Government Regulation Term Paper

Government Regulation of Financial Institutions

In reference with the term of financial economics, financial institutions are agents that provide a wide range of financial services to their clients. There are several types of financial institutions, such as building societies, stock brokerages, asset management companies, banks, credit unions, etc. As their business is tightly connected with money and other financial instruments, all financial institutions are regulated by correspondent institutions of government authorities. Government regulation of financial institution varies from country to country and from jurisdiction to jurisdiction. It is obvious that before starting its activity, each financial institution should receive the license for carrying out particular financial activity. There are particular license requirements that should be kept by each company. For example, asset management companies generally should receive license for carrying out asset management activity at the stock market, or there are special requirements imposed on banks, the minimum most important one of which is minimum capital ratio.

Government regulation of each separately taken financial institution has definite objective and is very important. For example, bank regulation objectives are the following: constant and systematic risk reduction (to decrease the risk of disruption that can be resulted from adverse conditions of trading for banks causing multiple banks failure), prudential (to decrease the risk level of bank creditors, to protect clients- depositors, etc.), to secure and protect confidentiality of the bank, credit allocation (to guide credits to the necessary sectors of the country’s economy) and, of course, avoid misuse of banks (meaning to decrease risk of the banks being utilized for criminal purposes, including money laundering). The stated goals are objectively very important to all financial institutions and correspondent government authorities set definite rules and regulations; require reporting on the daily, monthly, quarterly and yearly basis from financial institutions.

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Government regulation is important and necessary not just to ensure that particular laws and requirements are followed, but primarily to protect financial institutions from unexpected risks and losses.

Returning to the example with banks, there are a series of requirements that must be met by banks in general. First is the capital requirement, which sets the framework and principles on how banks must handle their capitals in regard to their assets. There is special capital measurement system (latest version of which is referred to as Basel II) that is very complicated, but in the same time risk sensitive. Then, there are reserve requirements that set the minimum necessary reserve for each bank to hold. But nowadays this requirement is losing its importance, giving way to capital adequacy. There are also requirements concerning corporate governance, which are aimed to encourage banks to be successfully managed (may regard corporate body, location, minimum number of directors, organizational structures with set number of offices and officers, approved articles with particular clauses describes, so that directors and staff act for the best interests of the company, etc.).

Financial reporting, disclose and prospectus requirements are essential to protect interests of the government, clients and the company itself. Banks are generally required to prepare annual financial statements in accordance with financial reporting standard, which must be checked and signed by the auditor, registered and published in commonly accessible source. More frequently financial disclosures are also expected, as well as it is required that directors attest the identity and accuracy of such disclosures, etc.

Banks can be also required to receive and uphold credit ratings from approved rating agency, which is very valuable information for investors and prospector investors.

Banks may be also restricted from having large exposures to individual counterparties or connected ones. There are also related party exposure restrictions, activity and affiliation restrictions, payments systems requirements, etc. All those regulations are imposed to control financial market and secure money flows, as well as protect interest of all interested parties.

Prevention of money laundering obtained in the criminal way is a very important objective of government regulations, as it can be carried out in any kind of financial institution, and the purpose of government institutions is not only to minimize the possibility of its occurrence, but make it impossible to carry out such financial operations. In each country there are different authorities responsible for such issues, or a series of interconnected ones.

For example, in the United States banking sphere is regulated at state and federal levels. I am mentioning the case of the US, as it has one of the most regulated financial environments in the world. There are a lot federal-level and state-level laws and regulations, and therefore occurrences of financial crimes are less frequent as, for example, in European countries (especially Eastern Europe).

Government regulations are also assigned to decrease operational risks of financial organizations, which include potential occurrences of loss from deficiencies of internal controls, errors of personnel, physical systems failures, external events, etc. Government regulation in such cases demand placing of appropriate procedures and processes to identify, measure, monitor and control operational risks.

Financial institutions’ face risks on the daily basis, and it is task of government authorities to protect them from it, or at least minimize its consequences. Those risks include risks from default, market price fluctuations, fluctuations of exchange rates, operational losses, and others.

In the conclusion I would like to summarize that government regulation of financial institutions is the most important constituent of successfully managed market of financial services and the country’s economy in general. Structured approach to regulation of financial institutions allows not only minimize possible internal and external risks, but also promotes companies’ revenues to increase. Government regulation serves primarily for the benefit of financial institutions to support their reputations, secure confidentiality and stimulate for the best performance. Government authorities also act for the benefit of the market and its clients, protect their investments and overall interests. It is known that markets that are strictly regulated have less corruption, and therefore are very attractive for investors, and so existence of financial institutions is impossible without government regulation.

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