Why do we regulate banks?

Why do we regulate banks? As George Benston and George Kaufman point out in an article in the May 1996 issue of the Economic Journal, they don't serve food that might sicken unsuspecting customers and they don't deal in dangerous materials that might explode or cause plagues. Rather, they provide checking accounts and investment services, make loans, and facilitate financial transactions. Why should we be concerned about what they do any more than we are about what any ordinary business does?

Why regulate banks more than any other financial sector that has asymmetric information and externalities? In most countries, banks were private, unregulated entities. Historically, clearinghouses and other private monitors rather emerged to limit the risk taking of financial institutions and spillovers from one financial institution to others and the real economy. Private sector solution thus arose to deal with many of these concerns. In the last century or so, however, and especially following the Great Depression, Inherent instability -4 reasons-

High financial gearing. (high degree of debts to equity capital) is due to the intermediary role of banks. Banks' funds primarily comes from depositors, not from shareholders (which nowadays deliberately only hold about 4% in relation to total bank assets). This fact undermines the incentive of shareholders to- seriously calculate risk and balance it to potential earnings, naturally leading to moral hazard. Under the limited liability rule shareholders are protected from loosing more than their stake in the bank "Conditionally solvent".

(Dale 1984, 54) "The business of banking being . . . a large-scale confidence trick". The Regulation of International Banking because its high financial leverage. Bank loans are nor readily marketable assets and may in case only be sold at a significant discount in the short run. A bank's portfolio is therefore a highly specific asset (to use a term of Oliver Williamson): It will be much more worth to the bank itself than to any other investors. As a consequence, a liquidity squeeze may easily turn into a solvency crisis.

Self-fulfilling prophecy Diamond and Rajan (1998) argue further that the somewhat fragile capitalstructure of banks, which subjects them to runs, disciplines them to monitor corporations properly. Diamond Rajan (1998), "Liquidity risk, liquidity creation, and financial fragility: a theory of banking". Lack of transparency. Asymmetric information difficult for banks to secure loans from other banks. Even if the bank would be prepared to accept or offer a higher interest rate, this might be perceived a an indicator of higher risk rather than as a normal market reaction in case of a shortage.

Nevertheless, there is a type of liquidity risk which is peculiar, and, crucially, its existence enhances most of the other risks as well, at least in a subjective sense as seen from the position of banks' depositors. The specific liquidity problem of banks, though, has to be understood properly. It doesn't result from maturity mismatch as such, as is often claimed. A saving institution, for instance, too faces maturity mismatch without being prone to the same liquidity risk.

The peculiar nature of banks' liquidity problem stems from the fact that they create assets (normally more or less long-term loans) by simultaneously creating specific liabilities, which it cannot meet by themselves and which can fall due at any moment in time, but may not fall due at all. In short, a liquidity risk for the bank exists, because its liabilities are accepted as "money" in transactions while not being the only type of money. There are other banks (competing commercial banks as well as the central bank) creating their own money.

And any bank's money, in order to be accepted, must be convertible in any other bank's money. To quote from a prominent newer textbook: "[T]he bulk of the money supply used in modem economies is bank deposits, and these deposits are actually created by the commercial banking system. The money-creating function of banks is what distinguishes them from other financial intermediaries such as saving banks, brokers, and stock markets. All of those institutions collect, lend, and invest funds, but none of them has the right to create money, because none of them may legally lend more than they have received in deposits.

By lending money that they do not directly possess , commercial banks are in effect issuing money. … [B]y issuing a loan to a customer, a bank increases the volume of its assets … The increase is matched on the liability side by the amount of the loan credited to the customer's bank account. That is, in a nutshell, how new money is created by banks" (Burda/Wyplosz 2001, 201 f; italics are mine, WH). In short, the modem payment system owes its high flexibility exactly to this type of arrangement, which, however, is also responsible for its extreme fragility.