts to deter prevent and apprehend money launderers. Banking regulations are enacted to reduce the risk of banks being used for criminal purposes for example using banking channels for laundering the proceeds of crime.

Credit Allocation:

Banking Industry especially the Central Banks of any country play an active, important and direct role in supporting developmental activities in their respective country. This developmental role includes ensuring credit to productive sectors of the economy, creating institutions to build financial infrastructure, and expanding access to affordable financial services. Regulations enforce credit allocation to priority sector and encourage lending to these sectors by way of various initiatives and benefits.  These regulations also help access to credit to the neglected sectors in any economy, driving principle being to ensure adequate flow of bank credit to those sectors of the society/economy that impact large segments of the population and weaker sections, and to the sectors which are employment-intensive, such as, agriculture and small enterprises.