Why Is the Banking System Much More Heavily Regulated Than Other Areas of the Economy - Assignment Example

This paper looks at the question: Why is the banking system much more heavily regulated than other areas of the economy? Do you think that such heavyregulation adversely effects on financial development? And attempts to answer the same by looking at the theoretical basis for regulation and recent events in the context of the global financial crisis that were brought on by lack of regulation. Throughout the paper, I take the position that the banking sector needs to be regulated in order to prevent the recurrence of crises like the one that we have at the moment. Traditionally, the banking sector like other sectors was subject to regulation with the central bank playing the key role in determining to what extent the banks could be deregulated and the activities of the banking sector were monitored with the establishment of central banks around the world. To examine this issue further, one needs to look at the definition of a central bank and the functions of the same: A central bank is an institution that is mandated by constitutional decree to function along certain principles and entrusted with managing the fiscal side of the country’s economy. The Fed Reserve and Bank of England are examples of central banks. These banks have many functions, some of which are listed below. The central bank manages the monetary policy and sets interest rates to spur growth and rein in inflation. The role of the central banks has become prominent in these days of globalization and laissez- faire economics since the financial system has become more integrated and needs intervention by the central banks from time to time to keep the system together (Central Bank. The Encyclopaedia Britannica. Deluxe ed. 2001) Hence, the regulator for the banking system in every country has been the central bank of that country. To go deeper into the question as to why banks need to be regulated, it is pertinent to note that banks essentially deal with money (customer’s money, borrowers and lenders money). Hence, there is a need for prudence and caution to be exercised by the banks when they are transacting their business. It goes without saying that banks, being the custodians of other people’s money, need to act in ways that maximize the returns on investment. However, the other aspect is that banks in their haste to earn more money cannot throw caution to the winds and indulge in reckless behaviour and questionable business practices. It is this twin objectives of ensuring returns on money and at the same time be honest in their approach that is the basis of regulation of the banks. The regulators of the banking system watch out for these objectives on a constant basis though as we shall see later, the second part was conspicuously absent during the run-up to the present financial crisis. Till now we have looked at the reasons for the banking sector to be regulated and the way in which the banks need to be watched over for the simple reason that people’s hard earned money is at stake. Turning to the question of whether banks are hampered by heavy regulation, one can safely say that given the evidence from the recent global financial crisis, it goes without saying that the public around the world thinks that there is too much regulation. On the contrary, the absence of effective regulation and the fact that the Glass-Steagall act that was enacted in the aftermath of the Great Depression was repealed in 1998 have been cited as one of the factors that led to the global financial crisis. Atkinson and Elliott point out: The modern era has been characterised by slower growth in average real incomes, higher levels of debt to maintain living standards, greater job insecurity and financial crises that have become more frequent and more far reaching. The only class that has benefited unambiguously from this new world order is that of the gods of greed (Elliot and Atkinson, 2008). The absence of regulation can be seen from the following paragraph that details how the banks played havoc with the money that they had. The banking and financial sector started to experiment with leverage and trading at ratios of 20:1 to the underlying asset. What leveraging means is that for every $1 of “real assets”, the bankers “create” virtual assets in the form of derivates up to twenty times the value of the assets and in the process create a bubble of extraordinary proportions; Once the underlying assets started to depreciate in value, the mountain of securities and derivatives that were built on top of them became “toxic”. It is fairly obvious from the above paragraphs that inadequate regulation of banks does tend to encourage excessive speculation and reckless business practices. However, the discussion so far tended to focus on regulation in the Western World. There have been instances in the developing world or the so-called “Third World” where excessive regulation has led to the development of the financial system being hampered. However, such cases are far and few and most of the time, the financial systems of these countries are characterised by lack of depth rather than a lack of regulation. As is the norm when any crisis erupts in any sector, so is the case with the financial sector. Some questions that are being asked now are: “We advocates of relatively unfettered capitalism have strong exculpatory arguments: Who inflated the housing bubble with 1% money in a strong economy? (The Greenspan Fed.) Who encouraged all sorts of low-income, high-risk borrowers to acquire mortgages and homes they were doomed to lose? (Government agencies of all stripes) Who created the stock-option mania in big investment companies by capping tax deductions for executive salaries? (Congress, in the early 1990s) Who prolonged the current crisis with continuing destructive ambiguity, still unresolved, about which institutions would be bailed out and which wouldnt be? (Todays regulators and policy-makers)” (Foster, 2008). In conclusion, it is my firm belief that the banking sector needs to be regulated though in such a manner that innovation does not take a hit but at the same time, the interests of investors and customers are protected. Sources Central Bank. 2001. The Encyclopaedia Britannica. Deluxe Ed. Elliott, L & Atkinson D 2008, The Gods that failed. Bodley Head: London Foster, Peter. 2008. “No Fallen temple”. FP Comment [Online] Available from: http://network.nationalpost.com/np/blogs/fpcomment/archive/2008/09/23/no-fallen-temple.aspx [Accessed Apr 02 2010] Greenspan, Alan .2007. The Age of Turbulence: Adventures in a New World. Allen Lane. London Watson, William. 2008. “Regulating Hubris”. Financial Post. [Online] Available from: http://www.financialpost.com/story.html?id=798149&p=1 [Accessed Apr 02 2010] Read More