ByStephen D. Simpson, CFA

The 2007-2008 mortgage bubble in the United States, and worldwide credit crisis, highlighted why banks are so heavily regulated; with such a key role in the economy, malfeasance or mismanagement among banks can produce far-ranging waves when they fail.

There are multiple levels of bank regulation in the United States conducted at the federal and state levels. Banks can choose to operate under a state charter or a national charter, and while the differences between the two are seldom important, or even noticeable, to everyday customers, it has a significant impact on the regulation of the bank.

State banks receive their charter from, and are regulated by, an agency of the state in which they operate, often called a "Department of Banking" or "Division/Department of Financial Institutions." At this level, regulators can establish rules on permitted practices and restrict the amount of interest banks can charge for loans. State agencies are also responsible for auditing and inspecting banks, and periodically reviewing their compliance with regulations as well as their financial performance.

State banks can also choose to belong to the Federal Reserve System. Participation in the Federal Reserve System brings certain advantages to a bank, including greater access to capital, but also greater regulation. Also, any bank that carries FDIC insurance, which is the vast majority, also falls under the regulatory supervision and authority of the FDIC. Consequently, almost every state bank submits to some degree of federal supervision and regulation.

Alternatively, banks can choose the option of going with a national charter. Generally speaking, the decision to become a national bank exempts a bank from many state banking laws and regulatory activities, particularly those that pertain to usury laws. Even still, the Supreme Court has ruled that certain state regulations, generally those pertaining to fair lending laws, do apply to national banks.

The history of the U.S. has included many fits and starts when it comes to a national bank, or a central bank, and banking regulation. The current national bank system can be traced back to President Lincoln and the passage of the National Currency Act in 1863, and the National Bank Act in 1864. Now there are over 2,000 banks in the national banking system, under the supervision of the Office of the Comptroller of the Currency.

The OCC charters and regulates both national banks and branches of foreign banks. In addition to monitoring bank capital levels, liquidity and asset quality, the OCC also monitors bank sensitivity to market and interest rate risk, and the adequacy of banks' compliance and IT systems.

Another level of supervision and regulation exists through the Federal Deposit Insurance Corporation. Established in response to the bank failures of the Great Depression, the FDIC offers deposit insurance, guaranteeing that depositors' funds will be protected up to a state amount, in the event of a bank failure. The FDIC is run by a five-member board with three of the members appointed by the President of the United States.

Through its insurance operations, the FDIC effectively acts as another layer of regulation and supervision over U.S. banks. The FDIC categorizes banks by their capital ratio and reserves the right to force changes in management or bank policies, if the risk-based capital ratio falls below 6%. If a bank becomes "critically undercapitalized" (2% or below) the FDIC can declare the bank insolvent and take it over, often facilitating the sales of the bank's assets to another bank.

The National Credit Union Association supervises and insures both federal and state credit unions. While the Office of Thrift Supervision previously oversaw savings and loan institutions, the Dodd-Frank Act of 2010 mandated that the OTS's functions be merged into, and taken over by, the OCC, FDIC, Federal Reserve Board, and Consumer Finance Protection Bureau.

The Federal Reserve is also a major regulatory body within the U.S. banking system and worthy of its own separate discussion, later in this tutorial. (For one side of the argument, see The Pitfalls Of Financial Regulation.)

Other Rules and Regulations
Banks are not only regulated in terms of their balance sheet and capital ratios, but their conduct as well. Banks have to abide by the same anti-discrimination laws as any other business, (due in large part to the Equal Credit Opportunity Act of 1974, but banks get additional scrutiny in this regard. The Community Reinvestment Act of 1977, and its numerous amendments over the years, effectively forced banks to lend more to lower-income communities.


Likewise, there are rules in place to ensure that banks adequately disclose the rates, costs and terms for loans (Truth In Lending Act), disclose the terms for savings accounts (Truth In Savings), and conduct themselves transparently with electronic transactions (Electronic Fund Transfer Act). Banks also must abide by state laws limiting the statutory rates of interest they may charge.

International Regulation
As markets and economies tend to be interdependent, countries have sought to harmonize some of the standards between them. The Basel Committee was formed in 1974 by the
Group of Ten, to develop guidelines for bank regulations and best practices recommendations.

The first Basel Accord (Basel I), came out in 1988 and largely dealt with recommended capital ratios and risk weightings. The Basel Committee published Basel II in 2004 and was intended to introduce international standards for minimum capital requirements, supervisory review and disclosure requirement. In response to the perceived gaps, loopholes and deficiencies of the Basel II system, new regulations called Basel III are on the way. Broadly speaking, Basel III is going to increase bank capital requirements, place additional limitations on leverage and improve liquidity.

The proposed Basel III rules will more than double the requirement for common equity (4.5% versus 2%), increase Tier 1 capital requirements by 50% (from 4 to 6%), introduce a minimum 3% leverage ratio, and create additional buffers to reduce the likelihood of bank runs and liquidity traps, in the future.

There is no requirement for any country to adopt the Basel standards, wholly or in part. That said, regulators in most of the developed world are broadly supportive of the Basel proposals. One complicating factor in implementing the standards is the risk that the banks of a country that do not implement the regulations, or use a less conservative version, will have a competitive advantage over those that do.

While there is a counterargument that the debt and equity market will enforce a uniform level of discipline, by charging a premium for the credit default swaps of less-regulated banks, for instance, the reality is that banks have to abide by the rules of each country and any cross-border "competitive advantage" is limited. (To learn more, check out Understanding The Basel III International Regulations.)


Next: The Banking System: Commercial Banking - Where Commercial Banks Are Vulnerable »



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