5: Industry Regulation
Banking operations are inherently fragile because they absorb risks for many others in the economy - but it is only because this risk is absorbed that people with money are willing to lend it to strangers who need money to fund production. Without banking, national economies would stagnate - hence it is in the interests of all to have a stable banking system - and this is the justification for government oversight of the banking industry.
Historically, the most common cause of banking crises have been bank runs, where consumer panic caused depositors to rush to the bank to withdraw their money and the bank did not have enough cash in reserve to pay them all. This was most common when banks were independent and customers would lose faith in the solvency of a particular bank, and has largely been eliminated by FDIC insurance, which guarantees deposits even if a bank fails.
While bank runs are largely a historical footnote, there are still instances when this occurs, such as the 2007 collapse of Northern Rock bank in the UK. The depositors' funds were insured, so the net result of this bank run to the public was the temporary inconvenience of some depositors who had to wait for their claims to be paid, but the bank itself was unable to recover. While it was able to restore its solvency through a "fire sale" of assets, selling at a loss was detrimental to the bank's equity and consumer confidence in the brand was never restored.
In most industries, there are no elaborate regulations and business owners are free to conduct their affairs as they see fit. The collapse of one hairdresser or the failure of one bookstore does not damage their competition. But the banking industry is very incestuous: the collapse of one bank harms not only its retail customers, but also its business customers as well as other banks from which it has borrowed money or holds assets. So in most countries, there is tight regulation and close supervision of banks.
In the US, banks may be licensed by the federal or state government, each of which has mechanisms in place for monitoring and control. Banks submit to other requirements in order to be supported by the Federal Reserve, and more still to be covered by FDIC insurance.
There's a return to the topic of moral hazard. FDIC insurance protects the depositors, so they can seek the highest interest rate for their savings and are not concerned about whether their bank engages in risky investment behavior. The availability of emergency funding from the Federal Reserve further encourages banks to take risks because of the safety net.
There is also some concern about the special and unlimited protection that is extended by governments to large banking organizations that are considered "too big to fail." The sense is that if they can always depend on an unlimited amount of help if they mismanage themselves into a crisis, there is less incentive to manage themselves responsibly - and as a result, they can offer higher returns and attract customers away from smaller banks that are not too big to fail, hence may not invest with wild abandon.
In general, regulations attempt to control the investing behavior of banks to ensure they are not taking excessive risk so that they remain stable - and in instances where a bank begins to fail, the government has powers to take control of the bank, perhaps taking partial to full ownership of it, to restore it to solvency or manage its collapse to minimize collateral damage to other financial institutions.
Regulating Capital Adequacy
As with any business, the net worth of a bank is the excess of its assets over its liabilities. If it owes more than it has, it is not viable because it will eventually run out of money before it has paid all its debts. A business can remain afloat in the short term by managing its liquidity (collecting enough from its borrowers to make debt payments on time), but it will eventually run aground.
With this in mind, the bulk of bank regulation is geared to ensure the adequacy of its capital: that it has enough assets t cover its liabilities, that it has sufficient liquidity to service its debts (collecting receivables before payables are due), and that it has reasonable risk management measures in place (to be able to honor its debts if some of its borrowers default entirely).
Here, the authors go into detail about the Basel accords, a set of guidelines that most governments have adopted into their own banking laws, which are measures by which a bank's solvency may be addressed. There's a great deal of detail about the precise calculations that is dreadfully boring and excessive, and more than necessary to have a general understanding.
Other Forms of Regulation
The methods and degree to which banking are regulated are as random and capricious as government itself - which will do or refrain from doing as it pleases.
Consumer protectionism is mentioned, as it is the most common defense of a person who has defaulted on his obligations to claim not to have understood the contract he was signing. Various regulations are in place that require banks to make full disclosure of the terms in language that a mildly inebriated person of subnormal intelligence can understand.
There is also a body of legislation to promote competition and prevent large banks from creating barriers to entry, even though much of the legislation is itself a barrier to entry that creates unfair competition in favor of large banks. At yet, some lip-service is paid to the necessity of competition to maintain fair pricing to the market, and some token efforts are made by legislators to appear to have integrity.