Banking systems that don’t work well stymie economic development, aggravate poverty, and disrupt economies. In particular, a large body of research shows that well-functioning banks boost economic growth, which reduces poverty. Apart from that more recently there has been evidence of the financial crisis of a disruptive nature (Klomp, J., and De Haan, J. (2015).
Magnitude among recent crises, along with evidence of banking systems’ positive impacts on economic growth, has prompted demands for bank regulation and supervisory changes. There is a significant belief that bank “safety and soundness” would improve if policymakers in nations throughout the world implemented specific regulatory and supervisory methods, hence fostering growth and stability.
The central bank’s main responsibilities include supervising and regulating the operations of financial institutions. The financial sector can only play a full role in macroeconomic regulation and control, and monetary policy aims can be met easily if the power of supervision and regulation is effectively pursued and exercised. As a result, all central banks throughout the globe have placed a high priority on supervision and regulation, creating dedicated departments and staffing levels to support them.
The distinction between these two conceptions is critical. If regulation establishes the rules of the road, supervision assures adherence to those rules, as well as to standards that exist outside of them. The carefully orchestrated process of fostering public participation in the establishment of regulations is known as regulation. The practice of managing public and private responsibility for the hazards that the financial system creates is known as supervision.
While banking and financial institutions play a vital role in helping economic progress by gathering and allocating resources to those who require them, they may also cause financial instability in the economy. Because this is a sensitive and delicate business, banking supervision is essential to monitor the banking system to identify and measure risks to safeguard not only financial institutions but also clients from a contagious risk that would occur if there was no warning. Furthermore, banking oversight is created to shield depositors from needless losses, therefore adding to financial system credibility.
While making supervisions on banks and entities that are similar to banks the supervising entities tend to ensure that during the supervisory period banks maintain financial sound practices. Among the things that can make a supervisory body compel banks to modify or get sold or collapse is when they discover that the bank is operating on very dangerous loans or that their bank net worth is way too low and may be negative.
The purpose of bank regulation is mostly to ensure that banks can stay in business by not engaging in behaviors that are way too risky. Some of the examples of regulation include the limiting of the investments that a bank can place itself in, requirements of capital nature, and requirements of reserve nature. To ensure a bank stays afloat its net worth should be positive when it is not it is regarded as insolvent or bankrupt which implies that it may not be able to cover its expenditures or commitments using its asserts (World Bank 2019). This can also be termed as bank capital which is defined as the space or gap in between the bank’s credits and liabilities and the value of the assets belonging to the bank.
It is important to understand that bank supervision can be used as an important tool towards measuring the growth of a bank which also enables it to be utilized as an anticipatory factor towards a long term economic growth of a country and also used in the assessing of society savings towards a private firm. Even in countries that may have accounting and legal policies that are not proper, supervisory policies may be used as a tool by the public sector to monitor the levels of bank development. Strong government supervision, on the other hand, has a negative influence on bank development, according to (Shleifer and Vishny’s, 1998) results.
The financial stability of an economy is relied on to ensure a smooth-running economy. The bank failure is very expensive to a real economy one good example of this is the 2007-2008 financial crisis that affected the global financial markets. To concentrate on the stability of a financial system, it is necessary to ensure the soundness and safety of particular individual institutions (Bermpei et al 2018). One view is micro, focusing on a particular institution, while the other is macro, looking at the entire system. In any case, the basic objectives of bank regulation are to protect the safety and soundness of individual institutions as well as the stability of the system as a whole.
There exist reasons why there is emphasis by certain theoretical models to ensure the benefits of giving some considerable authority to supervisors. The reasons include; first, it is quite very difficult and expensive to manage. Therefore sometimes banks may become less monitored which leads to poor performance and engagement of risky behaviors. This can very well be salvaged ensuring mitigation and regulation by a government authority. Secondly supervision and regulation may serve the purpose of ensuring that banks do not get vulnerable to inequities of information. Thirdly it is evident that some nations globally have opted to engage in deposit insurance plans which is very dangerous because firstly it acts as an encouragement to the banks to take excessive loans and secondly may ensure that depositors are no longer able to supervise the banks in such circumstance bank supervision is essential to ensuring that banks are barred from engaging in quite risk-taking activities which would ultimately ensure bank development, stability, and good performance. (Carretta, et al 2015).
There are five main theoretical grounds for restricting bank activities and banking commerce linkages. First, conflicts of interest can arise when banks engage in operations such as securities underwriting, insurance underwriting, and real estate investment. For example, to assist firms with outstanding loans, such banks may try to “dump” shares on uneducated investors (John et al., 1994, and Saunders, 1985). Second, because moral hazard encourages risky behavior, enabling banks to engage in a wider range of activities gives them more chances to increase risk (Boyd et al., 1998). Third, keeping track of sophisticated banks is difficult. Fourth, such banks may become politically and economically strong enough to be “too big to regulate.” Finally, massive financial conglomerates can suffocate efficiency and competition. According to these viewpoints, governments may improve banking by restricting bank activities.
There are, however, theoretical arguments for allowing banks to engage in a variety of activities. For instance, fewer regulatory constraints allow for the utilization of size and scope economies (Claessens and Klingebiel, 2000). Second, fewer regulatory restrictions may improve a bank’s brand value, offering extra incentives for good activity. Finally, diversifying revenue streams may assist banks to become more stable by increasing their operations.
Reference
John, K., John, T. A., & Saunders, A. (1994). Universal banking and firm risk-taking. Journal of Banking & Finance, 18(2), 307-323.
Saunders, A. (1985). Conflicts of interest: an economic view. Deregulating wall street, 207-230.
Boyd, J. H., Chang, C., & Smith, B. D. (1998). Moral hazard under commercial and universal banking. Journal of money, credit and banking, 426-468.
Claessens, S., & Klingebiel, D. (2001). Competition and scope of activities in financial services. The World Bank Research Observer, 16(1), 19-40.
Shleifer, A., & Vishny, R. W. (1998). The grabbing hand: Government pathologies and their cures. Harvard University Press.
World Bank. (2019). Global financial development report 2019/2020: Bank regulation and supervision a decade after the global financial crisis. The World Bank.
Klomp, J., & De Haan, J. (2015). Bank regulation and financial fragility in developing countries: Does bank structure matter?. Review of Development Finance, 5(2), 82-90.
Bermpei, T., Kalyvas, A., & Nguyen, T. C. (2018). Does institutional quality condition the effect of bank regulations and supervision on bank stability? Evidence from emerging and developing economies. International Review of Financial Analysis, 59, 255-275.
Carretta, A., Farina, V., Fiordelisi, F., Schwizer, P., & Lopes, F. S. S. (2015). Don’t stand so close to me: The role of supervisory style in banking stability. Journal of Banking & Finance, 52, 180-188.
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