The Banking Regulatory Structure
by
Charles Lamson
The primary reason the banking system is regulated is to preserve its safety and soundness, and insure the fair and efficient delivery of banking services to the public. From the regulator's perspective, continuous oversight is needed to ensure that banks are operated prudently and in accordance with standing statutes and regulations. Broadly speaking, regulation involves the formulation and issuance of specific rules to govern the structure and conduct of banks.
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For the most part, the regulatory structure prevailing at the beginning of the 1970s was inherited from and the product of the 1930s. The structure was put in place as a result of events that occurred at the start of and during the Great Depression. In October 1929, prices on the New York Stock exchange collapsed. The Dow Jones Industrial Index, a measure of stock market values, stood at 200 in January. They rose to 381 in September 1929 and then collapsed. Eventually, the Dow reached a low of 41 in July 1932. From 1929 through 1933, more than 8,000 banks failed, industrial production fell more than 50 percent, and the nation's unemployment rate rose from 3 percent to 25 percent. At the time people believed that these events were intimately connected and that the Great Depression was caused, and/or severely aggravated, by serious defects in the structure and regulation of the financial system. More specifically, the failure of many financial institutions was alleged to be the result of (1) excessive and destructive competition among banks, which had led to the payment of unduly high interest rates on deposits, and (2) the granting of it was believed that banks sought out such loans and the high yields they carried because of the high rates being paid on deposits. When the stock market crashed, the value of the speculators' portfolios collapsed, leading them to default on their bank loans. The banks, in turn, became insolvent (bankrupt) or were left so weakened that depositors rushed to withdraw their funds.
Given this diagnosis, the legislative and regulatory remedies established at the time are readily understandable. Among the most widespread and ultimately pernicious "cures" was the establishment of maximum ceilings on the interest rates banks could pay on deposits. The ceilings, which were imposed under the Glass-Steagall Act of 1933, were popularly known as Regulation Q. Interest payments on demand deposits, which were the only type of checkable deposit in existence at the time, were prohibited, and interest payments on time and savings deposits were not to exceed the rate ceilings set by the relevant regulatory authority. The rationale for the ceilings was seductive and attractive: By holding down the rates on deposits (sources of bank funds), the rates on loans (uses of funds) could be held down. Banks would no longer need to seek out and grant high-risk, high-yield loans.
To further limit bank failures, the Glass-Steagall Act put deposit insurance into place with the creation of the Federal Deposit Insurance Corporation (FDIC). Most banks and other depository institutions are now fully insured up to $100,000. The presence of deposit insurance eliminated bank runs or bank panics in which depositors fearing that their bank would fail, "ran" to get their funds out.
In addition, the Banking Act of 1933 (also known as the Glass-Steagall Act) separated commercial banking from investment banking, which is the underwriting and marketing of primary corporate securities. Banks were no longer allowed to own or underwrite corporate securities. Thus, the assets commercial banks could hold were efficiently limited to cash assets, government securities, and loans. The commercial banks' role was to accept deposits paying up to the Regulation Q interest rate ceilings and to make predominantly commercial loans.
We have already seen the Fed is the most important regulator of commercial banks that are members of the Fed. The Fed also sets reserve requirements and provides discount facilities for all depository institutions. Under the regulatory structure that prevailed from the 1930s until the early 1980s, the Fed shared regulatory responsibilities with two federal bodies---the Comptroller of the Currency and the FDIC---and with state banking departments. Prior to the 1980s, the scope of regulation included more restrictions on entry, branching, types of assets and liabilities permitted, financial services that could be offered, and interest that could be paid on certain types of deposits and charged on certain types of loans. Today, banks have found ways around many of these regulations, and many regulations have been relaxed, if not totally eliminated. Recently, other regulations, dealing mainly with bank capital requirements and risk management, have gained in importance.
To aid in understanding this complex regulatory structure, it is useful to begin with the birth of a bank. None of us could just decide to open a bank tomorrow. Commercial banks in the United States are chartered, that is, they are given permission to engage in the business of commercial banking by either the federal government or one of the 50 state governments. When applying for a charter, the applicant must demonstrate a knowledge of the business of banking and have a substantial supply of capital funds. If a bank's charter is granted by the federal government, the bank is called a national bank. The office of the Comptroller of the Currency is the federal government agency charged with chartering national banks. For example, Wells Fargo Bank of San Francisco is a federally chartered bank. A bank can also be chartered by a state banking authority. This system, in which commercial banks are chartered and regulated by the federal government or a state government, is usually referred to as the dual banking system. Think of it as a duel chartering system.
Banks that are federally chartered must belong to the Federal Reserve System, and must subscribe to federal deposit insurance with the FDIC. The latter provides insurance for individual deposit accounts up to $100,000 per account and charges banks an insurance premium that varies with the reserves that the insurance fund has available. The premium is slightly more for high-risk banks. Thus, national banks are subject to the regulatory and supervisory authority of the Comptroller, the Fed, and the FDIC.
A state-chartered bank will be regulated by its banking authority. If it chooses to join the Federal Reserve System. the state bank will also have to subscribe to federal deposit insurance, since all Fed members must have FDIC insurance without joining the Fed.
One of the interesting and probably unique features of the system is that those being regulated can choose the regulator. In effect, they can "vote with their feet." By this I mean that banks can apply for either a state or federal charter, or attempt to shift from one to the other.
Historically, most banks, especially smaller ones, found it more profitable to be state-chartered non-Fed members. State banking authorities were often viewed as being more friendly in regulating and supervising institutions, and more lenient in allowing non-banking activities than their federal counterparts. In addition, the reserve requirements, which specify that a bank must hold reserve assets equal to a portion of its deposit liabilities, were often lowered for state-chartered/regulated banks than for national banks regulated by the Fed. Lower reserve requirements meant more potential profits. Because a smaller portion of deposits were held as reserve assets, a larger portion could be used for loans and other interest-earning investments. (Reserve requirements are now the same for all depository institutions.) Larger banks, which usually were Fed members, often provided nonmembers with many of the services the Fed would normally have provided. Fed members also have to buy stock in the Fed equal to 3 percent of their assets. The stock pays dividends that are lower than what banks could earn by making loans.
More than 97.5 percent of all banks have elected to be part of the FDIC. Apparently banks feel it is important to offer the depositors the safety and peace of mind federal deposit insurance engenders. For those who think this point is trivial, recall that in the midst of the Great Depression---between 1929 and 1933, to be exact---more than 8,000 banks failed in the United States. As those banks failed, depositors in other banks rushed to withdraw their funds out of fear that the problems would spread. Such a run on even a healthy solvent bank can cause severe difficulties because the bank's asset portfolio may be illiquid with not enough cash or liquid assets on hand to pay off the many depositors making withdrawals. Limiting cash withdrawals to, say, $25 a week, or closing the bank temporarily, as often occurred, reinforced the public's perception that this bank, and perhaps all banks, were in serious difficulty. As the epidemic spread, such illiquid banks were often forced out of business, and the entire financial system was threatened. In what must be judged one of the most successful pieces of legislation in history, Congress created the FDIC in 1933. This, by and large, halted the runs on solvent but illiquid banks, and thus, restored some stability to the banking and financial systems. Deposit insurance was first made a "full faith and credit obligation" of the federal government in 1989. Prior to that year, the FDIC was on somewhat the same footing as private insurance companies, in that the federal government was not required by law to pay off depositors if the FDIC ran out of funds in the face of widespread bank failures.
Clearly, having a dual banking system with a variety of regulatory authorities leads to a considerable overlap of responsibilities, with some institutions subject to regulation and supervision by as many as three regulatory authorities. In an attempt to minimize the overlap, primary regulatory responsibility for each category of banks has been assigned to one regulator, who then shares the resulting information. Regulatory responsibility has been distributed in the following manner: (1) the FDIC for state-chartered, insured banks that have not joined the Fed; (2) the Comptroller of the Currency for national banks, which also must be FDIC insured and Fed members; (3) the Fed for state-chartered, insured members of the Fed and all bank holding companies; and (4) the states for state-chartered banks that do not subscribe to FDIC insurance or belong to the Fed. Exhibit 1 gives additional details for each category.
1. Regulatory Responsibilities
Some people believe that the current set of regulations, supervising authorities, and statutes of the dual chartering system provides an incentive for local banks with state charters to adapt and structure their services, so as to fulfill the needs of the local community, while guidelines for federally chartered banks may relate to national and international concerns. They also argue that the dual system fosters competition and innovation among banks. Opponents of the dual system argue that the overlapping of regulatory agencies breeds considerable confusion and leads to lax enforcement; they maintain that this system gives banks considerable freedom to escape proper supervision and regulation.
*SOURCE: THE FINANCIAL SYSTEM & THE ECONOMY, 3RD ED., 2003, MAUREEN BURTON & RAY LOMBRA, PGS. 253-258*
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