Rationale for the regulation of banks, and regulatory arrangements for the banking industry since the financial crisis of 2007-2009

Alex Mouatt, Harry Walker and Sandijs Meisters
Industry, Region, and Environment
Level I / Year 2
BA (Hons) Economics
Bournemouth University
Word Count: 3048
Introduction
Regulation is a form of government intervention that is adopted in order to influence, in a socially desirable manor, the way industries operate (Cambridge Dictionaries, 2015). Ultimately, government intervention exists to correct market failures whereby market forces “fail to deliver an efficient allocation of resources” (Riley 2012). Recently, the government has maintained the idea that “bureaucracy stifles businesses” at the expense of innovation and growth, and has sent the country down a pathway of deregulation and regulatory reforms (Gov.uk 2015). However, this has not been the experience of the banking industry. This essay will look at: reasons why regulation exists, its causes, and regulations during the financial crisis and the regulations since the financial crisis.

Why Regulation Exists
To begin with, this part of the report will look at some of the underlying reasons behind the regulation of the UK’s banking industry. Primarily it can be explained by the presence of a market failures, which cannot be prevented without government intervention. Three of these market failures are: the “too-big-to-fail” status banks poses, the incomplete market with the provision of liquidity and barriers to competition. Furthermore several other regulatory motivs shall be identified.
The first market failure that shall be acknowledged is idea that banks are “too-big-to-fail”. Due to the size of banking institutions and the important influence they have on an economy, a bank failure would have disastrous economic contagion effects. It would create a shock to public confidence which would ripple through the banking system as a result of its interconnected nature (Aharony and Swary 1983). Consequently households would be disinclined to use banking services, entrepreneurs and investors will engage in less risk-taking behaviour, at the detriment of an economies wealth and job creation prospects and companies are reluctant to reinvest for expansion (Morris and Vines 2014). Ultimately, the banking industry will suffer, its ability to fulfil its roles within the economy would be restricted and all the other industries it underpins would be affected.
A second market failure is that there is an incomplete market for the provision of liquidity. Liquidity provision is one of the core roles the banking industry fulfils and involves using depositor’s money to create loans whilst still meeting the demands of the depositors (Bouwman 2013). This market failure becomes particularly apparent during financial crises when returns on bank deposits are usually very low. Depositors therefore seek higher yielding alternatives, impeding the bank’s ability to provide liquidity (Allen 2007). This problem highlights the incomplete market within the banking industry due to the inability of intermediaries to minimise and manage risks to provide an appealing return to savers. Without sufficient liquidity the efficient allocation of capital and level of economic opportunity is restricted causing growth and welfare to suffer (Furse 2015).
Another market failure in the industry is the insufficient competition demonstrated by the oligopolistic market structure (the Economist 2013a). Regulation acts as a surrogate for competition and is conducted by the Office of Fair Trading (OFT) and the Competition Commission (CC) (Economics Online 2015). Large institutions dominate the UK’s banking system and pose high barriers to entry into the market through their enormous economies of scale and levels of customer inertia. Competition is essential in economics and banking in order to promote fairer prices, greater choice and a greater quality of services provided (European