ABSTRACT
There are several ways in which the failure of banks can be avoided, ranging from the supply of lender of last resort facilities to the encouraging of confidence through deposit insurance schemes. However, perhaps the main technique used to minimise the risk of banks failing is the establishing of a system of regulation. In most jurisdictions, bank regulation has among its objectives the avoidance of systemic risk. In the U.K., although this is not explicitly stated as an objective of regulation, the maintaining of confidence in the financial system is, and it is primarily through this confidence that systemic risk is avoided. It will be argued in this Chapter that an effective system of regulation is an essential prerequisite to a sound financial system, and that having a sound financial system is the best way to avoid the failure of banks. Regulation gives economic actors the confidence that banks have been authorised on the basis of meeting minimum standards, and will continue to be monitored and supervised to ensure that those standards are maintained. They are therefore less likely to be poorly capitalised, and fraudulently or incompetently run than if no system of external regulation were in place. However, as will soon be seen, regulation should not, and does not, act as an alternative for regulation by the market, nor does it replace the need for management to take prime responsibility for a bank’s activities. There has been increasing recognition of both the limitations of regulation, and the role that market discipline can play in ensuring a sound and efficient financial system.1 It is likely that market discipline will play a greater role in financial regulation in the future, and this is likely to bring benefits. However, an effective system of regulation is likely to remain the main factor in reducing the risk of bank failure, and maintaining confidence in the banking system.
