Why Regulate Banks?

Why do we regulate banks? Do banks provide dangerous instruments that could harm people? Or the banks deal with dangerous material that could cause plagues on people? No! But banks are being considerably regulated and supervised in every corner of the world. Banking is also a business, and why we should concern more about the bank’ than we concern of any other ordinary business!

It is because banking business is the business of receiving funds from the public through the acceptance of money deposits and use of such funds for investments or any other operation either authorised by law or by customary banking practise.

To protect such depositors, banks should not be allowed to take any risk which could lead them to fail. Therefore banks must be properly regulated by an authorised body and it is a duty of a government to ensure that monetary and banking policy of banks are directed to protect the financial system of the country and the public interest.

Therefore reasons for regulating the banks are mainly link with the protection of depositors, guaranteeing the functioning and protection against the systemic risk.

However, the basic reason for regulating the banks is to maintain confidence of the public’ in the banking system and to ensure that banks can be relied upon to meet depositor’s request for withdrawals. If the people are not in confident of the banking system they might all try to withdraw their funds at once, and the banks will collapse on sudden disposal of assets to meet the withdrawals.

When depositors all withdraw money at once, it is said that there is run on bank. Some depositors will loss their money as the bank holds only a fraction of the total funds reserve. Then the bank has no option without going out of the business.

Hence it is government’s job to ensure that the banks are holding adequate capital to bear the cost of losses. This capital requirement has to be imposed on bank through the regulations

 However capital requirement is the most important minimum requirement in the banking regulations and it could set a frame work on how a bank should handle their capital.  Then every bank should comply with this capital adequacy to start and maintain their banking business.

In addition, Bank must publicly disclose their financial and other information so that depositors could use this information to assess the level of risk. To make the banks to follow this guideline, it should be imposed on bank through the regulations.  

On the other hand these regulations enable the regulator to supervise whether the banks are complied with the prudential regulation and ultimately make a decision to revoke the bank’s licence.   

 However it is important to know that the banks are the repositories of the liquidity of an economy and providing a strength backbone to the financial and payment system of a country. Therefore every state intervenes to protect the banking system from systemic risk by authorising a government agent to operate monitoring and supervision over the banks. Generally Central banks is authorised to monitor the work of the commercial banks and maintain the supervision over the banks to ensure that the function of banks are complied with the standards of prudential regulations.

 Finally, it should be noted, since the regulations are still directed to avoid the failure of an individual bank, the problems in an individual bank might spread and affect   other institutes, and those contagions could collapse the functioning of entire financial system. Therefore systemic risk is important motive for the regulations and new regulations should be brought focusing on the systemic risk.