In a free economy, the market constitutes the main tool for fairly and effectively managing the allocation of resources. Yet, there are certain situations which require interference from an external agent to correct the course of the market. Governments are the primary parties which possess the capacity to artificially manage the market. Their regulations arise as a response to the imperfections observed in the market. The major objective which governments pursue when introducing regulations is ensuring better welfare for the citizens.
The usual objects of regulations include monopolies which stifle competition, banks which provide excessive credit, problems concerning contract enforcement, and property rights. While in the context of the banking industry, the typical issue regulations seek to resolve is information asymmetries, situations which imply that one party to a transaction is more knowledgeable than the other one. Moreover, the existence of information asymmetry in the market may lead to the creation of oligopolies, a market form where several major players dominate the whole industry.
Information problems are inherent to the banking industry. For instance, banks may keep their private databases containing information on their borrowers. Other financial institutions which cannot access these databases are at a disadvantage since they do not have vital information on how potential borrowers may act in the future. Additionally, bank managers usually possess more knowledge about their bank’s condition than shareholders and creditors, which creates information imperfections.
Thus, the need emerges for controlling the activity of banks to avoid any substantial harm to the country’s welfare as a result of information imperfections. Countries implement Public Interest Approach to achieve the goals of increasing economic output, decreasing variance, and ensuring equal access to capital.
Essentially, Public Interest Approach implies introducing regulations which protect the public and benefit it. This approach is particularly visible in the wake of financial crises, which tend to have disastrous effects on the economy by reducing output and generating volatility. Therefore, countries tend to take measures targeted at alleviating credit rationing and fostering economic development.
Financial crises stem from imperfect information and partially from the fact that banks usually enjoy limited liability. Subsequently, they may take large risks by attracting depositors to invest large sums of money and promising them high returns. For instance, in the 1990s, the Venezuelan banking crisis occurred due to the fact that certain banks offered interest rates of up to 50% on their deposits. In response to such events, countries embrace Public Interest Approach and adopt regulations in an attempt to protect consumers and ensure economic stability.
The ultimate goal of the approach after crises concerns the necessity to persuade people to trust banks once again and keep their money there. Stricter requirements to attain better transparency in the field of accounting are another popular measure, and the Sarbanes-Oxley Act of 2002 is an example of such a regulation.
Countries set up special agencies which have an obligation to regulate the economy according to the Public Interest Approach, usually, these are central banks which also may serve as lenders of last resort. Yet, there is also evidence which shows that the banking industry can regulate itself without the presence of any state institutions. Private clearinghouse associations which were active in the 19th and 20th century are an example of private organizations with a capacity to regulate the market. These associations constituted alliances of banks and had different functions, including expelling and fining members, imposing price ceilings, establishing capital and reserve requirements, engaged in audit, and provided credit to weaker members.
In the US, the establishment of the Federal Reserve System indicated the nationalization of these associations and the complete adoption of the Public Interest Approach. However, it is important to know that this approach also can be subject to criticism. One of the main weaknesses of the Public Interest Approach and the utilization of regulatory agencies is a high chance of failure. Central banks and government can simply be incompetent in terms of introducing effective regulations and worsen the situation. Moreover, even if the regulators are extremely professional and seek to work to benefit the public, they may simply lack any capacity to positively affect a dire economic situation.