#1097: Money & the Business Cycle Why do banks need to be regulated?

The nature of banking and the role of banks have evolved tremendously over the last few decades and this change has brought along with it new implications and fresh questions for regulators and financial authorities. To understand the need for regulation in this sector, we first need to look at the traditional role of banks as financial intermediaries and then consider the incentive problems that arise between banks and regulators. Next we examine recent developments in the capital markets and consider how recent events provide added impetus for regulation in the banking sector. Traditional theories of banking have focused on banks performing various functions of asset and liability transformation through monitoring and screening, allowing them to achieve diversification and lower costs for both lenders and borrowers. The bank facilitates the channeling of funds between lenders and borrowers by providing maturity intermediation where they invest in illiquid long term projects and finance them with liquid short term demand deposits thereby creating liquidity in the economy. In addition, by collecting from large number of lenders and lending to a diversified group of borrowers, the bank performs a risk intermediation function reducing the risk to both parties. Such an arrangement enhances the welfare of both lenders and borrowers, but subjects the bank to the risk of coordination failure. This occurs when a fraction of lenders prematurely withdraw from the system. When this exceeds the amount lenders expect to receive in the future, it induces other lenders to withdraw from the system resulting in the premature liquidation of investment projects and subsequently a bank run. Such runs have been empirically documented to have be precipitated by poor investment management and thus served as effective market discipline. However, massive bank failures in the early 1930s in the US led to sharp hikes in the cost of credit and resultantly a drop in output and investment leading to the Great Depression which had lasting economic consequences on the US. Since then, the need to protect banks from such failures and contain the negative social externalities arising has led to regulation in the form of deposit insurance whereby deposits are backed by federal funds. The advent of deposit insurance however, raises a moral hazard problem for regulators. While the investment decisions of banks were traditionally restrained by market discipline, deposit insurance may reduce the incentive for information monitoring and raises the incentive for managers to invest in favor of more risky projects to earn higher interest. Regulatory restrictions would thus be necessary to control moral hazard. Since the 1950s, cash-asset reserve requirements, risk-sensitive capital requirements and tough bank closure policy have been implemented and have served to improve risk control and limit excessive risk taking. However, in light of recent developments in the capital markets, fresh questions arise as to the relevance and adequacy of such regulations. The growth of the money market in recent years has led to fresh sources of capital funding for banks. In particular, securitization has allowed banks to obtain funding from investors by selling them asset-backed securities. Although such a function allows for better risk sharing, it results in a dilution of monitoring incentives as the risks are now borne by the investors. In particular, the originate-to-distribute model of securitization led to an underestimation of the risks involved and banks overstretching themselves in terms of liquidity, seen through the immense stress faced by such banks during the 2008 financial crisis. Such an example highlighted the added need for regulatory requirements in monitoring and screening and revealed the inadequacy of existing capital requirements for banks. While recent developments in the interbank lending markets have also improved risk sharing opportunities available to banks, they pose additional challenges for regulators as banks become increasingly integrated. Coupled with increased integration comes an increase in systemic risk or a contagion effect where a localized liquidity and solvency problem might flow quickly through a system resulting in a threat to the safety of the system as a whole. In todays increasingly internationally connected financial markets, regulators thus need to be concerned with the financial system as a whole and put in place adequate mechanisms for international coordination and containment when a crisis occurs. In conclusion, while it is essential that adequate regulatory requirements must be in place for an effective functioning of banks in the financial system, we must also note that this must be balanced with the operation and discipline of market forces. Excessive regulation might serve to restrain the banking system while inadequate regulation might lead to regulatory arbitrage where participants exploit the system for private gain. Moving forward in an increasingly complex world, transparency, due diligence and sustainability must continue to feature in the minds of regulators as they navigate through increasingly tough challenges ahead. 790 Words Tee Chin Min Benjamin (h1350428)