Regulation of Financial Institutions

Introduction

Banks have proved to be effective engines for the advancement of trade around the world. They have played a significant role in America’s development into the largest economy in the world. Besides, American has some of the biggest financial markets in the world. The growth and development of the banking industry in the United States has been significantly influenced by an ever-changing regulatory framework. The history of banking regulation in the United States is characterized by a mix of federal and state legislations that have shaped the industry, spanning hundreds of years. Regulation of financial institutions has been driven by the need to increase centralized control in order to maintain stability in the banking sector (Reinhart & Rogoff, 2008). Regulation of banks plays a significant role in the protection of all the stakeholders in the banking industry, right from the individual banks to the ultimate consumers. 

History of Bank Failures in the United States

Regulation of banks in the United States dates back to as early as 1791, when the First Bank of the United States was established. The regulation was motivated by the need for increased centralized control, as well as the fear of too much control being concentrated in a few hands. Although the First Bank of the United States brought some degree of financial and economic stability in the nation, it was vehemently opposed based on the idea that it was not constitutional. Many players in the industry feared that the regulation served to relegate too much power to the federal government. As a result, the First Bank of the United States failed to fulfill its mandate as its charter was discontinued in 1811. 

In 1812, however, the government turned to state banks to finance the War, and there was an over-expansion of credit. This meant that the industry would ultimately fail given such undesirable events. The over-expansion of credit would eventually affect the banks negatively. As such, there was need for order in the banking industry, leading to the charter of the Second Bank of the United States. The Second Bank of the United States tenure was short-lived, as it was dissolved in 1836. The bank was dissolved following political fears regarding the amount of control it relegated to the federal government. Besides, many banks that sought legislative charter went as far as bribing the legislature. This meant that even banks with little competence on financial matters would be chartered based on political affiliations. Thus, there was a great need to escape from legislative chartering, which had been characterized by corruption. This was followed by passage of laws that abolished the requirement for legislative chartering prior to operating a bank. 

The environment of free banking meant that banks operated under no regulation. As a result, anyone could operate a bank on the condition that all the notes issued were backed by proper security. Although such a condition served to ensure the credibility of the notes issued by banks, it failed to guarantee immediate redemption in gold or silver. As such, this particular era of free banking was characterized by financial instability, with several banks undergoing crises. Free banking saw thousands of notes from different banks circulating at varying discount rates. The instability and disorder caused significant suffering on the part of the consumers and other stakeholders, as losses were registered. The undesirable results of the deregulation served to renew the call for more regulation of banks in order to facilitate an effective and centralized oversight of bank operations in the United States.

The National Banking Act of 1863 was aimed at correcting the mistakes of the Free Banking Era. The National Banking Act served to replace the various state banks with those that were nationally chartered. This was followed by the creation of the Office of the Comptroller of the Currency (OCC). The responsibility of OCC was to issue the new banks with charters that would allow them to legally operate in the country. Besides, the OCC played an instrumental role in ensuring that the national banks maintained the requirement to back all their note issuances with holdings of the United States government securities. The move helped greatly in returning the country to a more secure and uniform currency. However, the gain was at the expenses of an elastic currency with the ability to expand and contract in responses commercial and industrial conditions. The United States economy continued to grow in complexity, rendering the inelastic currency inadequate. This resulted in frequent financial panics in the country. This problem persisted for the rest of the nineteenth century, culminating in the Bank Panic of the 1907. 

The failure of the banking system manifested in the Bank Panic of the 1907. The Bank Panic of 1907 came as a result of shrinking market liquidity, plans to regulate trust companies, as well as the declining depositor confidence (Moen & Tallman, 1992). The impending regulation of trust companies subjected them to immense public scrutiny. As a result a run on the trust companies was triggered. Several trust companies could not withstand the run, ultimately failing. Although some of the leading financiers at the time, such as J.P. Morgan, provided some vital liquidity, some of the largest trust companies failed. The events undermined the public confidence in the country’s financial industry, leading to bank runs. The impact of the bank panic led to the establishment of the Federal Reserve System (Gorton, 1985). Consequently, the central bank operated under a dual mandate of maximizing employment and stabilizing inflation using monetary policy tools.

As the United States banking system was immersed in chaos, the banking systems in Europe were stable, thanks to the presence of a central bank. The central bank in the European banking systems could inject liquidity into the market, particularly during times of financial distress. It is often argued that a central bank would have prevented the occurrence of the 1907 bank panic. The central bank would have provided an extra source of liquid assets into which the financial institutions could have tapped. The leading financiers in the United States finally drafted an early framework of monetary policy and reform in the country’s ailing banking industry. Although the report was shelved for some time, it was ultimately signed into law in 1913 by the then-President Woodrow Wilson. The Federal Reserve System was then established, with Charles Hamlin as the first chairman. 

The Federal Reserve helped significantly in improving America’s payments system, as well as in creating a more flexible currency. However, the Federal Reserve’s success was short-lived as it failed to appropriately respond to the financial crisis that followed the 1929 stock market crash. The stock market crash subjected the United States to a severe economic crisis economic crisis, which came to be popularly known as the Great Depression (Calomiris & Mason, 1994). The bull market that had seen the Dow Jones rise 400 percent in five years was unfortunately followed by the stock market crash. The public utility companies, particularly the electricity companies, had been consolidated into holding companies by 1929. Such holding companies were themselves owned by other holding companies, controlling two-thirds of the country’s industry. These highly leveraged pyramids even had ten layers separating the top and the bottom, implying that these holding companies were engaged in serious malpractices in the country. The holding companies were involved in fraudulent accounting, posing a serious threat to the innocent investor. The Federal Reserve System failed to address the problem in time by deciding to reign in speculation. This was made even worse by the news in October 1929 that the holding companies would be regulated. This prompted the investors that had bought stocks at a premium were rendered forced sellers. Mistakenly, the Federal Reserve failed to stabilize the financial system. Instead, it though that the crash was desirable. It did literally nothing to salvage the situation. By choosing not to act, the Federal Reserve failed to prevent a wave of bank failures that significantly paralyzed the country’s banking system. This made the slump much worse that it would have been. The problem was further exacerbated by a steep decline in the demand for American goods. This is because of the huge sums that had been lent to overseas borrowers. Consequently, a quarter of the American working population was rendered jobless, as the Great Depression heralded a period of protectionism, isolationism, and nationalism. The lack of government oversight due to laissez faire economic theories was touted as the cause of the 1929 market crash. The Congress responded to the crisis by passing important federal regulations, which included the Glass Steagall Act of 1933 and the Public Utility Holding Companies Act of 1935. The Glass Steagall Act served to create the Federal Deposit Insurance Corporation (FDIC). The FDIC was responsible for implementing the regulation of deposit interest rates, as well as separating commercial banking from investment banking. 

The reforms helped to stabilize the country’s financial system and led to the expansion of the economy. However, it was criticized for making the American banks less innovative and competitive. This prompted a wave of deregulation. The deregulation is credited for accelerating a trend towards increasing the complexity of the financial institutions in the United States. Besides, the deregulation was followed by a wave of consolidation and conglomeration, leading to an increase in mergers (Wheelock & Wilson, 2000). The total number of banks reduced from a previous peak of about 15,000 banks to fewer than 8,000 banks in 2008. The conglomeration of various financial services under a single entity significantly increased the complexity of the services (Naceur & Omran, 2011). For instance, banks began to offer new financial products such as derivatives, as well as packaging traditional financial assets like mortgages through securitization. Although the new innovations were hailed for risk diversification, they would ultimately lead to the 2007 sub-prime mortgage crisis, which later metamorphosed into a global financial crisis (Aalbert, 2016). The United States banks were in dire need of bail out following the crisis. The Dodd-Frank Wall Street Reform and the Consumer Protection Act of 2010 are some of the legal frameworks adopted to address the weaknesses within the country’s financial system. Given the fact that the investors and consumers are worst hit by bank failures, it is important to ensure that laws are passed to safeguard them from loss (Tallman et al., 1990). Deregulating the banking system may result in malpractices that may end up harming the public, while too much regulation may render it inadequate to meet the changing commercial and industrial needs. As such, a balance should be struck to ensure that the banking system is efficient and effective. 

Importance of Capital Adequacy in the Banking System

Capital adequacy refers to the amount of capital a bank or other financial institution is required to hold by the bank regulators. Capital adequacy is normally expressed as a capital adequacy ratio of equity that a bank has to hold as a percentage of risk-weighted assets. The bank regulators put into place capital adequacy requirements in order to ensure that financial institutions do not take on excess leverage and become insolvent (Naceur & Omran, 2011). This is very important to the regulators because they have a responsibility to make sure that banks are managed prudently. Thus, the bank regulators protect the banks themselves, the government, and the consumers. It is important to realize that capital adequacy is a very important measure of the financial soundness of a bank. Therefore, it is proper to ensure that all firms in the banking industry have the required capital adequacy ratio. Essentially, banks have liabilities that are usually in excess of 10 times their equity capital, and a significant amount of those liabilities are in the form of deposits that customers have entrusted to the bank. The regulators recognize the nature of risk under which financial institutions operate. As such, capital regulations require banks to hold a minimum level of equity per loans and other assets. This ensures that banks are in a better position to sustain any unplanned losses. The amount of capital that banks receive from shareholders determines the amount of deposits that they can attract from the public. Shareholders’ equity also set the limit on the value of loans a bank can lend to its customers. Thus, if a bank sustains significant losses, its ability to offer loans is negatively affected. 

Bank regulators are concerned about capital adequacy in the banking system for several important reasons; financial stability, protection of the federal deposit insurance fund, consumer protection, and competition. Financial stability is considered one of the most important aspects of any financial system. This is because any incidence of financial instability can have significant ripple effects into other sectors of the economy, locally and internationally. As such, there should be supervision that is primarily focused on financial stability of all the players in the banking industry. The supervision should look at trends, as well as analyze the potential for financial contagion. By ensuring financial stability in the banking sector, the regulators play a significant role in protection other related industries. 

Another important reason for bank regulation is the need to protect the Federal Deposit Insurance Fund, which insures the deposits held in the United States banks. The fund insures the deposits up to a defined amount, currently standing at $250,000 per depositor. As such, the federal government acts as a backstop to the federal deposit insurance fund. The banks normally pay an insurance premium for the insurance guarantee. Besides, the banks are subject to various safety and soundness assessments by the state or federal regulatory agencies. Essentially, the oversight of individual financial institutions by state or federal regulatory agencies is normally referred to as micro-prudential supervision. Although the federal deposit insurance fund protects the bank depositors, it does not offer a similar protection to the shareholders of the banks. As such, banks will definitely fail and get liquidated in the event that they take inappropriate risks that turn out to be unsuccessful. 

The need for consumer protection is also the drive behind the regulation of financial institutions. The federal government has been formally obliged to protect the consumers across industries, particularly after the creation of the Federal Trade Commission Act of 1914. Following the creation of the act, several laws and regulations have been established by various agencies in order to effectively protect bank customers, as well as promote fair and equal access to credit facilities. Basically, the banks conduct financial transactions with consumers by lending to them and taking deposits from them. As such, the banking regulators play a significant role in enforcing consumer protection laws through comprehensive review of banks operations relating to lending and deposits. Besides, the banking regulators serve to investigate consumer complaints with a view to recommend resolutions. 

Regulation of the banking industry helps to promote healthy competition among the players. The banking regulators are concerned about the interests of the various players in the financial market. The regulators usually monitor the United States banking markets for competitiveness. As such, they can stop bank mergers that would affect the availability and pricing of banking products negatively. Thus, it is the responsibility of the banking regulators to ensure that there is fair competition in the United States banking industry.

Responsibilities of Bank Regulatory Agencies

The federal and state governments in the United States have established several agencies to regulate the country’s financial markets. The various agencies have different duties and responsibilities that ensure that they act independently of each other to ensure the smooth running of the industry. The various regulatory agencies serve to accomplish similar objectives. However, opinions differ regarding to the effectiveness, efficiency and even the need for these individual agencies in the United States. The various bank regulatory agencies include the Federal Reserve Board, Federal Deposit Insurance Corporation, Office of the Comptroller of the Currency, Office of Thrift Supervision, Commodity Futures Trading Commission, Financial Industry Regulatory Authority, and Securities and Exchange Commission. 

Federal Reserve Board 

Federal Reserve Board is one of the most popular banking regulatory bodies in the United States. The regulatory body is often blamed for economic downfalls or praised for stimulating economic growth. The FSB is primarily responsible for influencing liquidity, money and overall economic conditions in the country. One of the regulator’s main tool for implementing monetary policy is its open market operations. Through open market operations, FSB controls the purchase and sale of the United States Treasury securities, as well as the Federal agency securities. The board also serves to supervise and regulate the overall banking system for purposes of stability. 

Federal Deposit Insurance Corporation

The Federal Deposit Insurance Corporation was established to provide insurance on deposits in order to guarantee the safety of savings deposits at United States banks. The mandate of the FDIC is to protect up to $250,000 per depositor. The run on banks during the Great Depression of the 1920s was the driving force behind the formation of the FDIC.

Office of the Comptroller of Currency

Office of the Comptroller of Currency is perhaps one of the oldest federal agencies in the United States. The OCC was established by the National Currency Act of 1863. The primary responsibility of the agency is to regulate, supervise, and provide charters to banks operating in the country. Besides, the regulatory agency is charged with ensuring the soundness of the country’s overall banking system. The supervision enables the financial institutions to compete and provide quality financial services. 

Office of Thrift Supervision 

The office of thrift supervision is responsible for regulating federal savings associations. The regulatory agency was established in 1989 by the Department of Treasury. The agency is funded mainly by the institutions it supervises. 

Commodity Futures Trading Commission 

The Commodity Futures Trading Commission was established as an independent agency to regulate commodity futures, as well as option markets in 1974. The main purpose of the agency is to ensure competitive and efficient market trading. Besides, the CFTC endeavors to protect participants from market fraud, as well as maintain fluid processes for clearing. 

Financial Industry Regulatory Authority 

The Financial Industry Regulatory Authority is widely considered as a self-regulatory organization. The body was originally created by the 1934 Securities Exchange Act. The main responsibility of the regulatory body is to supervise all the firms in the securities business with public (Naceur & Omran, 2011). Additionally, the agency trains financial services professionals and oversees the arbitration and mediation of disputes between brokers and customers.

Securities and Exchange Commission 

The Securities and Exchange Commission (SEC) was established following the Security and Exchange Act of 1934. The agency acts independently of the United States government. SEC is considered one of the most powerful agencies, and it enforces the federal securities laws. Besides, the SEC regulates the majority of the country’s securities industry. 

Conclusion

In conclusion, the United States banking system has undergone a lot of changes in terms of regulation. The regulatory changes have been made in response to prevailing economic conditions, as well as the commercial and industrial needs of the economy. Some of the major highlights in the country’s banking industry’s regulatory journey include the Bank Panic of 1907, the 1929 stock market crash, and the sub-prime mortgage crisis of 2007. The United States has responded to the various problems in the banking industry through a series of legislations. Several regulatory agencies have also been established to ensure that the banks, the government and consumers are protected from the risky adventures of individual banks. 

References

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Gorton, G. (1985). Clearinghouses and the origin of central banking in the United States. The Journal of Economic History, 45(2), 277-283.

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