The link between regulatory restrictions and banking sector stability

By Syed Sadaqat Ali Shah

Economic growth accelerates when backed by efficient financial intermediaries and financial services respectively. The banks perceived, over its history, as facilitators of supplying funds from person with surplus money to demander of funds for investment purposes, have transformed, in general, economic outlook of countries around the globe in terms of ensuring credit availability to all segments of population and have led to the conclusion that economic prosperity relies heavily on presence of robust and sound financial system in general and financial institutions in particular.

Besides known as engine of economic growth banking sector over decades of its operation has given birth to ‘Boom’ and ‘Bust’ cycle which, apart from economic expansion, have washed-up and ruined world economies, each crisis with its own style and ripple effects on overall economy and trading partners. Each crisis followed another crisis with its widespread impact on population directly and indirectly which forced policymakers to revisit regulations and monitor banking sector incessantly. This situation in banking sector when intensified called for financial sector reforms, greater transparency and international financial authority, by national governments on urgent and perpetual basis to strengthen the sector’s performance and boost economic development.

The failure of banking sector to wrestle with the crisis and problems gave birth to Basle Committee on Banking Supervision which since its inception in 1974 by the central bank governors of the group of ten countries provides regular cooperation on banking supervisory matters and enhancing understanding of key supervisory issues and to improve and strengthen quality of banking supervision worldwide. The Committee, if have not eliminated crisis, have been successful in mitigating the risk of vulnerability to crisis.

The financial system, in early 1970s, were characterized by pervasive restriction on market forces including control on prices- interest rate control and other price control such as fees, restriction on market access, allocation of credit. The objectives of imposing these restrictions by governments were to save small savers with limited information and to maintain macroeconomic management, with overall goal to sustain financial stability.

The financial system or banking sector, therefore, when momentarily breaks down the investment activities curtail due to unavailability of credit to firms. Such painful time can even result in financial crisis which have catastrophic consequences for economy in terms of undermining and weakening future growth and social progress. Research has shown since 1980 more than 130 countries around the globe have experienced banking dilemmas that have been, according to them, destructive for the national economic progress and development.

Multiple reasons were and are given for financial crisis. In the era of regulatory restrictions banks were restricted to access entire market, in terms of branching out, price control restrictions imposed on banks, the discretionary power employed by government to allocate funds for privileged class for investment purpose, and in some cases restriction on allocation of credit for investment. These restrictions employed by government and regulator with the aim to retain market stability had limited banks abilities to innovate and provide services efficiently for its population, the depositors. Furthermore during this era due to restrictions on banks finances were allocated for preferred industries, thereby having an adverse impact on small borrowers.

To unshackle financial system and to boost competition in banking sector many countries experienced regulatory reforms in mid 1970s. The reforms were aimed at to liberalize financial sector of the economy and encourage market-based regulations that involve partial or complete liberalization in; price control, which was restricted until early 1970s, amount of investment and restriction on to not allow foreign banks in the financial system-foreign banks after deregulation were allowed to enter domestic market, line of business and ownership linkages among financial institutions.

The deregulation in banking sector has several factors including; globalization and the development of off-shore financial institutions due to globalization, technological development, competition in international market again due to globalization, agreements containing liberalizing financial sector and finally competition between financial institutions under different regulatory environments.

The benefits were reaped by countries at large, developing countries in particular, and by financial sector of the economy specifically. Banks after deregulations did well by penetrating and exploring international market including; lowering the cost of financial services and improving the quality of services rendered by financial sector, rapid innovation and technological development, increased competition and access to diversified financial instruments. The banking sector experienced tremendous growth in profitability, employment injection and credit availability to investors and entrepreneurs.

Besides the mentioned gains harvested by financial sector the lesser regulatory restrictions did achieved up to certain point financial stability but not to a considerable level. In the post-deregulatory era when banks were unshackled from restrictions the market oriented policies too did not save banks from financial instability. The massive competition turned banking sector aggressive thereby becoming immoral in trading.

The banks, for instance, involved in other than deposits taking and making loans activities such as securities underwriting, insurance underwriting, real estate investment and owning nonfinancial firms that led to catastrophic financial crisis and financial instability. Moreover expanding the permissible activities by banks in financial system provided greater opportunity for banks to commit moral hazards by distorting the investment decision of the banks.

The proponents of substantial freedom for banks, despite experiencing cataclysmic financial crisis, argue banks with lesser regulatory restriction creates place for innovation, efficient services, access to diversified financial services at lower cost, low cost services and that fewer regulatory restrictions allow banks to meet market needs more efficiently. Such situation however, with few regulatory restrictions and lesser legal impediments, has, as discussed, turned banks aggressive which some times lead to financial crisis and even run on the bank. At the same time it is of immense significance to note that sever regulatory restrictions can result in banking sector fragility and can even restrict banking abilities to fulfill demand of the market.

It is understandable that restricting and restraining commercial banks conspicuously results in welfare losses. Banks in fact with monopoly exercise their abilities to derive rent, which is actually their profit, by charging businesses and entrepreneurs with higher interest rates while distributing among depositors lower rates of return thus creating less space for further capital accumulation in future.

The higher lending rates have consequences for businesses, entrepreneurs and economy at large. The higher rates limit firms’ and entrepreneurs’ ability to obtain loan due to high costs associated with it and if they succeed in obtaining loans they invest the loaned money in risky projects thus weakening the stability of credit market and creating space for financial fragility. The firms after acquiring loans at higher rates limit their funds to Research and Development, thus discouraging technological innovation and productivity of the economy in the medium and long term.

Banking sector stability can be achieved with sufficient-not rigid and inflexible, regulatory restrictions on commercial banking activities and substantial periodic inspection of banks operating in the financial system.  Banks should be penalized for non-compliance such that the amount of penalty transcends the amount of profit they fetched from their activities so executed. There is a need to achieve equilibrium to maintain a positive link between regulatory restrictions and banking sector stability.

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Syed Sadaqat Ali Shah

Syed Sadaqat Ali Shah is a researcher and works on banking regulations, competition and reforms.

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