Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets Edward V. Murphy Specialist in Financial Economics January 30, 2015 Congressional Research Service 7-5700 www.crs.gov R43087 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Summary Financial regulatory policies are of interest to Congress because firms, consumers, and governments fund many of their activities through banks and securities markets. Furthermore, financial instability can damage the broader economy. Financial regulation is intended to protect borrowers and investors that participate in financial markets and mitigate financial instability. This report provides an overview of the regulatory policies of the agencies that oversee banking and securities markets and explains which agencies are responsible for which institutions, activities, and markets. Some agencies regulate particular types of institutions for risky behavior or conflicts of interest, some agencies promulgate rules for certain financial transactions no matter what kind of institution engages in them, and other agencies enforce existing rules for some institutions, but not for others. These regulatory activities are not necessarily mutually exclusive. Banking U.S. banking regulation traditionally focuses on prudence. Banks’ business decisions are regulated for safety and soundness and adequate capital. In addition, banks are given access to a lender of last resort, and some bank creditors are provided guarantees (deposit insurance). Regulating the risks that banks take is believed to help smooth the credit cycle. The credit cycle refers to periodic booms and busts in lending. Prudential safety and soundness regulation and capital requirements date back to the 1860s when bank credit formed the money supply. The Federal Reserve (Fed) as lender of last resort was created following the Panic of 1907. Deposit insurance was established in the 1930s to reduce the incentive of depositors to withdraw funds from banks during a financial panic. Securities, Derivatives, and Similar Contract Markets Federal securities regulation has traditionally focused on disclosure and mitigating conflicts of interest, fraud, and attempted market manipulation, rather than on prudence. Securities regulation is typically designed to ensure that market participants have access to enough information to make informed decisions, rather than to limit the riskiness of the business models of publicly traded firms. Firms that sell securities to the public must register with the Securities and Exchange Commission (SEC). SEC registration in no way implies that an investment is safe, only that material risks have been disclosed. The SEC also registers several classes of securities market participants and firms. It has enforcement powers for certain types of industry misstatements or omissions and for certain types of conflicts of interest. Derivatives trading is supervised by the Commodity Futures Trading Commission (CFTC), which oversees trading on the futures exchanges, which have self-regulatory responsibilities as well. The Wall Street Reform and Consumer Protection Act (Dodd-Frank Act, P.L. 111-203) required more disclosures in the over-the-counter (off-exchange) derivatives market than prior to the financial crisis and has granted the CFTC and SEC authority over large derivatives traders. Government Sponsored Enterprises The Federal Housing Finance Agency (FHFA) oversees a group of government-sponsored enterprises (GSEs). Two of the GSEs, Fannie Mae and Freddie Mac, securitize residential mortgages, and they were placed in conservatorship following mortgage losses in 2008. In the conservatorship, the Treasury provides financial support to the GSEs and FHFA and Treasury Congressional Research Service Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy have managerial control over the enterprises. FHFA also regulates the Federal Home Loan Bank (FHLB) system, a GSE composed of regional banks to bankers owned by the 8,000 financial institutions that they serve. Changes Following the 2008 Financial Crisis The Dodd-Frank Act created the interagency Financial Stability Oversight Council (FSOC) and authorized a permanent staff to monitor systemic risk and consolidated bank regulation from five agencies to four. The DFA granted the Federal Reserve oversight authority and the Federal Deposit Insurance Corporation (FDIC) resolution authority over the largest financial firms. The Dodd-Frank Act consolidated consumer protection rulemaking, which had been dispersed among several federal agencies, in the new Consumer Financial Protection Bureau. Special Topics The appendices in this report include additional information on topics, such as the regulatory structure prior to the Dodd-Frank Act (DFA), organizational differences among financial firms, and the rating system that regulators use to evaluate the health of banks. A list of common acronyms and a glossary of common financial terms are also included as appendices. Congressional Research Service Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Contents Introduction...................................................................................................................................... 1 Policy Problems in Banking and Securities Markets ....................................................................... 5 Banks ......................................................................................................................................... 5 Markets to Trade Securities, Futures, and Other Contracts ....................................................... 7 The Shadow Banking System .................................................................................................... 9 What Financial Regulators Do ......................................................................................................... 9 Regulatory Architecture and Categories of Regulation ........................................................... 10 Regulating Banks, Thrifts, and Credit Unions ............................................................................... 15 Safety and Soundness .............................................................................................................. 16 Capital Requirements .............................................................................................................. 17 Asset Management .................................................................................................................. 19 Consumer Protection Compliance ........................................................................................... 20 Regulators of Firms with Bank Charters ................................................................................. 20 Office of the Comptroller of the Currency ........................................................................ 21 Federal Deposit Insurance Corporation............................................................................. 21 The Federal Reserve .......................................................................................................... 23 National Credit Union Administration .............................................................................. 23 Regulating Securities, Derivatives, and Other Contract Markets .................................................. 23 Non-Bank Financial Regulators .............................................................................................. 24 Securities and Exchange Commission .............................................................................. 24 Commodity Futures Trading Commission ........................................................................ 26 Federal Housing Finance Agency ..................................................................................... 27 Consumer Financial Protection Bureau............................................................................. 28 Regulatory Umbrella Groups .................................................................................................. 28 Financial Stability Oversight Council ............................................................................... 28 Federal Financial Institution Examinations Council ......................................................... 29 President’s Working Group on Financial Markets ............................................................ 30 Non-Bank Capital Requirements ............................................................................................. 30 Federal Housing Finance Agency ..................................................................................... 30 The SEC’s Net Capital Rule .............................................................................................. 31 CFTC Capital Requirements ............................................................................................. 32 Foreign Exchange Markets ...................................................................................................... 32 U.S. Treasury Securities .......................................................................................................... 33 Private Securities Markets ....................................................................................................... 34 Figures Figure 1. An Example of Regulation of JPMorgan Derivatives Trades........................................... 3 Figure B-1. National Bank ............................................................................................................. 37 Figure B-2. National Bank and Subsidiaries.................................................................................. 37 Figure B-3. Bank Holding Company ............................................................................................. 38 Figure B-4. Financial Holding Company....................................................................................... 38 Congressional Research Service Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Tables Table 1. Federal Financial Regulators and Organizations ............................................................... 2 Table 2. Policies for Banking Regulation and Securities Regulation .............................................. 4 Table 3. Federal Financial Regulators and Who They Supervise .................................................. 13 Table A-1. Capital Standards for Federally Regulated Depository Institutions ............................. 36 Appendixes Appendix A. Capital Requirements: Provisions in Dodd-Frank .................................................... 35 Appendix B. Forms of Banking Organizations.............................................................................. 37 Appendix C. Bank Ratings: UFIRS and CAMELS ....................................................................... 39 Appendix D. Regulatory Structure Before the Dodd-Frank Act .................................................... 41 Appendix E. Acronyms .................................................................................................................. 42 Appendix F. Glossary of Terms ..................................................................................................... 43 Contacts Author Contact Information........................................................................................................... 51 Acknowledgments ......................................................................................................................... 51 Congressional Research Service Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Introduction Most people in the United States (and other developed nations) have rejected the Shakespearean maxim, “neither a borrower nor a lender be.” Many people use loans to finance at least part of their education and job training during their youth, use mortgages to finance at least part of their home while starting a family, invest in stocks and bonds during middle age, and rely on the returns to the value of their stocks, bonds, and homes to at least partially pay for retirement during old age. Business firms, municipalities, and sovereign governments also rely on the financial system to help build the productive capital necessary for a well-functioning society and to foster economic growth. Financial regulatory policies are of interest to Congress because of the repercussions for individual constituents, the financing of firms and governments, and long-run economic growth. This report provides a framework to help answer the question, “who regulates whom in U.S. financial markets, and how?” At the federal level, the answer often depends on first identifying both the policy problem and the proposed solution. For example, there are federal regulatory overlaps in which one agency can oversee a firm because of the firm’s charter, a second agency regulates some of the activities that the firm is engaging in, but a third agency controls a government initiative to resolve or alleviate a problem related to the firm or its activities. On the other hand, there are regulatory gaps in which some of the firms participating in a financial activity do not have regulated charters, and the activity believed to be causing a problem does not have a regulator. Thus, answering “who regulates whom” requires first identifying the problem to be regulated, and how. This report provides an analysis of financial regulatory policy. It is not intended as a roadmap of legal jurisdiction; rather, it helps to match financial regulatory agencies to financial regulatory policies based on the kinds of financial difficulties that they generally address. Many of these difficulties are related to what economists call market failures, which can be loosely described as instances in which market prices and participants do not fully take into account all of the costs and benefits of their actions. Table 1 presents a list of financial regulators. In the United States, it may be useful to distinguish between regulators that generally focus on prudence (i.e., monitoring and regulating the risks that a specific firm engages in) and regulators that generally focus on disclosure (i.e., monitoring and regulating the information that firms and exchanges provide to potential market participants). Four federal agencies have prudential authority to examine banks, thrifts, and credit unions.1 Two agencies oversee markets for financial contracts (securities and derivatives). The agencies listed in the “other” category regulate housing government-sponsored enterprises (GSEs) and consumer financial products, respectively. The entities listed in the coordinating forum category are made up of the other financial regulators with related duties or functions and facilitate communication and coordination among member agencies. Two agencies either regulate an activity regardless of the type of institution that engages in it or provide prudential regulation to nonbanks.2 The agencies are discussed in more detail below. 1 A fifth agency, the Office of Thrift Supervision (OTS), was abolished in 2010, and its responsibilities were spread among other agencies. Its prudential regulation of thrift depositories was transferred to the Office of the Comptroller of the Currency. Its prudential regulation of thrift holding companies was transferred to the Federal Reserve. 2 The Federal Reserve also provides prudential regulation to certain nonbank financial companies and financial-market (continued...) Congressional Research Service 1 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Table 1. Federal Financial Regulators and Organizations (acronyms and area of authority) Prudential Bank Regulators Securities and Derivatives Regulators Other Regulators of Financial Activities Coordinating Forum Office of the Comptroller of the Currency (OCC) Securities and Exchange Commission (SEC) Federal Housing Finance Agency (FHFA) Financial Stability Oversight Council (FSOC) Federal Deposit Insurance Corporation (FDIC) Commodities Futures Trading Commission (CFTC) Consumer Financial Protection Bureau (CFPB) Federal Financial Institutions Examinations Council (FFIEC) National Credit Union Administration (NCUA) President’s Working Group on Capital Markets (PWG) Federal Reserve Board (FRB, or the Fed) Source: The Congressional Research Service (CRS). The policy problems and regulatory approaches of the agencies listed in Table 1 vary considerably. Before providing a detailed analysis of each agency, it may be useful to consider how the agencies are related to each other and briefly sketch the types of policies they generally pursue. The prudential bank regulators and the Federal Housing Finance Agency (FHFA) examine firms with specific charters and monitor and limit the risks that their chartered firms engage in. Securities and derivatives regulators monitor exchanges that host the trading of financial contracts, oversee the disclosures that market participants provide, and enforce rules against deceptive or manipulative trading practices. Unlike prudential bank regulators, securities regulators generally do not monitor the composition of assets and liabilities of the firms participating in their markets (although they may require collateral or margin to be posted for some activities, and they may monitor the financial condition of exchanges).3 These and other general differences may exist because of the various missions and risks to financial stability that the agencies address. A specific event in the financial industry is often regulated by multiple agencies because firms subject to institution-based regulation often conduct financial transactions that that are subject to activity-based regulation. JPMorgan’s losses in derivatives markets in 2012 may provide a helpful illustration. JPMorgan’s depository bank subsidiary had a risk management unit called CIO. This unit had significant losses on trades related to complex derivatives (called the London Whale trades at the time), which JPMorgan asserted were designed to guard against systemic risk. When revelations of the losses became public, and people wanted to know who JPMorgan’s regulator was, the answer was that there were many regulators related to JPMorgan’s London Whale trades, depending upon which aspect of the event a person was interested in. (...continued) utilities that are designated as systemic. 3 Although the distinction between prudence-based regulators and disclosure-based regulators may be true in general, bank regulators can regulate the disclosures of their chartered firms and securities and derivatives regulators do have some prudential responsibilities. For example, Section 731 of the Dodd-Frank Act instructs derivatives regulators to set capital requirements for major swap participants. Congressional Research Service 2 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The regulatory policy areas of agencies related to JPMorgan’s derivatives trades are presented in Figure 1. As a bank, JPMorgan’s risk management was subject to prudential regulation by the OCC at the depository level, and by the Federal Reserve on a consolidated basis at the holding company level. As a public company, JPMorgan’s disclosures of the trades to its stockholders were regulated by the SEC. As a participant in derivatives markets, JPMorgan’s transactions were subject to CFTC regulation. As an insured depository institution, JPMorgan’s safety and soundness was also subject to the FDIC. Figure 1. An Example of Regulation of JPMorgan Derivatives Trades Source: CRS. Table 2 compares the general policy options and approaches of the banking regulators to the securities market regulators, which is drawn from Banking Regulation versus Securities Regulation, by Franklin Allen and Richard Herring. The table lists many of the categories of regulations that are often considered for banks and securities markets. It does not mean that each category is in place at all times; for example, there have been times during which the United States has restricted interest payments on bank deposits, and times when the United States has not. Many of these categories of policy options are discussed in more detail in later sections of this report. Congressional Research Service 3 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Table 2. Policies for Banking Regulation and Securities Regulation Types of Banking Regulatory Policies Types of Securities Regulatory Policies Asset Restrictions Disclosure Standards Capital Adequacy Registration Requirements Conduct of Business Rules Manipulation Prohibition Competition Policy (Anti-Trust) Insider Trading Prohibition Conflict of Interest Rules Takeover Rules Investment Requirements Protection of Minority Shareholders Customer Suitability Rules Investment Management Rules Deposit Insurance Fit and Proper Entry Tests Limits on Interest on Deposits Limits on Interest on Loans Liquidity Requirements Reporting Large Transactions Reserve Requirements Restrictions on Geographic Reach Restrictions on Services and Product Lines Source: Banking Regulation versus Securities Regulation, Franklin Allen and Richard Herring, Wharton Financial Institutions Center, 2001. In Allen’s and Herring’s view, banking regulatory policies and securities regulatory policies are directed at fundamentally different problems. They view bank regulation as being directed at systemic risk, which may be loosely defined as risk faced by the financial system as a whole, distinct from the costs and benefits faced by the failure or losses of a single firm or a price movement in a single market. In contrast, they attribute many of the securities market regulator’s policies to investor protection and efficiency enhancement (including aligning corporate management with stockholder interests). Therefore, it may be useful to compare the general policy problems of banking and securities markets. This report is organized as follows. The first section briefly discusses several policy problems associated with financial intermediation. The second section describes various modes of financial regulation to address these concerns and includes a table identifying the major federal regulators and the types of institutions and markets they supervise. The table also identifies certain emergency authorities available to the regulators, including those that relate to systemic financial disturbances. The third section focuses on the regulation of firms with bank charters. The fourth section focuses on the regulation of financial trading markets, especially securities and derivatives. The fifth section focuses on certain other financial regulators and markets that either do not easily fit into banking or securities or markets that do not have a dedicated regulator. The appendices topics include organizational differences among financial firms, the rating system that regulators use to evaluate the health of banks, the regulatory structure prior to the Dodd-Frank Act, a list of common acronyms, and a glossary of common financial terms. Congressional Research Service 4 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Policy Problems in Banking and Securities Markets Ultimately, the function of the financial system is to coordinate the flow of resources from savers to borrowers, and back again. Two common methods to provide this financial intermediation include (1) firms that directly gather funds from savers to directly lend to borrowers (banks, for example) and (2) markets that facilitate the trading of financial obligations (securities and derivatives exchanges, for example). The range of financial obligations includes, but is not limited to, • debts—repayment of principal and interest, • equities—share in ownership and returns, • hybrids—mixture of debt and equity features, • insurance—payment contingent on occurrence of a future event, • swaps—promises to exchange one type of stream of payment for another, and • forwards—promises for future delivery at a particular place and time. Although there are many ways to organize a firm that offers bank-like services, and there are many types of contracts that combine elements of bank-like loans with securities contracts, the regulation of the financial system in the United States has historically focused on distinguishing banks, securities markets, and insurance. The analytical tradition in the United States has been to distinguish commercial banking from investment banking. Commercial banks accept customer deposits and offer commercial loans. Investment banks underwrite and register new securities and market them to individual or institutional investors. Investment banks also provide brokerage services, advice on corporate financing and proprietary trading, and assistance to merger and acquisition proposals. Although insurance issues are beyond the scope of this report, banking and securities markets are discussed briefly below. Banks Banks are intermediaries between savers and borrowers. In its simplest form, the business model of commercial banks is to accept deposits from savers in order to make loans to borrowers—in other words, banks borrow from depositors and offer loans to individuals, business firms, nonprofits, and governments. Although savers could offer loans directly to potential borrowers, there are several advantages of relying on specialized lenders. For example, savers essentially pay banks to act on their behalf (an agency relationship4), identifying credit-worthy borrowers, writing and administering loan contracts, and enforcing the loan terms if the borrower defaults. Another potential source of profit centers on timing. Since long-term interest rates are generally higher than short-term interest rates, banks can earn profits by borrowing short-term in order to offer longer-term loans (often referred to as a maturity transformation or maturity mismatch). 4 The term agency is being used to describe the functional relationship and does not imply any contractual obligation. Congressional Research Service 5 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy This is not an exhaustive list of commercial bank services or earnings, but it is a useful list to illustrate several recurring economic issues. The business model of banks also creates a number of economic policy problems. Like any other agency relationship, bank managers do not necessarily always act in the best interests of bank investors or depositors. The maturity mismatch makes banks vulnerable to interest rate volatility and to “runs” if depositors withdraw their funds simultaneously in a panic. The effort to identify credit-worthy borrowers and projects can cause bankers to affect pools of borrowers in ways that create credit shortages, or base lending decisions on criteria that do not further social goals of the community (e.g., discrimination). These policy problems may be addressed by regulations for individual banks. Some of these regulations include restrictions on conflicts of interest of bank managers, the use of deposits, and the ability of depositors to withdraw their funds; limitations on the proportion of bank resources that can be devoted to or drawn from particular markets or counterparties; rules on the loan application process; and laws to prevent lending discrimination. Banking is also subject to systemic problems beyond the activities of any one institution. Another potential source of profit (related to the agency relationship) is for the bank to take excessive risk. That is, compared with other banks, an individual bank can keep fewer resources available against the possibility of depositor withdrawal, or offer more loans in the heightened-risk categories (that typically pay higher interest), and depend on its ability to borrow from other banks if it suffers excessive withdrawals or higher defaults. Although a single bank that follows a higher-risk strategy might be able to borrow from other banks if it suffers higher than expected losses or greater than expected depositor withdrawals, all banks cannot successfully follow this strategy simultaneously because there would be too few healthy banks to borrow from should loan defaults be higher than expected or should depositors withdraw funds in greater amounts than expected. This systemic banking problem involves a fallacy of composition, and it can be illustrated using the example of a stadium. If a single person stands at the stadium, it is likely that the person will be able to see the event better, but if everyone stands in the stadium, most people will not have a better view of the event and will be less comfortable. Similarly, if a single bank expands its lending for a given amount of capital, that bank is likely to make higher profits without endangering financial stability, but if many banks follow a similar strategy, none gains a competitive advantage over the others, and all are less able to obtain interbank loans during a crisis. Excessive risk taking by banks can have systemic consequences. One systemic problem may be that a large number of banks will attempt to borrow from each other at the same time, causing a spike in interest rates or the absence of new bank credit altogether. If many banks follow this strategy, then all banks may be unable to find an institution willing and able to lend to them in the event of depositor withdrawals, and the banking system as a whole may temporarily cease to be a source of credit for the wider economy. Banks might contribute to a boom-bust cycle for debt-sensitive assets. During booms, banks that intend to rely on emergency lending from other banks may offer too much credit, and on terms that do not adequately account for the risk that the bank’s own access to credit may decline if market conditions change. The resulting cheap credit may help fuel a price bubble in the asset or trading activity financed with the debt. During busts, more banks are likely to fail than would Congressional Research Service 6 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy have occurred if banks had reserved the appropriate amount of resources for the amount of risk that they incurred. Thus, the higher bank failure rate (compared to if more banks had been cautious during the boom) could cause the total amount of credit available to the wider economy to shrink more than would have occurred if financial risks had been adequately accounted for. There are a number of possible policy responses to these systemic concerns in banking. Bank regulators can be empowered to restrict bank balance sheets. Some of these restrictions, discussed in more detail below, include safety and soundness regulation and requirements to hold adequate capital. Even though these regulations may be applied at the institution level, they have systemic effects because in the aggregate the lending activity of the banking system as a whole has an important impact on credit booms and busts. Bank depositors could be offered insurance to reduce their incentive to withdraw funds. Banks that cannot borrow from other banks during emergencies can be provided a lender of last resort. Markets to Trade Securities, Futures, and Other Contracts In contrast to a commercial banking institution that originates and holds loans, a securities market is just a venue to exchange financial contracts. Markets can facilitate the trading of debts, equities, futures, or a variety of other financial instruments. Financial institutions that help facilitate the marketing of debts, equities and other financial instruments are sometimes called investment banks. Although these financial markets are being presented as an alternative to commercial banking, there is no reason that a commercial bank would be unable to participate in securities markets as either a buyer or a seller (although in some cases it may be unlawful to do so). Loans to the government of the United States may be a useful illustration. While it is possible for a single bank to originate and hold an individual loan to the U.S. government, the borrowing of the government is overwhelmingly conducted by issuing debts (Treasury securities) that are traded. Banks are just one group among the many buyers of U.S. Treasury securities. Private firms have also issued tradable debt securities for centuries. Like lending institutions, tradable contracts have a long history and are subject to a number of well-known potential market failures. Several enduring economic inefficiencies related to securities markets are caused by the limited availability of information and potential conflicts of interest. Some market participants may have an information advantage—such as providers of confidential services to financial firms. A related issue is the “lemons problem,” named for the used-car market in which potential buyers of used cars might discount all used cars because of the fear that used-car salesmen may withhold negative information about the quality of a specific car being offered. Potential securities buyers may fall prey to securities dealers and brokers if the latter have an incentive to help place securities that the seller knows may have some undisclosed flaw (lemons). Furthermore, like any agent5 relationship, securities professionals may not always act in the best interests of their clients. Other potential economic inefficiencies can arise that are related to specific types of contracts that are traded. For example, some financial contracts are for future delivery of a physical commodity, such as wheat of a certain quality and quantity, at a particular place and time (forward or futures 5 The term agent is being used to describe the functional relationship, not any contractual obligations. Congressional Research Service 7 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy contract). This means that at any time, for example, there will be both a spot market for wheat (its price to be obtained currently) and the forward price (the current price for delivery on the specified future date). If there is no formal organization of trading rules, it might be possible for someone to use forward contracts to lock up most of the deliverable supply on a specific future date, leaving only a “corner” of the spot market for sale on that date. But even if such attempts to corner commodity markets are rarely successful, the attempts themselves might introduce additional price distortions that could contribute to financial instability. Potential economic inefficiencies are also related to formal trading organizations and platforms, if they are used. Having experienced many of the policy problems described above, financial traders have from time to time organized formal market exchanges, adopted rules of trading, and limited membership. However, the exchange itself can then become a potential source of financial instability if it does not have enough resources to withstand the failure of one of its members to honor its obligations to the exchange, or if its rules exacerbate the problems described above. For example, nonmembers of the exchange could lose confidence (and willingness to participate) if they feel that members have important trading advantages, such as if the trades of members are executed first even if they are not submitted first. There are a number of policy responses to concerns related to trading financial contracts. Some are listed in Table 2, including requiring that securities and traders be registered and investors be provided adequate disclosures regarding the characteristics of the securities. Given that formal exchanges are organized in part to address some of the known inefficiencies, policymakers might require that certain types of contracts be traded on formal exchanges. The organization and membership of the formal exchanges could be regulated. Providers of securities-related services may be regulated for minimum professional qualifications and potential conflicts of interest. Issuers of new securities may be required to meet certain financial thresholds and disclose specific information in a format and venue that is readily accessible to the investing public. Some potential buyers of securities may be excluded for lack of sufficient financial literacy or sophistication or have to exceed a minimum financial wherewithal (as a proxy or substitute for sophistication). Securities markets may also create systemic concerns. Like bank lending, if securities markets fail to adequately address the risks of the activities being funded (thus overstating potential rewards compared with risks), then “too much” savings may be channeled into a particular asset class. As a result, prices in that asset class will tend to be bid up until the true risks manifest themselves, at which time the market collapses. Leveraged and collateralized funding can also cause securities markets to contribute to a boom-bust cycle. That is, if securities buyers are able to increase their purchasing power with debt, especially if the purchased securities form the collateral of the loan, then a decline in the price of the security can lead to “fire sales” as the loans taken out by the buyers default, and then the securities purchased with the loans are liquidated in an already falling market. Some are concerned that algorithmic or program trading can also contribute to systemic events if unanticipated events or technical shortcomings cause trading algorithms, which may be on autopilot, to pursue extreme strategies. A number of possible policies can address systemic concerns in securities markets. One approach is to temporarily halt trading if market prices vary by more than some pre-specified amount during a set time. Another approach is to limit the amount, and collateral, of debt that can be used to fund securities purchases under some circumstances. Yet another approach is to require firms that facilitate securities issuance to retain some of the risk of the securities issued, sometimes referred to as skin in the game. Congressional Research Service 8 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The Shadow Banking System As discussed above, banking and securities markets are not mutually exclusive, nor are all financial obligations easily categorized. The term shadow banking is sometimes used to refer to the funding of loans through securities markets instead of banks—or to the funding of banks through securities markets instead of deposits. Other times, shadow banking is used to refer to financial activity that is ineligible for a government backstop. One type of government backstop is a financial guarantee, such as deposit insurance. Another type is access to emergency loans from the government, such as the ability to borrow from the Federal Reserve’s discount window. What the definitions have in common is they describe alternatives to the simplistic banking model, that is, alternatives to banks that are funded with insured deposits and that only offer commercial loans. Parts of the shadow banking system are regulated. For example, a lender could borrow money through securities markets rather than from traditional retail depositors. One way to do that is through a repurchase agreement (repo), in which the lender sells a security (such as a U.S. Treasury) today and promises to repurchase it in the near future at a higher price. The price differential represents a form of interest payment similar to a collateralized loan. Thus, rather than a bank borrowing money from traditional depositors, a bank can borrow from other financial institutions through repos. If a chartered bank signs a repo with a chartered bank, both firms are banks and both are regulated; nevertheless, under some definitions the transaction would be considered shadow banking. However, chartered banks are not the only firms that can use repurchase agreements—non-banks can raise funds through repurchase agreements in order to fund other investments, including loans. If a non-bank signs a repo with a non-bank, and uses the proceeds to fund other investments, neither non-bank may be subject to prudential regulation, have access to the Federal Reserve’s discount window, have creditors with deposit insurance. The repos described above are only one of many alternatives to deposits that can be used to fund loans. Other examples include relatively short-term commercial debt that is backed by pools of loans (asset-backed commercial paper, or ABCP). A bank could sponsor a facility that issues ABCP in order to buy loans. If so, the bank’s participation (usually promising to provide liquidity if the market is unexpectedly disrupted) is subject to prudential regulation. As with repos, banks are not the only firms that can sponsor ABCP; thus, it is possible for the market to be funded by firms without access to the Fed’s discount window and without insured deposits. However, activities being called shadow banking are often still subject to securities regulation. Many of the general policy problems of banks and securities markets also apply to shadow banking. For example, if a class of loans (such as mortgages or sovereign debt) is funded through securities markets, potential flaws in securities issuance and pricing can contribute to a boom-bust cycle in assets purchased with those loans. If nonbanks (such as money market mutual funds and hedge funds) invest a fraction of the funds they gather, and promise to allow their own investors to withdraw funds at will, these nonbanks can suffer runs if many investors attempt to withdraw simultaneously. The reach of financial regulators to address policy problems in shadow banking varies from activity to activity and from class of firm to class of firm. What Financial Regulators Do The regulatory missions of individual agencies vary, sometimes as a result of historical accident. Some agencies have powers over particular firms, but not over all of the other participants in the Congressional Research Service 9 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy market that the firm might participate in. Other regulators have authority over markets or activities, and this authority applies to a variety of the firms that participate. As a result, a single firm might have to answer to both the regulator of its charter and to the regulator of a particular activity (i.e., regulatory overlap). However, there may also be instances in which a corner of the financial system has neither a regulator of the specific firms, nor a regulator of the particular activities (i.e., regulatory gap). This section of the report summarizes several categories of regulation, provides a table of specific financial regulators in the United States and their policy spheres, and describes the basic regulatory approach for banks (prudence) and securities markets (disclosure). Regulatory Architecture and Categories of Regulation The term regulatory architecture describes the organization of the agencies that regulate a particular policy sphere. A possible architecture is to have a single regulatory agency with examination powers over all industry firms, rulemaking authority for all industry-related activities, and power to enforce its rules and resolve controversies that arise in the industry. An alternative architecture is to have specialized regulators that focus on a subset of industry-related policy problems. The United States has historically provided one or more regulator for each category of financial regulation, rather than a single agency with authority for all financial markets, activities, and institutions. From time to time, the perceived drawbacks to the multiplicity of federal regulators bring forth calls for regulatory consolidation. Even prior to the financial panic in September 2008, the Department of the Treasury had issued a framework for financial reform.6 After the crisis, the legislative debate over the Dodd-Frank Act included different views on the topic: early versions of the Senate bill would have replaced all the existing bank regulators with a single Financial Institution Regulatory Authority. Dodd-Frank created two new agencies (and numerous regulatory offices) and merged the Office of Thrift Supervision (OTS) with the Office of the Comptroller of the Currency (OCC). Choosing a regulatory architecture may involve trade-offs. As one economist explained, On the one hand, one might conclude that the need to compete with other agencies would motivate a regulator to perform its tasks as effectively and efficiently as possible. On the other hand, one might argue that the desire to attract more clients could drive a regulatory agency to be loose.7 In addition, it is not clear that countries with single regulators fare better during crises or are more successful at preventing them. For example, the 2008 financial crisis damaged the financial systems of countries with significantly different regulatory approaches. While the U.S. response was to create a single council to coordinate its varied regulators, the United Kingdom (UK) in May 2010 broke up its Financial Services Authority, which had jurisdiction over securities, banking, derivatives, and insurance. 6 See, e.g., U.S. Department of the Treasury, Blueprint for a Modern Financial Regulatory Structure, March 2008, which called for a three-agency structure: a systemic risk regulator, a markets supervisor, and a consumer regulator. 7 “Competition Among Bank Regulators,” John Weinberg, Economic Quarterly, Fall 2002, available at http://www.richmondfed.org/publications/research/economic_quarterly/2002/fall/pdf/weinberg.pdf. Congressional Research Service 10 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Here is a description of different ways to regulate financial firms and services: • Regulate Certain Types of Financial Institutions. Some firms become subject to federal regulation when they obtain a particular business charter, and several federal agencies regulate only a single class of institution. Depository institutions are a good example: a depository may be subject to the regulations of multiple prudential regulators, but typically only one agency is granted primary oversight authority based on the bank’s charter—national bank, state bank, credit union, etc.—and the choice of charter may not greatly affect the institution’s permissible business mix. Government-sponsored enterprises (GSEs) also have a primary prudential regulator. Regulation keyed to particular institutions has at least two perceived disadvantages. First, regulator shopping, or regulatory arbitrage, may occur if regulated entities can choose their regulator. Second, unchartered firms engaging in the identical business activity as regulated firms may escape institutional regulation altogether. • Regulate a Particular Market. Some markets become subject to federal financial regulation when they host the trading of covered financial products. The New York Stock Exchange (NYSE) and the Chicago Mercantile Exchange (CME) are two examples. The Securities and Exchange Commission (SEC) regulates the trading of stocks and bonds and the Commodity Futures Trading Commission (CFTC) regulates the trading of commodity futures. The SEC and CFTC generally do not regulate the prices of stocks or futures traded on the exchanges; rather, they regulate the organization and membership of the exchanges, rules for trading, and attempt to prevent fraud, conflicts of interest, or manipulation by market participants. Regulation keyed to markets has at least two perceived disadvantages. First, market evolution can create jurisdictional ambiguities among the regulators. Second, innovation in financial products may create regulatory gaps. • Regulate a Particular Financial Activity. Some financial activities are subject to federal regulation no matter which institutions engage in them and no matter who hosts the trades in them. For example, the Consumer Financial Protection Bureau (CFPB) regulates certain classes of loans to consumers no matter who extends the loan (bank or nonbank). If the lender is a bank, the lender has to comply with both the regulations of the CFPB and the rules of its bank regulator. Regulation keyed to activities can be problematic. As discussed above, there are often multiple methods to achieve similar financial objectives (combining different contracts). Therefore, if one type of transaction is regulated, it may be possible for people to use another type of contract, one that is not currently regulated or through institutions that are not regulated. • Regulate for Systemic Risk. One definition of systemic risk is that it occurs when each firm manages risk rationally from its own perspective, but the sum total of those decisions produces systemic instability under certain conditions. Similarly, regulators charged with overseeing individual parts of the financial system may satisfy themselves that no threats to stability exist in their respective sectors, but fail to detect risks arising from the interaction of firms and markets. Yet, regulation of institutions, markets, and activities may also have a component Congressional Research Service 11 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy of systemic risk regulation. For example, regulation of bank capital may affect the potential for booms and busts in asset markets. The Dodd-Frank Act created the Financial Stability Oversight Council (FSOC) to assume a coordinating role among the heads of financial regulatory agencies; the FSOC has a permanent staff to monitor financial-sector risks as a whole. What does it mean to be regulated? It is common to refer to a firm or a market as being regulated or unregulated. However, this simplification can mask important distinctions for any given policy discussion because regulators can have limited scope of operation. That is, agencies may have rulemaking authority or enforcement powers to address one set of policy concerns but not for other policy issues. Firms may be subject to different regulators for different aspects of their business. The point can be illustrated with a more familiar industry. Are restaurants regulated? There is no federal Department of Restaurants; however, the Occupational Safety and Health Administration (OSHA) can make rules for worker safety (including food service employees), and the Department of Justice can enforce employment discrimination laws (including in restaurants). Furthermore, restaurants are typically subject to state and local health inspectors and related laws. If the policy topic is health and safety, it would be inaccurate to characterize restaurants as unregulated. On the other hand, many potential policy issues related to restaurants are typically unregulated. For example, the restaurant menu and prices are not typically regulated. A food service is typically free to pair nonstandard items (white wine with red meat) and charge very high prices. Are financial institutions, markets, and activities regulated? Like the restaurant example above, the answer depends on the policy issue being discussed. Take the example of stocks. Firms with outstanding common stock must register with the SEC, file a prospectus, and make regular public disclosures. Marketplaces that facilitate stock market trading must register and comply with SEC regulations. However, the price of an individual stock is not typically regulated, and the amount of stock that an individual firm wishes to offer for sale is not typically regulated. However, even stock prices and trading volume may be subject to circuit breakers to temporarily limit trading during periods of exceptional volatility. The information in Table 3 sets out the general federal financial regulatory architecture for banks and securities markets. Appendix D contains a pre-Dodd-Frank version of the same table. Supplemental material—charts that illustrate the differences between banks, bank holding companies, and financial holding companies—appears in Appendix B. Congressional Research Service 12 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Table 3. Federal Financial Regulators and Who They Supervise Regulatory Agency Federal Reserve Institutions Regulated Bank holding companies and certain subsidiaries, financial holding companies, securities holding companies, savings and loan holding companies, and any firm designated as systemically significant by the FSOC. State banks that are members of the Federal Reserve System, U.S. branches of foreign banks, and foreign branches of U.S. banks. Payment, clearing, and settlement systems designated as systemically significant by the FSOC, unless regulated by SEC or CFTC. Emergency/Systemic Risk Powers Lender of last resort to member banks (through discount window lending) In “unusual and exigent circumstances,” the Fed may extend credit beyond member banks, to provide liquidity to the financial system, but not to aid failing financial firms. Other Notable Authority Numerous market-level regulatory authorities, such as checking services, lending markets, and other banking-related activities. May initiate resolution process to shut down firms that pose a grave threat to financial stability (requires concurrence of two-thirds of the FSOC). The FDIC and the Treasury Secretary have similar powers. Office of the Comptroller of the Currency (OCC) National banks, federally chartered thrift institutions Federal Deposit Insurance Corporation (FDIC) Federally insured depository institutions, including state banks and thrifts that are not members of the Federal Reserve System. After making a determination of systemic risk, the FDIC may invoke broad authority to use the deposit insurance funds to provide an array of assistance to depository institutions, including debt guarantees. Operates a deposit insurance fund for federally and state chartered banks and thrifts. National Credit Union Administration (NCUA) Federally chartered or insured credit unions Serves as a liquidity lender to credit unions experiencing liquidity shortfalls through the Central Liquidity Facility. Operates a deposit insurance fund for credit unions, known as the National Credit Union Share Insurance Fund (NCUSIF). Congressional Research Service 13 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Regulatory Agency Securities and Exchange Commission (SEC) Institutions Regulated Securities exchanges, brokers, and dealers; clearing agencies; mutual funds; investment advisers (including hedge funds with assets over $150 million) Emergency/Systemic Risk Powers May unilaterally close markets or suspend trading strategies for limited periods. Other Notable Authority Authorized to set financial accounting standards in which all publicly traded firms must use. Nationally recognized statistical rating organizations Security-based swap (SBS) dealers, major SBS participants, and SBS execution facilities Corporations selling securities to the public must register and make financial disclosures. Commodity Futures Trading Commission (CFTC) Futures exchanges, brokers, commodity pool operators, and commodity trading advisors May suspend trading, order liquidation of positions during market emergencies. Swap dealers, major swap participants, and swap execution facilities Federal Housing Finance Agency (FHFA) Fannie Mae, Freddie Mac, and the Federal Home Loan Banks Bureau of Consumer Financial Protection Nonbank mortgage-related firms, private student lenders, payday lenders, and larger “consumer financial entities” to be determined by the Bureau Acting as conservator (since Sept. 2008) for Fannie Mae and Freddie Mac Writes rules to carry out the federal consumer financial protection laws Consumer businesses of banks with over $10 billion in assets Does not supervise insurers, SEC and CFTC registrants, auto dealers, sellers of nonfinancial goods, real estate brokers and agents, and banks with assets less than $10 billion Source: The Congressional Research Service (CRS), with information drawn from agency websites, and financial regulatory legislation. a. See Appendix B. Congressional Research Service 14 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy Regulating Banks, Thrifts, and Credit Unions In general, the term bank will be used in this section to refer to firms (or subsidiaries) with bank, thrift, or credit union charters.8 Banking regulators in the United States attempt to address many of the general policy problems described in the introduction by focusing on the health of chartered banks. Bank charters limit the range of permissible activities and affiliations of banks. Bank regulators employ examiners to monitor and evaluate the financial health of the banks they regulate. Furthermore, deposit insurance and a system to coordinate bank reserves and provide emergency lending is available to participating banks. The primary prudential regulator of a given bank depends on its charter; however, other policies (such as lending to a troubled bank or resolving a failed bank) are applied by a single agency regardless of the charter. Activity-based regulation applies to chartered banks—thus the SEC retains its authority for communications between publicly traded banks and their stockholders, and the CFPB regulates many classes of loans that banks make to consumers. Is this a bank? Functionally, the simplest form of bank accepts deposits in order to offer loans.9 Although this is not a legal definition of a bank, it does capture the basic intermediary function of banking. In practice, it is often difficult to precisely distinguish banking from other services. It is tempting to ascribe this difficulty to financial innovation, but in reality many modern “innovations” are really just minor variations on old practices. Because in discussions of financial regulation, the term bank is often reserved for firms with specific charters, it may be useful to distinguish chartereddepository banks from other institutions and people who offer similar services. Many institutions and organizations have offered bank-like services throughout history. For example, ancient Chinese records describe lenders that required borrowers to offer small goods as collateral for loans (similar to a modern pawn shop). People in Medieval Europe sometimes deposited precious metals with silversmiths (who had their own reasons for extra security) for safekeeping, and some silversmiths then offered loans to third parties, counting on the depositors to not withdraw simultaneously. One controversial example is Whalebone Cafe Bank (WCB), an ice cream shop in Pittsburgh, Pennsylvania. Reportedly, customers can make a deposit at the ice cream shop and receive the equivalent of 5.5% interest in gift cards for ice cream and other goods sold at the store.10 It has also been reported that WCB offered loans, including a $510-cash loan to a man who will pay it back in $60 installments, which includes a $25 fee. The Pennsylvania Department of Banking, according to reports, is investigating, but there are questions as to whether the agency can shut down an ice cream shop or ban stores from rewarding customers with gift cards.11 Several major banking laws limit their application to firms with federally insured deposits, specific banking charters, or affiliations with depository banks. As a result, some investment firms that are sometimes referred to as Wall Street banks are not banks for certain regulatory purposes, nor are some pawn shops and ice cream stores, even if they offer bank-like services. 8 Illustrations of several forms of depository organization are presented in Appendix B. Historically, “banks” also referred to firms with special charters that issued debt, which often circulated as currency. The Bank of England had been granted a monopoly on this form of banking (note issue), which was determined not to extend to depository banking in the nineteenth century. 10 As described in a Wall Street Journal article, available at http://online.wsj.com/article/ SB10000872396390444433504577649971326432962.html. 11 This report will not track the ultimate fate of the ice cream shop. The owner reportedly changed the name to remove the word bank. Regulatory interaction is likely to be ongoing. For example, see “Pittsburgh ice cream bank owner says regulators are backing off,” WTAE News, available at http://www.wtae.com/news/local/allegheny/Pittsburgh-icecream-bank-owner-says-regulators-are-backing-off/-/10927008/19522712/-/asy08i/-/index.html. 9 Congressional Research Service 15 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy As listed in Table 1, four prudential regulators coordinate the examinations policies of depositories through the Federal Financial Institution Examinations Council (FFIEC) in order to prevent inconsistencies in the stringency of regulatory oversight. A bank or thrift may organize itself with a depository subsidiary owned by a larger holding company, in which case the holding company may have a different primary regulator than the depository subsidiary. The OCC regulates depository banks and thrifts that have a federal charter (subsidiaries if in a holding company structure). The FDIC regulates banks with a state charter that are not members of the Federal Reserve System (subsidiaries if in a holding company structure). The NCUA regulates credit unions that have a federal charter. In addition to these federal regulators, state governments have their own agencies to administer state banking laws. The Federal Reserve regulates statechartered member banks (subsidiaries) and holding companies of banks and thrifts. The Conference of State Bank Supervisors (CSBS) serves as a forum for state banking agencies, but is not itself a regulator. State banking supervisors choose a nonvoting representative to serve the FSOC in an advisory capacity. Many prudential regulations are of degree, not of kind. That is, there are many categories of activities that banks may participate in, but they must either limit their concentration or offset related risks in another manner. For example, banks may offer 30-year fixed-rate mortgages; but, an individual bank may have to manage its resulting interest rate risk by offering other loans with shorter maturities or by acquiring derivatives that hedge interest rate risk. As a result, prudential regulation is not always about catching lawbreakers or policing legal violations, but is often about monitoring the risks that banks engage in or the procedures bank managers have in place to control risk. Even banks that have not violated any statute may be required to adjust their lending or other business practices in response to the regulator’s evaluation of risks in current conditions. This section describes five prominent elements of bank regulation that each primary prudential regulator supervises for its chartered firms: (1) safety and soundness, (2) capital requirements, (3) asset management, (4) consumer compliance, and (5) community reinvestment. In many cases the primary prudential regulator will not be the sole policymaker or regulatory authority for these issues. For example, rules for capital requirements and safety and soundness may be coordinated with other bank regulators, and banks may have to comply with consumer regulations issued by the CFPB in addition to satisfying their own primary prudential regulator. There may not be a clear delineation between each regulatory element; for example, adequate procedures for asset management might be important to maintain safety and soundness. Appendix C includes a discussion of the official ratings system that regulators apply to covered firms. Safety and Soundness Safety and soundness refers to a broad range of issues that relate to the health of a financial institution. Safety and soundness encompasses risk management, capital requirements, the diversification of a bank’s portfolio, provisions for liquidity, allowances for loan and lease losses, concentrations of transactions with a single counterparty or in a single region, exposure to potentially expensive litigation, adequate training and expertise of management and staff, adequate procedures for internal controls, and many other issues. This section will not attempt to address all of the categories of safety and soundness regulation listed in Table 2 above. Safety and soundness regulation is conducted prospectively—that is, banks can be examined prior to any indication of excess risk or any evidence of wrongdoing. Safety and soundness regulation relates to economic policy issues because it can affect the credit cycle and conflicts of interest. The rapid decline in the price of one product (and thus a rapid rise Congressional Research Service 16 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy in loan defaults by related firms, employees, etc.) is less likely to cause a wave of bank failures if banks are not permitted to concentrate their loan exposure to one industry or one line of business. Owners and counterparties of banks are more likely to effectively monitor bank managers if banks maintain clear and transparent systems of control. Each loan has a variety of risk characteristics of concern to lenders and their regulators. Some of these risks can be estimated at the time the loan is issued. Credit risk, for example, is the risk that the borrower will fail to repay the principal of the loan as promised. Rising interest rates create another risk because the shorter-term interest rates that the lender often pays for its funds (e.g., deposit or CD rates) rise while the longer-term interest rates that the lender will receive from fixed-rate borrowers remain unchanged. Falling interest rates are not riskless either: fixed-rate borrowers may choose to repay loans early, reducing the lender’s expected future cash flow. Federal financial regulators take into account expected default rates, prepayment rates, interestrate exposure, and other risks when examining the loans issued by covered lenders. The risk of a portfolio of bank assets is not just the sum of the risks of the individual loans and securities that make it up. Lenders can adjust the composition of their balance sheets to reduce or enhance the risks of the individual loans that make it up. A lender with many loans exposed to prepayment risk when interest rates fall, for example, could compensate by acquiring some assets that rise in value when interest rates fall. One example of a compensating asset would be an interest-rate derivative contract. Lenders are required to keep capital in reserve against the possibility of a drop in value of loan portfolios or other risky assets. Federal financial regulators take into account compensating assets, risk-based capital requirements, and other prudential standards when examining the balance sheets of covered lenders. When regulators determine that a bank is taking excessive risks, or engaging in unsafe and unsound practices, they have a number of tools at their disposal to reduce risk to the institution (and ultimately to the federal deposit insurance fund). They can require banks to reduce specified lending or financing practices, dispose of certain assets, and order banks to take steps to restore sound balance sheets. In enforcement, regulators have “life-or-death” options, such as withdrawing deposit insurance, revoking the charter, or taking over a failing bank. In practice, bank regulators rarely use draconian tactics, and banks are given an opportunity to address concerns raised during an examination if the failure of the bank is not imminent. Capital Requirements As a general accounting concept, capital refers to the equity of a business—the amount by which its assets exceed its liabilities.12 The more capital a firm has, the greater its capacity to absorb losses and remain solvent. Capital is related to leverage (various measures of the firm’s reliance on debt and derivatives to fund its activities); firms that fund themselves with more equity capital (instead of debt) tend to have lower leverage ratios. Capital regulation relates to economic policy problems because it can affect the credit cycle. One way higher bank capital affects the credit cycle is its potential to make the banking system more resilient during downturns. Unexpected loan losses are less likely to cause a bank to fail if it holds more capital. In the aggregate, higher capital requirements will tend to make the banking system 12 Regulatory uses of “capital” include more specific definitions and classifications. Congressional Research Service 17 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy more resilient because distressed banks may drain other banks of their liquid reserves while general liquidity is declining. On the other hand, banks are part of a broader financial system, therefore it may be possible that higher capital requirements for banks might not make the system as a whole safer if the cost of capital causes more financial activity to migrate to securities markets or shadow banking. Capital regulation can also affect the credit cycle by affecting the amount of bank credit made available. Higher bank capital requirements tend to lower the leverage that banks can achieve, which reduces the potential lending that the banking system can offer to the broader economy. Whether higher capital requirements for banks lower total lending in the economy is more difficult to determine because it depends in part on how securities markets and shadow banking react. Financial regulators require the institutions they supervise to maintain specified minimum levels of capital—defined in various ways—to increase the resilience of firms to shocks and to minimize losses to investors, customers, and taxpayers when failures occur. The riskiness of a bank’s business model affects its capital requirements; for example, a bank that specializes in relatively risky credit card lending may have higher effective capital requirements than a bank that has a relatively safer and more diversified portfolio of commercial lending. Capital requirements, if they are set above what a firm would choose on its own, represent a cost to businesses because they reduce the amount of funds that may be loaned or invested in the market. Thus, there is a perpetual tension: individual banks adjust their own capital ratio to maximize profits, whereas regulators continually modify capital standards to either prevent excessive risktaking or to promote the availability of credit to the wider economy. The actual capital held by banks should not be confused with statutory minimums. Banks may choose to hold excess capital if bank management believes that economic conditions may deteriorate. For example, in 2007 and 2008, JPMorgan executives referred to their portfolio as a “fortress balance sheet” in part because it was believed to be prepared for a worsening economic environment. Bank regulators may encourage regulated banks to hold additional capital to make the banking system more resilient. Following the financial turmoil of September 2008, banking regulators oversaw an increase in bank capital without the need for new legislation, new notice and comment rulemaking, or new international negotiations because bank regulators can require changes by insured depositories under existing authority (whether due to encouragement of regulators or changed preferences for prudence by bank managers). U.S. banking regulators cooperate with banking regulators in other countries. The general approach to capital standards are based on the Basel Accords, an international framework developed under the auspices of the Bank for International Settlements.13 Although the Basel Accords use the term requirement, Basel capital standards are not enforceable if a member country does not implement them (unlike the WTO dispute resolution process, for example). In other words, each participating country sets its own capital standards, but member countries use the Basel framework to establish best practices and harmonize banking regulation. The Basel committee describes its function thusly: 13 See CRS Report R42744, U.S. Implementation of the Basel Capital Regulatory Framework, by Darryl E. Getter. Congressional Research Service 18 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The Basel Committee on Banking Supervision provides a forum for regular cooperation on banking supervisory matters. Its objective is to enhance understanding of key supervisory issues and improve the quality of banking supervision worldwide. It seeks to do so by exchanging information on national supervisory issues, approaches and techniques, with a view to promoting common understanding. At times, the Committee uses this common understanding to develop guidelines and supervisory standards in areas where they are considered desirable. In this regard, the Committee is best known for its international standards on capital adequacy; the Core Principles for Effective Banking Supervision; and the Concordat on cross-border banking supervision.14 A guiding principle of the Basel standards is that capital requirements should be risk-based. The riskier an asset, the more capital a bank should hold against possible losses. Risk-based regulations can be more prudent than simple leverage ratios because two firms with identical amounts of debt may have very different probabilities of failure if their assets are different. For example, one might lend primarily to households (credit cards, mortgages, student loans, and auto loans), whereas the other lends primarily to manufacturing businesses or agricultural service providers. One possible drawback of a risk-based capital adequacy approach is that the regulation may become procyclical. That is, the capital standards themselves may reinforce the tendency for the banking system to expand credit during economic booms and contract credit during economic busts as views of risk evolve. If so, then risk-based capital requirements will make it more difficult for macro-prudential regulators to mitigate asset bubbles when they form, and will make it more difficult to promote additional credit expansion during economic downturns. Procyclicality could occur if economic forecasters and financial analysts are overconfident that stable economic environments will continue or are over-pessimistic during unstable economic environments. To the extent that evaluating the risk of a long-term asset involves evaluating the probability of future economic instability, over-confidence will lead to lower than optimal capital requirements and over-pessimism will lead to higher than optimal capital requirements. If regulators and market participants are using the same financial models with similar historical data, it is unlikely that the regulators would provide much of a check on some sources of procyclicality in a risk-based system because the regulators and the banks could have similar measures of risk. On the other hand, regulators could require additional stress tests for the system as a whole, which an individual firm would not have the incentive or ability to conduct. Asset Management Asset management refers to providing financial products or services to a third party for a fee or commission. Examples of asset management include personal fiduciary services, such as wealth management for private clients. Other examples include acting as a custodian, providing security holder services, and offering investment advice. Regulation of asset management activities relates to economic policy issues because the asset management services of banks can have broader effects. An example of the relation of asset management to the policy issues is the custodian role of banks for some complex financial 14 Bank for International Settlements, “About the Basel Committee,” January 23, 2013, available at http://www.bis.org/ bcbs/about.htm. Congressional Research Service 19 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy transactions. For example, some forms of interbank lending include collateral, but who will hold the collateral for the duration of the contract? If custodian banks mismanage the assets, then disruptions in interbank lending markets can be magnified during periods of financial turmoil. During financial instability, banks may be turning to collateralized lending precisely because they have greater desire for safety, certainty, and speed. Disruptions to asset management services, through either the failure of central custodian banks or slow processing of existing custodian banks, may reinforce other banks’ fears of uncertainty and slow processing. Banks are not the only firms that offer asset management services. Thus, as discussed above, bank regulators do not make rules for the entire asset management industry; rather, they issue guidance to the firms with particular charters, and they provide examinations to insure that chartered banks have procedures in place that are consistent with sound asset management principles. Consumer Protection Compliance Lenders must comply with a variety of statutes and regulations when offering financial products to consumers. Prior to the financial crisis, authority to oversee consumer financial protection had been spread among a number of banking regulators, HUD, and the FTC. The Dodd-Frank Act gathered much of this authority and personnel into a new Consumer Financial Protection Bureau (CFPB), but bank regulators still supervise many consumer activities of their chartered firms. One reason is that poor customer relations can be a threat to the safety and soundness of the institution, in part because it is usually bad for business. The banking agencies examine banks for compliance with consumer laws and assist in resolving consumer complaints. Bank regulators can facilitate consumer compliance by offering an ombudsman to assist in resolving complaints. Ombudsman offices are usually separate from those of the safety and soundness examiners. Such offices may help insure that consumers receive a fair and expeditious resolution of their concerns with a firm that is regulated by that agency. This may help reduce the time and expense of more formal complaint resolution options where consumers might otherwise seek redress (such as courts). Some rulemaking activity for consumer compliance is shared between the CFPB and the bank regulators. For example, the CFPB has issued rules for appraisals of residential properties and mortgages. However, banks also rely on appraisals to establish collateral for their mortgage loans; thus, both the CFPB and bank regulators are involved in rulemaking for residential real estate appraisals. Regulators of Firms with Bank Charters In many cases, depository banks are owned within a larger holding company structure, and the primary prudential regulator of the holding company may not be the same as the primary prudential regulator of the bank subsidiary. There is a dual banking system, in which each depository institution is subject to regulation by its chartering authority: state or federal. In addition, because virtually all depository institutions are covered by federal deposit insurance, they are subject to at least one federal primary regulator (i.e., the federal authority responsible for examining the institution for safety and soundness and ensuring its compliance with federal banking laws). Congressional Research Service 20 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The federal banking agencies are briefly discussed below, along with certain powers that these agencies have that are not limited to the firms of which each is the primary prudential regulator. Office of the Comptroller of the Currency The Office of the Comptroller (OCC) was created in 1863 as part of the Department of the Treasury to supervise federally chartered banks (i.e., “national” banks) and to replace the circulation of state-bank notes with a single national currency (Chapter 106, 13 Stat. 99). The OCC is the primary prudential regulator for federally chartered banks and thrifts. The head of the OCC, the Comptroller of the Currency, is also a member of the board of the FDIC and a voting member of FSOC. Like the other prudential regulators described below, the OCC has examination powers to enforce its responsibilities for the safety and soundness of nationally chartered banks, and strong enforcement powers, including the ability to issue cease and desist orders and revoke the charter of covered firms. In addition to institution-level examinations, the OCC oversees systemic risk among nationally chartered banks and thrifts. One example of OCC systemic surveillance is the regular survey of credit underwriting practices. This survey compares underwriting standards over time and assesses whether OCC examiners believe the credit risk of nationally chartered bank portfolios is rising or falling. In addition, the OCC publishes regular reports on the derivatives activities of U.S. commercial banks. Federal Deposit Insurance Corporation The FDIC was created in 1933 to provide assurance to small depositors that they would not lose their savings if their bank failed (P.L. 74-305, 49 Stat. 684). The FDIC is the primary federal prudential regulator of state-chartered banks that are not members of the Federal Reserve System. It has, to some extent, similar examination and enforcement powers for the firms it regulates, as the OCC has for federally chartered banks. In addition to its role as a prudential bank regulator, the FDIC administers a deposit insurance fund and resolves failing depositories and certain systemic non-banks. Deposit insurance relates to economic policy issues because it may help to stabilize an important source of bank funding during times of financial turmoil. Prior to the 1930s, American financial crises were often accompanied by rapid withdrawal of deposits from banks rumored to be in trouble (or actually in trouble). Even prudent, well-managed banks could have difficulty surviving these runs by depositors. Federal deposit insurance assures depositors that the full-faith and credit of the federal government guarantees their deposits up to a preset level. Despite occasional periods of bank failures, banks with insured deposits have suffered almost no depositor runs since the establishment of deposit insurance. Banks are assessed premiums by the FDIC for the deposit coverage. The agency provides deposit insurance to all federally insured banks and thrifts (but not credit unions). In 2008, as the financial crisis worsened, Congress passed a temporary increase in the deposit insurance ceiling from $100,000 to $250,000 for most accounts.15 The increase was made permanent by the Dodd-Frank Act. 15 Section 135 of the Emergency Economic Stabilization Act of 2008 (EESA; P.L. 110-343). Congressional Research Service 21 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The deposit insurance system has been revised a number of times. For example, legislative reform (P.L. 109-173, 119 Stat. 3601) in the mid-2000s raised the coverage limit for retirement accounts to $250,000 and indexed both its limit and the general deposit insurance coverage ceiling to inflation. The reform act made changes to the risk-based assessment system to determine the payments of individual institutions. Within a range set by the reform act, the FDIC uses notice and comment rulemaking to set the designated reserve ratio (DRR) that supports the Deposit Insurance Fund (DIF). The FDIC uses its power to examine individual institutions and issue regulations for all insured-depository institutions to monitor and enforce safety and soundness.16 Using emergency authority it received under the Federal Deposit Insurance Corporation Improvement Act of 1991 (FDICIA; P.L. 102-242),17 the FDIC made a determination of systemic risk in October 2008 and announced that it would temporarily guarantee (1) newly issued senior unsecured debt of banks, thrifts, and certain holding companies and (2) non-interest bearing deposit transaction accounts (e.g., business checking accounts), regardless of dollar amount.18 Under Dodd-Frank, the FDIC’s authority to guarantee bank debt is made explicit. Although the 2008 emergency measures have expired, the FDIC has the authority to create some programs during a possible future crisis. The financial crisis of 2008 revealed a number of lessons related to bank runs and deposit insurance. Several non-banks suffered the equivalent of depositor runs, including money market mutual funds and the interbank repo market. Because the equivalent of depositor runs can occur in other financial activities, Dodd-Frank expanded the assessment base for FDIC premiums to include a bank’s entire balance sheet, not just its insured deposits. Furthermore, creditors of failing financial institutions may, under extreme circumstances, be provided with additional guarantees if the failure is determined to be a threat to the financial stability of the United States. When banks fail, the FDIC disposes the assets and liabilities. The FDIC manages the DIF, which is derived from risk-based assessments levied on depository institutions. The fund is used for various purposes, primarily for resolving failed or failing institutions. The FDIC has broad jurisdiction because nearly all banks and thrifts, whether federally or state-chartered, carry FDIC insurance. The Dodd-Frank Act also expanded the FDIC’s role in liquidating troubled financial institutions. Under the act, the Financial Stability Oversight Council (FSOC) will designate certain financial institutions—banks and nonbanks—as systemically important. In addition to more stringent capital regulation, those firms are required to draw up “living wills,” or plans for orderly liquidation. The Federal Reserve, with the concurrence of two-thirds of the FSOC, may determine that a firm represents a “severe threat” to financial stability and may order it closed. The FDIC will administer the resolution process for nonbanks as well as banks.19 16 CRS Report R41718, Federal Deposit Insurance for Banks and Credit Unions, by Darryl E. Getter. FDICIA created a new Section 13(c)(4) of the Federal Deposit Insurance Act, 12 USC §1823(c)(4)(G). 18 FDIC, “FDIC Announces Plan to Free Up Bank Liquidity,” press release, October 14, 2008, http://www.fdic.gov/ news/news/press/2008/pr08100.html. 19 For more detail, see CRS Report R41384, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Systemic Risk and the Federal Reserve, by Marc Labonte. 17 Congressional Research Service 22 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy The Federal Reserve The Federal Reserve System was established in 1913 to provide stability to banks and trusts through the regulation of reserves (P.L. 63-43, 38 STAT. 251). The Federal Reserve System has three components: the Federal Reserve Board (FRB), the regional Federal Reserve Banks (FRBNY, FRBSF, etc.), and the Open Market Committee. The Fed is the primary prudential regulator for a variety of lending institutions, including bank holding companies, certain U.S. branches of foreign banks, and state-chartered banks that are members of the Federal Reserve System. Under the Gramm-Leach-Bliley Act (GLBA; P.L. 106-102), the Fed serves as the umbrella regulator for financial holding companies, which are defined as conglomerates that are permitted to engage in a broad array of financially related activities. As a primary prudential regulator, the Federal Reserve has similar authority as the OCC. In addition to the charter class that the Federal Reserve regulates, the Dodd-Frank Act made the Fed the primary regulator of all financial firms (bank or nonbank) that are designated as systemically significant by the FSOC (of which the Fed is a member). Capital requirements for such firms may be stricter than for other firms. In addition, Dodd-Frank made the Fed the principal regulator for systemically important financial-market utilities. The Fed also regulates savings and loan holding companies and securities holding companies, formerly defined in securities law as an investment bank holding company. In addition to its powers as a primary prudential regulator, the Federal Reserve conducts monetary policy, monitors the financial system, acts as the fiscal agent of the United States, and regulates the payment system and a number of financial activities. Examples of additional activities regulated by the Fed (sometimes only as a monitor and sometimes jointly with other agencies) include equal credit opportunity (Reg-B), Community Reinvestment Act (CRA) related agreements (Reg-G), and extensions of credit by brokers and dealers (Reg-T). The list of regulatory topics now extends from Reg-A to Reg-YY. National Credit Union Administration The National Credit Union Administration (NCUA), originally part of the Farm Credit Administration, became an independent agency in 1970 (P.L. 91-206, 84 STAT. 49). The NCUA regulates all federal credit unions and those state credit unions that elect to be federally insured. It administers a Central Liquidity Facility, which is the credit union lender of last resort, and the National Credit Union Share Insurance Fund, which insures credit union deposits. Credit unions are member-owned financial cooperatives and must be not-for-profit institutions. As cooperatives, they are exempt from corporate income tax. Many credit unions offer similar services as community banks, and this differential tax treatment is often the subject of legislative proposals in each congressional session. Regulating Securities, Derivatives, and Other Contract Markets Regulators of financial trading attempt to address many economic policy problems. As discussed in the introductory sections, financial markets may not be level playing fields—some people with access to confidential information may have a trading advantage. Furthermore, the people who issue and market new securities (or derivatives) may have the incentive to withhold or Congressional Research Service 23 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy mischaracterize some of the information they have about the securities or derivatives being offered. Even if these market facilitators provide full information, the outcome might still be less than optimal if other market participants simply believe that material information is not being disclosed or that insiders are behaving strategically. As a result, much of the regulation of securities and derivatives markets has focused on resolving conflicts of interest and requiring full disclosure of material information, unlike bank regulation that tends to focus on prudence. In addition, much securities market regulation has been applied through enforcement against afterthe-fact violations, rather than as prospective examinations of covered firms. Non-Bank Financial Regulators Securities and Exchange Commission The SEC was created as an independent agency in 1934 to enforce newly written federal securities laws (P.L. 73-291, 48 Stat. 881). Although the SEC is concerned with ensuring the safety and soundness of the firms it regulates, its primary concern is maintaining fair and orderly markets and protecting investors from fraud. The SEC generally20 does not have the authority to limit risks taken by non-bank financial institutions or the ability to prop up a failing firm, with some exceptions. Two types of firms come under the SEC’s jurisdiction: (1) all corporations that sell securities to the public and (2) securities broker/dealers and other securities markets intermediaries. Firms that sell securities—stocks and bonds—to the public are required to register with the SEC. Registration entails the publication of detailed information about the firm, its management, the intended uses for the funds raised through the sale of securities, and the risks to investors. The initial registration disclosures must be kept current through the filing of periodic financial statements: annual and quarterly reports (as well as special reports when there is a material change in the firm’s financial condition or prospects). Beyond these disclosure requirements, and certain other rules that apply to corporate governance, the SEC does not have any direct regulatory control over publicly traded firms. Bank regulators are expected to identify unsafe and unsound banking practices in the institutions they supervise and have the power to intervene and prevent banks from taking excessive risks. The SEC has no comparable authority; the securities laws simply require that risks be disclosed to investors. Registration with the SEC, in other words, is in no sense a government endorsement that a security is a good or safe investment. To enable investors to make informed investment choices, the SEC has statutory authority over financial accounting standards. All publicly traded firms are required to use generally accepted accounting principles (GAAP), which are formulated by the Financial Accounting Standards Board (FASB), the American Institute of Certified Public Accountants (AICPA), and the SEC itself. Besides publicly traded corporations, a number of securities market participants are also required to register with the SEC (or with one of the industry self-regulatory organizations that the SEC oversees). These include stock exchanges, securities brokerages (and numerous classes of their 20 A counter example would be SEC’s net capital rule as discussed below in “The SEC’s Net Capital Rule.” Congressional Research Service 24 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy personnel), mutual funds, auditors, investment advisers, and others. To maintain their registered status, all these entities must comply with rules meant to protect investors’ interests, prevent fraud, and promote fair and orderly markets. The area of SEC supervision most analogous to banking regulation is broker/dealer regulation. Several provisions of law and regulation protect brokerage customers from losses arising from brokerage firm failure. The Securities Investor Protection Corporation (SIPC), created by Congress in 1970, operates an insurance scheme funded by assessments on broker/dealers (and with a backup line of credit with the U.S. Treasury). SIPC guarantees customer accounts up to $500,000 for losses arising from brokerage failure or fraud (but not market losses). Unlike the FDIC, however, SIPC does not examine broker/dealers and has no regulatory powers. Since 1975, the SEC has enforced a net capital rule applicable to all registered broker/dealers. The rule requires broker/dealers to maintain an excess of capital above mere solvency, to ensure that a failing firm stops trading while it still has assets to meet customer claims. Net capital levels are calculated in a manner similar to the risk-based capital requirements under the Basel Accords, but the SEC has its own set of risk weightings, which it calls “haircuts.” The riskier the asset, the greater the haircut. Although the net capital rule appears to be similar in its effects to the banking agencies’ riskbased capital requirements, there are significant differences. The SEC has no authority to intervene in a broker/dealer’s business if it takes excessive risks that might cause net capital to drop below the required level. Rather, the net capital rule is often described as a liquidation rule—not meant to prevent failures but to minimize the impact on customers. Moreover, the SEC has no authority comparable to the banking regulators’ prompt corrective action powers: it cannot preemptively seize a troubled broker/dealer or compel it to merge with a sound firm. The differences between bank and securities regulation with respect to safety and soundness came into sharp focus with the collapse of Bear Stearns, one of the five largest investment banks, in March 2008.21 The SEC monitored Bear Stearns’ financial condition until shortly before the collapse (which was precipitated by the refusal of other market participants to extend short-term credit to Bear Stearns), and it believed that the firm had sufficient levels of capital and liquidity. When bankruptcy suddenly loomed, it was the Federal Reserve that stepped in to broker the sale of Bear Stearns to JP Morgan Chase by agreeing to purchase $30 billion of “toxic” Bear Stearns assets. The Bear Stearns situation highlighted several apparent anomalies in the U.S. regulatory structure. The SEC lacked safety and soundness powers over the institutions it supervised, and the Fed was forced to commit funds to an investment bank over which it had no regulatory jurisdiction. The anomaly became even more pronounced when the Fed subsequently established a lending facility to provide short-term credit to other investment banks.22 The Bear Stearns collapse showed the inability of the SEC to respond to a brokerage failure with systemic risk implications. There is more to the story, however, than the differences between bank regulation and the SEC’s net capital rule. In 2004, the SEC devised a voluntary supervisory scheme for the largest investment banks, called the Consolidated Supervised Entities (CSE) 21 See CRS Report RL34420, Bear Stearns: Crisis and “Rescue” for a Major Provider of Mortgage-Related Products, by Gary Shorter. 22 See CRS Report RL34427, Financial Turmoil: Federal Reserve Policy Responses, by Marc Labonte. Congressional Research Service 25 Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy program.23 The CSE firms were all registered broker/dealers, but were also large holding companies with extensive operations carried on outside the broker/dealer unit. Thus, the SEC had no capital requirement that applied to the entire investment bank. Under CSE, this was to change: as a substitute for the net capital rule, the firms agreed to abide by the Basel risk-based standard and maintain that level of capital at the holding company level. On a voluntary basis, the firms agreed to grant the SEC the authority to examine and monitor their compliance, above and beyond the SEC’s explicit statutory authority.24 Whatever the intent of the CSE program, it did not succeed in preventing excessive risk-taking by the participants.25 By the end of September 2008, all five CSE investment banks had either failed (Lehman Brothers), merged to prevent failure (Merrill Lynch and Bear Stearns), or applied for bank holding company status (Morgan Stanley and Goldman Sachs).26 On September 26, 2008, SEC Chairman Cox announced the end of the CSE pr...
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