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Regulatory

Regulatory Byte 1 – Trust & Accountability

Why banks are so heavily regulated, who sets the rules – from Basel to national regulators – and how they're enforced through reporting and inspections.

Anand N Panicker

• 7 min read
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Photo by micheile henderson / Unsplash

Table of Contents

  1. Introduction
  2. What Banks do
  3. Why Banking is one of the most regulated sectors
  4. The Foundations of Regulation : Trust & Accountability
  5. Rule Setting
  6. Regulation Coverage
  7. Enforcement
  8. What’s next

Introduction

Every industry has regulations & Banking sector is one of the most regulated. Why?

Banks hold other people's money, move funds within and across economies, and are a key channel through which central banks steer interest rates and credit. When trust in banks breaks down, the damage rarely stays inside one institution.

This is the first post in a series on banking regulation. At a high level, we explore why banks are regulated, who sets and enforces the rules, and how those rules are enforced, with examples from the US, UK, Europe, India and the GCC (Bahrain, Kuwait, Oman, Qatar, Saudi Arabia and the UAE). Later posts will go into each area in detail.

What banks do

The main function of banks is to take deposits from savers and lend money to borrowers. Savers are people who have funds available, and borrowers are those who want funds for some purpose. Banks are the trusted intermediary that allows savers to deploy their funds through savings or deposit products, and borrowers to borrow funds in a legal and regulated manner.

Also, banks are central to any economy. Why? Because they move money within the economy, and across economies through trade and capital flows. These actions drive the economy. The plumbing for money flows runs through banks, and the foundation it rests on is trust.

Why banking is one of the most regulated sectors

All industries are regulated in some form or other, but some are far more heavily regulated than others – nuclear power plants and airlines, for example. Banking and the wider financial sector sit firmly in that group, because they deal with third-party funds: other people's money.

There is a second reason. Banking is the sector through which central banks influence the economy. Central banks set policy interest rates, which influence the rates banks charge on loans and pay on deposits. In India, for example, the RBI requires banks to link new floating-rate retail loans and loans to small businesses to an external benchmark (from October 2019, extended to medium enterprises from April 2020), and the RBI policy repo rate is one of the allowed benchmarks. These rates in turn set the conditions for credit, which drive other sectors and industries. You can check out my deep dive on interest rates.

In a growing economy with a high probability of inflation, central banks may raise interest rates to discourage excessive borrowing: higher rates increase the cost of funds for borrowers, reducing borrowing and spending. In a stagnating economy, they may do the reverse. Much of this works through banks, though financial markets and expectations also play a part. So banks must be sound for these policies to work.

The foundations of regulation: trust and accountability

Banks and other financial institutions are regulated by central banks and/or other dedicated regulators to make sure there is trust in the plumbing that directly or indirectly drives the flow of money.

Deposit insurance is a very good example of trust at work: it protects ordinary savers' deposits up to a limit and helps prevent panics. The US FDIC was created in 1933, during the Great Depression, "to maintain stability and public confidence in the nation's financial system". About 9,000 US banks suspended operations between 1930 and 1933. Today, deposits are insured up to $250,000 per depositor, per FDIC-insured bank, for each account ownership category.

Another source of trust is the central bank acting as lender of last resort, providing emergency liquidity to banks under stress. The classic principle is to lend to solvent banks, against good collateral and at penalty rates, though in practice central banks' approaches vary considerably.

Alongside trust comes accountability. Because banks deal with third-party funds, they must be accountable for how they manage every penny of those funds, through sound processes and governance mechanisms. Accountability is key in regulation.

Hence it is critical that central banks and/or regulators put proper regulations in place, so that trust is strong and resilient and accountability is enforced. Regulation reduces the chance, and the cost, of failure.

Rule Setting

Global standard setters

Who guides central banks on what adequate regulation looks like? There is a central bank for central banks: the Bank for International Settlements (BIS), which describes itself as "a bank for central banks". It is not itself a regulator. Based in Basel, Switzerland, the BIS hosts the committees that set global standards for central banks and supervisors. It was established in 1930 and is owned by 63 central banks.

The banking standards themselves (Basel III and others) come from the Basel Committee on Banking Supervision (BCBS), which the BIS hosts. They cover capital, liquidity and supervision. As the BCBS charter puts it, "Its decisions do not have legal force"; countries implement them through their own domestic rules.

Membership varies across the GCC and India. The central banks of Saudi Arabia, the UAE and Kuwait are BIS members; those of Qatar, Bahrain and Oman are not. Saudi Arabia and India are BCBS members; the Central Bank of the UAE is an observer.

Two other global bodies matter here:

  • The Financial Stability Board (FSB) "monitors and makes recommendations about the global financial system". It was established in April 2009 as successor to the Financial Stability Forum, and G20 leaders endorsed its charter.
  • The Financial Action Task Force (FATF) sets anti-money-laundering standards. MENAFATF, an independent FATF-style regional body for the Middle East and North Africa, was set up in 2004 and is headquartered in Bahrain.

None of these standards binds a bank on its own. They become binding only when each country adopts them into its own laws or regulations.

National regulators

That is where national regulators come in. Some examples from major jurisdictions:

Regulation Coverage

At a high level, bank regulations across the world can be grouped under these broad headings:

  1. Licensing
  2. Governance
  3. Risk (including capital and liquidity)
  4. Operations and compliance
  5. Reporting
  6. Resolution
  7. Conduct and consumer protection

For a more formal view, the Basel Core Principles (29 principles, revised April 2024) split into supervisors' powers (principles 1–13) and prudential requirements for banks (principles 14–29).

On conduct and consumer protection, regulators also oversee how banks treat their customers. One of the UK FCA's operational objectives, for example, is to "Protect consumers".

Enforcement

Reporting

Reporting is key because central banks want to know what banks were doing & how they were performing in each reporting period, through summarized balance-sheet and statistical data. The major reporting requirements cover capital adequacy, liquidity, risk and statistical returns (see, for example, the EU's supervisory reporting standards).

The reports are expected to answer two main questions:

  1. Are the banks in a position to carry out the functions they have been entrusted with?
  2. Are there risks in any one bank, or across multiple banks? Remember the 2008 financial crisis: Basel III was developed "in response to the financial crisis of 2007-09".

That second question covers two perspectives: supervising individual banks (micro-prudential) and supervising the system as a whole (macro-prudential). As the IMF puts it, the health of individual institutions is "a necessary, though not sufficient, condition for system-wide stability".

Central banks also use the data in statistical returns to feed monetary analysis: the ECB's bank balance-sheet data are "the basis for the production of the euro area monetary aggregates". Prudential returns (capital, liquidity) mainly feed supervision and financial stability.

Suspicious transaction reporting is a separate channel, aimed at money laundering and terrorist financing. The global standard is FATF Recommendation 20: "If a financial institution suspects or has reasonable grounds to suspect that funds are the proceeds of a criminal activity, or are related to terrorist financing, it should be required, by law, to report promptly its suspicions to the financial intelligence unit (FIU)."

Each country has its own FIU that receives these reports, for example:

Inspections and enforcement

Beyond reporting, central banks and regulators conduct periodic inspections to check that banks have followed the rules on governance, risk and operations, and they monitor banks off-site between inspections. In the US, the Fed keeps a continuous presence at large firms and runs periodic exams for smaller ones. In India, the RBI moved to risk-based supervision from 2013.

When things go wrong, supervisors generally escalate step by step, though they can go straight to more severe action when circumstances warrant:

supervisory findings → rating downgrades → formal actions (e.g. cease-and-desist orders) → fines → license revocation

  • In 2024 the Fed completed 58 formal enforcement actions and assessed about $372 million in civil money penalties.
  • Under Saudi Arabia's Banking Control Law, after persistent breaches the Minister of Finance (with Council of Ministers approval) can revoke a bank licence.

What's next

Banks are regulated because they run on trust and handle other people's money. Global bodies set the standards, national regulators turn them into binding rules, and the rules are enforced through reporting, inspections and, when needed, penalties.

We will go into different aspects of regulations & its objectives in later posts.