.. s of confidence and large-scale withdrawals usually as a result of a mismatch between the date to maturity of assets and liabilities (Stewart, 1996). These bank runs can have a drastic effect on the public as banks are where the vast majority of people carry out their financial transactions such as savings and mortgages. The public tends to have an inherent trust in the banks and therefore depositors have a reduced capacity for evaluating and monitoring their banks. Banks will not impose strict self-regulations unnecessarily.
The danger of this situation is that banks might not provide services efficiently and therefore drag down the quality level of services in the industry. The need for public protection against these bank runs gives rise to the need for intervention to provide this protection: The State guarantees to depositors and guarantees by central banks to act as lender of last resort may prevent sudden losses. (Stewart, 1996). Those who are against government intervention argue that it should be possible for banks to attain all levels of financing at any time in an efficient market, and that the existence of emergency financing will only ensure that banks will be negligent about their risk levels since they can rely on the central bank to aid any crises. In fact, banks hold forms of illiquid debt financing, so if a ‘run’ were to occur, it would not be possible to liquidate this debt.
It has also been suggested that the real effects of a banking collapse are felt in the macro-economy. Quinn suggests that the banking collapse of the 1930s has severe effects on the ‘depth and duration of the Great Depression which followed’ (Quinn, 1992). Combined with the lack of motivation on depositors’ behalf to monitor and screen banks, there is a clear case for government intervention. The other primary reason for market failure in the banking system lies in the provision and screening services that they provide to offset informational problems. The relationship which requires the most attention is that between the depositor and the bank.
A depositor cannot distinguish between a bank that has a high risk strategy or has a low risk strategy and since deposit rates must reflect average risk then a bank which follows a high risk strategy is hidden. The misallocation of resources which ensues may lead people to believe that individual deposit rates should be applied to each different bank reflecting their riskiness. In fact, such differential deposit rates will be undermined by the public good nature of the evaluation and monitoring of banks (Quinn, 1992). A very strong argument exists against Government intervention. In most of the other industries in our economy, there is quite a lot of transparency for consumers regarding how risky it is to buy goods and services and therefore, would it not be better to allow the public to deal with the informational asymmetries inherent in the banking system. One particular response to this problem of unidentifiable risk has been to impose flexible capital adequacy ratios.
(Bank of International Settlements (BIS) and EU). increasing the ratio of own capital to total capital as a means of ensuring bank solvency (Stewart, 1996). This ratio has three different effects. (1) Since the capital asset ratio has been reduced, banks take on less risk; (2) It ensures that banks who take on higher levels of risk must have a higher proportion of their own capital in reserve; (3) Since it is difficult to establish whether higher ratios really represent a risky portfolio, banks will cooperate. However, the establishment of these ratios has caused problems for banks and regulators.
Banks are required to both define and measure capital and income. Since income is turned into capital on the balance sheet, there has been much emphasis placed on the measurement of income by the regulators. Another issue which needs attention is who should measure capital and income. Is internal auditing sufficient or is there a need for an independent, external auditor. The most vital issue, however is on which country’s accounting standards should the ratios be based on. Stewart illustrates this in his article using the US and UK Generally Accepted Accounting Practices to calculate different figures for capital and income.
This emphasises the need, expressed earlier, for harmonisation at an EU level. What about non banking financial firms? It is needed here to assess the level of risk taken on between companies. In general, it is not possible to quantify and correlate financial risk across all firms operating in the industry. So this means that systematic risk of failure in non-bank firms is much lower than in banking. Benston argues strongly against regulation in financial markets, concentrating heavily on statutory disclosure of information of firms quoted on the US exchanges. The weight of the arguments and data strongly supports the conclusion that the costs of government-required disclosure exceed any possible benefits (Benston, 1985. He asserts that the pre 1997 UK way of self regulation is superior to the strict rules of the SEC in the US.
The question of whether interventionist statutory legislation is useful is being constantly discussed. Perhaps the UK have got it right now with a combination self-regulation and statutory regulation. There will perhaps be change in the US over the next few years with the advent of a new president who will appoint a new chairman of the SEC in the near future when Arthur Levitt steps down. ‘In addition, as many as three of the five top-level commissioner positions at the SEC are either vacant or will be vacant in the coming year, positions that to a great extent shape SEC policymaking with the chairman’ (Financial Times, 2000). Change may also come from Phil Gramm the US senator and head of the Senate banking committee, who has ordered a review of US securities law.
Mr. Gramm is a well-known regulation opponent in the US. Change is without a doubt imminent. The most important concern is to keep markets orderly and transparent. For some countries it has come in the form of strict regulation, for others in relatively flexible regulation. The challenges now come from the increasing need for harmonisation of regulations in the EU and also the need to react to the effect that technology can have on financial markets, something that many current financial regulatory systems have yet to tackle. Economics.