Banking Operations: Understanding the Regulatory Framework
When a bank fails, the depositors suffer as much or more than the bank’s owners. Failure of one large bank can trigger losses across the boundaries of nations. This makes the banking industry an excellent candidate for government regulations. Bank’s lending policy directly impacts the economy, especially during economic downswing & upswings. Acting overly cautious, they restrict funds availability, and taking more risks can create the inflationary boom. Let us explore various banking regulations and how they safeguard our interests as consumers.
Protecting banks and bank customers from bank failures is the aim of most government banking regulations. Government regulations strive to protect bank depositors and other stakeholders from bank failures and to encourage banks to become a stabilizing force in the economy. Commercial banks are institutions dealing with money. These are governed by various regulations prescribed in each country to regulate the banking industry, for example, in India banks are governed under the Indian Banking Regulation Act, 1949.
What are Bank Regulations?
Bank regulations are a form of government regulation that subjects 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.
Why we need Banking Regulations?
Banking is commonly treated as a matter of public interest. The banking industry is tightly regulated by various laws and regulations (prescribed and enforced by various governments) that controls and influences many aspects of banking. This article explains how bank regulations have evolved across the globe to serve numerous goals. 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.
Banks & Financial Stability of System
This enormous influence that banks hold over the economy is because banks are very important and 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 the keystone in the edifice of the financial stability of the system. Ensuring the 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): Deposits held by banks belong to public at large and it needs to be protected, hence the need for the regulation. Banking in most countries works on the concept of fractional reserve system where deposits are only partially backed by the reserves. The objective of such a regulation is to reduce the level of risk to depositors.
Systemic Risk Reduction: Banking regulations are enforced to ensure that fluctuations in business activity and issues at an individual bank do not impact the flow of transactions across the economy as a whole.
Efficient and Competitive Financial System: Regulatory framework encourages competition and ensures an adequate level of banking services throughout the economy. Another objective of regulations is to enable a competitive environment conducive to changing economic conditions and technological advances.
Avoiding Money Laundering: Another aim of banking regulations is to avoid the misuse of banks to disguise the true source of funds or disguise the ultimate disposition of the funds. This also ensures that banks are not used for criminal purposes.
Credit Allocation: Banking plays an important role in the economic development of any nation and Central Banks play an active role to ensure credit to productive sectors of the economy, as well as taking care of neglected sectors that may impact large segments of the population or employment-intensive sectors such as agriculture or small enterprises.
Areas of Banking Regulations
Banking regulations can vary widely across nations and jurisdictions. This section of the article describes general areas and underlying principles of bank regulations, which are mostly used throughout the world.
- Minimum requirements like maintaining minimum capital ratios
- Supervisory review by providing directions and ensuring compliance
- Market discipline through transparency and financial disclosure requirements
- Capital requirement through capital measurement system such as Basel Capital Accords
- Reserve requirement prescribing minimum reserves to ensure liquidity
- Corporate governance to encourage close watch on all operational aspects
- Financial reporting and disclosure requirements to ensure accuracy and reliability
- Credit rating requirement to provide an estimation of relative risk dealing with the bank
- Large exposures restrictions to individuals/groups to safeguard capital from unnecessary risk
- Activity and affiliation restrictions to prevent ownership or controlling interest in other businesses
- Too Big To Fail and Moral Hazard to avoid situations in which the government must decide whether to support a struggling bank or to let it fail
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