Introduction
Traces of financial crisis and negative externalities have been present across the banking sector for the last several decades, so their impact on economic stability can be explained via two inherent descriptions. The first vital concept is the existence of microprudential purposes that gave birth to balance sheet rules but also amplified some of the shockwaves related to asset prices at the same time (Acharya, Le, and Shin, 2017). Therefore, a negative financial externality, in this case, could be described as a pecuniary accelerator that has to be applied to intermediary subjects. The second crucial concept is the existence of issues related to coordinating creditors, as instances of panic among the latter could cause changes to the equity base. This is a serious problem for banks because they recurrently fail to cope with the negative externalities through the interface of partnering with creditors (Korinek, 2018). Similar issues would also be seen in investment banks, as liquidity insurance would lose its power under the influence of the most common market shocks.
When answering the question of whether any systemic risks could be reduced with the help of specific banking regulations, it should be noted that there are two diametrically opposite outlooks on the subject. First of all, stringent regulations are going to have a negative impact on the banking sector because of the possible increase in systemic risks (Acharya et al., 2017). The higher the number of restrictions imposed on local banks, the more issues the given sector is going to experience linked to capital stringency and correction authority. On the other hand, regulations could become a mere supervisory instrument intended to help the teams decrease possible banking risks and establish an environment where consistency would be the key to predicting or even preventing severe market declines (Battaglia and Gallo, 2017). The introduction of banking regulations is a dichotomy that has to be addressed in future research in order to provide a more detailed outlook on the issue.
This research paper is intended to answer the question of whether banking regulations are actually that important and have to be considered during policy-related decision-making and activities intended to undermine the financial crisis. Most regulatory mechanisms that are currently active have been designed in a rather stringent manner, which increases the probability of systemic risks (Cai et al., 2018). Despite a visibly utopian outlook on the banking sector affected by the rigidity of previously installed regulations, the author of the current paper is going to investigate the value of addressing banking risks with the help of regulatory incentives and the process of managing those risks based on both theoretical and empirical evidence.
Review of Evidence
Background Information
Banking regulations are necessary because they pursue four key objectives within the financial sector. The first is depositor confidence, and its vital role can be explained by the inherent fear experienced by bank clients at times when they do not feel secure (Harnay and Scialom, 2016). Ultimately, banks would quickly run out of resources due to a critical upsurge in clients. Hence, the role of certain banking regulations is to encourage more active participation in the financial system among most clients and seek depositor confidence established through limitations intended to protect them.
The second essential objective behind the application of banking regulations is the willingness of banks to prevent risky behaviors. Given that most banking operations are linked to financial resources and, more specifically, customers’ money, it should be noted that any given loan brings an extreme level of risk to the field (Nayak, 2021). Therefore, the direct link between high-level risks and respective rewards drives many bank administrations to incorrect verdicts regarding improvement opportunities. This is where banking regulations step in and restrict the inherent level of exposure that a bank could achieve when building a partnership with any given client.
Evidently, banking regulations are also required to identify and prevent any kind of criminal activity aimed at the government, customers, or the organization itself. Recent developments in the area of hacking and Web-based threats have made customers significantly more prone to facing a digital attack on their own (Sum, 2016). In order to limit such instances of exposure, many banks introduce regulations that intend to monitor all kinds of suspicious activity and the amount of money transferred between clients.
The ultimate reason for the advent of banking regulations was the willingness of banking administrations to direct credit and encourage customers to come back or bring a ‘friend’ from a different industry or a social class. The rationale behind this activity can be outlined as an attempt of the banking sector to build connections with minority populations and promote the value of independent businesses and aspiring incentives (Ferreira et al., 2018). This approach to the client base is more than a mere social policy because it helps the organization establish a positive environment where clients have the opportunity to voice their opinions.
Managing Risks
The first type of risk that could be met within the banking industry is credit risk. It can be characterized as the most impactful since it relates to the inability to meet contractual obligations (DeAngelo and Stulz, 2015). The nature of most banking business models makes them prone to credit risks in a natural way since they can only limit their exposure and not remove it completely. One of the possible means of predicting or restricting the negative impact of credit risk is to diversify and engage in activities that would allow the administration to reduce the level of exposure and avert large monetary losses (Nolde and Ziegel, 2017). In this case, banks would choose to partner with clients who have a good credit history in order to maintain a positive input on the transaction side and have more chances to predict the probability of a client paying back the loan.
The second type of risk is the operational risk which can be described as a potential loss caused by human error, flawed processes or systems, and internal interruptions or errors. According to Chernobai, Ozdagli and Wang (2021), simple business procedures rarely cause an upsurge in operational risks, as retail banking and asset management do not represent a threat for clients and organizations. On a larger scale, cybersecurity breaches could also be considered an operational risk for an organization since customer information would be misused by the wrongdoer, and the bank will be held responsible for not being able to protect the financial resources that had been in the client’s possession (Hoque et al., 2015). One of the possible ways to avoid operational risks is to invest in monitoring programs and nurturing a sense of unity across the whole team. Without these two, banks would be prone to bending internal rules and exposing both the organization and customers to cybersecurity-related and other threats.
The presence of market risks is mostly reliant on the activities that occur within capital markets, as many of those are too unpredictable and hold a great deal of risk associated with interest rates, equity markets, and credit spreads (Lim et al., 2017). When a bank organization is often engaging in sales and trading, it naturally exposes itself to increased levels of risk since commodity prices fluctuate and put the bank’s assets on the line eventually. The shifts in supply and demand are also crucial for a better understanding of how banks could be impacted by market risks. Again, diversification could be a possible solution since modern banks are much more versatile than their counterparts from two decades ago (Levitin, 2016). In order to diversify properly, the bank administration would have to widen its investment options and ensure that the most re-occurring types of risks are mitigated.
The inability of a bank to meet funding obligations is ultimately referred to as the liquidity risk. For instance, when customers cannot access their deposits, it could cause a snowball effect and force numerous clients to lose confidence in the bank. In most cases, it might lead to a bank run and decrease the ability of the organization to provide funds to clients and partners (Bonner, Van Lelyveld and Zymek, 2015). The most important reason why liquidity risks transpire is the willingness of banking organizations to rely on short-term sources. The chances to mismanage resources increase, and the bank risks becoming prone to liquidity problems when the incursion of outside funds either slows down or gets shut down completely. A possible way of evading liquidity risks is to meet obligations while ensuring that there are mismatches between liability and asset maturity (Ghenimi, Chaibi and Omri, 2017). This approach would reduce the level of interdependency and make the asset management process less challenging.
Types of Regulations
microprudential. This type of regulation relates to the ability of individual banking organizations to maintain a stable stance and protect the customers instead of contributing to the economy as a whole. Therefore, microprudential approaches mostly rely on the concept of resilience and ensure that financial stability is achieved and most external risks are approached with the help of existing resources and instruments (Messai and Gallali, 2015). Even though the systemic implications are mostly ignored across the microprudential approach, it cannot be outlined as either a positive or negative type of regulation. In the words of Walther (2016), microprudential regulations could be a predictor of financial crises while also impacting the market in multiple unpredictable ways. When certain assets are either sold or purchased simultaneously by many players in the market, it is most likely to be a sign of microprudential regulations being passed. Nevertheless, a healthy financial system could not be established with the help of microprudential regulations only.
macroprudential. This type of policy, in turn, mostly focuses on the overall stability of the financial background within the country. Based on the evidence presented by Jeanne and Korinek (2020), it may be concluded that stable economic growth should become central for preventive operations against market disruptions and inappropriately exposing financial services. A high level of vulnerability is a negative factor that cannot be underestimated since short-term funding is often left uninsured, and the interconnections between investors and banks are too impervious.
Basel III regulations, for example, became one of the most coherent responses to the global financial crisis. Its main objective was to address the previous regulatory framework in a critical way and build up the level of resilience among banking organizations through closing at least some of the existing gaps (Roulet, 2018). Systemic vulnerabilities that appeared due to the global crisis were significantly impacted by quality improvements and the focus of Basel III on a number of internal components. During the initial phase of deploying the new regulations, policymakers intended to highlight the importance of loss-absorbing capital. It was a crucial task for the officials to build up a decent level of resilience in order to have the bank industry react differently to inherent stressors and different types of losses (Naceur, Marton and Roulet, 2018). Another essential reason behind implementing Basel III was the willingness of policymakers to calibrate the risk capture process and improve the existing standards for spotting the four types of risks presented earlier. The biggest role in the Basel III framework was given to capital buffers that served as restrictions for procyclicality.
On the other hand, the Volcker Rule was passed in 1999 in order to restore the destructive impact of the Glass-Steagall policy. The latter was an unsuccessful attempt to manage investment banks and establish an environment where corporations could become public in order to raise capital. Therefore, privately-run banks could not be regulated while not having to expand or reduce their fees (Lehmann, 2016). The Volcker Rule became a game-changer since it allowed for transforming the nature of commercial banks and making depositors aware if they could actually gain a little interest and also protect their money. The inherent regulation of interest rates turned out to be a positive change for commercial banks even though they had rather thin profit margins (Krawiec and Liu, 2015). The unfair competitive advantage achieved under the Glass-Steagall policy was gone, as investment banking was no longer superior to credit unions and community banks. The presence of banks that could be called too-big-to-fail also sped up the deployment of the Volcker Rule, ultimately reducing the risk of a bank having to depend solely on taxpayer funds.
Impact of Regulations on Bank Profitability
arguments for bank regulations. Based on the information above, it may be concluded that most banks utilize regulations to shrink assets and gain access to fresh capital. One of the most evident benefits of regulations for the banking sector is an opportunity to reduce lending and, in turn, increase the interest rate and avert multiple organizations from borrowing investment money relentlessly (Plantin, 2015). Nevertheless, bank regulations limit such activities in order to protect customers as well because inappropriate exploitation of this kind of approach would reduce the number of employees. Financial institutions will no longer have a chance to abuse taxpayers by denying access to loans or deposit insurance.
Systemic risks could also be managed through the interface of bank regulations, as protected liabilities would limit the number of financial difficulties experienced by the given bank. In the words of Zhang et al. (2016), many banks are interconnected, which leads to other organizations failing simultaneously due to the lack of improvement opportunities. It is rather common that mutual funds are protected by bank regulations and prevent organizations from exposing themselves to bigger risks.
Another essential benefit of bank regulation is the ability of given organizations to protect investors from the negative market influence or improper decision-making. When investors and clients gain access to valid information regarding the bank operations, they can be expected to develop a long-term relationship with the organization via a sense of trust or responsibility (Angelini et al., 2015). As soon as transaction terms are exposed, the client would get a chance to peek at interest rates, for example. Therefore, it is one of the central responsibilities of bank regulations to provide every stakeholder with trustworthy information and help them generate sound decisions.
arguments against bank regulations. The most evident disadvantage linked to the implementation of bank regulations is the fact that many banking organizations begin engaging in riskier practices. This is mostly based on the idea that there is always a safety net that could prevent banks from filing for bankruptcy and not being able to meet client expectations (Mayes, 2018). Many administrations do not take the time to assess the level of riskiness of their approaches because they believe that bank regulations are going to establish proper protection. This ultimately makes clients (taxpayers) vulnerable to the outcomes of bank activities.
On the other hand, it should also be noted that the economic crisis of 2008 was basically caused by the process of shrinking assets. Therefore, banking regulations could be a dangerous strategy to follow because of the inability to protect illiquid securities and respond to the increased returns to potential clients (Calomiris and Haber, 2015). The process of deploying banking regulations would affect the privacy of the given financial institution and leave them responsible for every potential challenge faced by clients and third-party organizations. In the case where this information gets into the hands of wrongdoers, it would affect every individual and organization affiliated with the given bank.
The biggest issue with banking regulations is that this process ultimately causes financial institutions to redirect the majority of risks and security concerns to the alleged borrowers. According to Vives (2019), this is a serious problem because individuals who do not realize the underlying credit risks would be the most probable unwanted victims of regulations. As in the case with mortgage credits, the investor is going to bear all the risks while the bank would not be held responsible for any challenges affecting the given organization. Hence, the majority of difficulties would be dodged by the given banks at the expense of other individuals and organizations interconnected with the financial institutions.
an interim verdict. Financial stability could be achieved with the help of both micro- and macro-prudential regulation instruments. The idea should be to reduce the possible tensions between the two and create scenarios where banks would be able to come up with complementing strategies instead of clashing the two. The essential recommendation for the banking sector would be to minimize all kinds of friction between the two types of regulations by ensuring cooperation and proper communication among all existing stakeholders. Recessions are the most likely periods for conflicts arising between micro- and macro-prudential types of regulation, so it means that the banking sector should remain sound and collaborative when diagnosing the initial symptoms of an upcoming financial crisis.
Conclusion
Bank profitability is a complex subject that is often affected by numerous external variables that cannot be controlled. The results obtained within the framework of the current paper suggest that the impact of banking regulations cannot be profit-efficient at all times, meaning that the alleged supervisory power does not always create market discipline. The increasing level of disclosure would also make banks subject to issues related to the effects of the regulations intended to protect banks and not expose them. Macroprudential regulations, for example, seem to interfere with banking operations intended to validate the authority that banks have when it comes to monitoring the market and intervening when necessary. Banking regulations create an environment where a timely and accurate disclosure would only be possible under strict rules and proper agent-led monitoring. Without enhancing market discipline, no bank will ever be able to capitalize on certain regulations or increase its profit efficiency.
Nevertheless, the existence of enhancement opportunities could also be explained by higher capital requirements that would, in turn, reduce the probability of financial distress. It would generate multiple scenarios where risk management activities would become unnecessary, ultimately reducing the cost of risk-related operations for the given bank. In order to see how the organization could achieve lower return assets, the bank administration would have to rely on an increased level of liquidity and restrict some of the activities. This actually signifies a potential trade-off between profit efficiency and the growing cost of bank operations. The presence of specific supervisory power is a crucial condition that cannot be underestimated or ignored, especially when negative externalities arise and increase market competition by a notch. Therefore, the effectiveness of banking regulations can be deemed positive but only under the condition where financial stability and improved market competition have been achieved by the given organization.
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