Theoretical and empirical literature
Critically review the theoretical and empirical literature which investigates the impact of bank regulations, market structure and institutions on the cost of financial intermediation.
Bank existed since ancient times, and so has fraud existed long ago in the banking industries. The misused of banks have always place the banking industry in a systemic risk. However, no one person in this world would to prefer to take risk provided that there are many risk takers around. The risk takers take risk solely because they want a better return at the end of the day. 'The higher the risk, the greater the return', is what everyday risk takers aim to achieve. On the other hand, there are consumer protection and deposit insurance aimed to protect banking customers. Additionally, there are many bank crimes insider and outsider fraud, money-laundering, terrorist financing and enforcement action. These crimes are sometimes caused by conflict of interest. The insider fraud, for instance, the employee may be in need of money therefore aspired to trade bank information with someone who is willing to pay for the particular information. Furthermore, these crimes and regulations impacts under the traditional 'competition-fragility' view and 'competition-stability' view. The Basel II Accord was then produced as a guideline to the banking industry since the many downfalls of banks around the world.Reasons of Bank Regulation
Since the collapse and downfall of many banks, and in response to that, governments have regulated certain requirements, restrictions and stringent guidelines which are subjected to banking laws. Prior to the secondary banking crisis of the early 1970s, banks were unregulated. The Banking Act 1987 was, therefore, implemented. According to Statement of Principles (Banking Act 1987), the Banking Act 1987 was designed and published a statement of principles proposed to improve prudential control in exercising its power to grant, revoke or restrict an authorisation. The collapse of Barings Bank has led to everyone's attention on multifunctional banking in fraud (Cranston, 2002, p.65).
The emergence and formation of bank regulation has brought in the implementation of supplant of the Basel Convergence Accord of 1988 in 2004. It was established based on a greater extent than the Basel Accord on credit ratings and internal models defining risk capital and weightings. The Basel II Accord was proposed based on three pillars. The first pillar focuses on the improvement of minimum capital requirements, the second pillar illustrate a focus on enhanced supervisory practices and the third pillar looked into bank in disclosing information, making them transparent to create a larger market discipline (Barth et al, 2004, pp.206-207). Countries around the globe are urged and encourage to adopt the Basel Committee's finalised list of 'best practices', in order for banks to regulate and supervise to gain and promote functionality. Evidence has not show that the best practice is appropriate for promoting well function banks; however, it is just a guideline in order to achieve performance and to promote development and stability.
According to Cranston (2002), there are 5 reasons to regulation in the banking sector: the systemic risk reduction, prevention of misuse of banks, prudential, consumer protection and deposit insurance and competition policy. The systemic risk emerges large in the bank regulation and financial intermediation, it is meant to reduce disrupting risk. These risks were caused by unfavourable trading environment for banks resulting in major bank failures. Cranston (2002, pp.66-67) explains that the interbank linkages is part of the systemic risk derivation. Barth et al (2004, p.209) add that the systemic risk may be define as conflict of interest when the bank engages in a diverse activity.
Another reason to the bank regulation is the prevention of misuse of banks. Cranston (2002, pp.68-76) indicates that bank failures are caused by bank crimes such as insider and outsider fraud, money-laundering, terrorist financing and enforcement action. The collapses of many banks are mainly caused by insider fraud. Cranston (2002, pp.68-69) shows that the collapse of the Bank of Credit and Commerce International (BCCI) was being highlighted as an insider crime. The downfall of Barings Bank, despite it being the oldest merchant bank and a powerful firm, was another case of insider crime in the banking industry. Although Barings Bank survived the Napoleonic Wars and both World Wars, Barings was brought down in 1995 by the head derivatives trader due to unauthorised insider trading. Money-laundering is another crime of misuse of the bank, and Cranston (2002, pp.69-72) define it as dishonest concealing or transferring the true source of moneys. Boyd et al (cited in Barth et al, 2004, p.209) add that the money-laundering behaviour is a dishonest moral hazard, increasing the banks' risk if these activities are allowed. According to Cranston (2002, p.70), the Global Anti Money Laundering Guidelines for Private Banks was launched in 2000 which highlighted banks in the legal obligation of their customers. This was launched to curb and control any further money-laundering and to enforce money-laundering law.
The third cause of bank failure is the terrorist financing, that is stealing or confiscating money for terrorism funding. Cranston (2002, pp.72-75) illustrated terrorism funding as the obligation of banks in disclosing terrorist funding and freezing and prohibiting orders against terrorism. Such variety of techniques of legal control is to avoid as much as possible any further terrorism. Without the financing, making it difficult for the terrorists suspects to achieve their purpose. Cranston (2002, p.73) also argued that some small amount of money-laundering are involved in terrorism financing. Legal business can sometime be the source of funding to the terrorism. However, it is not substantive. Another misuse of bank is the enforcement action, Cranston (2002, pp.75-76) describe as confidentiality being overridden to facilitate investigation. At some point, such an act has a combination of the insider fraud, money-laundering and terrorist financing, where the insider of the bank mutually assist terrorism by laundering money to support the act. Despite the duty of the bank's employees of confidentiality, the whistle blower may disclose confidential information to the bank regulators. According to Cranston (2002, p.76), the bank regulators may trump a judicial order against disclosure.
Another reason to regulation in the banking sector is the consumer protection and deposit insurance. The prudential protection ensures a safe and protected banking system for the customer (Cranston, 2002, pp.76-79). The marketing regulation, in addition, have long been found in the history controlling the price of money (Cranston, 2002, pp.76-79). The practice of lending money at unreasonably high interest rates, known as usury, was made lawful under certain controls on the interest rates. Later, this act was made lawful; however, it excluded banks and financial institutions.
Cranston (2002, pp.78-80) identify deposit insurance as a robust alteration in the control of protection of the depositors from bank failures. Barth et al (2004, p.237) listed two approaches of protection to depositor: deposit insurance scheme and bank fragility. The first approach has always been confined to protecting smaller savers while the second approach bestow on depositors over bank fragility. Based on Barth et al (2004, p.237) research, debates whether the future bank crises can be predicted using the deposit insurance, where there is a huge economic relationship between them. There are other arguments that strongly point that the depositors should not lose their savings if these banks were to go into insolvency (Cranston, 2002, pp.78-79). Demirguc-Kunt and Huizinga (1999, p.402) study have examined that the government should decrease the deposit rate for the sum insured for insurance protection. Another side of the study shows that the ceiling high deposit insurance engages banks in much riskier lending strategies.
Any ordinary depositors are not merely in the position to be vigilant, as the information provided require expert interpretation. Hence, the information provided by the banks is not transparent. In Barth et al (2004, p.238) article, they stressed that there is a strong preference on tighter official supervision and more stern requirements on ordinary deposit insurance. This would, eventually, act as a remedy to the issue. However, it does not mean it can be eliminated. It could only be reduced or minimised.
The fifth reason to regulation in the banking sector is the competition of antitrust policy. It is renowned that the policy to bank mergers (Cranston, 2002, pp.80-81). The effect of the regulation is to control entries of banks in the market, hence promote stability (Barth et al, 2004, p.210). There is a conflicting view that monopolising the market would bring a very beneficial effect as compared to the open competition effect.Impacts on Bank Regulations
Bank regulations differ with countries and across countries. The effect of bank regulation is seen in two views, the traditional 'competition-fragility' view and the 'competition-stability' view. The traditional 'competition-fragility' view shows a more erode market power in bank competition, decrease profit margins and results in decrease franchise value (Berger et al, 2009, p.100). On the other hand, under the 'competition-stability' view, there is a more market power in the loan market (Berger et al, 2009, p.100).
The traditional 'competition-fragility' view encourages the banking industry to more risk taking, in order to expect higher returns (Marcus, 1984, Keeley, 1990, Demsetz et al, 1996, Carletti and Hartmann, 2003 cited in Berger et al, 2009, p.100). By increasing the competition and deregulation of the banking industry and the removal of ceiling high interest, in many arguments seen, will eventually, erode monopoly rents, encourage moral hazard behaviour (Berger et al, 2009, p.100). It will lead to more insider and outsider fraud, money-laundering, terrorist financing and enforcement action. Ultimately, leads to more and more failure in the banking industry. Conversely, the 'competition-stability' view imply that the higher the interest rate, the more risk involve giving an impression that the banks are too big to fail and are more likely to be protected by the government (Berger et al, 2009, p.100). The high bank rates may be caused by the high interest rates charged to customers loans making repayment impossible (Boyd and De Nicolo, 2005 cited in Berger et al, 2009, p.100) or eventually a bailout by the government. It will eventually swing from a risk adverse to a risky market. With the higher interest, the banks are prone to be exposed to riskier borrowers who are willing to borrow at a ceiling high interest rate.
Nonetheless, these banks can offset the high risk exposure by having more franchise. As the banks franchise increase, they increase the franchise value as well as gain market power (Berger, 2009, p.103). By having a more diverse business, the risk exposure of the bank will be more wide spread and therefore faces less risk. Transferring the risk held to other diverse sub business units. Reducing the risk, therefore, increases control over the sub business units as well as the core business itself.Regulating and Deregulating Financial Intermediation
Norton (1991, pp.97-120) shows that regulation vital seen as a potential innovation factor, which attempt to accelerate the increase of inflation. Inflation increases the marginal returns, hence, regulating the banks do not attempt to change forces in the market. Innovation reflects the demand and supply forces (Norton, 1991, p.104). The demand forces include the various functions of the financial improvement, on the other hand, the supply forces embarks the technology and increase competition in the banking industry.
At some point, 'restrictive regulations' are designed to reduce, curtail or discourage some kind of inappropriate financial activities, while the 'liberalising regulations' acts as the catalysts and stimulant the innovation activity in the banking industry (Norton, 1991, p.104). A minimum requirement of bank regulations should be imposed on banks, in order to support the regulator's objective. Then, there is a need to maintain minimum capital ratios. This is to ensure that the banking industry is not monopolised. The Basel II Accord should be applied to the banking industry to set a comfort level for the banks to obtain. Another regulation is to set a requirement for the foreign banks to establish a subsidiary or a joint venture with a local bank (Cranston, 2002, p.104), which the approach will simplify the banking regulations, hence, protect the local banking industry. Should the bank be local or foreign bank, it should not escape regulation (Cranston, 2002, p.105). Many countries are applying this approach to protect their own banking industry, avoiding any further collapse of banks and government wasting resources bailing them out of the crisis. As argue in Barth et al (2004, p.209) study, for some banks which are politically and economically powerful will be difficult to monitor and discipline.
Under supervisory review, banks are required to obtain a bank trading license by the regulator in order to precede the business as the bank. The licensed banks are supervised by the regulator on the compliance requirements and breaches of requirements will have the bank license revoked. By having the license, certain activities or banking activities may be restricted by the government in order to improve banking as well as the banking industry environment.
Banks are subject to market discipline as they are required by the regulator to publicly disclose their financial information. By being transparent to the public, the depositor, other creditors as well as other stakeholders are able to assess the level of risk based on the information provided. Hence, their decision in depositing or investing and whether to take any risk would be based on the provided information. For this reason, banks are subject to market discipline. Above, the banks financial health can be assess using the market pricing information. Not only will the stakeholders have more opportunity, banks will have more opportunity to increase risk if allowed to engage in a more diverse or franchise activities (Boyd et al, 1998 cited in Barth et al, 2004, p.209).
Empirical evidence shows that negative repercussion occur due to banks restricted regulations (Barth, 2002, p.209). Regulated banks may have lower efficiency in the banking-sector (Barth, 2002, p.209), due to the restriction, these banks may lose out in competition. They may never explore the banking industry as openly as the rest of the bank. In the rat race, these restricted and regulated banks have not had the opportunity of trade and compete at a equal level in the open market. According to Claessens and Klingebiel (2000 cited in Barth et al, 2004, p.209), the lesser regulation permits the economies of scale and scope to be exploited.
By deregulating the banking industry, there is a higher probability for banks to suffer a major banking crisis (Barth et al, 2004, p.209). Evidence suggests that deregulating spurred the consolidation in the US (Berger, 1999, p.150). Local banks in the country are prone to direct competition with other politically and economically powerful banks in the world. Having no barriers to entry, these banks will be exposed to more and stronger competition. Not only are they prone to fair competition, they are also exposing to economic crisis which will cause downfall in the banking industry if they are not strong politically and economically.
Some countries have institution, like the regulator, that restricts competition, in order to protect medium and smaller banks from the politically and economically powerful banks in the industry. Some form of regulation should be imposed in the banking industry to curb the banks collapsing issue; however, being overly stringent in the regulations will literally discourage competition between banks. Possibly the 'restrictive regulation' will not achieve any achievement due to the stringent restriction on regulations. However, the 'liberalise regulation' may encourage some form of competition, at the same time regulating the banking industry. The Basel scheme is concern with credit risk, which is the risk of counterparty failure (Norton, 1991, pp.114-115), and will not ignore the riskiness of assets of a bank. By adopting the Basel II Accord, it measure the riskiness of the bank's activity.
Due to so many recent and non recent collapses in the banking industry, deregulation in the banking industry would place the banking industry in a risk. The misuse of banks by its own employees, management or non related staff, is putting the banking industry in a huge risk. Fraud caused is unexpected and it cannot be eliminated. However, the risk given towards the environment and change in the interest rate will achieve ceiling high rate will, eventually, bring them to an equilibrium characteristic by compensating the risk. On the other hand, the more risk adverse government may choose to stringent the regulation. Avoiding any further risk of downfall in the banking industry, the Basel II Accord is supplant of the Basel Accord, is established proposing three pillars to harmonise and to curb the modern financial crisis. There are debates that restricted banks bring negative repercussions. Flexibility in the regulation in the banking industry should be implemented, giving a balance in the banking industry. Therefore, it is entirely up to the government, whether is it a risk-taker or a risk-adverse. So, risk takers should deregulate the banking industry and the risk-adverse should regulate the banking industry.
- Bank of England. 1993. Statement of Principles: Banking Act 1987. The Banking Coordination (Second Directive) Regulations 1992. Greenaways
- Cranston, R. 2002. Principles of Banking Law. Second Edition. Oxford: Oxford University Press
- Barth, J. R., Caprio Jr, G. and Levine, R. 2004. 'Bank Regulation and Supervision: What Works Best?' Journal of Financial Intermediation. 13(2004) 205-248. Elsevier Inc
- Demirguc-Kunt, A., Laeven, L and Levine, R. 2004. 'Regulations, Market Structure, Institutions, and the Cost of Financial Intermediation'. Journal of Money, Credit and Banking. Vol.36, No.3 Part 2, The Ohio State University Press
- Berger, A. N., Klapper, L. F. and Turk-Ariss, R. 2009. 'Bank Competition and Financial Stability'. Journal Finance Service Reserve. 35:99-118. Springer Science + Business Media
- Demirguc-Kunt, A. and Huizinga, H. 1999. 'Determinants of Commercial Bank Interest Margins and Profitability: Some International Evidence'. World Bank Economic Review. Vol. 13 No. 2: 379-404. The International Bank for Reconstruction and Development/ THE WORLD BANK
- Norton, J. J. S. J. D. 1991. Bank Regulation And Supervision in the 1990s. London: Lloyd's of London Press Ltd