Financial regulations can be viewed as rules or restrictions that subject financial transactions or entities to certain guidelines or requirements, generally aimed at maintaining the integrity of the financial system, at least in the eyes of those who make these regulations. Financial regulations can be made by either a government or nongovernment entity, and the rules and guidelines are monitored by financial regulators. Today, however, the vast majority of financial regulations are put in place by government entities rather than nongovernment or self-regulating entities.
II. Government Financial Regulations and Regulators
III. The Constantly Evolving and Growing Nature of Financial Regulation
IV. A Broad Chronology of the Evolution of Federal Financial Regulation
A. Regulations Spawned by the Great Depression
B. Post–Great Depression Regulation
V. Other Financial Intermediary Regulators
A. Regulation of Credit Unions and Thrift Institutions
B. Regulation of Other Financial Intermediaries
VI. Financial Market Regulators
A. The Securities and Exchange Commission
B. Self-Regulating Organizations
C. The Commodity Futures Trading Commission (CFTC)
The basic purpose of financial regulation in the United States can be viewed as protecting persons and property, particularly from being taken by force or fraud, and as providing enhanced consumer confidence in financial dealings. There is near universal agreement that there is a role to be played by a “financial constable” to assure that such abuses are prevented.
Financial regulations come with their costs, sometimes explicit and sometimes implicit opportunity costs, imposed on the regulated industry. Another broad concern about the cost of financial regulation relates to the notion of regulatory capture, where there exists a cozy, crony relationship between the regulator and the parties being regulated. In this case, the government fails to establish a regulatory state that operates efficiently. But financial regulations also may bring benefits to financial participants. These benefits generally consist of improving participant confidence and convenience as well as circumventing other financial agents’ abilities to accumulate and exercise market power to the detriment of others.
Government Financial Regulations and Regulators
Financial regulations in the United States are generally established by lawmakers, and these same lawmakers frequently create financial regulatory agencies to see that the regulations are adhered to through supervision. In the United States, federal lawmakers make laws that are passed by the U.S. Congress and signed into law by the president. In addition, state lawmakers make state laws that are passed by state congressional offices and signed into law by the governor. At both the federal and state levels, regulatory agencies are created to make sure the laws are enforced.
The most heavily regulated area of the U.S. financial system is the banking industry. It has long been recognized in the United States that banks, which accept deposits and make loans, are important in the shaping of financial activities and economic growth. Broadly, government regulations of banks (and other depository institutions) do each of the following: (1) restrict competition, (2) specify what assets a bank can hold, (3) define how bank capital is measured and require banks to hold a minimum level of bank capital, and (4) require that the public be informed about banks’ financial conditions.
Since 1863, the United States has had a dual banking system with both state-chartered banks and nationally chartered banks. This means that, to even open a bank, one needs to obtain regulatory approval. The National Currency Act of 1863 created the Office of the Comptroller of the Currency to charter, regulate, and supervise all national banks. Coexisting with this federal bank regulator, all states also have their own state departments of banking, which charter, regulate, and supervise state banks, serving as state banking regulators. Thus, today we have both federal and state banking regulators in our financial system.
The Constantly Evolving and Growing Nature of Financial Regulation
While the purpose of financial regulation is simple, the experience in the United States is that financial regulation is both increasing and becoming increasingly complex over time. There are a number of reasons for the growth and increased complexity of financial regulation. First, financial services are becoming increasingly important in the United States. Many individuals have in the past provided their own financial services, such as financial intermediation of lending to family members or self-insuring potential losses, but now find it more advantageous to use a financial agent. Second, there is a general recognition that it is natural for private entities to seek ways around rules that limited profit potential. Edward Kane (1988) has referred to the process as a regulatory dialectic. The process starts with new regulation, followed by avoidance of this regulation, as economic agents seek to avoid costly aspects of the regulations, only to be followed by reregulation. Indeed, the term reregulation better characterizes most of the evolution of financial regulations than the term deregulation. Although the term deregulation, meaning the removal of existing regulation, is frequently used, the term deregulation rarely applies, and it would be better to refer to reregulation.
Another reason for the growth in financial regulations stems from financial innovation. Financial innovation can be thought of as a new financial product introduced as a result of technological advances or to satisfy some previously unknown demand.
A Broad Chronology of the Evolution of Federal Financial Regulation
In addition to the above reasons for increased financial regulation, each successive financial and economic crisis seems to spawn new financial regulators and regulations put in place by the federal government. For example, it is widely understood that the Federal Reserve System, a banking regulator, was created in 1913 in response to earlier banking panics in the United States. The Federal Reserve Act, among other things, authorized the creation of the country’s third central bank, the Federal Reserve, to lend to banks that were solvent but needed liquidity. This lending activity is done through the Federal Reserve’s discount window, and the U.S. central bank is referred to as a lender of last resort. The Federal Reserve was further authorized to levy reserve requirements on member commercial banks, requiring banks to hold a fraction of their deposits in certain liquid forms. The Federal Reserve was further charged with the supervision and examination of banks in the United States.
The McFadden Act was passed by the U.S. Congress in 1927, giving individual states the authority to limit bank branches located in their state. This limitation on branches also applied to national banks located within the state’s borders.
Regulations Spawned by the Great Depression
Even with the Federal Reserve in place—or, as many charge (see Friedman and Schwartz 1963), because of the Federal Reserve’s poor monetary policies in place—the United States experienced the Great Depression in the early 1930s. As suggested by the thesis that financial and economic crises spawn new financial regulation and regulators, the U.S. Congress imposed a new broad array of financial regulators and regulations not seen before.
Legislation in the Great Depression era, generally referred to as Glass-Steagall after the legislators who proposed the legislation, prevented the commingling of commercial banking (accepting deposits and making loans), investment banking (aiding in the insurance of securities of all types), and insurance (providing either property and causality or life insurance products) from being administered under one single business. Prior to this legislation, financial institutions were much freer in their abilities to offer all such financial services under one corporate structure.
In addition, the Federal Deposit Insurance Corporation (FDIC), another banking regulator, was established by Glass-Steagall. The FDIC was created to offer depositors federal insurance for limited amounts of bank deposits. The legislation also granted the FDIC the ability to supervise and examine banks that offer insured deposits and granted the FDIC the resolution authority to close banks that it deemed as having failed financially.
The Great Depression further led the U.S. Congress to put into law legislation that created the Securities Exchange Commission (SEC). The Securities Act of 1933, together with the Securities Exchange Act of 1934, which created the SEC, was designed to restore investor confidence in capital markets by providing investors and the markets with more reliable information and clear rules of honest dealing. Thinking that abuses in securities markets occurred during the Great Depression that made the economic decline worse, Congress added a new financial constable overseeing securities transactions.
Post–Great Depression Regulation
The economic struggles in the early 1970s led the U.S. Congress to remove limitations on interest rates that banks and other depository institutions could pay on deposits. For years, Regulation Q limited the maximum rate of interest that could be paid on various deposit accounts. These limits were eliminated by Congress in an effort to allow depository institutions to better compete for funds in a rising interest rate environment. The financial and economic difficulties in the United States in the late 1970s and early 1980s, as the nation experienced relatively high inflation, caused Congress to expand this reserve requirement to all commercial banks as well as thrift institutions and credit unions.
The significant numbers of failures for both commercial banks and thrift institutions in the late 1980s and early 1990s led to more regulatory changes. In this case, the term deregulation is appropriate. The Interstate Banking and Branching Efficiency Act of 1994 removed many of the limitations placed on depository institutions regarding interstate banking and branching, opening up the United States for the first time to nationwide banking and reversing the McFadden Act.
The late 1990s, while relatively tranquil in terms of economic and financial issues, ushered in another instance of deregulation by reversing the Glass-Steagall Act. In 1999, the Gramm-Leach-Bliley Act allowed financial intermediaries under one corporate structure, the financial holding company, to engage in commercial banking, investment banking, and insurance activities.
Even the terrorist attacks of September 11, 2001, led to banking regulations. In particular, the U.S. Congress amended the Bank Secrecy Act of 1970, with several anti– money laundering provisions and enhanced surveillance procedures under the USA Patriot Act of 2001.
As a response to the financial crisis of 2008–2009, Congress is working on legislation that proposes significant changes in financial regulatory reform. The thinking appears to suggest that, although financial regulations did not prevent the financial crisis, a fi ne-tuning of these regulations will indeed prevent future crises.
Other Financial Intermediary Regulators
The U.S. financial system includes other financial intermediaries aside from banks. Some of these are other depository institutions like credit unions and thrift institutions. Others provide other financial services like insurance companies and mutual funds.
Regulation of Credit Unions and Thrift Institutions
The United States has other financial institutions that also can be viewed as depository institutions, like credit unions and thrift institutions. Like banks, these institutions accept “deposit-like” funds and lend these funds out to others. Also like banks, these institutions can be chartered at either the state level or at the federal level. While credit unions and thrifts can be chartered by their individual states, both today generally offer federal deposit insurance. The National Credit Union Administration charters federal credit unions and offers deposit insurance to both state and federal credit unions. The FDIC offers federal deposit insurance to savings and loan associations, mutual savings banks, and other thrift institutions. The Office of Thrift Supervision charters and regulates national thrift institutions.
Regulations imposed on credit unions and thrift institutions entail restrictions on the types of loans they can make or the types of investments undertaken. Credit unions generally make loans to consumers and are limited to some extent on the amount of loans they make to businesses. Thrifts, on the other hand, have historically been encouraged to make residential mortgage-related loans. As such, they are generally restricted in the amounts of other types of loans—whether consumer or business—they can make. In addition to having the types of loan activities restricted, credit unions and thrifts are generally restricted in the types of securities they can invest in. Both are not allowed to make investments in common stock of other corporations and are limited in terms of the default risk their bonds can be subject to, generally not being allowed to invest in junk bonds or similarly low-rated debt instruments, as determined by credit rating agencies.
One key aspect of the regulations regarding credit unions in comparison to banks and thrifts relates to their tax treatment. Credit unions are nonprofit financial intermediaries and, as such, pay no income tax. Commercial banks and most thrift institutions (other than mutual savings banks) are for-profit institutions and thus do not get the tax exemption benefits granted to credit unions.
Regulation of Other Financial Intermediaries
In addition to regulating banks and other depository institutions, most states regulate other financial intermediaries such as insurance providers and securities firms. Most insurance activities offered in the United States are regulated at the state level, as state legislators have chosen to create most insurance regulations. Indeed, most states have created either state departments of insurance or state insurance commissions to ensure that the laws passed by the state are enforced and adhered to. Although there is a National Association of Insurance Commissioners, this is simply an organization of state insurance regulators. There is little federal regulation of insurance although the health care insurance legislation signed by President Barack Obama mandating health insurance coverage suggests that this is changing.
Because mutual funds and money market mutual funds generally invest in securities, it is only natural that their activities are regulated by the SEC as well. As an example of such regulation, investors in mutual funds must be provided with a prospectus from the mutual fund, detailing the types of investments purchased by the fund, the rules that guide its investment choices, as well as the financial risks to investing in the fund.
Financial Market Regulators
Most states also have passed laws dealing with securities transactions. Today, most states have state securities boards, commissions, or departments to regulate the securities industry in their state and make sure that the state laws are being met. The primary mission of these entities is to protect investors—the buyers of securities—in their states.
In the 19th century, many states also imposed usury law, although there was much variation across states. These laws placed a maximum upper limit on interest rates charged in individual states by all lenders. New evidence (see Benmelech and Moskowitz 2010) indicates that these laws came with broad societal costs, such as less credit availability and slower economic growth, but that wealthy political incumbents benefited by a lower cost of capital. Today, only a few states impose usury laws that have any meaningful effect on credit transactions.
The Securities and Exchange Commission
Federal regulations pertaining to the securities industry did not become important in the United States until the establishment of the Securities Exchange Commission in 1934. The SEC is charged with maintaining fair, efficient, and orderly markets by regulating market participants in the securities industry. To the extent that securities transactions are becoming increasingly important in the U.S. financial system, the SEC’s role as regulator is also growing over time. The SEC regulates issuers of securities and tells them what types of securities they can issue and the information that must be provided by them to investors—for example, in the form of prospectus and most recently in the Sarbanes-Oxley Act. It also regulates investors and monitors what investors are doing, making sure that investors do not break insider trading laws that preclude investors from availing themselves of insider information that is not publicly known and use that to their advantage in trading. To the extent that mutual funds, including money market mutual funds, invest primarily in financial securities, the SEC regulates the mutual fund industry, requiring that mutual funds let investors know the risks and returns investors can anticipate, providing this information in the form of a prospectus. The forms of mutual funds known as hedge funds traditionally have faced less stringent regulation, although under the 2010 Dodd-Frank Wall Street Reform and Consumer Protection Act the reporting (or disclosure) requirements of such funds have increased.
In addition to the numerous governmental entities involved in regulating the U.S. financial system are many self-regulating organizations. These include the Financial Industry Regulatory Authority; the Municipal Securities Rulemaking Board; and stock and other financial instrument exchanges and clearinghouses, such as the New York Stock Exchange and the Chicago Mercantile Exchange, to name the largest, most well-known exchanges.
The Commodity Futures Trading Commission (CFTC)
Futures contracts are instruments that allow market participants to buy and sell items, including financial assets, for future delivery but at a price set today. These contracts obligate both parties to fulfill commitments to make or accept delivery. Option contracts, on the other hand, only commit one party, called the writer of the contract, to a particular action, while the buyer of the contract has the option or choice to take a certain action or not. Futures contracts have been traded in the United States for over 150 years, and option contracts have been around for quite some time as well. In 1974, the U.S. Congress passed the Commodity Futures Trading Commission Act, which established the CFTC as the key federal regulator of both futures and options trading activities in the United States. The mission of the CFTC is to protect market participants in futures and options trading from fraud, manipulation, and other such abusive practices and to foster financially sound markets.
Financial regulation in the United States is in a constant state of flux but seems to change the most in response to economic and financial crises. The financial crisis of 2008–2009 does not appear to be an exception to this rule. The U.S. Congress recently passed, and President Obama signed into law, the Dodd-Frank Wall Street Reform and Consumer Protection Act, legislation that will significantly alter the financial regulatory landscape going forward. Indeed, the mind-set in Washington, DC, following the financial crisis is that it was generally a lack of federal financial regulation that led to the crisis. Even with the 2010 act in place, much debate continues to take place as to how the new rules are to be applied by regulators and to what extent they will be shaped by such regulatory actions.
Included in the Dodd-Frank Act is a provision to establish a new Bureau of Consumer Financial Protection that is charged with making sure that consumers are not taken advantage of by “unscrupulous lenders,” such as putting home buyers into mortgage loans that are not in the consumer’s best interest. While numerous financial regulators were charged with such responsibilities in the past, this new regulator will have this as its chief focus. The Dodd-Frank Act also includes new laws and regulations dealing with the very largest financial institutions in the country that are deemed “too big to fail.” The financial crisis has shown evidence of rippling effects throughout the financial system when a large financial institution, like Lehman Brothers, fails. To prevent such rippling effects, many large, systemically important financial institutions were provided federal aid during the crisis to prevent their financial failure. While the new legislation does address many aspects of the too-big-to-fail issue, it does not appear to settle the issue of the optimal method of dealing with large, systemically important institutions that are on the brink of failure. The act also includes some new regulation on derivatives other than futures and option contracts, such as swap agreements.
While the U.S. political leadership today seems to believe that the next financial crisis will be prevented by these new regulatory reforms, a reading of U.S. financial history suggests that future crises are still likely to occur in the not-too-distant future.
Scott E. Hein
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