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Financial Institution and Monetary Theory4


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FinancialInstitution and Monetary Theory

Financialinstitutions are subjected to particular requirements, guidelines, aswell as restrictions by government. This is achieved by imposingcertain kinds of regulations by the government to banks in additionto other institutions in order to meet certain objectives. One of theobjectives includes generating transparency between financialinstitutions and the companies and people with whom they carry outbusiness (Benston1983). Provided the interconnectedness of the financial institutions andthe dependence offered to them by the international economy, it issignificant for regulatory bodies to sustain control over theirunvarying practices (Stigler1971).Those who support regulation of financial institutions base theirargument on the “too big to fail” aspect. They argue that themajority of the financial institutions, and specifically investmentbanks, have a large amount of control over international economy thustheir failure would pose massive repercussions. Governments offerfinancial support in the form of bailouts to financial institutionsparticularly those which are in the verge of collapse. It is arguedthat without such support crippled financial institutions would bothdevelop into bankruptcy and generate undulating impacts in thegeneral economy resulting in universal failure (Stigler1971).The current paper investigates regulations of financial institutions.In particular, some of the issues to be addressed encompass thereasons for regulating financial institutions, rationale forregulation, the regulations in place in Australia, impact ofregulation on commercial bank lending, and criticisms of regulation.

Formsof Regulation

Regulationof financial institutions instigated from the concern ofmacroeconomic regarding the capacity of bank depositors to scrutinizethe risks stemming from the lending side as well as the stability offinancial institutions in case of a crisis. Besides theadministrative and statutory regulatory stipulations, financialinstitutions are subject to a wide array of informal regulation(Rashe &amp Marcela 2007). This means that the government employsdiscretion externally from the official legislation, with theintention of swaying the end results of the financial institutions.These encompass bailing out bankrupt banks, deciding on bank mergersas well as sustaining considerable state ownership (Benston1983). There are numerous financial regulations that are subjected tofinancial institutions and they include:

  • Limiting new entry and branching

  • Limitation on pricing. It includes control on interest rates, fees and additional prices.

  • Limitations on line-of-business

  • Regulations ownership association amongst financial institutions

  • Limitations on assets range which can be held by banks encompassing kinds of securities to be held

  • Reserve requirements

  • Compulsory deposit insurance

  • Capital adequacy requirements

  • Obligations to direct credit to preferential enterprises or sectors through unofficial pressure or formal rules

  • Particular rules regarding mergers

Inthe contemporary time, regulation of financial institutions hasturned out to be invasive and has moved from structural regulation tonovel oriented types of regulation. Competition has also played asignificant duty in credit allocation and in the enhancement offinancial services. For instance, the Basel Committee created thecapital requirements framework which gave way in the creation ofstiff competition in the financial institutions (Rashe &amp Marcela2007). It is therefore indisputable that throughout the globe, thereis increased competition amongst new as well as existing financialinstitutions.

Objectivesof Regulation

Thereare various objectives which underlie the regulation of financialinstitutions. These objectives differ from one jurisdiction to theother. The key objectives encompass:

  • Prudential: It entails protecting depositors by lessening the degree of risk which they are exposed to.

  • Protecting the confidentiality of financial institutions.

  • General reduction of risk by lessening the risk of disturbance stemming from undesirable conditions for financial institutions resulting in key failures.

  • Credit allocation which entails directing credit to preferential segments

  • Preventing exploitation of financial institutions by lessening the risk of financial institutions being employed for illegal intentions.

  • Rules and regulations regarding treating customers in a fair manner and encompassing corporate social responsibility.

GeneralPrinciples of Financial Regulation

Althoughregulations to financial institutions differ from one jurisdictionand country to the other, there are a number of general principlesthat are applicable all over the globe. They encompass minimumrequirements, supervisory review and market discipline (Kaufman1996). Minimumrequirements are required for financial institutions with theintention of promoting the objectives of the agencies imposing theregulations. In most cases, the obligations are strongly linked withthe degree of menace coverage for a specific sector of the financialinstitution. Sustaining minimum capital ratio is the key essentialminimum requirement in the regulation (Kaufman1996).In the United States, financial institutions have to a certain extentsome flexibility in the determination of the regulator as well assupervisors. Supervisory review is the second principle. Prior toconducting business activities, the regulator issue financialinstitutions with a license, in addition to supervising them toensure they comply with the requirements. The regulator also respondsto violation of the requirements by acquiring undertakings, obligingpenalties, giving directions, as well as retracting licenses. Lastly,market discipline is whereby the regulators necessitate financialinstitutions to reveal their financial information. This informationis significant in that it is employed by creditors and depositors toformulate investment decisions and to evaluate the degree of risk(Stigler1971).On account of this, financial institutions are exposed to marketdiscipline whilst the regulator employs information on market pricingwhich acts as an indicator of the financial wellbeing of theinstitutions.

Reasonsfor Regulation

Unlikeother companies, it is important to closely regulate financialinstitutions due to various reasons. To start with, financialinstitutions are amongst the leading depository of individual andfamily savings among other kinds (Benston1983). Whilstthe majority of saving among individuals is put under comparativelyshort term and extremely liquid deposits, financial institutions aswell hold huge amounts of lasting savings particularly insequestration accounts. As a result, in case of bank failure,considerable loss would be experienced and disastrous to mostpersons. Nevertheless, it has been shown that the majority of saversdo not have the financial expertise required to properly assess theriskiness of financial institutions. As a result, regulatoryorganizations have the duty of obtaining and assessing informationrequired to evaluate the accurate condition of financial institutionswith the intention of safeguarding the public in case of loss.

Anotherreason for regulating financial institution is that they have theauthority to generate money through investments and loaningdepositors. Through this, they are able to obtain spendable deposits.The modifications in the amount of money generated by theinstitutions seem to be strongly linked with economic environment,including intensification of jobs as well as inflation. Nevertheless,some critics argue that generation of money that affects the vivacityof the general economy is not an adequate reason to for regulatingfinancial institutions. They base their argument on the fact that thecapacity of government policymakers to regulate money supply in acountry implies that the money generated by financial institutionsshould therefore be of little concern towards the regulatory bodies(Rashe&amp Marcela 2007).

Regulationis also practiced based on the reason that financial institutionsoffer the public as well as corporations with loans with theintention of supporting investment and consumption spending (Kaufman1996). Accordingto regulatory bodies, the general public is interested in asufficient credit supply originating from the financial system. Inaddition, there may be discrimination in the provision of financialservices and this poses greater concerns in the well-being as well asthe living standards of the affected parties. Such discrimination mayoccur with respect to age, nation of origin, race, sex, amongst otheraspects. Such discrimination is eliminated by regulatory bodies byimposing regulations. Critics of regulations put forth that suchdiscrimination could be eliminated in the provision of financialservices through promotion of increased rivals amongst providersinstead of through regulation. These encompass enforcing dynamicantitrust laws and regulations.

Lastly,financial institutions and banks in specific involve themselves withlocal, state, as well as federal governments (Nicolas&amp Firzli 2011).During the olden times, some of governments spending initiated frombank credit. Nevertheless in the contemporary time, this hasmodified. Financial institutions are used by governments to help incarrying out economic policy, dispense government payments, inaddition to collecting taxes. However, some critics have attackedthis rationale for regulation currently. They argue that even withoutregulation, financial institutions could still offer finances togovernments as it is their daily business dealings.

Asaforementioned, regulation of financial institutions varies from onejurisdiction to the other. In the United States for instance, atwofold banking system is used to regulate banks. Furthermore, stateand federal agencies have considerable regulatory authority. Whilststate regulations allow different states to control financialinstitutions in the respective localities, federal regulations makecertain that financial institutions are treated in a fair manner bylocal and individual states. The main regulatory authorities in theUnited States government encompass the Federal Reserve System,Comptroller of the Currency, as well as the Federal Deposit InsuranceCorporation (Black2004).At the state level, banking commissions are the key regulators in theU.S banks.

Insummary, the main reasons why financial institutions are subjected toregulations encompass: safeguarding the safety of savings of thepublic, controlling credit and money supply with the intention ofattaining the general economic objectives of a country encompassinglow inflation and increased employment, making certain equality andequal opportunity in accessing credit as well as other essentialfinancial services, offering government with tax revenues andcredits, assisting certain economic sectors with exceptional creditrequirements including small businesses and housing, preventingfinancial power to be concentrated in a small number of institutions,and promoting confidence amongst the public regarding financialsystem in order to ensure smooth flow of savings into the requiredactivities and sectors (Black2004). It is nevertheless significant to balance and limit regulationfor various reasons. They include: financial institutions have thecapability of developing novel services demanded by the public, andpresence of strong rivalry in the financial sector in order to makecertain realistic prices and provision of enhanced service quality.

Regulationin Australia

TheAustralian Financial Services is regulated by the AustralianPrudential Regulation Authority (APRA) (Adamset al. 2007).APRA is the prudential regulator as well as a statutory authority inAustralia. It was founded in the year 1998 and obtains its financialresources from the companies it oversees. The body has theresponsibility of keeping an eye on financial institutions includingbanks, friendly societies, credit unions, reinsurance firms, buildingsocieties, general insurance, as well as the majority of firms in thesuperannuation industry. In the current time, APRA overseesorganizations with an asset base of 4 trillion U.S dollars forapproximately 23 million policymakers, depositors, as well assuperannuation members in Australia (Adamset al. 2007).The aim of the regulation is to make certain that the financialinstitution in Australia maintain their financial promises. Itimplies remaining financially sound besides having the capability ofmeeting their requirements to policyholders, depositors, and fundmembers. The chairmanship of APRA is headed by Dr John Laker whilstIan Laughlin is his deputy.

Theresponsibilities of APRA include prudential regulation as well aslicensing of financial institutions encompassing superannuationfunds, general and life insurance, and Authorized Deposit-takingInstitutions (ADIs) (Adamset al. 2007).The financial institutions controlled by APRA are necessitated toreport to the authority on a cyclic basis. In order to ensure thatregulation keeps in line with the needed requirements, APRA hasformulated and provided capital adequacy principles that match withthe Basel II principles. APRA does not apply its prudentialsupervision over investment banks considering that they do notfunction under ADIs. This implies that they are not regulated orlicensed by APRA. Nevertheless, the majority of investment banks areobligated by the Financial Sector Act 2001 to offer statistical datato APRA.

Otherregulators in Australia include the Reserve Bank of Australia (RBA).The body has the responsibility of overseeing central bankingoperations encompassing supervising the majority of payment systemsas well as formulating monetary policy (Adamset al. 2007).Another body is the Australian Securities and Investment Commission(ASIC) which has the responsibility of regulating anti-rivalry acts(Adamset al. 2007).To ensure that the regulators carry out their duties as required,they are sovereign statutory bodies without direct supervision fromthe government. APRA and the RBA are administered by boardsconsisting of independent and ex officio non-executive governors anddirector who are chosen by the Treasurer. On the other hand, ASIC isadministered by executive commissioners with daily responsibility forthe functioning of the agency. The commissioners are closelyscrutinized by parliamentary committees to ensure that they act inaccordance with the requirements. Some critics argue that in spite ofthis scrutiny, miniature supervision is directed towards theactivities of the regulators.


Theprocedure of regulatory transformation in the financial institutionsstarted in the 1970s in many nations (OECD1997).The procedure entailed a movement towards market oriented structuresof regulation. It also engaged part or absolute liberalization ofvarious aspects including the ones mentioned below. The first aspectis control of interest rates. In many nations, control on lending andborrowing was invasive near the beginning of 1970s. The controls wereimportant in that they kept the rates beneath the levels of freemarket (Mathias&amp Jean n.d).Accordingly, financial institutions allocated credit to advantagedborrowers. However, just a few nations maintained these controls. Thesecond aspect is quantitative investments limitations on financialinstitutions. Such limitations on financial institutions took anumber of forms encompassing rules on credit allocation, obligationsof holding government securities, necessitated lending to preferredinstitutions, as well as controls on overall amount of growth incredit (OECD 1997)Prudential rationalization and obligatory government securities was aconcealed type of taxation as it permitted governments to maintainlow security yields. By 1990s however, the controls becameprincipally eliminated. Some controls lingered on lasting capitalmovements, and in particular with regard to overseas ownership offoreign direct investment (FDI). Significant limitations on worldwideportfolio diversification of insurance funds as well remained (OECD1997).

TheImpact of Regulation

Regulationof financial institutions has a number of impacts. In spite of thefact that the motives of regulation are acknowledged by many, theprobable effects of regulation on financial institutions havegenerated heated discussion. Various theories exist concerningregulation, including the one developed by Stigler George, aneconomist who put forward that regulated companies prefer theprocedure based on the reason that it is beneficial in terms ofmonopolistic rents (Diamond&amp Dy bvig 1983).Stigler argues that generally regulation prevents entry of new firmsin the regulated industry (Stigler1971). As a result, lifting regulations may cause financialinstitutions to lose money as they are incapable of benefiting fromsafeguarded monopoly rents which amplify their earnings. Anothertheorist of regulation is Peltzman Samuel. He argues that regulationis important as it protects companies from modifications of cost anddemand thus, lessening its risks. Assuming the argument is accurateit then implies that financial institutions would be subjected tohigher risk and ultimately lead in failure in case regulations arelifted (Stigler1971).

Inthe recent past, Kane Edward has put forward that regulations havethe capacity of amplifying confidence among clients and thissequentially generates increased client loyalty on the regulatedcompanies. According to Kane, regulators in reality rival with oneanother in the provision of regulatory services (Diamond&amp Dy bvig 1983).This is aimed at enlarging their influence amongst regulatedinstitutions and with the public at large. In addition to this, Kanecontends that there exist a regulatory dialectic between regulatedcompanies and their regulators. It is a continuing struggle betweenthe two which arises due to various reasons.

Afterregulations have been put in place by the regulators, managers fromfinancial institutions have the responsibility of searching for noveltechniques around the novel rules with the intention of lesseningcots and permitting innovation to take place. Success in dodging thesubsisting regulations implies that the subsisting rules would beformulated. This would in turn encourage financial managers tocontinue with the innovation thus alleviating the burden of novelregulations. Therefore, regulated companies together with theirregulators continue with the struggle for an indefinite time. As putforth by Kane, regulated companies lack the opportunity of growing up(Diamond&amp Dy bvig 1983).He argues that regulations offer encouragement for lowly regulatedfirms to attempt to attract clients from highly regulated companies.This act has taken place in the banking sector in the contemporarytime considering that the upcoming financial institutions togetherwith lowly regulated financial companies have taken away customersfrom the banking sector.

Criticismsof the Regulations

Althoughregulation is deemed appropriate as it controls the manner in whichfinancial institutions operate, it has obtained various criticismsespecially in the current time. For instance, some of the criticshave criticized certain forms of the regulations contending that theynegatively affect the profitability of financial institutions andtherefore, interests charged on shareholders. For example,regulations on lending and borrowing would impact the amount of moneythe financial institutions are able to lend to its depositors.Considering that financial institutions usually obtain their moneyfrom interest on lending, low lending implies low profitability.Therefore, such regulations would in turn amplify the rates ofinterest charged by financial service providers.

Othercritics argue that some international regulations of financialinstitutions are extremely strict and this in turn affects thefunctioning of such institutions. This was particularly mentioned bya number of lawyers during the International Bar Associationconference held in the current year in Dubai. For instance, accordingto Hendrik Haag put forward that the forthcoming obligation of novelliquidity and capital requirements on financial institutions couldobstruct market recovery (Nicolas&amp Firzli 2011).Imposing further capital obligations on financial institutions meansthat cost of borrowing credit would be amplified. It would thereforebe hard for financial institutions to go on with their responsibilityof funding the market as put forth by Haag. The economy could onlygrow speedy if financial service providers have the capacity to offercheap credit to the public.

BaselIII rules were formulated by the Basel Committee on BankingSupervision. It is an international supervisory committee of thefinancial sector. The rules brought forth essential modificationswhich were termed by Jean-Claude Trichet, the president of EuropeanCentral Bank, as significant in strengthening international capitalstandards (Nicolas&amp Firzli 2011).These rules were anticipated to compel financial institutions toefficiently triple their capital reserves. From the year 2013,financial service providers were required to amplify their amounts oftier-one-capital reserves, and in particular shareholder equity. Thiswould amplify from 2% to 4.5% of overall risk bearing assets.Besides, they are not supposed to employ favored debt equity or stockto assist in hitting the target. Another requirement of financialinstitutions is that they should keep a further tier-one shield equalto 2.5% of the entire possible losses. Failure to meet the novelstandards would subject financial institutions to various impedimentsincluding prevention of giving dividends to their shareholderspending improvement of the balance sheets (Nicolas&amp Firzli 2011).

StandardInstruments of Regulation

Thereare various standard instruments used by regulators in financialregulation. They encompass deposit insurance, lender of last resortand capital adequacy requirements (Black2004). Depositinsurance is aimed at safeguarding the smallest bank depositors frominsolvency. Lender of last resort assists in reducing the jeopardy ofinsolvencies offering financial institutions with Emergency LiquidityAssistance resources which are intended to prevent impermanentilliquidity circumstances (Stigler1971).Lastly,capital adequacy requirements are significant in that they makecertain that bank managers to pursue an efficient credit policywhereby useful control does not exist. The regulation subsists inmany nations and it takes various forms. In many nations, an absoluteamount of required capital is acknowledged. The maintenance ofsolvency ratio is also necessitated. Nevertheless, there are variousdifficulties linked with capital adequacy requirements and theyencompass difficulties in designing capital adequacy requirementsadequately, problems may initiate with inter-banking lending, rapidinnovation and growth in financial products due to advancement intechnology, and sheathing regulatory developments may obstruct theadoption of novel financial products. This is turn may delay andstifle the speed of innovation.


Regulatingfinancial institutions is deemed important as it allows thegovernment as well as other regulators to control the operation ofsuch institutions. This paper has focused on regulation of financialinstitutions. Financial institutions are subjected to particularrequirements, guidelines, as well as restrictions by government. Thisis achieved by imposing certain kinds of regulations by thegovernment to banks in addition to other institutions in order tomeet certain objectives. These objectives encompass prudential,protecting the confidentiality of financial institutions, generalreduction of risk by lessening the risk of disturbance stemming fromundesirable conditions for financial institutions resulting in keyfailures, credit allocation which entails directing credit topreferential segments, preventing exploitation of financialinstitutions by lessening the risk of financial institutions beingemployed for illegal intentions, and rules and regulations regardingtreating customers in a fair manner and encompassing corporate socialresponsibility. There are numerous financial regulations that aresubjected to financial institutions and they include: Limiting newentry and branching, Limitation on pricing. It includes control oninterest rates, fees and additional prices, Limitations online-of-business, Regulations ownership association amongst financialinstitutions, Limitations on assets range which can be held by banksencompassing kinds of securities to be held, Reserve requirements,Compulsory deposit insurance, Capital adequacy requirements,Obligations to direct credit to preferential enterprises or sectorsthrough unofficial pressure or formal rules, and Particular rulesregarding mergers.

Thereare a number of reasons why financial institutions are regulated.Some of the main reasons why financial institutions are subjected toregulations encompass: safeguarding the safety of savings of thepublic, controlling credit and money supply with the intention ofattaining the general economic objectives of a country encompassinglow inflation and increased employment, making certain equality andequal opportunity in accessing credit as well as other essentialfinancial services, offering government with tax revenues andcredits, assisting certain economic sectors with exceptional creditrequirements including small businesses and housing, preventingfinancial power to be concentrated in a small number of institutions,and promoting confidence amongst the public regarding financialsystem in order to ensure smooth flow of savings into the requiredactivities and sectors. It is nevertheless significant to balance andlimit regulation for various reasons. In Australia, there are anumber of agencies responsible for regulation including APRA, RBA,and ASIC. Although regulation is deemed important, it has beencriticized by some commentators. They argue that that they negativelyaffect the profitability of financial institutions and therefore,interests charged on shareholders. Besides, regulations of financialinstitutions are extremely strict and this in turn affects thefunctioning of such institutions. In a nutshell, provided theinterconnectedness of the financial institutions and the dependenceoffered to them by the international economy, it is significant forregulatory bodies to sustain control over their unvarying practices.


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