Banking Basics

Understanding the Importance of Regulations in Banking System

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Banks are the repositories of the liquidity of an economy and it provides a strong backbone for the payments and financial system of a country. Therefore, the banks are very important financial institutions and every state intervenes to protect the banking system from the systemic risks.

What is banking business?

Banking business is defined in most enactments as a business of receiving funds from the public through the acceptance of money deposits payable upon demands by checks, draft, order or otherwise, and use of such funds for investment or any other operation either authorized by law or by customary banking practice.

Therefore the most important part of the banking business is to protect the depositor’s confidence of the banking system. Hence it is very important to maintain the confidence of public in the banking system.  

What is the need for regulation?

However, the banks are vulnerable to sudden loss of depositors’ confidence. Therefore, banks should be regulated and supervised in a proper manner so as to protect the public confidence and not to be allowed to take any risks which could lead them to fail.

Hence, the prudential regulations need to be imposed on the banking system to mitigate some of the risks inherent in banking business. Thus, these regulations lay down the prudential requirements that the banks should comply with relating to their operations.

For example, regulations relating to capital requirement are intended to ensure that the banks are holding adequate capital to bear the cost of losses.

In addition, there are certain regulations relating to the bad and doubtful debts, restricting the exposure to single borrowers, and submission of annual audited financial statements.   

Hence, the objective of prudential regulations imposing on banks is to promote the banking systems stability, through a safe and sound banking business.

Thus, it is essential to maintain the confidence in the stability of the banking system by regulating the works of commercial banks on a continuous basis.

We have to understand that a stable banking system is necessary for the healthy functioning of the entire economy.

Thus, If the banking system is not stable, they might fail to repay their depositors and remit the payments to due parties locally as well as internationally. Therefore, the banking systems stability is essential for day -to-day life and the entire performance of the economy.

When considering the recent financial crisis, the wide spread failure of banks is one of the main features and weak risk management mechanism of a bank would be one cause for such failure.  Therefore, improving the risk management of banks through the standard regulations will enable them to protect from the adverse outcomes of the economic downturns and avoid the systemic risk.

In addition, prudential regulations on banking system are essential to prevent the bank being misused. For an instance, money launderer could use the banking system to launder the proceeds of crime. Therefore, it is very impotent to implement particular regulations on banking system to monitor and supervise such activities.

Thus, the regulations imposed in the banking system play a vital role and it provides a formal control over the banking system so as to ensure the stability of the entire financial system of a country.

More about this author: Menaka Ratnayake

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