Regulation of Banks Banks are an important aspect of any modern economy. They provide financing for commercial businesses, access to payment systems and a variety of financial services for the economy as a whole. The integral role that banks play in the national economy is demonstrated by the need for and practice of banking regulation and as part of the lessons learnt from the recent global financial crisis, provides a government safety net to compensate depositors when banks fail thus providing depositor protection.[footnoteRef:1] One of the main reasons why banking regulation is vital is because of systemic risks; the risk that financial difficulties at one or more banks spill over to a large number of other banks or the financial system as a whole. Systemic risks were traditionally bank -- based. Bank regulators traditionally focused on systemic risk in the banking sector while securities regulators traditionally focused on investor protection and market practices however recent crisis shows that systemic risk can arise from a general drying up of liquidity in capital markets. Other goals of banking regulation are to ensure the stability and soundness of the financial system and the safeguard of confidence and trust. Economists tend to share a different view in that they argue that regulation is only necessary in the presence of market failure or deficiency. This paper will examine the function of banking in society, the difference in commercial "deposit-oriented" versus investment banks, the role of government regulation and how the regulation of these entities shape their behaviors and their customers. [1: Allen, F. And Douglas, G. 2000. Comparing Financial Systems. MIT Press: Cambridge. MA.]

Functions of a Bank

The Canadian-American economist John Kenneth Galbraith once wrote, "The study of money, above all other fields in economics, is one in which complexity is used to disguise truth or to evade truth, not to reveal it. While the question of what a bank does and what function it serves in society may seem elementary, the answer can be quite complex as suggested by Galbraith. Understanding what banking is all about will help this paper to illustrate the role of banks and their regulation better. A bank is a financial institution where an individual can deposit money. Banks provide a system for easily transferring money from one person or business to another. Using banks and the many services they offer saves an incredible amount of time, and ensures that the funds of micro as well as macroeconomic agents "pass hands" in a legal and structured manner. There are also other financial institutions that operate like banks.

The functioning of a bank is among the more complicated of corporate operations. Since banking involves dealing directly with money, governments in most countries regulate this sector rather stringently. The regulation in most industrialized countries has traditionally been very strict. The multiplicity of policy and regulations that a bank has to work with makes its operations even more complicated, sometimes bordering on illogical. This section attempts to give an overview of the functions in as simple manner as possible. An excellent definition of banking comes from the Banking Regulation Act of India, 1949 which defines Banking as "accepting, for the purpose of lending or investment of deposits of money from the public, repayable on demand or otherwise and withdraw able by cheques, draft, order or otherwise." Deriving from this definition and viewed solely from the point-of-view of the customers, Banks essentially perform the following functions: 1. Accepting Deposits from public/others (Deposits); 2. Lending money to public (Loans); 3. Transferring money from one place to another (Remittances); 4. Credit Creation; 5. Acting as trustees; 6. Keeping valuables in safe custody and 7. Investment Decisions.[footnoteRef:2] [2: Allen, F. And Douglas, G. 2000.]

In addition to providing a safe custodian of money, banks also loan money to businesses and consumers. A large portion of a bank's business is lending. How do banks get the money they loan? The money comes from depositors who intend to save a portion of their wealth. Banks acting as intermediaries use these deposits as loans to prospective borrowers. The objective of commercial banks like any other organization is profit maximization. This profit generally originates from the interest differential between borrowers and lenders. In the present day, however, the banking operation has extended much beyond simple lending exercise. So there are other different channels of profit ensuing from other investment programs as well. However, it should be mentioned in this context that the entire...

And Honohan, P. 2001. Finance for Growth: Policy Choices in a Volatile World. World Bank: Washington, DC.]
Banks create money in the economy by making loans. The amount of money that banks can lend is directly affected by the reserve requirement set by whatever national government. This amount can be held either in cash on hand or in the bank's reserve account. To understand the importance of this on the national economy, an example is useful. When a bank gets a deposit of $100, assuming a reserve requirement of 10%, the bank can then lend out $90. That $90 goes back into the economy, purchasing goods or services, and usually ends up deposited in another bank. That bank can then lend out $81 of that $90 deposit, and that $81 goes into the economy to purchase goods or services and ultimately is deposited into another bank that proceeds to lend out a percentage of it.[footnoteRef:4] [4: Allen, F. And Douglas, G. 2000.]

Types of Banks

While regulation has changed the businesses in which commercial and investment banks may now participate, the core aspects of these different businesses remain intact. In other words, the difference between how a typical investment bank and a typical commercial operate bank can be simplified: A commercial bank takes deposits for checking and savings accounts from consumers while an investment bank raise capital by acting as an intermediary between sellers and buyers of stocks and bonds.

Commercial banks

A commercial bank may legally take deposits for checking and savings accounts from consumers. Most national governments provide some form of insurance guarantees on this deposit. For example, in the United States the federal government provides guarantees on these deposits through the Federal Deposit Insurance Corporation (the FDIC), on amounts up to $100,000. To get FDIC guarantees, commercial banks must follow a myriad of regulations. The typical commercial banking process is fairly straightforward. The consumer deposits money into a bank and the bank loans that money to other consumers and companies in need of capital. One can borrow to buy a house, finance a car or finance construction of a home. Companies borrow to finance the growth of their company or meet immediate cash needs. Companies that borrow from commercial banks can range in size from the simple grocer on the corner to a multinational conglomerate. The commercial bank generates a profit by paying depositors a lower interest rate than the bank charges on loans.[footnoteRef:5] [5: Macey, J.R. And O'Hara, M. 2003. The Corporate Governance of Banks. Economic Policy Review, Federal Reserve Bank of New York. 9: 91-108.]

Importantly, loans from commercial banks are structured as private legally binding contracts between two parties - the bank and the consumer or the company. Banks work with their clients to individually determine the terms of the loans, including the time to maturity and the interest rate charged. One's individual credit history determines the amount you can borrow and how much interest you are charged. Perhaps a company needs to borrow $200,000 over 15 years to finance the purchase of equipment, or maybe your firm needs $30,000 over five years to finance the purchase of a truck. Maybe for the first loan, the consumer and the bank will agree that to an interest rate of 7.5%; perhaps for the truck loan, the interest rate will be 11%. The rates are determined through a negotiation between the bank and the company. Thus, commercial banks make money by taking advantage of the large spread between their cost of funds and their return on funds loaned.

Investment banks

An investment bank operates differently. An investment bank does not have an inventory of cash deposits to lend as a commercial bank does. In essence, an investment bank acts as an intermediary and matches sellers of stocks and bonds with buyers of stocks and bonds. Note, however, that companies use investment banks toward the same end as they use commercial banks. If a company needs capital, it may get a loan from a bank, or it may ask an investment bank to sell equity or debt (stocks or bonds). Because commercial banks already have funds available from their depositors and an investment bank typically does not, an investment bank must spend considerable time finding investors in order to obtain capital. Note that as investment banks are increasingly seeking to become "one-stop" financing sources, many have set aside billions of dollars of their own capital to…