From the Encyclopedia of Economics:
Financial regulation in the United States, and elsewhere in the developed world, breaks down into two basic categories: safety-and-soundness regulation and compliance. While this entry focuses on U.S. financial services regulation, it broadly reflects what occurs elsewhere.
Financial institutions serve various purposes. Depository institutions (banks, savings and loans [S&Ls], and credit unions) transform liquid liabilities (checking accounts, savings accounts, and certificates of deposit that can be cashed in prior to maturity) into relatively illiquid assets, such as home mortgages, car loans, loans to finance business inventories and accounts receivable, and credit card balances. Depository institutions also operate the payments system where bank balances are shifted between parties through checks, wire transfers, and credit and debit card transactions. Insurance companies fall into two broad categories—life and health insurers, whose policies provide financial protection against death, disability, and medical bills; and property and casualty insurers, whose policies protect policyholders against losses arising from fire, natural disasters, accidents, fraud, and other calamities. Stockbrokers and related investment banking firms are central players in the capital markets where businesses raise capital and where individuals and institutional investors buy and sell shares of stock in business enterprises.
The basic goal of safety-and-soundness regulation is to protect “fixed-amount creditors” from losses arising from the insolvency of financial institutions owing those amounts, while ensuring stability within the financial system. Fixed-amount creditors are bank depositors, beneficiaries and claimants of insurance companies, and account holders at brokerage firms who are owed fixed amounts of money. Investors in a stock or bond mutual fund are not fixed-amount creditors because the value of their investments is determined solely by the market value of the fund’s investments. Financial institutions with fixed-amount creditors include banks, S&Ls, credit unions, insurance companies, stockbrokers, and money-market mutual funds (MMMF). Compliance regulation broadly seeks to protect individuals from “unfair” dealing by financial institutions and in the financial markets and to impede such crimes as “money laundering,” although this crime is hard to define.
Financial regulation in the United States is carried out by an alphabet soup of federal and state agencies. The federal bank regulators include the Federal Reserve System, the Federal Deposit Insurance Corporation (FDIC), the Office of the Comptroller of the Currency, the Office of Thrift Supervision, and the National Credit Union Administration. The Securities and Exchange Commission (SEC) regulates stockbrokers, MMMFs, stock and bond mutual funds, stock trading—including the stock exchanges—and financial disclosures by publicly traded corporations. State regulators oversee state-chartered banks, savings institutions, and credit unions as well as all insurance companies. State securities regulators are a junior partner to the SEC in that field.
Safety-and-soundness, or solvency, regulation seeks to prevent financial institutions with fixed-amount creditors from becoming insolvent. Because government regulation cannot prevent all insolvencies, however, governments have created mechanisms to protect at least small fixed-amount creditors from any loss when a depository institution, insurance company, or brokerage firm has become insolvent—that is, has “failed.” These mechanisms, such as deposit insurance, insurance guaranty funds, and investor protection funds, can properly be viewed as a product warranty for solvency regulation. That is, they protect fixed-amount creditors against losses when the “product,” regulation, which is supposed to protect fixed-amount creditors, fails to prevent a financial institution’s insolvency.
For the more than three centuries that banks and insurance companies have been chartered by governments, notably with the founding of the Bank of England in 1694, governments have imposed regulations to ensure that these institutions remain both solvent (the value of their assets exceeds their liabilities) and liquid (they can meet payment requests, such as checks and insurance claims, when presented). The principal solvency regulation today centers on capital regulation; that is, the financial institution must maintain a positive capital position (its assets exceed its liabilities) equal to at least a certain portion of its assets. Other solvency regulations force asset diversity by limiting loan and investment concentrations among various classes of borrowers or the amount of credit extended to any one borrower.
In 1988, banking regulators in the industrialized world began to implement a bank capital regulation, now called Basel I, which related the amount of capital a bank had to hold to the riskiness of its assets. Although Basel I was crude in many regards, many banks are financially stronger today because the amount of capital they hold bears a better relationship to the riskiness of their assets. Banking regulators are now attempting to implement a more sophisticated capital standard, called Basel II. When or if Basel II will be fully implemented is an open question.
Solvency regulations are enforced by examiners who assess the value of an institution’s assets and determine the scope of its liabilities, a particularly important function in property and casualty insurance companies. A financial institution can become insolvent (its liabilities exceed the value of its assets) if it suffers a large sudden loss or a sustained period of smaller losses. Likewise, a seemingly solvent bank or insurance company can turn out to be insolvent if examiners find hidden losses—assets have been overvalued or liabilities have not been recognized. Quite often, fraud is the underlying cause of those losses.
Even honest managements can experience sudden losses if a large natural disaster causes a spike in insurance claims or if the value of loan collateral plunges. While there was some fraud in the twelve hundred S&Ls that failed during the U.S. S&L crisis of the 1980s, much of the insolvency loss in those failures arose from the collapse of real estate values, particularly in Texas. To help prevent another S&L crisis, in 1991 the U.S. Congress enacted a set of regulatory reforms, called Prompt Corrective Action, to ensure that regulators would not again drag their feet in closing insolvent banks and S&Ls. While these reforms seem to be working, they have not been tested by a full-fledged banking crisis.
Often, insolvent banks are illiquid—that is, they do not have enough cash on hand to pay customer checks and deposit withdrawals. This almost certainly is true when there is a run on the bank. Illiquidity also can strike a solvent bank, although that is relatively rare. To prevent banking panics in the event that banks cannot honor withdrawal requests, Congress has authorized the Federal Reserve to act as a lender of last resort; that is, the Fed stands ready to lend to an illiquid bank when no one else will, provided the bank can fully collateralize its loan with high-quality assets.
MMMFs represent a special case with regard to solvency regulation and liquidity concerns. By design, MMMFs have no capital, that is, the value of their assets must always equal the face value of the shares they have issued to their shareholders; these shares usually are valued at one dollar per share. Also, MMMFs are not authorized to borrow from the Federal Reserve. SEC examiners therefore must determine that an MMMF’s assets can readily be sold or redeemed for their stated value. Since MMMFs have no fixed-amount creditor protection comparable to deposit insurance, they can invest only in low-risk assets so that no MMMF will “break the buck,” which could unleash a “run” on all MMMFs—that is, MMMF shareholders would attempt to cash in their MMMF shares at the same time. Given that MMMFs had $2.1 trillion of shares outstanding at the end of 2006, that is a legitimate fear. Although the Federal Reserve does not admit to this, it is widely believed that the Fed would provide emergency liquidity to the MMMFs should there be a run on them, in order to maintain the stability of the U.S. financial system, even though this action might be costly to taxpayers.
Deposit Insurance and Other Fixed-Amount Creditor Protection Schemes
Various fixed-amount creditor protection schemes have emerged in the United States, usually in response to crises arising from regulatory failures. State-provided deposit insurance dates to 1829 with the formation of the New York Safety Fund. Fourteen state deposit insurance funds eventually operated, but all had failed by the onset of the Great Depression. In 1933, following the failure of nine thousand mostly small banks in 1930–1933, Congress chartered the FDIC. Shortly thereafter, it created the Federal Savings and Loan Insurance Corporation (FSLIC) to insure S&Ls. In the aftermath of the S&L debacle, which so far has cost taxpayers about $124 billion, Congress abolished the FSLIC and gave the FDIC responsibility for all bank and S&L deposit insurance.
While deposit insurance for credit unions (called “share insurance”) started at the state level, in 1970, Congress created the National Credit Union Share Insurance Fund (NCUSIF) to give credit union members the same level of protection that bank and S&L depositors have. Today, with the exception of 175 state-chartered credit unions served by a private insurer, the federal government insures all bank, S&L, and credit union depositors.
Since 1980, the basic deposit insurance limit has been $100,000 per depositor per bank, S&L, or credit union (up from an initial $5,000 in 1934). However, because bank accounts can legally be titled in various ways, a family can hold many times that amount in insured deposits in a bank. While business deposits are insured, too, deposits in the foreign offices of U.S. banks are not. On December 31, 2006, the estimated amount of insured deposits approximated $4.6 trillion. Uninsured deposits in domestic and foreign offices of banks, S&Ls, and credit unions totaled another $3.8 trillion.
Congress intended, when it passed major deposit insurance reforms in 1991, that uninsured depositors not be protected should their bank fail. Instead, Congress wanted uninsured depositors (presumably more sophisticated than small depositors) to monitor their bank’s condition and to withdraw funds from the bank if it got into trouble. In effect, bank runs are supposed to wake up regulators who fail to close a failing bank before it becomes insolvent. However, Congress’s desire to share insolvency losses with uninsured depositors clashed with a real-world reality: depositor flight from a large bank could undermine confidence in large sound banks, leading to a banking collapse, a freeze-up of the payments system, and serious economic damage. Therefore, as a practical matter, the $100,000 insurance limit applies only to small banks, and not to so-called too-big-to-fail banks.
U.S. banking regulators have been loath to publicly identify America’s too-big-to-fail banks, preferring to maintain the fiction that no bank is too big to fail. In its 1991 reform legislation, however, Congress included a “systemic risk” exception, which gives the regulators (with the approval of the president and the secretary of the treasury) the authority to protect all depositors (domestic and foreign) and all other creditors of a large failing bank if the regulators have determined that trying to impose losses on uninsured depositors and other creditors “would have serious adverse effects on economic conditions or financial stability.” In other words, uninsured deposits are, in fact, insured if they are in a large bank.
Governments in other industrialized countries have stated their belief that some banks are too big to fail. Therefore, despite deposit insurance schemes similar to those of the United States, only large depositors in small banks have to worry about suffering a loss should their bank fail. Even then, many countries are reluctant to enforce their deposit insurance limits. Japan is an excellent example, as its government postponed implementing explicit deposit insurance limits while cleaning up its massive banking problems, without any loss to depositors.
The home countries of globally active banks—those with branches or banking subsidiaries in other countries—will find it difficult not to protect depositors and other creditors in other countries in which a troubled bank operates because of concerns of regulatory retribution if it tries to protect only home-country depositors. New Zealand, where most banking assets are controlled by very large banks headquartered elsewhere (principally Australia), is a beneficiary of this phenomenon.
Because U.S. insurance companies are chartered and regulated solely by the states, the states have assumed protection of insureds through two sets of “guaranty funds,” one for life and health insurance companies and one for property and casualty companies. The types of protections and the dollar limits of those protections vary among the states. State governments’ intent is to protect small insureds and those with relatively small insurance claims—a few hundred thousand dollars at most—from any loss.
Although similar to deposit insurance, guaranty funds differ in one important respect. While the FDIC and NCUSIF collect premiums in advance of the payment of losses, the guaranty funds (with the exception of New York’s) collect funds from surviving insurance companies only as they make payments to insureds and claimants. Like deposit insurance, though, the guaranty funds are actuarially unsound because they do not charge risk-sensitive premiums: riskier institutions pay no more, per dollar of protection, than safer institutions.
The Securities Investor Protection Corporation (SIPC) protects customers of failed stock and bond brokerages from brokerage fraud (stolen cash and missing securities), but not from loss in the market value of securities they own. The maximum SIPC protection per customer is $500,000, including a maximum of $100,000 for cash claims.
Another federal financial insurance venture is the Pension Benefit Guaranty Corporation (PBGC). Unlike the insurance and guaranty funds described above, the PBGC is not a “product warranty” for failed regulation. Instead, it protects beneficiaries of defined-benefit pension plans that have been taken over by the PBGC because the pension plan sponsor (usually a financially troubled corporation) has gone bankrupt or out of business. Steel companies and airlines are among the firms that have dumped their unfunded pension liabilities on the PBGC. As happened with the FSLIC, federal taxpayers may eventually be forced to bail out the PBGC.
Common to all government insurance and guaranty programs is “moral hazard,” the risk that the insured or guaranteed institution will make economically unwise bets because severe losses from these bets will fall on taxpayers, while owners and managers will profit from winning bets. As insurers learned long ago, properly priced insurance premiums are key to minimizing moral hazard. This moral hazard was the main cause of the s&l crisis in the 1980s. Unfortunately, government insurers cannot charge truly risk-sensitive premiums without experiencing severe political opposition from those who would pay high premiums because of their riskiness. Hence, moral hazard will continue to plague government insurance and guaranty programs. (read more)