Regulation of commercial banks

Minimum cash reserves have been a long-established form of bank regulation. The requirement that each bank maintain a minimum reserve of base money has been justified on the grounds that it reduces the bank’s exposure to liquidity risk (insolvency) and aids the central bank’s efforts to maintain control over national money stocks (by preserving a more stable relationship between the outstanding quantity of base money, which central banks are able directly to regulate, and the outstanding quantity of bank money).

A third objective of legal reserve requirements is that of securing government revenue. Binding reserve requirements contribute to the overall demand for basic money—which consists of central bank deposit credits and notes—and therefore enhance as well the demand for government securities that central bank banks typically hold as backing for their outstanding liabilities. A greater portion of available savings is thus channeled from commercial bank customers to the public sector. Bank depositors feel the effect of the transfer in the form of lowered net interest earnings on their deposits. The higher the minimum legal reserve ratio, the greater the proportion of savings transferred to the public sector.

Some economists have challenged the concept of legal reserve requirements by arguing that they are not necessary for effective monetary control. They also suggest that such requirements could be self-defeating; if the requirements are rigidly enforced, banks may resist drawing upon reserves altogether if doing so would mean violating the requirement.

As discussed above, bank capital protects bank depositors from losses by treating bank shareholders as “residual claimants” who risk losing their equity share if a bank is unable to honour its commitments to depositors. One means of ensuring an adequate capital cushion for banks has been the imposition of minimum capital standards in tandem with the establishment of required capital-to-asset ratios, which vary depending upon a bank’s exposure to various risks. The most important step in this direction has been the implementation of the various Basel Accords.

Instead of attempting to regulate privately owned banks, governments sometimes prefer to run the banks themselves. Both Karl Marx and Vladimir Lenin advocated the centralization of credit through the establishment of a single monopoly bank, and the nationalization of Russia’s commercial banks was one of the first reform measures taken by the Bolsheviks when they came to power in 1917. Nonetheless, the Soviet Union found itself without a functioning monetary system following the Bolsheviks’ reform.

Nationalized banks can be found in many partially socialized or mixed economies, especially in less-developed economies, where they sometimes coexist with privately owned banks. There they are justified on the grounds that nationalized banks are a necessary element of a developing country’s economic growth. The general performance of such banks, like that of banks in socialist economies, has been poor, largely because of a lack of incentives needed to promote efficiency. Some have experienced higher delinquency rates on their loans, partly because of government-mandated lending to insolvent enterprises.

There are exceptions, however. While nationalized banks have tended to be overstaffed, slow in providing services to borrowers, and unprofitable, the State Bank of India is recognized for customer satisfaction, and many state-owned banks in South Asia perform on a par with their private-sector counterparts.

Most countries require banks to participate in a federal insurance program intended to protect bank deposit holders from losses that could occur in the event of a bank failure. Although bank deposit insurance is primarily viewed as a means of protecting individual (and especially small) bank depositors, its more subtle purpose is one of protecting entire national banking and payments systems by preventing costly bank runs and panics.

In a theoretical scenario, adverse news or rumours concerning an individual bank or small group of banks could prompt holders of uninsured deposits to withdraw all their holdings. This immediately affects the banks directly concerned, but large-scale withdrawals may prompt a run on other banks as well, especially when depositors lack information on the soundness of their own bank’s investments. This can lead them to withdraw money from healthy banks merely through a suspicion that their banks might be as troubled as the ones that are failing. Bank runs can thereby spread by contagion and, in the worst-case scenario, generate a banking panic, with depositors converting all of their deposits into cash. Furthermore, because the actual cash reserves held by any bank amount to only a fraction of its immediately withdrawable (e.g., “demand” or “sight”) deposits, a generalized banking panic will ultimately result not only in massive depositor losses but also in the wholesale collapse of the banking system, with all the disruption of payments and credit flows any such collapse must entail.

Deposit insurance eliminates or reduces depositors’ incentive to stage bank runs. In the simplest scenario, where deposits (or deposits up to a certain value) are fully insured, all or most deposit holders enjoy full protection of their deposits, including any promised interest payments, even if their bank does fail. Banks that become insolvent for reasons unrelated to panic might be quietly sold to healthy banks, immediately closed and liquidated, or (temporarily) taken over by the insuring agency.

Although various U.S. state governments experimented with deposit insurance prior to the establishment of the FDIC in 1933, most of these experiments failed (in some cases because the banks engaged in excessive risk taking). The concept of national deposit insurance had garnered little support until large numbers of bank failures during the first years of the Great Depression revived public interest in banking reform. In an era of bank failures, voters increasingly favoured deposit insurance as an essential protection against losses. Strong opposition to nationwide branch banking (which would have eliminated small and underdiversified banks through a substantial consolidation of the banking industry), combined with opposition from unit banks (banks that lacked branch networks), prevailed against larger banks and the Roosevelt administration, which supported nationwide branch banking; this resulted in the inclusion of federal deposit insurance as a component of the Banking Act of 1933. Originally the law provided coverage for individual deposits up to $5,000. The limit was increased on several occasions since that time, reaching $250,000 for interest-bearing accounts in 2010.

Deposit insurance has become common in banking systems worldwide. The particulars of these schemes can differ substantially; some countries require coverage that amounts to only a few hundred U.S. dollars, while others offer blanket guarantees that cover nearly 100 percent of deposited moneys. In 1994 a uniform deposit-insurance scheme became a component of the European Union’s single banking market.

Ironically, deposit insurance has the potential to undermine market discipline because it does nothing to discourage depositors from patronizing risky banks. Because depositors bear little or none of the risk associated with bank failures, they will often select banks that pay the highest non-risk-adjusted deposit rates of interest while ignoring safety considerations altogether. This can encourage bankers to attract more customers by paying higher rates of interest, but in so doing, the banks must direct their business toward loans and investments that carry higher potential returns but also greater risk. In extreme cases losses from risky investments may even bankrupt the deposit insurance program, causing deposit guarantees to be honoured only through resort to general tax revenues. This was, in essence, what happened in the United States savings and loan crisis of the 1980s, which bankrupted the FDIC.

Most countries insure bank deposits up to a certain amount, with few offering blanket deposit coverage (i.e., 100 percent of the amount any depositor holds with a bank). In the United States, blanket deposit coverage was established for non-interest-bearing transaction accounts (which allow an unlimited number of withdrawals and transfers) by the Dodd-Frank Wall Street Reform and Consumer Protection Act (2010).