Why should banks be regulated?

Background from Risk Management and Financial Institutions, Regulation, Basel II and Solvency II

The main purpose of bank regulation is to ensure that banks have enough capital in relation to the risks they take. It isn't possible to eliminate all risk - after all, taking risks is very much the business of banks - but regulators want to make the probability of default for any given bank very small.

Even though the economic self interest of banks would argue for banks maintaining adequate capital requirements on their own, historical experience has shown that this is not always the case.

According to John C. Hull (Risk Management and Financial Institutions), regulation has played an important role in increasing banks capital and making them more aware of their risks.

Another reason to regulate banks is deposit insurance. Without it, risky banks would find it hard to attract customers. Deposit insurance makes depositor less discriminating between banks, as the government bears the final responsibility for their assets. To overcome the moral hazard inherent in such risk allocation, regulators need to insure that banks keep sufficient capital to the risks they bear.

Another reason banks need to be regulated is systematic risk. This is a topic that is central in the current bail-out debate in Europe. If a bank is allowed to fail, the opaque nature of banks obligations to each other can cause reduced trust in the system. This increases borrowing costs for all banks. If trust falls enough, it can even lead to banks refusing to lend to each other.

To deal with the problem of systematic risk, it's imprudent for regulators to issue bail-outs frequently as it increases the moral hazard in the system. Banks start assuming that their risk levels are unimportant as the government bears the ultimate cost of it. To address this issue, regulators impose minimum capital requirements on banks based on their risk profiles.