There are two main reasons. First, the financial industry is the repository for the wealth of a large number of small savers. For most of these savers, it is very difficult and costly to make a personal judgment of the risks involved in doing business with a particular bank, credit union, or insurance company. The second reason has to do with what we call systemic risk, or contagion. This refers to the risk that problems in one particular financial institution will be transmitted to others.
Contagion can occur when depositor nervousness about one institution spreads to others.
As well, since the payments system links financial institutions closely together, the failure of one institution can potentially lead to serious losses for others. Governments have addressed safety concerns by imposing capital requirements on financial institutions, restricting their ability to engage in risky activities, supervising their adherence to risk-reducing practices, and setting up deposit insurance. To limit contagion, central banks have the power to make liquidity loans to financial institutions in the payments system. And most central banks in industrial countries have been involved in initiatives to minimize the potential for systemic risk in their payments systems. Thus, governments feel a greater need to regulate to reduce the risks of institutional failure.