Why do we need to regulate commercial banks?

The main function of any commercial bank is accepting deposits and lending money to borrowers. Apart from these two activities, commercial banks provide a host of other services to their customers, like discounting bills of exchange, acting as a custodian of a customer's will, and so on. In the absence of a proper regulatory framework or proper regulations in place, the commercial banks would have ended up charging exorbitant or varied rates of interest or service charges on the funds loaned by them or the services performed by them.

The formation of a regulatory framework for commercial banks

• The early-stage: In the early twentieth century, in most of the developed countries like the United States (US) and the United Kingdom (UK), special charters were granted to companies to carry out the business of banking. The small-town bankers held commendable political clout and used it to restrict competition and increase local monopoly by bringing about federal regulations like the Glass-Steagall Act that prevented inter-state banking. However, there was a growth in the non-bank finance companies that provided customers with liquid financial instruments that could also be used as a checking facility.
• The later stage: Eventually, in the year 1994, the US passed the Riegle-Neal Interstate Banking And Branching Efficiency Act to permit interstate banking. The banking regulations were further eased in the US in 1999 by the passage of the Gramm-Leach-Bliley Act that encouraged the banking companies to collaborate with financial institutions like investment firms and securities companies to provide a plethora of services to the customers. The great recession of 2008-2009 saw further bank regulation measures being undertaken globally. The post-crisis era saw a major overhaul of the bank regulations and major changes in the US financial regulatory system.
• Recent regulations: The Dodd-Frank Wall Street Reform and Consumer Protection Act was enacted in July 2010 to overhaul the banking and financial regulatory system in the US. This act aims at strengthening financial stability and safeguarding customers from repressive practices in the financial services sector. This act created new agencies like the Financial Stability Oversight Council, the Bureau of Consumer Financial Protection and amended the existing Federal Reserve Act to safeguard the rights of consumers and make the financial and banking systems more transparent and accountable. Regulatory agencies like the Federal Reserve, the Federal Deposit Insurance Corporation (FDIC), the Securities Investor Protection Corporation, and the Securities and Exchange Commission, etc. were most positively impacted by the act.
• Regulations related to auditing of public companies: The Sarbanes-Oxley Act was formulated and adopted by the US Securities and Exchange Commission (SEC). The Act was a regulatory amendment to the existing regulatory framework of the SEC and focuses on accounting regulation, corporate responsibility, corporate auditing of broker-dealers and other financial institutions. It contains new protection and regulatory measures for customers and issues penalties and criminal punishment to the concerned agency or corporate in case of non-adherence to the regulations.

Reasons for regulating the commercial banks

The central bank of a country acts as a regulator of the country's banking system. The Federal Reserve System supervises, regulates, and controls the working mechanism of all the banks and the non-bank finance companies, and bank holding companies in the US. The following reasons justify the regulation of commercial banks and financial institutions.

• Banks have the ability to create credit or liquidity. Any instability in the banking system causes a ripple effect in the entire economy. An unstable banking system can bring the whole economy down by adversely impacting lending rates. In the absence of cheap credit, all the sectors of the economy will gradually start slowing down and eventually will stop functioning. So, to prevent such a scenario, it is very important to regulate the banking system.
• Most commercial banks are mandated to provide deposit insurance to their depositors. The deposits of customers in the US banks are protected up to a specified limit by the Federal Deposit Insurance Fund. It means that in the event that the bank is unable to pay its dues, the amount covered under the deposit insurance will be refunded to the depositors by the State. While deposit insurance protects the depositors in case of a default by the bank, there is no deposit insurance available for the shareholders of the banks. Further, there is no regulation in place to prevent the banks, financial institutions, and bank holding companies from taking unwanted risks that would bring about such defaults. This necessitates the commercial banks to be regulated.
• Commercial banks, financial institutions, bank holding companies, and non-banking finance companies together provide a range of services to the customers. In order to protect the rights of customers, the banking system needs to be regulated.
• Healthy competition is good for the banking system as a whole. The US government has adopted several laws and regulations to restrict and abolish monopolistic practices in the banking sector. The commercial banks and the banking sector, as a whole, need to be regulated to prevent mergers or acquisitions that will adversely impact the competition in the banking industry.

Tools available for regulating the commercial banks

Commercial banks can be regulated directly and indirectly. The direct measures available to regulate the banking industry include regulatory measures by the country's central bank. The Federal Reserve System regulates the US banking industry. The indirect measures include regulation through formulating a monetary policy that impacts the interest rates, mandatory reserve requirements, and revises the repo rates. Apart from the direct and indirect regulatory measures, commercial banks also have several internal control measures.

• The Federal Reserve System: The central bank of a country is the apex body that regulates the banking system. In the US, the Federal Reserve System has been vested with the power to regulate and supervise the banking and non-bank institutions. The Federal Reserve System oversees the working of the financial system to ensure that the economy functions smoothly. It does so by formulating an appropriate monetary policy. The Federal Reserve can directly regulate commercial banks by increasing or decreasing the printing of currency or fiat money.
• Monetary policy: The set of policies and rules formulated by the national banks to regulate the banking system as a whole is known as the monetary policy. Tools of a monetary policy include interest rate regulation, regulating capital requirements, etc.
• Interest rate control: Banks earn income from the interest charged on the loans given to borrowers. The banks give interest to depositors. The difference in the interest earned on loans and the interest provided on deposits is the income for the banks. When there is excess liquidity in the economy, the Federal Reserve System increases the interest rates on loans given by commercial banks. This reduces the money supply in the economy and helps in curbing inflation. The reverse happens in the case of deflation. Interest rate controls imposed by the central banks help in regulating the commercial banks and ensuring optimum liquidity in the economy. Further, the Federal Reserve sets a maximum rate of interest that can be charged by commercial banks from customers. This helps in protecting the interest of borrowers.
• Regulation of capital requirements: Commercial banks are required to maintain different types of reserves as mandated by the Federal Reserve. The most common are the cash reserve and the statutory liquidity reserve. The cash reserve ratio refers to the ratio of cash deposits that commercial banks need to maintain to ensure daily liquidity. The statutory liquidity reserve refers to the number of deposits that the commercial banks need to maintain mandatorily with the central banks. Central banks regulate the money supply of commercial banks by increasing or decreasing the capital requirements.
• Regulating repo rates: Repo rate is the rate at which the commercial banks borrow money from the central bank. The central bank can regulate the commercial banks by increasing or decreasing the repo rate according to the money supply in the economy.
• Internal control measures: The internal control measures of commercial banks include measures related to the acceptance, recording, and reporting of custody of cash and other financial assets, internal review of the personal and expense accounts of bank employees and shareholders, etc. The central bank regulates the commercial banks by mandating strict adherence to the internal control measures.

Risk-based capital requirements

• The availability of capital helps to meet the financial risk of credit of the commercial banks.
• As per the regulations, commercial banks must maintain adequate capital to asset ratio to meet the contingencies.
• The capital to asset ratio helps to meet the risk and its exposure.
• It also helps to maintain the internal control system of the banking and non-banking institutions.
• It helps to maintain the soundness of capital structure and an effective financial system.
• It helps to estimate the risk-based factors in the non-banking system. It reduces the risk factor and maintains liquidity and flexibility.
• The capital to asset ratio helps to meet and reduce the high-risk exposure.

Context and Applications

This topic is significant in the professional exams for both undergraduate courses & postgraduate courses and competitive exams, especially for:

• Masters of Business Administration
• Bachelor of Business Administration
• Bachelor of Commerce
• Masters of Commerce

Practice Problems

Common Mistakes

Students are unable to discriminate the role of commercial banks and cooperative banks. It becomes difficult for them to understand the banking system and its regulations. They should focus on the activities and operations of different banking institutions.

Related Concepts

While studying this topic, it is important to read the following topics to get a better knowledge:

• Financial services
• Banking Regulation Act
• The federal reserve system