Financial intermediation is one of the most regulated industries throughout the world because it is impressed with public trust. Laws and regulations seek to protect the individual, the financial intermediary, and the entire economy from the adverse effects of financial malpractice. The economic crises are grand testaments as to how circumvention of laws can shake the industry and the world economy. Cases are also filed in the courts everyday on accounts of violations in bank secrecy and consumer welfare. From consumer transactions to corporate finance, one should expect a never-ending list of legal intricacies.
Simplifying Financial Intermediation
Financial intermediaries are middle-men—agencies which serve as bridges between those who need funds, and those who have excess funds. Financial intermediaries receive funds from the public and identify opportunities where the funds can earn.
To illustrate this, it is best to look at banks. Banks accept funds from the public in the form of deposits. When an individual deposits his money to the bank, he is lending his excess funds to the institution. In return, he expects to earn interest. Because the interest is a cost to the bank, the bank needs to find a borrower who requires extra funds and is willing to pay a premium for them. Once the funds have been lent to a credit-worthy borrower, he can now put it to good use. In this case, all parties are better-off: the depositor earns interest, the borrower uses the funds for his intended purpose, and the bank earns profit from the difference between the interest he gives the depositor and the interest he receives from the borrower.
Some Laws on Financial Intermediation
Upon providing funds to banks, the public trusts that the bank will find good use for it. The public expects that the bank will give back the entire amount deposited, plus interests. The pressure is now on the bank to meet this expectation. However, the pressure can be overwhelming for the bank. This can cause the bank to pursue risky undertakings and undermine the public’s trust. This highlights the necessity for regulations and laws.
One of the most famous laws enacted to hamper risky bank behavior is the Glass-Steagall Act of 1933. This law prohibited banks to engage in investment banking activities. Although investment returns can be promising, the issue with investment activities is that it is hinged on speculation. To put it simply, the amount you get from your investment may be less than what you placed in it. While the Glass-Steagall Act has been repealed, this law is a reminder that without stringent regulations, the banking industry can trigger an economic meltdown.
A legal principle that protects bank clients is Bank Secrecy. It prohibits third parties to inquire and the bank to disclose information about the financial dealings and accounts of bank clients. This law is very controversial as it can be used to facilitate criminal activities such as money laundering, and tax evasion. This principle alone can ignite many legal battles as in some countries, mere disclosure that an individual is maintaining an account with a bank is forbidden.