DEFINITION of Functional Regulation

Functional regulation is a concept stating that a company with a specific business should be supervised and reviewed by the proper regulating body. Functional regulation is there to ensure that the most qualified and knowledgeable people are overseeing the daily functions of a specialized field.
For example, ideally an insurance company would be supervised by state insurance commissioners, whereas sellers or underwriters of securities would be supervised and regulated by the Securities and Exchange Commission (SEC).

BREAKING DOWN Functional Regulation

Functional regulation is based, not on the type of entity or organization being regulated, but one the commodities, transactions, or products it offers. Therefore, a bank or financial institution that offers multiple types of financial products and handles multiple types of transactions may come under the purview of multiple regulatory bodies, each one overseeing the transactions, products or commodities in its jurisdiction.

Regulatory Bodies Involved in Functional Regulation

In the United States, functional regulation of the financial system 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 United States include the SEC, the Financial Industry Regulatory Authority (FINRA), the Commodities Futures Trading Commission and state securities regulators and insurance commissioners.

Flaws in Functional Regulation

Functional regulation is typically linked to an economy’s financial architecture, which means that it requires consistent monitoring and regular updates to keep abreast of changes in that architecture. Some have blamed the 2008 financial crisis in part on a failure to monitor and appropriately update the functional regulatory system in the United States, which was based on a system of funding dominated by banks. This basis, it is argued, precipitated the collapse of the banking system when the source of most funding shifted to non-bank sources.

It has been argued that a second 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 have already happened, in the spirit of preventing them from happening again. In the United States, 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.