How Can Governments Regulate Banks and Financial Firms?

oversight of financial institutions varies by nation

By Jonny Lupsha, Wondrium Staff Writer

Government oversight of the banking industry is a controversial subject. Regulation can provide financial system stability, but can also be costly. How do governments regulate banks and financial firms in the United States?

Wooden piggy bank with inscription deposit insurance.
During the Great Depression, the Banking Act of 1933 created the Federal Deposit Insurance Corporation (FDIC) that protects customers’ bank funds up to $250,000. Photo by Vitalii Vodolazskyi / Shutterstock

Economic instability can lead to financial horror stories. Hyperinflation has led to citizens bringing wheelbarrows of cash to stores to buy loaves of bread, while events like the Great Depression and the Great Recession were felt around the world. Financial institutes and governments are closely linked, after all, and countries have the right to exert some control over their banks.

The extent of this relationship came into question recently with the collapse of Silicon Valley Bank and its takeover by regulators from the Federal Deposit Insurance Corporation (FDIC). Critics quickly pointed to 2018 deregulations as the cause for the FDIC’s failure to prevent Silicon Valley Bank from making the risky investments and poor decisions that led to its demise.

How much can regulatory committees like the FDIC oversee banks and financial firms? In his video series Money and Banking: What Everyone Should Know, Dr. Michael K. Salemi, Professor of Economics at The University of North Carolina at Chapel Hill, lists several regulatory measures the government uses and why.

What Is Deposit Insurance?

When customers of a bank fear that it is going to fail, they may hurriedly withdraw all their money from the bank to keep their finances safe. This is known as a bank run. One type of regulation that prevents that from happening is deposit insurance, which is currently set at the amount of $250,000 per customer. What does that mean?

“Deposit insurance keeps depositors from running their bank when they hear news that that bank is in trouble or they hear news that banks in general are in trouble,” Dr. Salemi said. “Deposit insurance […] makes it unnecessary for depositors to monitor the lending practices of their banks.”

Knowing that the money in your bank account is guaranteed by the government certainly helps depositors sleep at night.

Additionally, deposit insurance solves a problem known as “asymmetric information.” The asymmetric information problem occurs when one party in a transaction knows more relevant information than the other. In banking, banks know more than governments do, which can cause oversight problems. Deposit insurance makes that knowledge irrelevant by guaranteeing depositors’ money regardless of the bank’s financial status.

What Is a Bank Charter?

One often overlooked regulation on banks is that of the bank charter.

“Banks must obtain a charter, a right to operate, from the controller of the currency if it’s a national bank or from the state banking authorities,” Dr. Salemi said. “This means that entry into the banking industry is limited to those who can gain charters.”

This limitation lowers competition to the banks that qualify to obtain charters, and ideally makes the charters more valuable to protect. This should provide banks with an incentive to perform up to standards in order to hold their charters. However, obtaining a bank charter can have averse affects, as well.

“On the other hand, of course, that limited entry of those who would be bankers raises costs to bank customers,” Dr. Salemi said.

And what does government do for banks in this situation?

“Once the government guarantees deposits and signals that it will bail out a big bank, it makes sense for government to create a situation in which banks are profitable. Charters limit entry into the bank industry and keep profits higher than they otherwise would be. So, a cost of safety is allowing banks to be profitable.”

Money and Banking: What Everyone Should Know is now available to stream on Wondrium.

Edited by Angela Shoemaker, Wondrium Daily