Functional Regulation Definition

What Is Functional Regulation?

The term functional regulation refers to an approach that aims for supervisory regulation of an individual company's products and services by qualified, independent parties. The appropriate supervisory body is normally an entity with special expertise in the organization's functions, products, or services. Functional regulation is the opposite of institutional regulation, which focuses on the structure or nature of the organizational entity.

Understanding Functional Regulation

Functional regulation is based on the products and services that an organization offers, including commodities and transactions. This is in contrast to institutional regulation, which is made up of a series of rules that govern the actual organization as a whole. As such, a bank that offers different financial products and handles multiple transactions may come under the purview of multiple regulatory bodies. Each one of these oversees the transactions, products, or commodities that fall under its jurisdiction.

Functional regulation ensures that the most qualified and knowledgeable people supervise and monitor the daily functions of a specialized field. For example, an insurance company would ideally be supervised by state insurance commissioners, whereas sellers or underwriters of securities would be supervised and regulated by the Securities and Exchange Commission (SEC). It also ensures that the interests of those who use products and services are fully protected, especially consumers.

In the United States, functional regulation of the financial sector means that multiple regulatory bodies may oversee the operations of banks and other financial institutions, depending on the types of products and services they offer. Some of the regulatory bodies involved in functional regulation in the U.S. include:

• The SEC
• The Financial Industry Regulatory Authority (FINRA)
• The Commodities Futures Trading Commission (CFTC)
• State securities regulators
• Insurance commissioners

Criticism of Functional Regulation

The products, services, and operations of organizations in the financial sector are typically subject to functional regulation. This type of regulation normally involves monitoring and adjusting to keep abreast of the evolution of these services, products, and operations.

Some blamed the 2007-2008 financial crisis on a failure to monitor and appropriately update the functional regulatory system in the U.S., which was based on a system of funding dominated by banks. This basis precipitated the collapse of the banking system when the source of most funding shifted to non-bank sources.

Another flaw in functional regulation is its vulnerability to political whims and its excessive reactivity to the financial crises of the past. Regulations and regulatory bodies are typically updated in response to financial crises that already took place, in the spirit of preventing them from happening again.

In the U.S., the establishment of financial regulatory bodies and the creation of new regulations is heavily based on the prevailing political climate, which has led some to argue that functional regulation in the U.S. is less stable than it could be. For instance, one presidential administration may undo regulations put in place by the previous one.

Functional Regulation vs. Institutional Regulation

As noted above, functional regulation is the opposite of institutional regulation. While functional regulation involves the regulatory supervision of the products and services that companies produce and offer to the public.

Institutional regulation, on the other hand, refers to a series of rules and laws that pertain to institutions as a whole, including banks and other financial institutions. This type of regulation provides the framework for how an institution is governed.

For instance, the Federal Reserve is one of the regulatory agencies that oversee certain banks. The institutions under its purview must abide by the rules set forth by the Fed or be disciplined.

The Bottom Line

Regulations are rules that are put in place by governing bodies or agencies. They are used to manage systems and put controls in place. This comes in different forms, including functional regulation. These rules and laws govern the products and services that companies offer to the general public. Agencies that are responsible for functional regulation are qualified in providing oversight because of the expertise they have. These checks and balances are in place to ensure that the rights and interests of consumers are protected.