Why do we regulate banks?

We want to keep the financial system stable and individual banks safe.
This page was last updated on 17 June 2019

When a bank fails, it can create problems for the wider economy.

People and businesses can lose money they have placed with the bank. This can mean they also lose confidence in banks so are unwilling to bank with them again. It can also disrupt the services that banks provide to customers. For example, payments systems – you might not be able to use your account for a while if your bank failed.

But why do banks fail?

Banks can fail for a number of reasons, for example:

  • If they make poor investment decisions and not enough profits so they go bust (just like any company).
  • If people and companies who have put their money in a bank account take it out quicker than the bank can manage. This is what happens in a bank run – there is a great example of this in the 1946 film It’s a wonderful life (and a real example is Northern Rock in 2007). 

When banks fail, they can also make it more likely that other banks will, too. The 2007–09 financial crisis showed that problems can spread from one bank to another, like a fire spreading. The crisis wreaked havoc on the rest of the economy.

How does regulation help?

Regulation helps make sure that banks have good management so they don’t make bad investments or are too risky. An example of this is the Senior Managers Regime which makes sure that senior bankers are held accountable for their decisions. Regulation also makes banks hold shock absorbers to help deal with bad investments. These shock absorbers are referred to as capital.

Regulation is used to make it less likely people will take out their money unexpectedly. There is a deposit guarantee scheme that ensures that even if a bank fails all deposits under £85,000 will be protected. Banks also have to hold cash (or assets that can be sold very quickly) to cover unexpected withdrawals. This should help make bank runs less likely.

Throughout 2018, regulation is also being used in large UK banks to ‘ring-fence’ some services from other parts of the bank. Doing this helps to protect your access to the banking services we all depend on every day.

Why don’t banks just look after themselves?

Banks’ managers and owners understand these risks, but as businesses they also need to make profit. When trying to make profit they have sometimes not acted as safely as depositors or investors would like them to. The financial crisis showed this clearly. When banks are doing well and making money they might take too many risks assuming that everything will keep going well. This is summed up by a quote from the CEO of Citigroup (one of the largest banks in the world) in 2007, who said:

When the music stops, in terms of liquidity, things will be complicated. But as long as the music is playing, you’ve got to get up and dance. We’re still dancing.

A few months later, the music had stopped and a global financial crisis had taken hold.

When trying to make money banks have sometimes sold products that aren’t suitable for their customers. For example, some banks made billions of pounds from mis-selling PPI (payment protection insurance) to their customers. Regulation and strong supervision can help stop banks making similar mistakes in the future.

Banks also won’t think about how their actions could affect other banks, the whole financial system and even the wider society.

Financial crises can cause people to lose their jobs, or face pay cuts, and many more will suffer from a higher cost of living. On their own, banks don’t take this into account when making decisions – regulation helps make sure they do.

Regulation helps to reduce many of the problems that could get a bank into financial difficulty. This will mean there will be fewer bank failures in the future. But whilst banks are much safer now than they were a decade ago, we can’t expect that even well-regulated banks will never fail.

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