Essay About Commercial Banks And Negative Externalities

Banking Regulations
Introduction        Currently, commercial banks are subjected to a number of restrictions as a measure to attain both economic and political stability. Apart from depositing and lending, these banks also face restrictions on their geographical extent of operations. For example, the US government regulates the intrastate and interstate branching to achieve economic and political stability at the state level. Although the national legal systems still control government agencies responsible for banking regulation in some countries, these agencies have adopted a model in which they outline their rules and regulations. For example, EU countries have set common minimum standards and provide their national agencies with implementation. The purpose of the main banking regulationAccording to Schooner & Taylor (2010), governments conduct banking regulation for two reasons: to improve efficiency of market operations and to change market results to accomplish social goals. In most countries, the primary aim of banking regulation is to correct market failure. Conventional Economic Theory outlines two types of market failures in the context of banking that generally call for regulatory intervention. The first market failure is the existence of information asymmetries. Generally, banks are in much better positions than their depositors to judge their ability or desire to fulfill their promises. For example, a bank may accept deposits that it is unable to honor. Similarly, a bank may use a depositor’s money to benefit the owner of the business. Even if information is available, majority of depositors do not have the technical expertise to assess the information they are offered. As a result, bank creditors and depositors are affected by information asymmetry that stems from the kind of a bank’s assets. In addition, information asymmetry is likely to cause problems of adverse selection. Adverse selection is a form of information asymmetric problem in which a party that is most likely to produce objectionable results is the one most likely to be chosen. In such cases, governments intervene and regulate the banking operations as a measure to protect the depositors. Second, systemic risk or negative externalities as market failures result when the economic processes of some parties in the market indirectly affect negatively the economic well-being of others. A negative externality, for example, exists when the price of a product does not depict the real cost to the society of producing it. The possible impact of tightening these regulationsAlthough banking regulation is purposefully in place to achieve, particularly, economic stability, playmakers should determine and carefully assess the financial and economic market effects of all forms of regulatory tightening. As argued by Macey (2006), sometimes banking regulation imposes more risks on firms and taxpayers. For example, although tightening the current limits on lending would minimize bank credit risks, the policy is likely to cause some creditworthy borrowers lose access to credit. Similarly, although increasing the capital adequacy requirements is likely to strengthen the banking system, the process associates with reduced financial intermediation and increased prices for the services.