Topic 6: Prudential Control and Regulation in Banking (Part 1)

Lecture Outline Arguments for prudential control / regulation Problems with external prudential regulations Prudential control and regulations in the UK

Regulation: Introduction All firms have to ensure capital adequacy, and (banks in particular) have to also ensure sufficient liquidity.  Hence regulation is important. Control is necessary due to two conflicting objectives:  Profit - high to keep shareholders happy.  Liquidity- low/high to earn profit/serve better and insure depositors.

Introduction Should prudential controls or regulation be compulsory? Should these regulations be imposed by the state? Should they be imposed by the bank management itself?  Bank also has an interest in long-term survival.

Why Should we Regulate? Protection of the public’s savings. Control of the money supply. Asymmetric information and vulnerability of depositors.

Why Should we Regulate? Contagion (panic or domino) effects. Bank’s ability to diversify assets. Competition and excessive risk taking.

Problems with Regulation Cost Competition  Hampers competition and innovation. Competence?  Question mark over competence of supervisor. Complexity

Problems with Regulation Moral hazard Asymmetric information Government Guarantee  Deposit insurance has ended risk of systematic failure (?) Capital adequacy  Capital adequacy has ended credit risk (?)

A Case for Free Banking The Scottish System (1716 – 1844).  Banks allowed to enter the market w/o chartering or licensing. Results:  intense competition, innovation and economic growth  system introduces branch banking, interest paid on deposits, overdraft facilities and private deposit insurance.

Regulation in the UK: Pre-1979 No specific banking law in the UK Private banks treated like any other commercial concern Individual agents or firms could accept deposits without any formal licence.

Regulation in the UK: The Banking Act 1979 Identified two classes of institutions: orecognised banks and olicensed deposit takers Main Features: oAct created a Deposit Protection Fund (DPF), to which all recognised banks to contribute. oFunds compensate 75% of any deposit up to £10,000.

Regulation in the UK: 1987 Amendment Collapse of Johnson Matthey Bank (JMB) paved the way for amendment to the 1979 Act. Main Features: oCreated supervisory board headed by the Governor of BOE. oEliminated the distinction between deposit takers and banks.

1987 Amendment Private auditors were given greater access to BOE information. Exposure to a single borrower > 10% of banks capital reported to BOE. Supervisor consulted directly on any lending which exceeds 25% of bank capital to a single borrower. Act also specified BOE control over the entry of foreign banks.

1987 Amendment Act increased the deposit insurance limit to £20,000. Under Act, BOE acts as a regulator. The asset side of a bank balance sheet is regulated through capital adequacy and liability side through liquidity adequacy. Act clarified that a firm seeking status as a recognised bank from the BOE must offer a broad range of services.

Further Examples of Regulation….  1971-Competition and Credit Control Act.  , , The Special Supplementary Deposit Scheme.  1979 End of Exchange Control.  1983 Stock Exchange Reforms.  1986 Financial Services Act.  1986 Building Societies Act.

Conclusions Regulation is a necessary tool for managing the modern bank and controlling risk exposure oDrawbacks of Regulation – is the process necessary after all? There are historical examples of free banking markets working to the advantage of society oThe Scottish Example In the UK, we have observed a gradual shift in regulatory attitudes from relatively lax to relatively stringent. oParticularly from 1978 (pre Banking Act) – 1987 oHowever…….