The subprime mortgage crisis has shown that capital requirements settled by Basel II were insufficient and that is why Basel III came out. Not everywhere yet though (2019 ), the main goal is increasing the amount of liquidity and so lessening leverage which should lead to a more stable banking system. Also, besides capital requirements, other types of regulation affect banks and the financial system such as bank activity regulatory, deposit insurance schemes or even market structure indicators. However, are they efficient? Can regulation make a solid banking system? As Bhattacharya et al (1998) said: “The basic message of contemporary banking theory is that banks may be inherently fragile in their role as providers of liquidity, and that this creates a role for a public safety net, either through governmental deposit insurance or through other mechanisms like a Central Bank functioning as a lender of last resort. However, the public safety net has numerous costs, including deadweight taxation costs, distorted asset portfolio choices of banks, and artificial restrictions on banking activities that may be efficiency depleting. Given the explosive growth in market-provided liquidity as well as off-balance sheet banking, a serious look at the desirability of governmental deposit insurance is called for.”
Originally, banks were mainly retail by only bringing help to consumers and entrepreneurs. Today, commercial and investment banking is strongly criticized because this system might occur very risky problems like asymmetric information or moral hazard and also a very arrogant, overconfident and “dangerous” way of thinking to banks leaders as shows this saying from Goldman Sachs’ CEO Lloyd Blankfein “I am just a banker doing God’s work” (2010). That is why people want banks to go back to their first role in order to avoid any such problems and therefore instability. According to Boyd et al (1998), moral hazard and its different forms are the cause of instability and widen activities would lead to more risk taken, inducing more moral hazard problems. To the contrary, some studies show that the less banks develop their activities, the riskier to occur moral hazard problems, like Barth et al (2001) discuss in their research paper.
Nonetheless, governments, institutions and companies still depend upon banks which explain why they are very special and therefore nobody can’t let them fail. “Too big to fail” comes from this statement and also brings us to the main event during the financial crisis of 2007/2008: Lehman Brothers collapse. Why did not the American government bail Lehman Brothers out? Again, this leads leaders to get a very overconfident way of thinking, inducing a deficient involvement in weaken the general risk and therefore maintaining a stable banking system.
Besides regulation, competition plays a very big role in the banking stability. Lots of studies, theories and research show equivocal results about the relationship between competition and stability in the banking sector. On the one hand, competition might impact positively on banking stability according to Schaeck et al (2013) saying that competition conducts to stability and that regulators must condition policy on the health of existing banking. On the other hand, according to Claessens et al (2004), vigorous competition may not be the best for banking sector performance, but it could be very costly and exhibit a poor service provided. However, the main theory available about this relationship is that more competition impacts negatively on the stability of the financial system, supported by Berger et al (2009) explaining that the more bank rivalry, the less profit margins and the more risk taking to increase return. Both theories being discussed and generally accepted, a compromise between competition and stability is undeniably present.