Banks are among the most regulated businesses. Ever since the inception of banking as a business in the medieval period, the state has exercised some form of control. By the 19th century, banks had become more numerous, larger, and a significant part of the economy in the Western world. With that, the extent of control over them increased. By the end of the 20th century, banks were subject not only to national but also international regulations, such as those under the Basel regime.

While banks have been regulated since their inception, the approach to regulation has followed an evolutionary path where we can discern different paradigms. In this article, I shall describe two paradigms that were prevalent over the last two centuries and a third emergent one that may become more relevant in the future. I will call these three paradigms the Money paradigm, the Intermediation paradigm, and the emerging Marketplace paradigm.

The Money paradigm views banks essentially as monetary institutions whose primary role is to “create" money. Until the end of 19th century, the main function of banks was to issue bank notes that were then used as a means of exchange. Banks would issue notes against stocks of gold (the earliest depositors were goldsmiths) that could be used as money. This practice set the foundation of the gold standard which dominated until the mid-20th century.

When banks are seen primarily as issuers of money, issuing loans is incidental. The approach to bank regulation focuses on the role they play in the creation and use of money, and on controlling the price of money i.e interest rates. In most economies, there was some form of interest rate regulation on liabilities up until the 1980s. Controlling the quantity of money issued also resulted in adherence to the gold standard.

Central banks became more powerful in the 20th century, with a monopoly in issuance of money which transformed note issuance of banks into deposits. Post World War II, under the Bretton Woods system, the gold standard was abandoned and central banks started issuing “fiat" money, making the money role much less important. The intermediation role became more prominent and progressively became the focus of regulation. This led to the Intermediation paradigm of regulation.

In the Intermediation paradigm, the role of banks is to use loans with deposits as “raw material". The Banking Regulation Act of 1949, which is the principal law for banking regulation in India, defines banking as an activity of “accepting for the purpose of lending or investing, deposit of money from public", thus indicating the primacy of the Intermediation paradigm.

Regulating banks as financial intermediaries anchors regulations on the asset side. The most prominent example of the Intermediation paradigm is the Basel regime that has at its core capital regulation based on risk-weighted assets.

These two traditional paradigms of bank regulation sit somewhat uncomfortably with each other. The Money paradigm results in some form of administered interest rates, which will invariably result in mispricing of risk and, hence, misallocation of capital by banks due to artificially and somewhat arbitrarily determined cost of funds. The Intermediation paradigm, on the other hand, will mostly result in capital regulation with unregulated deposit pricing, which will invariably dampen monetary transmission. Policy conversations on monetary policy transmission focus on lending rates of banks, with very little, if any, attention paid to deposit pricing. As a result, the banking channel is quite poor in transmitting monetary policy, as we witness in India.

With the development of financial markets, the role of banks has evolved. Banks have more tradable assets and liabilities on their balance sheets. With this, a third paradigm has emerged, which we could call the Marketplace.

The banking system can be viewed as a marketplace for funds where banks act as market makers. We could view the two sides of the balance sheets of banks as autonomous businesses that operate under independent competitive dynamics. Banks, as market makers, are constantly giving two-way quotes (the bid-ask quotes) through deposit and loan pricing. Regulating market making is primarily about regulating the liquidity provided by the market maker. It means that the primary approach to banking regulation should be to act on both sides of the balance sheet so that the system stays liquid.

In the more developed financial systems, there is a clear evolution of the regulatory approach from the Money to the Marketplace paradigm, reflecting the underlying evolution in the role and functioning of banks. As the financial markets develop in India and bank balance sheets have more tradable securities and loans, this paradigm will become more relevant. But we are not there yet. A comprehensive approach should carefully balance these three paradigms. Banks are a collection of several businesses and activities. For specific businesses or activities, one of the three paradigms may be more relevant.

Banks are complex and regulating them is always challenging. Their central role in the economy, especially for a developing country like India, means that regulating banks is an important component of the management of the overall economy. Effective regulation must recognize the complexity of banks. Striking a balance between the three paradigms outlined above can help in more effective regulation.

Harsh Vardhan is with Bain and Co. and these are his personal views. The author is thankful to Prof. Morgan Ricks of Vanderbilt Law School, US, for his inputs.

Comments are welcome at theirview@livemint.com

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