Prudential and conduct of business regulation
Prudential regulation is mainly concerned with consumer protection. It relates to the monitoring and supervision of financial institutions, with particular attention paid to asset quality and capital adequacy. The case for prudential regulation is that consumers are not in a position to judge the safety and soundness of financial institutions due to imperfect consumer information and agency problems associated with the nature of the intermediation business.
Conduct of business regulation focuses on how banks and other financial institutions conduct their business. This kind of regulation relates to the information disclosure, fair business practices, competence, honesty and integrity of financial institutions and their employees. Overall, it focuses on establishing rules and guidelines to reduce the
Consumers receive bad advice (possible agency problem);
Supplying institutions become insolvent before contracts mature;
Contracts turn out to be different from what the customer was anticipating;
Fraud and misrepresentation takes place;
Employees of financial intermediaries and financial advisors act incompetently.
Edwin G. West (1997), freedom of entry is the most important condition of competition. Competition brings with it market discipline. However in most countries entry into the financial sector requires specific authority from a licensing authority. The power to grant licenses or similar entry authorizations provides the possibility of exercising
preventive action against the entry of institutions whose presence might be prejudicial to the interests of depositors and the soundness of the system. Specific entry requirements are designed to strengthen the authorities control on the soundness of institutions allowed to conduct banking business, this could have an indirect impact on
the structure of banking sector by limiting the scope of market entry. From a regulatory viewpoint, licensing aids the adoption of the principle that a bank must be effectively
managed by at least two persons of proven expertise, competence and trustworthiness. The rationale behind the adoption of this principle (the four eyes principle) is to ensure a certain depth of management and to provide for better internal control on compliance with banking laws and regulations’. In essence whereas licensing increases transaction costs, it also serves to cushion the entire economy against entry of investors whose integrity is questionable. There is a moral for licensing because deposits can be misappropriated easily; runs in one bank affects other banks and the economy. Besides since deposits are insured by government agencies there is need to keep off undesirable
Reserve requirements force banks to hold a portion of their assets in a liquid form easily mobilized to meet sudden deposit outflows. Bernanke (1983) indicates that the bank runs of 1930-1933 in US led to large withdrawals of deposits, precautionary increases in reserve deposit ratios and an increased desire by banks for liquid or rediscount able assets. These factors plus the actual failures forced a contraction of the banking system’s role in the intermediation of credit’. Banks are in intermediation service and high reserves can harm the process. Diamond et al (1986) argue that 100% reserve requirement would restrict banks from transformation services. The effect of this would divide the bank into two. The proposal would then effectively pass the problem of runs and instability to the successors in the intermediary business. The policy would reduce the overall amount of liquidity.
Reserve requirements are a back up to deposits. In case of a bank run, a bank experiencing temporary liquidity problem could use the reserves to solve the shock. Besides if the regulatory authority discovered that the bank was fatally illiquid then the reserves could be used to pay off depositors before DI is used.
Bank capital is the equity that the bank shareholders acquire when they buy the banks stocks and since it equals the portion of the banks assets that is not owed to depositors it gives the bank an extra margin of safety in case some of its other assets go bad. Bank regulators set minimum required level of bank capital to reduce system’s vulnerability to failure.