Regulation of Financial Institutions: A Functional Analysis

This study has three main objectives: First, to examine the reasons for the existence of financial institutions that simultaneously lend to one group and borrow from another; second, to analyze the reasons for the special treatment of these institutions in terms of the regulation that governs their activities; and third, to assess the types of regulation that can be explained as a consequence of the reasons for regulation. The analysis suggests that deposit-taking institutions that offer fixed-value liabilities to their customers are best explained either through their advantages in monitoring and enforcement of investments or through the economies inherent in being payments intermediaries. A case for the regulation of financial institutions arises because of the nature of the assets of financial institutions and the transactions costs required to co-ordinate their many creditors. The forms of regulation suggested by the analysis include minimum capital ratios, eligibility requirements for investments, prohibitions on the joint ownership of financial institutions and other enterprises, and limitations on the terms and scale of transactions between associated enterprises.