Saint mary’s university

Types and kinds of regulation

1. 
   Regulations on bank activities and banking-commerce links
   

There are five main theoretical reasons for restricting bank activities and banking commerce links. First, conflicts of interest may arise when banks engage in such diverse activities as securities underwriting, insurance underwriting, and real estate investment.

Such banks, for example, may attempt to “dump” securities on ill-informed investors to assist firms with outstanding loans. Second, to the extent that moral hazard encourages riskier behaviour, banks will have more opportunities to increase risk if allowed to engage in a broader range of activities. Third, complex banks are difficult to monitor. Fourth, such banks may become so politically and economically powerful that they become “too big to discipline.” Finally, large financial conglomerates may reduce competition and efficiency. According to these arguments, governments can improve banking by restricting bank activities.

There are alternative theoretical reasons for allowing banks to engage in a broad range of activities, however. First, fewer regulatory restrictions permit the exploitation of economies of scale and scope. Second, fewer regulatory restrictions may increase the franchise value of banks and thereby augment incentives for more prudent behaviour. Lastly, broader activities may enable banks to diversify income streams and thereby create more stable banks.

2. Regulations on capital adequacy

Traditional approaches to bank regulation emphasize the positive features of capital adequacy requirements. Capital serves as a buffer against losses and hence failure. Furthermore, with limited liability, the proclivity for banks to engage in higher risk activities is curtailed with greater amounts of capital at risk. Capital adequacy requirements, especially with deposit insurance, play a crucial role in aligning the incentives of bank owners with depositors and other creditors.

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