Banking regulation
Aims and learning objectives
Understand why banks need regulation
Illustrate the main cases of non-regulated banking systems in history and explain their economic rationale
Explain the main arguments for and against the regulation of banking systems
Explain how banks are regulated through traditional regulation mechanism
Illustrate alternative regulation mechanisms
Discuss the main implications of the recent trend in harmonizing bank regulation across the world
Discuss the problems with the traditional regulation mechanisms revealed by the global financial crisis from 2007 to 2009
Evaluate the response of the Basel Committee on Banking Supervision to the global financial crisis of 2007 to 2009
Free banking
Unregulated banking
No central bank, money regulator or government intervention
Financial intermediaries operate freely, subject to market forces
Without regulation, depositors need more reassurance that their deposits are safe
Disclosure of a lot of information including audited accounts
Pursue prudent lending policies
Hold adequate amount of capital
More capital held increases buffer against market, credit and operational risk
Capital is expensive to hold as dividends need to be paid to shareholders
Will be able to maintain solvency in events of losses
Market would determine optimal amount of capital to be held since if depositors want more assurance, they will only place their deposits with banks with high capital held
Regulation by fund providers, depositors and shareholders
Seeks to encourage good behavior and discourage imprudent bad behavior
Conclusion
Since depositors are risk-averse, the banks are forced to take on the amount of risk depositors want them to take
Problems
Counterfeiting
Wildcat banking
Fraudulent banking
Over issuance of bank notes
Over expansion of banks
Free banking is unstable and prone to failures and can lead to systemic banking instability
Justifying bank regulation
Risks face by banks
Liquidity/Liability risk
Insufficient funds to meet all demands for deposit withdrawal
Inevitable because of nature of intermediation process
Credit/Default risk
Risk of loans not begin repaid
Most important risk arising out of the assets held by the bank
Influenced by the economic cycle for domestic lending and country-specific risks in the case of international lending
Market or price risk
Possibility of assets changing value
Main source is open position on trading books
Price risk can affect the following: foreign exchange, derivatives, equity and bonds (interest rate risk
Operational risk
Risk of loss resulting from inadequate internal processes, people or systems or from external events