Reasons For Bank Regulations – Gyankovandar

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REASONS FOR BANK REGULATIONS

Reasons For Bank Regulations - Gyankovandar

Banking is one of the most regulated industries in every country. Historically, regulatory authorities concentrated their regulatory activities on licensing the banks and services provided by banks. The first traditional regulatory activity — issuing the license for banking services, used to restrict the free entry and exit of banks. This is used to reduce competition and protect the existing banks. Before the Mid-1980s, the banking industry was not open to the private sector in Nepal. Only two public sector commercial banks — Nepal Bank Ltd. and Rastriya Banijya Bank used to provide banking services in Nepal.
Historically, in most countries, banks were restricted to offer diverse products. For example, in the U.S.A, domestic banks were prohibited from underwriting securities for U.S. firms. In Nepal, Agricultural Development Bank was allowed to offer credit only to farmers and agro-based industries. So, regulatory authorities used to regulate entry as well as products that banks could offer to their customers.
In general, the banking industry is heavily regulated to ensure the safety and soundness of banks, provide monetary stability, provide efficient and competitive financial services, protect the consumer and maintain the integrity of the payment system. Failure of large banks results in a contagious effect on the economy, disrupts the domestic and global economy, and causes a huge amount of losses to the deposit insurance companies. We discuss the fundamental reasons behind the heavy regulation of the banking industry in this section.

1. Safety and Soundness

Banks accept huge deposits from the general public. If they invest such public deposits in risky projects or concentrate their loan and advances in a few sectors or borrowers or do not diversify their investment portfolio, they are taking too much risk. Such excess risk injures the financial health of the bank and endangers the depositors and other investors. Higher exposure to risk may lead the banks to failure and disrupt the economy and may lose public confidence in the whole financial system. In addition, depositors may lose their money beyond the limit of compensation provided by deposit insurance companies. In Nepal, Deposit and Credit Guarantee Fund insures deposits only for Rs 200,000.
In case of failure of any bank to pay the depositors, they get their money up to Rs 200,000 and they may lose their money in excess of Rs 200,000. Regulating authorities should ensure the safety and soundness of banks to maintain domestic and international confidence, protect depositors and ultimately taxpayers, and maintain financial stability in the economy. So, the first and foremost reason behind the heavy regulation of the banking industry is to ensure the safety and soundness of banks and financial institutions.

2. Monetary Stability

Monetary instability adversely affects the economic growth, interest rate, price level, and standard of living of the people. So, central banks control the money supply in their respective nations through monetary policy. Money supply consists of a number of notes and coins and deposits. Notes and coins in the economy are called outside money and deposits are called inside money. The central bank controls only the volume of outside money directly by using the different monetary policy tools. Control in the quantity of outside money affects the banks’ reserve position, amount of deposits, and loans. Thus, the central bank controls the volume of money supply in the economy and maintains monetary stability. The second reason behind the regulation of banks is to maintain monetary stability for the stability of macroeconomic variables such as interest rate, price level, and economic growth rate.

3. Efficient and Competitive Financial System

Only an efficient and competitive financial system can allocate the resources efficiently for economic development. The undue concentration of banking resources and restriction in the entry of new banks reduce the competitive environment and may promote the inefficient allocation of scarce resources in the economy. In contrast, a competitive and efficient financial system brings about efficient and professional management in the banking industry and banks with efficient management deliver qualitative services at relatively lower prices. We can take the example of public sector banks before opening the banking industry to the private sector. In Nepal, before the financial liberalization, two public sector banks— Nepal Bank Limited and Rastriya Banijya Bank, had a monopoly in the banking industry. Both Nepal Bank Limited and Rastriya Banijya Bank had a huge amount of accumulated loss and poor service delivery. But after liberalization, the competition in the banking industry increased and they were compelled to improve their performance.

4. Protection of Customer

Regulatory authorities regulate the banks to protect the customers from any discrimination by banks. Borrowers should have equal opportunities to obtain loans from the banks. Depositors also should have equal opportunities to deposit their money in banks. Banks should not make any discriminate on the basis of race, religion, gender, geographical location, and so on. They should disclose the reason if customers are denied the services. Regulatory authorities regulate the banks to ensure that banks are providing their services ‘to all eligible customers without any discrimination.

5. Integrity of National Payment System

The national payment system is an important component of a country’s financial system. It is a configuration of institutions supported by an infrastructure of technology-driven processes and practices to facilitate commercial and financial transfers between buyers and sellers. Nowadays, in addition to the traditional instruments of payment systems such as checks and draft, many retail credit instruments such as credit and debit cards and electronic transfer platforms have been evolved in payment systems due to the revolution in information and communication technology. In a payment system, users should be ensured that financial transactions are settled in a fair and predictable way. Participants (both payee and payer) should have confidence that payment media can be used to effect transactions. In addition, users of payment systems want low transaction costs, interoperability between different systems, security, privacy, and legal protection. All these are possible only if the financial system has a sound payment system, So regulation of banks is desirable to maintain the integrity of the nation’s payment system.

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