Rationale for Banking Regulation〔*〕

Chen Zhenyun

(1.School of International Law Shanghai University of Political Science and Law，Shanghai201701;2.East China University of Political Science and Law，Shanghai200042)

There arediverse reasons for regulating the banking sector，and different authors have divergent opinions on the validity of these reasons.The next section will provide an analysis of the key underlying reasons for the range of regulations that face the banking sector.

Banking activities have continuously evolved from traditional deposit-taking and lending activities to in coverage of the entire sphere of financial services over the past three decades.〔1〕Subsequently，it is inevitable that banks are indeed confronted with greater and more complicated risks in order to enhance profits.〔2〕As a result，banking crises have developed many times over the past decades.Banks are subject to a wide series of risks in the course of their operations.According to Hennie and Sonja，banking risks can be divided into four categories namely financial，operational，business and event risks.Financial risks are made up of two types of risks that are pure risks including liquidity，credit and solvency risks and speculative risks which include interest rate，currency and market price risks.Both types of risks are able to lead to a loss if they are not properly managed.Operational risks refer to a bank’s overall business strategy;internal and operational systems including organization，computer-related and other technologies;in compliance with bank policies and procedures;and measures against mismanagement and fraud.Business risks are related to a bank’s business environment such as macroeconomic and policy concerns，legal and regulatory factors，the financial sector infrastructure and payment system，and the overall systemic risk for operations.Event risks are associated with all kinds of exogenous risks including politics，contagion，banking crisis and others.

The incorporation of new financial instruments to transfer risk has further increased information asymmetries.Along with competition from non-bank financial intermediaries and the financial market，banks have been pushed towards risky behaviour to ruin the interests of consumers and shareholders.As the financial markets have increasingly become sophisticated，it is difficult for banks to raise sufficient money to fund their lending activity.Therefore，savers are not likely to be interested in deposits because banks are unable to provide high returns to depositors.Consequently，banks are likely to make decisions that depend on other channels of funding and engage in activity beyond the traditional banking activity.〔3〕

When banks used to engage in securitization as an innovative tool to supplement deposit funding，they could convert non-marketable assets into marketable assets represented by securities.〔4〕As financial markets became more efficient，banks were no longer required to depend solely on expensive deposit financing for their lending activities.〔5〕In addition，financial markets are likely to reduce the risks incurred by the banks through these instruments in that the credit risk associated with the loan is transferred from the bank to the investor if investors buy a loan.It is possible to sell the credit risk by means of credit derivatives which are financial contracts for which the value is derived from the underlying asset(the loan).Banks insured themselves against credit risk by these financial instruments.However，the entities that now buy this risk may try to fund their operations by borrowing on the market.For example，banks have set up Structured Investment Vehicles that buy long-term loans and fund them by short-term debt.

Banks can move loans off their balance sheets and transfer risk to different entities by means of financial techniques so that the incentives for banks to engage in adequate monitoring of borrowers are reduced，and they will not have real limitations in making bad loans to bad borrowers.However，investors rely on ratings by credit rating agencies to buy packages.These rating agencies evaluate the quality of the diversification in the packages and take other economic and systemic factors into consideration.Therefore，the credit rating agencies is delegated to monitor the quality of the risk packages.Although independent ratings by these agencies theoretically assure that the process of diversifying and relocating risk is indeed resulting in a reduction of risk，some authors argue that the wide availability of the methodology of credit rating agencies reduced the independence between the packaging of risk by banks and the rating of the package by rating agencies.

To be specific，the individual depositors of a failing bank will bear the cost of such failure which is possible to be led by granting loans because of the lack of incentives upon banks to perform optimal monitoring and the mentioned information asymmetries.The depositors in banks are ultimately affected even though credit risk is transferred because loans get securitised.The first reason for regulating banking services is the private costs of bank failures.However，the importance of banking activity to public policy is that individual bank failures create social costs that reach beyond private costs.

When a bank fails，the influence is not only restrained to the customers of the bank or its managers and shareholders，but it will also affect other banks and financial institutions.The effects of bank failures are eventually felt in the real economy.This is because of the high level of interconnection between banks and the important role carried out by banks in the real economy.

Despite the lack of a precise definition，regulators and the academic literature often use the notion of systemic risk which is separate from the other risks facing individual banks:credit risk，market risk，and political risk and so on to discuss the crises in the banking system.Problems of contagion are always referred as domino effects.When a bank fails and depositors of the bank withdraw their deposits，depositors with other banks may also have worries on the soundness of the activities of their banks.As a result，the savers may also start to withdraw their deposits from their bank，even when the latter bank may be perfectly solvent.Therefore，problems are likely to spread to other banks.Information asymmetries cause this type of reaction.The main reason that the systemic risk is deemed as particularly relevant to the banking sector is probably to be found in the huge spill over costs from systemic banking crises to the real economy，in addition to the historical experiences of financial crises.〔6〕System risk partly derives from interbank linkages.It derives partly from the linkages between banks through the payment system.Moreover，the public views that other banks are in the same position as the suspect or failed bank causes systemic risk.

There are significantly different rationales for regulation and forms that the regulation should take between banking and non-banking financial services，particularly as long-term contracts are involved.〔7〕For instance，systemic issues are much more significant in the regulation of banks，while client protection issues are relatively more important for non-bank financial services.〔8〕The traditional rationale for bank regulation and supervision is on the basis of four main considerations including‘the pivotal position of banks in the financial system，especially in clearing and payments systems;the potential systemic dangers resulting from banks runs;the nature of bank contracts;adverse selection and moral hazard associated with the lender-of-lastresort role and other safety net arrangements that apply to banks’.〔9〕

Governments have introduced safety nets which consist of central bank credit of last resort and deposit insurance schemes so as to prevent systemic risk.Although the introduction of a deposit insurance scheme is always regarded as an effective instrument to prevent a bank run and to provide a safety net，deposit insurance has some drawbacks.〔10〕‘For instance，banks will invest in unduly risky assets and reduce reserves while incentives for depositors to monitor and to exert market discipline are reduced’.〔11〕Some scholars uncovered some other flaws and discussed distinct ways to optimize insurance schemes.〔12〕Pursuant to Chan et al.，deposit insurance schemes are unable to be implemented on the basis of risk-sensitive and actuarial calculations and strive for incentives to excess risk taking，while other insurance schemes result in inefficient cross-subsidisation within the banking sector.〔13〕Consequently，strong banks will opt out of the scheme.Moreover，Bhattacharya argues that deposit insurance may come along with deadweight losses for other sectors.〔14〕A distinct way is to promote market discipline through restraining coverage or incorporating coinsurance in a way that interest rates on deposits rely on a bank’s profitability，liquidity and risk.The approach to mitigate adverse incentives caused by full deposit insurance coverage is to further limit a bank manager’s scope of activities.Capital adequacy ratios may lead to an increasing probability of a bank’s default and thus cause bank instability.

In contrast to deposit insurance where the main purpose is to prevent single bank runs and to protect depositors，the priority of a lender of last resort(LLR)is to prevent bank-financed firms from being prematurely liquidated.Under the most circumstances，LLR refers to‘discretionary provision of emergency liquidity to a single financial institution or the financial markets by the central bank usually only against first-class collateral’.〔15〕Central banks sometimes take the provision of risk capital as being part of their LLR function due to systemic consequences possibly caused by the failure of an insolvent financial institution.However，a moral hazard is likely to emerge with some commercial banks and therefore，central banks tend to express doubts as to whether or not they are likely to perform as LLR and not disclose the circumstances and conditions that financial support will be granted.〔16〕

All in all，although externalities are able to justify bank regulations and supervision，the balance between efficiency and stability of the banking system can be changed by all measures taken by authorities.〔17〕Therefore，it still remains an open discussion regards to the issue of a first best in banking regulation and supervision.〔18〕Thus，it is not strange that distinct countries may have adopted different regulatory and supervisory frameworks.〔19〕In addition，the current regulatory and supervisory frameworks were evolved from a political discourse during a financial crisis，instead of the outcome of a theoretically founded debate.〔20〕

〔1〕Joseph J.Norton，“The New International financial Architecture and Global Banking Institutions”in Say Goo，Douglas Arner and Zhongfei Zhou(eds)，International Financial Sector Reform:Standard Setting and Infrastructure Development，Kluwer Law International，2002，p.13.

〔2〕Dewatripont and Tirole(n 135).Also，Dirk Heremans，“Regulation of Banking and Financial Markets”in Boudewijn Bouckaert and Gerrit De Geest(eds)，Encyclopaedia of Law and Economics，Edward Elgar 2000，p.956.

〔3〕Pim Lescrauwaet，Links between Institutional Investors and Banks，Background Paper for the Working Group Institutional Investors，Global Savings and Asset Allocation of the Committee on the Global Financial System，2006，http://www.bis.org/publ/wgpapers/cgfs27lescrauwaet.pdf.

〔4〕The marketable assets are secured on the non-marketable assets(namely the receivables，like interest payments for a loan).See Philip R Wood，Project Finance，Securitisations，Subordinated Debt，Sweet＆ Maxwell，2007，p.112.

〔5〕Kern Alexander，John Eatwell，Avinash Persaud and Robert Reoch，Financial Supervision and Crisis Management in the EU，Study for the Policy Department on Economic and Scientific Policy of the European Parliament IP/A/ECON/IC/2007-069，2007，p.8.

〔6〕Martin Summer，Banking Regulation and Systemic Risk，Open Economies Review，2003(14)，p.43.

〔7〕〔8〕〔9〕Charles Goodhart，Philipp Hartmann，David Llewellyn，Liliana Rojas-Suárez and Steven Weisbrod，Financial Regulation:Why，how and where now，Routledge，1998，p.10.

〔10〕〔11〕〔12〕Bebenroth，Dietrich and Vollmer(n 10)，p.182.

〔13〕Yuk-Shee Chan，Stuart I.Greenbaum and Anjan V.Thakor，Is Fairly Priced Deposit Insurance Possible，The Journal of Finance，1992(47)，p.227.

〔14〕Sudipto Bhattacharya，Arnoud Boot and Anjan V.Thakor，The Economics of Bank Regulation，Journal of Money，Credit and Banking，1998(30)，p.745.

〔15〕Bebenroth，Dietrich and Vollmer(n 10)，p.183.

〔16〕〔17〕〔18〕〔19〕〔20〕Xavier Freixas，Curzio Giannini，Glenn Hoggarth and Farouk Soussa，Lender of Last Resort:What Have We Learned Since Bagehot，Journal of Financial Services Research，2000(18)，p.63.