| 2.27.20

What Are Financial Regulations?

How do you feel about financial regulations?

BACKGROUND

The U.S. financial services industry is the largest in the world, encompassing everything from banking and insurance to asset management, and Americans interact with it every day when they use credit cards, take out mortgages or car loans, and make deposits into checking or savings accounts. Given the influence of the financial services industry, it is subject to a complex system of regulatory oversight.

OVERVIEW

Financial regulations come in many forms and affect how banks and other financial institutions interact with their consumers and conduct their business. Some notable examples that impact citizens and businesses every day include disclosures on loan or credit card documents, and capital requirements that require financial institutions to hold funds in reserve.

There are several major regulators of the financial services industry:

The Federal Reserve system is primarily known as the operator of America’s central banking system, but it also plays a role in the supervision and regulation of financial institutions that are large and systemically important.
The Federal Deposit Insurance Corporation (FDIC) examines and supervises member banks to ensure their soundness, manages banks that have failed, and guarantees the safety of up to $250,000 per depositor per bank in the event of bank failure.
The Office of the Comptroller of the Currency charters, regulates, and supervises all national banks and federally licensed branches of foreign banks in the U.S.
The Securities and Exchange Commission (SEC) regulates securities markets and protects investors in order to facilitate capital formation.
The Consumer Financial Protection Bureau (CFPB) is responsible for consumer protection and it has broad jurisdiction over the financial services industry. The U.S. Supreme Court will hear arguments in a case challenging the constitutionality of the CFPB in early 2020, with a decision expected in the summer.

WHAT IS THE DOWNSTREAM IMPACT OF OVER-REGULATING OR UNDER-REGULATING BANKS?

Excessive regulation can hurt consumers by making it too difficult for banks to lend and generate economic growth. It can also raise financial institutions’ compliance costs, which are ultimately passed on to consumers in the form of increased fees.

Insufficient regulation can hurt consumers by creating an environment where financial institutions take on risky investments that don’t pay off, which can jeopardize their ability to function as a going concern and threaten the stability of the broader financial market.

WHAT IS THE GLASS-STEAGALL ACT?

In response to the Great Depression, the Banking Act of 1933 (which is commonly referenced as the Glass-Steagall Act because of the names of its two lead sponsors) was enacted to, among other things, separate commercial and investment banking activities. It prevented securities firms & investment banks from taking deposits from customers; and it also prohibited federally chartered commercial banks from dealing in securities for customers, investing in non-investment grade securities, underwriting non-governmental securities, and affiliating with companies involved in those activities.

These barriers were repealed by the enactment of the Gramm-Leach-Bliley Act in 1999, which passed Congress with broad bipartisan support and was signed into law by President Bill Clinton. Its legacy has proven controversial in the wake of the 2008 financial crisis:

Opponents of Glass-Steagall’s separation of commercial & investment banking contend that it contributed to riskier behavior in the lead up to the financial crisis.
Supporters of the Glass-Steagall repeal argue that the more diversified banks with commercial & investment portfolios weathered the crisis better than those which focused solely on one or the other.

WHAT IS THE DODD-FRANK ACT?

The Dodd-Frank Wall Street Reform & Consumer Protection Act (often shortened to the Dodd-Frank Act) was signed into law by President Barack Obama in 2010 in the aftermath of a $700 billion bailout of the financial and auto industries necessitated by the financial crisis. It was an 848-page bill that passed on largely party-line votes and implemented regulations affecting nearly every aspect of the financial sector with an emphasis in several areas:

Addressing financial instability and liquidating failed banks and insurance companies.
Regulatory protections for investors.
Mortgage reforms aimed at reducing abusive lending practices.

To reduce the threat that large, complex financial institutions posed to the economy, Dodd-Frank created a Financial Stability Oversight Council that could vote to designate such firms as being “systemically important”. These systemically important financial institutions (SIFIs) would then be subject to additional oversight in the form of regular stress tests, and more restrictive capital requirements.

The bill also included the so-called “Volcker Rule” to prohibit commercial banks from engaging in speculative investments, created the CFPB, set minimum standards for “qualified mortgages”, and increased regulations on asset-backed securities (like those backed by mortgages). In addition to the legislative text, Dodd-Frank tasked federal agencies with drafting hundreds of regulations that have since translated to tens of thousands of pages of rules.

Dodd-Frank has remained controversial since its enactment:

Supporters argue that its safeguards helped stabilize financial markets and have curtailed excessive risk-taking, in addition to protecting consumers from predatory lending practices.
Detractors contend that Dodd-Frank’s excessive restrictions have impeded economic growth and unduly burdened smaller community banks. Others argue that it should have broken up the “too big to fail” banks and addressed the shortcomings of Fannie Mae and Freddie Mac.

Recent efforts to reform Dodd-Frank have been successful. Bipartisan majorities in Congress approved the Economic Growth, Regulatory Relief, and Consumer Protection Act (EGRRCPA), which overhauled Dodd-Frank’s community banking rules and also expanded credit protections for consumers. It was signed into law by President Donald Trump in May 2018.

WHAT ARE FANNIE MAE & FREDDIE MAC?

The Federal National Mortgage Association (Fannie Mae) and Federal Home Loan Mortgage Corporation (Freddie Mac) are government-sponsored enterprises (GSEs) that aim to provide liquidity in home lending markets. In general, they accomplish this by purchasing mortgages from commercial banks, bundling those mortgages into mortgage-backed securities (MBS), and selling those securities in financial markets.

As GSEs, Fannie Mae and Freddie Mac were chartered by the federal government and, initially, were privately owned. While they carried no explicit government guarantee or backing, the GSEs benefited from an implicit guarantee that the government wouldn’t allow them to fail or default and received favorable interest rates from lenders.

During the 2008 financial crisis, defaults among subprime mortgages (ie mortgages that had small down-payments or were made to borrowers with credit problems) that comprised part of the MBS portfolio held by Fannie Mae & Freddie Mac brought the GSEs to the brink of financial collapse. To prevent their failure, the federal government bailed out Fannie Mae & Freddie Mac to the tune of $116 billion & $71.3 billion, respectively, and took them over through a conservatorship arrangement. While those bailouts haven’t been repaid in full, the GSEs have been making dividend payments to the Treasury and they are rebuilding their capital reserves in an effort to exit conservatorship and become private companies once again.

WHAT DOES IT MEAN WHEN BANKS ARE “TOO BIG TO FAIL”?

The term “too big to fail'' is applied to financial institutions that because of their size and interconnectedness pose a threat to the stability of the broader financial system if they were to fail. It is commonly used to refer to those which received bailouts as part of the $700 billion Troubled Assets Relief Program (TARP), which has since been largely repaid. Several of those banks and other financial institutions have been designated as systemically-important financial institutions (SIFIs) by the Financial Stability Oversight Council established by Dodd-Frank.

WHAT DO SUPPORTERS OF MORE FINANCIAL REGULATION SAY?

They argue that existing financial regulations don’t do enough to prevent excessive risk-taking by firms and protect consumers from the negative consequences of those actions.

WHAT DO OPPONENTS OF MORE FINANCIAL REGULATION SAY?

They contend that excessive regulations on financial institutions inhibit economic growth by making it harder for firms to make investments, in addition to raising compliance costs that get passed on to consumers through increased fees.

RESOURCES

— Eric Revell

(Photo Credit: iStock.com / tunart)