Bank regulation refers to the set of laws, rules, and standards that govern banks and financial institutions. The main goals of bank regulation are to promote the safety and soundness of banks, ensure their financial stability, protect consumers, and encourage fair and transparent banking practices.
Banking regulation has a long history in the United States dating back to the 19th century. The National Bank Act of 1863 and Federal Reserve Act of 1913 established the Office of the Comptroller of the Currency (OCC) and Federal Reserve System to oversee national banks. The Great Depression led to major new regulations like the Glass-Steagall Act of 1933 which separated commercial and investment banking. Over time, regulations have aimed to constrain bank risk-taking while also protecting consumers and promoting financial inclusion.
Today, oversight of banks in the U.S. involves multiple regulators at both the federal and state level. Key federal agencies include the Federal Reserve, OCC, Federal Deposit Insurance Corporation (FDIC), and Consumer Financial Protection Bureau (CFPB). Regulation helps maintain confidence in the banking system and stability of the broader economy.
Regulatory Agencies
There are several major regulatory agencies involved in overseeing banks and financial institutions in the United States:
The Office of the Comptroller of the Currency (OCC) regulates and supervises all national banks and federal savings associations. They are responsible for ensuring the safety and soundness of the national banking system. The OCC was established in 1863 as a bureau of the U.S. Department of the Treasury (Source).
The Federal Reserve System is the central bank of the United States and regulates financial institutions. The Federal Reserve sets monetary policy, supervises banks, and provides financial services like check clearing and electronic funds transfer. They regulate bank holding companies and ensure the overall stability of the financial system (Source).
The Federal Deposit Insurance Corporation (FDIC) preserves and promotes public confidence in the U.S. financial system by insuring deposits in banks and thrift institutions. The FDIC identifies and monitors risks to the deposit insurance funds and limits the effect on the economy and the financial system when a bank fails (Source).
Capital Requirements
Capital requirements refer to the amount of capital banks must hold to protect against unexpected losses and ensure they have enough assets to meet their financial obligations. Capital requirements help ensure the safety and soundness of individual banks and the banking system as a whole.
Banks are required to maintain minimum capital ratios set by regulators like the Federal Reserve. There are two main components of capital under these rules: Tier 1 and Tier 2 capital. Tier 1 capital includes common stock and disclosed reserves, and is the highest quality form of capital. Tier 2 capital includes undisclosed reserves, revaluation reserves, general provisions, and subordinated debt. In addition to minimum Tier 1 and total capital requirements, banks must also maintain a capital conservation buffer above the minimum requirements to avoid restrictions on capital distributions and discretionary bonus payments.
The Federal Reserve sets minimum capital requirements and additional buffers based on a bank’s size and risk profile. Currently, the largest banks are required to maintain a minimum common equity Tier 1 capital ratio of 4.5%, a Tier 1 capital ratio of 6%, and a total capital ratio of 8%. On top of this, they must also hold a stress capital buffer determined based on the Federal Reserve’s annual stress tests. For example, as of 2023 the stress capital buffer requirement for major banks like JPMorgan Chase and Bank of America is 2.5-3.5% [1].
These robust capital standards ensure that even in periods of financial stress, large banks will have sufficient high-quality capital to absorb losses, continue lending, pay dividends and bonuses, and serve as financial intermediaries within the economy.
Liquidity Requirements
Liquidity requirements ensure that banks have enough liquid assets on hand to meet short-term obligations and potential deposit withdrawals. The two main liquidity requirements for banks are:
Liquidity Coverage Ratio (LCR)
The LCR requires banks to hold highly liquid assets equal to at least 100% of their projected net cash outflows over a 30-day stress period (Calomiris et al., 2015). This requirement ensures banks can withstand sudden liquidity shocks and bank runs without becoming illiquid.
Assets that qualify as “highly liquid” under the LCR include cash, central bank reserves, and high-quality government bonds. The LCR has made banks more resilient during periods of stress.
Net Stable Funding Ratio (NSFR)
The NSFR requires banks to maintain a sustainable maturity structure of assets and liabilities over a one-year timeframe. This means banks must have enough long-term stable funding to support their long-term assets and operations for a full year (Elliott, 2014).
The NSFR reduces banks’ reliance on short-term wholesale funding and encourages better assessment of liquidity risk across all on- and off-balance sheet activities.
Liquidity Buffers
Banks also maintain liquidity buffers of high-quality liquid assets that can be easily converted to cash during times of stress. These buffers provide an extra cushion above regulatory minimums (Van den Heuvel, 2022).
Liquidity requirements make the financial system more resilient by ensuring banks have the necessary liquidity to function even in adverse conditions.
Reserve Requirements
Reserve requirements refer to the fraction of deposits that banks must hold in reserve and not lend out. The Federal Reserve sets reserve requirement ratios for different types of bank deposits. For example, the reserve requirement for net transaction accounts over $16.9 million is 10% as of 2022 (Source). This means banks must keep 10% of those deposits on hand in reserves. Reserve requirements reduce the amount of money banks can lend out, as they must keep a portion in reserve. Higher reserve requirements tighten monetary policy as they decrease the lending capacity of banks. Lower reserve requirements have the opposite effect, increasing bank lending capacity and the money supply.
Reserve requirements give the Federal Reserve an additional tool to influence lending and economic activity. By changing the reserve requirement ratios, the Fed can directly impact how much banks must keep in reserves. Other central banks around the world also utilize reserve requirements to manage monetary policy in their jurisdictions (Source).
Stress Testing
One of the key regulatory requirements for large banks in the U.S. is annual stress testing conducted by the Federal Reserve. This was introduced after the 2008 financial crisis as a way to assess banks’ ability to withstand severe economic shocks. As part of the Dodd-Frank Act, banks with over $10 billion in assets are required to conduct their own internal stress tests and submit results to the Federal Reserve.
The Federal Reserve then conducts its own independent stress tests, called the Comprehensive Capital Analysis and Review (CCAR), using different scenarios than the banks’ internal tests. These scenarios include hypothetical recessions and financial market crashes to see how banks’ balance sheets would fare. The results determine how much capital banks need to hold to absorb losses in those adverse conditions. Banks that fail the stress tests may face restrictions on dividend payments and share buybacks.
According to the Federal Reserve Board, “The stress tests required under Dodd-Frank help ensure that large financial institutions have strong capital positions, enabling them to continue lending to creditworthy households and businesses even after unforeseen losses and during severe economic downturns.”
Overall, the goal is to identify bank weaknesses and ensure the stability of the banking system. Banks are now required to hold higher capital cushions and liquid assets to withstand crises. Stress testing provides transparency for regulators and investors into banks’ risk exposures. It has strengthened bank resilience, though some critique the tests for being too mild.
Sources:
January 22, 2Q18 Via email Rulemaking Porta! (federalreserve.gov)
Core principles for effective banking supervision (bis.org)
Deposit Insurance
Deposit insurance provided by the Federal Deposit Insurance Corporation (FDIC) protects bank customer deposits in the event of bank failure. The FDIC was created during the Great Depression to maintain stability in the banking system and prevent bank runs. According to the FDIC, “Deposit insurance helps protect local economies and the financial system” (https://www.fdic.gov/deposit/deposits/).
The standard deposit insurance amount is $250,000 per depositor, per insured bank. This means if you have deposit accounts at one FDIC-insured bank that total $250,000 or less, they are fully insured and guaranteed by the FDIC (https://www.bankrate.com/banking/fdic-insurance-limits/). The $250,000 limit includes checking and savings accounts, money market deposit accounts, and certificates of deposit. Certain retirement accounts like IRAs are insured separately up to $250,000.
In the event of bank failure, the FDIC acts quickly to reimburse depositors for insured funds. According to the FDIC, “Customers with deposit accounts in the failed institution typically receive new accounts at another insured bank” (https://ask.fdic.gov/fdicinformationandsupportcenter/s/article/My-Bank-Failed-What-Happens-to-My-Insured-Deposits). Deposit insurance helps maintain confidence in the banking system.
Consumer Protection
Consumer protection laws are integral for ensuring fair practices in banking. These regulations aim to safeguard consumers from predatory lending and unfair business practices. Some key consumer protection laws include:
The Truth in Lending Act requires lenders to disclose interest rates and terms to borrowers upfront. This enables consumers to make informed comparisons between loans. The act also gives borrowers the right to cancel certain loans within 3 days.
The Fair Debt Collection Practices Act prohibits debt collectors from using abusive tactics like harassment or false statements. Debt collectors must verify disputed debts and allow consumers to opt-out of communications.
The Equal Credit Opportunity Act bans discrimination in lending based on characteristics like race, religion, sex, or marital status. This aims to promote fair access to credit.
The Fair Credit Reporting Act regulates credit reporting agencies and ensures the accuracy of consumer credit reports. This protects consumers from errors on their reports.
The Consumer Financial Protection Bureau oversees consumer protection laws and field consumer complaints about banks or lenders. They have authority to investigate and penalize institutions engaging in unfair practices.
Mortgage Lending Regulations
There are several key regulations that impact mortgage lending in the United States:
The Home Mortgage Disclosure Act (HMDA) requires mortgage lenders to disclose detailed information about their mortgage lending activity. This includes data on the race, ethnicity, gender, and income of applicants. The goal is to identify discriminatory lending practices and ensure equal access to credit. Source
The Community Reinvestment Act (CRA) encourages banks to meet the credit needs of the communities where they operate, including low- and moderate-income neighborhoods. Banks are examined periodically and rated on how well they serve their communities. Source
The Real Estate Settlement Procedures Act (RESPA) requires lenders to provide homebuyers with disclosures at various stages of the mortgage process. This ensures borrowers understand the costs and terms of the loan. Source
The Truth in Lending Act (TILA) promotes transparency by requiring lenders to disclose full and accurate information about the costs of a mortgage. This includes the interest rate, monthly payments, and total interest paid over the loan term. Source
These regulations aim to promote fair lending, prevent discrimination, improve transparency, and expand access to mortgage credit for all consumers.
Conclusion
Bank regulation plays a critical role in maintaining the stability and integrity of the financial system. Prudent regulation helps prevent excessive risk-taking by banks and protects consumers from predatory practices. Some of the key regulations discussed in this article include capital requirements, liquidity requirements, reserve requirements, stress testing, deposit insurance, consumer protection regulations, and mortgage lending regulations.
Setting adequate capital and liquidity requirements ensures that banks have enough of a buffer to withstand losses and funding stress. Reserve requirements allow central banks to control money supply and lending. Rigorous stress testing reveals how banks would fare under adverse economic conditions. Deposit insurance protects consumers against bank failures. Consumer protection regulations prohibit unfair, deceptive, or abusive practices.
Overall, sensible bank regulation promotes financial stability for the economy as a whole. It provides checks and balances against the risks banks take while allowing them to function efficiently. Well-regulated banks in turn contribute to broader economic growth and prosperity. Though regulation does impose costs, the benefits of a safer, fairer, and more transparent banking system outweigh the costs for society.
