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Financial Regulators Protect The Monopoly And Prevent Competition Research Paper

Regulation on Financial Institutions

Introduction

The regulation of financial institutions in the US is a controversial subject, as there are arguments both for and against regulation. However, regulation for the most part is an accepted way of life and most people assume that without regulation banks would cause untold problems for themselves and the world. Ironically, it appears that the reality is just the opposite. Regulation tends to lead to reckless behavior, and then intervention is needed by the central banks to prevent collapse (Prosner, 2014; Wallison, 2005). This paper will discuss why banks are regulated, the history of bank failures, steps policy makers have taken to address those failures, lessons learned, why bank regulators are concerned with capital adequacy, what the responsibilities of various bank regulating agencies are, and how US regulation compares to European regulation overall and in spirit.

Why Banks are Regulated

Conventional reasons for why banks are regulated include the risk of bank instability, deposit insurance, the need for a central bank to be a lender of last resort, and the role of the central bank in monetary policy and large-dollar payments (Wallison, 2005). However, there are risks on the other side of regulation that are often assumed or accepted, and history shows that they are not insignificant. For example, there was the savings-and-loan industry scandal that hurt taxpayers and the economy. The banking and savings-and-loan industries had been heavily regulated prior to its collapse in the 1980s/90s; and regulation, rather than mitigate risk, quite possibly intensified that collapse (Barth, Trimbath & Yago, 2006; Wallison, 2005). Investors can be lulled into a false sense of security when they believe that sufficient or effective regulation is in place. Yet regulation can go sideways and lead to an environment in which risk is ignored and unethical practices encouraged. The decision of the Financial Accounting Standards Board (FASB) to allow fair value accounting is one such example of regulatory standards opening a Pandoras Box of problems, seen in companies from Enron to Lehman Brothers, where mark to market accounting was not only used but exacerbated by auditing firms like Anderson, which were permitted to act in an advisory role and not just as independent auditors. The problem became a major issue in 2008, as Young (2008) notes: As investors tried to delve into the details of the value of CDO assets and the reliability of their cash flows, the extraordinary complexity of the instruments provided a significant impediment to insight into the underlying financial data (p. 34). The FASB sought to serve various interests at onceeconomic interests, financial interests, and accounting interestsand in doing so its regulation became ineffective (Flegm, 2008). Wallison (2005) blames market discipline, but regulation can have an impact on market discipline, too.

In short, regulation is not a one-size-fits-all solution. There are effective regulations and there are ineffective regulations; there are regulations that promote stability and there are regulations that trigger instability. Wallison (2005) gives the example of how the best regulations are sometimes those that apply to the regulators themselves: The Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA) added significant new regulations, including draconian penalties for violating the regulations or the orders of bank and S&L supervisors. Ironically, however, the most successful elements of FDICIA were rules governing the behavior of the regulators themselves (p. 14-15). The conclusion that Wallison (2005) draws is that banks are regulated not so much out of necessity but because there is an interplay between private and public organizations, which results in government attempting to leverage control over private institutions in the form of regulation. The control is never total, and loopholes...

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…for stricter or laxer regulations as the case may be. As noted before, not all regulation is bad for the business model of big banks; some of it is bad for small banks that cannot reach capitalization requirements. At the same time, capital adequacy is a risk that central banks have shown themselves willing to mitigate by use of unconventional monetary policy. Thus, the purpose of regulation appears to be null and void, other than to keep smaller banks out of the industry. The central banks backstop the capital illiquidity of big banks and the regulators act as gatekeepers to prevent smaller firms from entering into the market. The case is the same in Europe as it is in the US in this regard.

Conclusion

Regulation on financial institutions is an issue that is often viewed as though it were a necessity. Regulators are seen as a line of defense; the banks as wolves that would otherwise take over the hen house. The situation, however, is quite the opposite. Small banks are kept out of the industry by regulators, who essentially are there to protect the monopoly of the big banks, as Posner (2014) explains. Regulation is for preventing competitors of the majors from entering the market. The majors are only marginally regulated, and whenever they have capital adequacy problems the Federal Reserve is there to step in, provide liquidity, and will add trillions of dollars to its balance sheet if it has to. The notion of being too big to fail is what that has become accepted in America. It is a noton that explains precisely the nature of the relationship between the financial institutions that dominate the market and the regulators. The regulators are not in a position to let these banks fail, and thus they are not in a position…

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References

Ayadi, R., Arbak, E., & Pieter De Groen, W. (2012). Regulation of European banks andbusiness models: towards a new paradigm?. Centre for European Policy Studies, Forthcoming. Brussels: Center for European Policy Studies.

Barth, J. R., Trimbath, S., & Yago, G. (Eds.). (2006). The Savings and Loan Crisis:Lessons from a regulatory failure (Vol. 5). Springer Science & Business Media.

Cabrera, M. (2020). US banking regulation. Retrieved from https://www.bbva.com/en/opinion/u-s-banking-regulation-a-change-in-the-trend/

English, C. (2020). Wells Fargo Forced to Cut Its Dividend After Fed Stress Test. Here’sWhat Other Banks Did. Retrieved from https://www.barrons.com/articles/wells-fargo-forced-to-cut-its-dividend-after-fed-stress-test-51593467664 FDIC. (2020). Bank failures in brief. Retrieved from https://www.fdic.gov/bank/historical/bank/

Federal Reserve. (2020). Stress test and capital planning. Retrieved from https://www.federalreserve.gov/supervisionreg/stress-tests-capital-planning.htm

Flegm, E. H. (2008). The Need for Reliability in Accounting. Why historical cost is morereliable than fair value. Journal of Accountancy, 205(5), 34.

Hall, J. (2007). Internal Auditing and ERM: Fitting in and Adding Value. Retrieved from https://global.theiia.org/about/about-the-iia/Public%20Documents/Sawyer_Award_2007.pdf

Manuel, D. (2020). A history of bank failures in the US. Retrieved from https://www.davemanuel.com/history-of-bank-failures-in-the-united-states.php

Mauldin, J. (2020). The Fed has quietly started QE4. Retrieved from https://www.forbes.com/sites/johnmauldin/2020/01/02/the-fed-has-quietly-started-qe4/#17970c233768

Posner, E. A. (2015). How Do Bank Regulators Determine Capital-AdequacyRequirements?. The University of Chicago Law Review, 1853-1895.

Schmidt, M. (2020). Financial Regulators: Who They Are and What They Do. Retrieved from https://www.investopedia.com/articles/economics/09/financial-regulatory-body.asp

Smillie, A., Epperlein, E., & Pandya, T. (2014). Use of stress scenarios in market riskeconomic capital. Journal of Risk Management in Financial Institutions, 7(1), 85-92.

Wallison, P. (2005). Why do we regulate banks? Retrieved from https://www.cato.org/sites/cato.org/files/serials/files/regulation/2005/12/v28n4-2.pdf#:~:text=Regulation%20is%20necessary%20to%20reduce%20or%20eliminate%20that%20risk.&text=system.,to%20banks%20that%20later%20fail.&text=the%20payment%20system%20in%20which%20banks%20transfer%20funds%20among%20themselves.

Young, M. R., (2008). Both sides make good points. Journal of Accountancy, 205(5), 34.

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