Regulation of Financial Institutions

Topics: Bank, Financial services, Basel II Pages: 5 (1748 words) Published: October 4, 2013


Regulation involves the formation of precise rules or guidelines for conducting daily duties in financial institutions. It consist of eight basic categories of banking regulation: “the government safety net, restrictions on bank assets holding, capital requirements, chartering and bank examination, assessment of risk management, disclosure requirements, consumer protection an restrictions on competition. An essential factor of financial regulation involves internalizing social cost of impending bank failures. “Financial regulation aims for transparency in the financial market and of financial institutions and investor protection, it imposes equal treatment (e.g. rules regarding takeovers) and the correct dissemination of information (insider trading and the rules dealing with exchanges in microstructure and price discovery).” Three objectives of regulation include: sustaining stability, maintaining the safety and soundness of financial institutions and protecting depositors. It depends on different imperfections and failures (e.g. asymmetric information) which when not in existence create sub-optimal results and reduce depositor welfare. It is said, “It should be limited to correcting for identified market imperfections and failures.” It is in this respect that this paper examines reasons for regulation, reasons against regulation and some characteristics of a sound regulatory and supervisory framework. Note, asymmetric information is a situation which involves a lack of similar information between contractual parties in a financial agreement. George Bentson (1999) presents a number of reasons for regulating financial services, which include the benefits to the government, consumer protection, benefits to the financial institutions themselves and concern about negative externalities. According to Benston consumers need to be confident in the financial institutions they engage in transactions with. He states that regulation is justified from the point of the consumer through the reduction of negative externalities stemming from failures on the part of insurance companies that provide the government with protection of non-contracting third parties ( as lenders of last resort) and from taxpayers, that is, others who have lost confidence in banking systems and decide to ‘run on the bank,’ which results in banks needing to be ‘bailed – out’ as they are unable to meet their contractual depository commitments. This is accomplished through the employment of a government safety net (a discount loan from the central bank) for depositors. These situations may arise due to the results of asymmetric information which leads to adverse selection (which occurs before the contract is issued) and moral hazard (which occurs after the contact has been issued). He argues that the reason for government regulation can be discovered by examining the benefits to the government, the appeal of regulation to popularly elected legislators and the benefits to regulated financial institutions, stating that regulation is enacted for the above mentioned reasons at the detriment of consumers. Insisting that governments benefit from the early regulation of banks primarily the restriction of entry, which was introduced so the government and those they favored could enjoy the benefits from production of money and from direct and indirect taxation banks. This can be tied to the incentive-conflict theory portrayed by Edward Kane (1997), where low cost mechanisms are utilized to resolve conflicts between regulators’ private and societal goals. Benefits to financial institutions themselves are evident through improved efficiency, increased consumer confidence and the protection from competitive alternate...

References: Barth, J. R., Jr. Caprio, G., & Levine, R. (2002, November 1). Bank Regulation and supervison: What works best? Cambridge, Massachussets, United States of America. Retrieved July 2, 2013, from
Benston, G. J. (1999). Regulating Financial Markets: A critique and some proposals. La Vergne: The AEI Press.
Giorgio, G. D., & Noi, C. D. (2001, January 2). Financial Regulation and Supervision in the Euro Area: A four- peak proposal. Retrieved July 1, 2013, from Google Scholar:
International Monetary Fund (2005). Financial Sector Assessment: A Handbook. In IMF eLibrary, . USA. Retrieved 9 Jul. 2013, from
kane, E. J. (1997, April 9). National Bureau of Economic Research. Ethical Foundations of Financial Regulation. Cambridge, Massachusettes, United States of America. Retrieved July 2, 2013, from NBER website:
Llewelyn, D. (1999, April 1). Financial Services Authority. Retrieved July 1, 2013 , from FSA Website:
Mishkin, F. S. (2004). The Economicsof Money,Banking,and Financial Markets. Columbia: Pearson, Addison Wesley.
Shippey, N., & Veitch-Christie, C. (2000). The central bank 's role as a regulator. Kingston: The Bank of Jamaica.
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