CRS Report for Congress Prepared for Members and Committees of Congress Who Regulates Whom? An Overview of U.S. Financial Supervision Mark Jickling Specialist in Financial Economics Edward V. Murphy Specialist in Financial Economics December 8, 2010 Congressional Research Service 7-5700 www.crs.gov R40249 Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service Summary This report provides an overview of current U.S. financial regulation: which agencies are responsible for which institutions, activities, and markets, and what kinds of authority they have. Some agencies regulate particular types of institutions for risky behavior or conflicts of interest, some agencies promulgate rules for certain financial transactions no matter what kind of institution engages in it, and other agencies enforce existing rules for some institutions, but not for others. These regulatory activities are not necessarily mutually exclusive. There are three traditional components to U.S. banking regulation: safety and soundness, deposit insurance, and adequate capital. The Dodd-Frank Wall Street Reform and Consumer Protection Act (P.L. 111-203) added a fourth: systemic risk. Safety and soundness regulation dates back to the 1860s when bank credit formed the money supply. Examinations of a bank’s safety and soundness is believed to contribute to a more stable broader economy. Deposit insurance was established in the 1930s to reduce the incentive of depositors to withdraw funds from banks during a panic. Banks pay premiums to support the deposit insurance fund, but the Treasury provides full faith and credit for covered deposits if the fund were to run short. Deposit insurance is a second reason that federal agencies regulate bank operations, including the amount of risk they may incur. Capital adequacy has been regulated since the 1860s when “wildcat banks” sought to make extra profits by reducing their capital reserves, which increases their risk of default and failure. Dodd-Frank created the interagency Financial Stability Oversight Council (FSOC) to monitor systemic risk and consolidated bank regulation from five agencies to four. For banks and non-banks designated by the FSOC as creating systemic risk, the Federal Reserve has oversight authority, and the Federal Deposit Insurance Corporation (FDIC) has resolution authority. Federal securities regulation has traditionally been based on the principle of disclosure, rather than direct regulation. Firms that sell securities to the public must register with the Securities and Exchange Commission (SEC), but the agency generally has no authority to prevent excessive risk taking. SEC registration in no way implies that an investment is safe, only that the risks have been fully disclosed. The SEC also registers several classes of securities market participants and firms. It has enforcement powers for certain types of industry misstatements or omissions and for certain types of conflicts of interest. Derivatives trading is supervised by the Commodity Futures Trading Commission (CFTC), which oversees trading on the futures exchanges, which have self- regulatory responsibilities as well. Dodd-Frank has required more disclosures in the previously unregulated over-the-counter (off-exchange) derivatives market and has granted the CFTC and SEC authority over large derivatives traders. The Federal Housing Finance Agency (FHFA) oversees a group of government-sponsored enterprises (GSEs)—public/private hybrid firms that seek both to earn profits and to further the policy objectives set out in their statutory charters. Two GSEs, Fannie Mae and Freddie Mac, were placed in conservatorship by the FHFA in September 2008 after losses in mortgage asset portfolios made them effectively insolvent. Dodd-Frank consolidated consumer protection rulemaking, which had been dispersed among several federal agencies in a new Bureau of Consumer Financial Protection. The bureau is intended to bring consistent regulation to all consumer financial transactions, although the legislation exempted several types of firms and transactions from its jurisdiction. Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service Contents Introduction 1 What Financial Regulators Do 1 Banking Regulation 6 Safety and Soundness Regulation 6 Deposit Insurance 7 Capital Regulation 7 Systemic Risk 8 Capital Requirements 8 Basel III 9 Capital Provisions in Dodd-Frank 10 Non-Bank Capital Requirements 12 The SEC’s Net Capital Rule 12 CFTC Capital Requirements 12 Federal Housing Finance Agency 13 The Federal Financial Regulators 14 Banking Regulators 14 Office of the Comptroller of the Currency 15 Federal Deposit Insurance Corporation 15 The Federal Reserve 16 Office of Thrift Supervision (Abolished by Dodd-Frank) 17 National Credit Union Administration 18 Non-Bank Financial Regulators 18 Securities and Exchange Commission 18 Commodity Futures Trading Commission 21 Federal Housing Finance Agency 21 Bureau of Consumer Financial Protection 22 Regulatory Umbrella Groups 23 Financial Stability Oversight Council 23 Federal Financial Institution Examinations Council 24 President’s Working Group on Financial Markets 24 Unregulated Markets and Institutions 25 Foreign Exchange Markets 25 U.S. Treasury Securities 25 Private Securities Markets 26 Comprehensive Reform Legislation in the 111 th Congress 26 Figures Figure A-1. National Bank 28 Figure A-2. National Bank and Subsidiaries 28 Figure A-3. Bank Holding Company 29 Figure A-4. Financial Holding Company 29 Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service Tables Table 1.Federal Financial Regulators and Who They Supervise 4 Table 2.The Basel Accords: Risk Weightings for Selected Financial Assets Under the Standardized Approach 9 Table 3.Capital Standards for Federally Regulated Depository Institutions 11 Appendixes Appendix A. Forms of Banking Organizations 28 Appendix B. Bank Ratings: UFIRS and CAMELS 30 Appendix C. Acronyms 32 Appendix D. Regulatory Structure Before the Dodd-Frank Act 33 Appendix E. Glossary of Terms 34 Contacts Author Contact Information 41 Acknowledgments 41 Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 1 Introduction Historically, major changes in financial regulation in the United States have often come in response to crisis. Thus, it is no surprise that the turmoil beginning in 2007 led to calls for reform. Few would argue that regulatory failure was solely to blame for the crisis, but it is widely considered to have played a part. In February 2009, Treasury Secretary Timothy Geithner summed up two key problem areas: Our financial system operated with large gaps in meaningful oversight, and without sufficient constraints to limit risk. Even institutions that were overseen by our complicated, overlapping system of multiple regulators put themselves in a position of extreme vulnerability. These failures helped lay the foundation for the worst economic crisis in generations. 1 In this analysis, regulation failed to maintain financial stability at the systemic level because there were gaps in regulatory jurisdiction and because even overlapping jurisdictions—where institutions were subject to more than one regulator—could not ensure the soundness of regulated financial firms. In particular, limits on risk-taking were insufficient, even where regulators had explicit authority to reduce risk. This report attempts to set out the basic principles underlying U.S. financial regulation and to give some historical context for the development of that system. The first section briefly discusses the various modes of financial regulation and includes a table identifying the major federal regulators and the types of institutions they supervise. The table also indicates certain emergency authorities available to the regulators, including those that relate to systemic financial disturbances. The second section focuses on capital requirements—the principal means of constraining risky financial activity—and how risk standards are set by bank, securities, and futures regulators. The next sections provide brief overviews of each federal financial regulatory agency and discussions of several major financial markets that are not subject to any federal regulation. What Financial Regulators Do The regulatory missions of individual agencies vary, partly as a result of historical accident. Here is a rough division of what agencies are called upon to do: • Regulate Certain Types of Financial Institutions. Some firms become subject to federal regulation when they obtain a particular business charter, and several federal agencies regulate only a single class of institution. Depository institutions are a good example: a new banking firm chooses its regulator when it decides which charter to obtain—national bank, state bank, credit union, etc.—and the choice of charter may not greatly affect the institution’s business mix. The Federal Housing Finance Authority (FHFA) regulates only three government- sponsored enterprises: Fannie Mae, Freddie Mac, and the Federal Home Loan 1 Remarks by Treasury Secretary Timothy Geithner Introducing the Financial Stability Plan, February 10, 2009, http://www.ustreas.gov/press/releases/tg18.htm. Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 2 Bank system. Regulation keyed to particular institutions has at least two perceived disadvantages: regulator shopping, or regulatory arbitrage, may occur if regulated entities can choose their regulator, and unchartered firms engaging in the identical business activity as regulated firms may escape regulation altogether. • Regulate a Particular Market. The New York Stock Exchange dates from 1793, federal securities regulation from 1934. Thus, when the Securities and Exchange Commission (SEC) was created by Congress, stock and bond market institutions and mechanisms were already well-established, and federal regulation was grafted onto the existing structure. As the market evolved, however, Congress and the SEC faced numerous jurisdictional issues. For example, de minimis exemptions to regulation of mutual funds and investment advisers created space for the development of a trillion-dollar hedge fund industry, which was unregulated until the Dodd-Frank Act. Market innovation also creates financial instruments and markets that fall between industry divisions. Congress and the courts have often been asked to decide whether a particular financial activity belongs in one agency’s jurisdiction or another’s. • Regulate a Particular Financial Activity. When regulator shopping or perceived loopholes appear to weaken regulation, one response is to create a regulator tasked with overseeing a particular type or set of transactions, regardless of where the business occurs or which entities are engaged in it. In 1974, Congress created the Commodity Futures Trading Commission (CFTC) at the time when derivatives were poised to expand from their traditional base in agricultural commodities into contracts based on financial instruments and variables. The CFTC was given “exclusive jurisdiction” over all contracts that were “in the character of” options or futures contracts, and such instruments were to be traded only on CFTC-regulated exchanges. In practice, exclusive jurisdiction was impossible to enforce, as off-exchange derivatives contracts such as swaps proliferated. In 2000, Congress exempted swaps from CFTC regulation, but this exemption was repealed by Dodd-Frank. On the view that consumer financial protections should apply uniformly to all transactions, the Dodd-Frank Act created a Bureau of Consumer Financial Protection, with authority (subject to certain exemptions) over an array of firms that deal with consumers. • Regulate for Systemic Risk. One definition of systemic risk is that it occurs when each firm manages risk rationally from its own perspective, but the sum total of those decisions produces systemic instability under certain conditions. Similarly, regulators charged with overseeing individual parts of the financial system may satisfy themselves that no threats to stability exist in their respective sectors, but fail to detect systemic risk generated by unsuspected correlations and interactions among the parts of the global system. The Federal Reserve was for many years a kind of default systemic regulator, expected to clean up after a crisis, but with limited authority to take ex ante preventive measures. Dodd- Frank creates the Financial Stability Oversight Council (FSOC) to assume a coordinating role, with the single mission of detecting systemic stress before a Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 3 crisis can take hold (and identifying firms whose individual failure might trigger cascading losses with system-wide consequences). From time to time, the perceived drawbacks to the multiplicity of federal regulators brings forth calls for regulatory consolidation. 2 The legislative debate over Dodd-Frank illustrates the different views on the topic: early versions of the Senate bill would have replaced all the existing bank regulators with a single Financial Institution Regulatory Authority. By the end, however, Dodd- Frank created two new agencies (and numerous regulatory offices), and eliminated only the Office of Thrift Supervision (OTS). There have always been arguments against regulatory consolidation. Some believe that a fragmentary structure encourages innovation and competition and fear that the “dead hand” of a single financial supervisor would be costly and inefficient. Also, there is little evidence that countries with single regulators fare better during crises or are more successful at preventing them. One of the first proposals by the Conservative government elected in the UK in May 2010 was to break up the Financial Services Authority, which has jurisdiction over securities, banking, derivatives, and insurance. Table 1 below sets out the federal financial regulatory structure as it will exist once all the provisions of the Dodd-Frank Act become effective. (In many cases, transition periods end a year or 18 months after July 21, 2010, the date of enactment. Thus, OTS does not appear in Table 1, even though the agency will continue to operate into 2011.) Appendix D of this report contains a pre-Dodd-Frank version of the same table. Supplemental material—charts that illustrate the differences between banks, bank holding companies, and financial holding companies—appears in Appendix A. 2 See, e.g., U.S. Department of the Treasury, Blueprint for a Modern Financial Regulatory Structure, March 2008, which called for a three-agency structure: a systemic risk regulator, a markets supervisor, and a consumer regulator. Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 4 Table 1.Federal Financial Regulators and Who They Supervise Regulatory Agency Institutions Regulated Emergency/Systemic Risk Powers Other Notable Authority Federal Reserve Bank holding companies a and certain subsidiaries, financial holding companies, securities holding companies, savings and loan holding companies, and any firm designated as systemically significant by the FSOC State banks that are members of the Federal Reserve System, U.S. branches of foreign banks, and foreign branches of U.S. banks Payment, clearing, and settlement systems designated as systemically significant by the FSOC, unless regulated by SEC or CFTC Lender of last resort to member banks (through discount window lending) In “unusual and exigent circumstances” the Fed may extend credit beyond member banks, for the purpose of providing liquidity to the financial system, but not to aid failing financial firms May initiate resolution process to shut down firms that pose a grave threat to financial stability (requires concurrence of 2/3 of the FSOC) Office of the Comptroller of the Currency (OCC) National banks, U.S. federal branches of foreign banks, federally chartered thrift institutions Federal Deposit Insurance Corporation (FDIC) Federally-insured depository institutions, including state banks that are not members of the Federal Reserve System and state-chartered thrift institutions After making a determination of systemic risk, the FDIC may invoke broad authority to use the deposit insurance funds to provide an array of assistance to depository institutions, including debt guarantees National Credit Union Administration (NCUA) Federally-chartered or insured credit unions Serves as a liquidity lender to credit unions experiencing liquidity shortfalls through the Central Liquidity Facility Operates a deposit insurance fund for credit unions, the National Credit Union Share Insurance Fund (NCUSIF) Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 5 Regulatory Agency Institutions Regulated Emergency/Systemic Risk Powers Other Notable Authority Securities and Exchange Commission (SEC) Securities exchanges, brokers, and dealers; clearing agencies; mutual funds; investment advisers (including hedge funds with assets over $150 million) Nationally-recognized statistical rating organizations Security-based swap (SBS) dealers, major SBS participants, SBS execution facilities Corporations selling securities to the public must register and make financial disclosures May unilaterally close markets or suspend trading strategies for limited periods Authorized to set financial accounting standards which all publicly traded firms must use Commodity Futures Trading Commission (CFTC) Futures exchanges, brokers, commodity pool operators, commodity trading advisors Swap dealers, major swap participants, swap execution facilities May suspend trading, order liquidation of positions during market emergencies. Federal Housing Finance Agency (FHFA) Bureau of Consumer Financial Protection Fannie Mae, Freddie Mac, and the Federal Home Loan Banks Nonbank mortgage-related firms, private student lenders, payday lenders, and larger “consumer financial entities” to be determined by the Bureau Consumer businesses of banks with over $10 billion in assets Does not supervise insurers, SEC and CFTC registrants, auto dealers, sellers of nonfinancial goods, real estate brokers and agents, and banks with assets less than $10 billion Acting as conservator (since Sept. 2008) for Fannie and Freddie Writes rules to carry out the federal consumer financial protection laws Source: CRS. a. See Appendix A. Who Regulates Whom? An Overview of U.S. Financial Supervision Congressional Research Service 6 Banking Regulation Absent regulation, the banking system tends to multiply the supply of credit in good times and worsen the contraction of credit in bad times. Bank profits in good times and losses in bad times amplify the cycle of credit in the aggregate economy even in the presence of a lender-of-last resort. One policy goal of bank regulation is to lessen the tendency of banks to feed credit bubbles and magnify credit contractions. The regulation of the funding and activities of individual banks, including capital requirements, is one policy tool that has been used to try to stabilize the aggregate credit cycle in the United States. There are three traditional components to U.S. banking regulation: safety and soundness, deposit insurance, and adequate capital. Dodd-Frank added a fourth: systemic risk. Safety and soundness regulation dates back to the 1860s when bank credit formed the money supply, and recent events have demonstrated that bank safety and soundness remains an important component of the aggregate credit cycle. Deposit insurance was established in the 1930s to reduce the incentive of depositors to withdraw funds from banks during a panic. Banks pay premiums to support the deposit insurance fund, but the Treasury provides full faith and credit for covered deposits if the fund were to run short. Deposit insurance is a second reason that federal agencies regulate bank operations, including the amount of risk they may incur. Capital adequacy has been regulated since the 1860s when “wildcat banks” sought to make extra profits by reducing their capital reserves, which increased their risk of default and failure. Dodd-Frank created a council to monitor systemic risk, and consolidated bank regulation from five agencies to four. For banks and non-banks designated as creating systemic risk, the Federal Reserve has oversight authority, and the Federal Deposit Insurance Corporation (FDIC) has resolution authority. Safety and Soundness Regulation As a general concept, safety and soundness authority refers to examining and regulating the probability of a firm’s default, and the magnitude of the losses that its owners and creditors would suffer if the firm defaulted. One public policy justification for monitoring the safety and soundness decisions of banks is that bank risk decisions suffer from the fallacy of composition— the consequences to a single bank acting in its own interests diverge from the aggregate consequences that occur if many banks choose similar risk strategies simultaneously. The fallacy of composition is sometimes illustrated by the stadium example—a single person standing up at a ballgame is able to see the field better, but if everyone stands up at the same time, few people will be able to see the field better, yet most people are less comfortable. In the case of banks and bank regulation, a single bank may be able to increase profits by making more risky loans or failing to insure against counterparty default, without significantly increasing the probability of losing its own access to liquidity should events turn out badly. However, if many banks simultaneously make more risky loans, or fail to insure against counterparty default, then no single bank may gain market share or be more profitable. Yet in the aggregate, interbank liquidity is more likely to collapse, and the broader economy can suffer a precipitous contraction of credit. Since the 1860s, federal bank regulators have had some authority to examine and regulate the riskiness of individual banks’ activities because the decisions of individual banks can affect the availability of aggregate credit and the size of aggregate financial losses. If there is more than one agency with examination powers, then there may be a race to the bottom in banking supervision. Some observers have claimed that the multiplicity of banking regulators allowed some banks to shop for their regulator prior to the financial crisis of 2008. To the extent [...]... Congressional Research Service 28 Who Regulates Whom? An Overview of U.S Financial Supervision Figure A-3 Bank Holding Company Figure A-4 Financial Holding Company Congressional Research Service 29 Who Regulates Whom? An Overview of U.S Financial Supervision Appendix B Bank Ratings: UFIRS and CAMELS Federal bank regulators conduct confidential assessments of covered banks The Federal Financial Institutions Examination... by Mark Jickling and Kathleen Ann Ruane 36 Dodd-Frank Section 1024 See CRS Report R41338, The Dodd-Frank Wall Street Reform and Consumer Protection Act: Title X, The Consumer Financial Protection Bureau, by David H Carpenter Congressional Research Service 27 Who Regulates Whom? An Overview of U.S Financial Supervision Appendix A Forms of Banking Organizations The structure of banks can be complex Currently,... expenses can reduce the rating for earnings Difficulties in forecasting and managing risks can also reduce the earnings rating 37 The Comptrollers handbooks are occasionally updated The most recent handbook for the Bank Supervision Process is dated September 2007 and can be found at http://www.occ.gov/handbook/banksup .pdf Congressional Research Service 30 Who Regulates Whom? An Overview of U.S Financial Supervision. .. account management’s ability to identify and manage the risks that can arise from the bank’s trading activities in financial markets It also takes into account interest rate risk from nontrading positions, such as any duration mismatch in loans held to maturity Congressional Research Service 31 Who Regulates Whom? An Overview of U.S Financial Supervision Appendix C Acronyms AICPA American Institute of Certified... of deposit insurance; and banks have been assessed an insurance premium by the FDIC based on the amount of their insured deposits The financial crisis of 2008 revealed a number of lessons related to bank runs and deposit insurance Several non-banks suffered the equivalent of depositor runs, including money market mutual funds and the interbank repo market Because the equivalent of depositor runs can... History and the Dodd-Frank Act, by Kathleen Ann Ruane and Michael V Seitzinger Congressional Research Service 26 Who Regulates Whom? An Overview of U.S Financial Supervision • Over-the-Counter Derivatives 35 OTC derivatives, a $600 trillion market, were generally not subject to the Commodity Exchange Act before Dodd-Frank Title VII of Dodd-Frank establishes a comprehensive regime for the regulation of swap... OCC Office of the Comptroller of the Currency OFHEO Office of Federal Housing Enterprise Oversight OFR Office of Financial Research OTS Office of Thrift Supervision PCS Payment, Clearing, and Settlement Systems PWG President’s Working Group on Capital Markets SEC Securities and Exchange Commission SIPC Securities Investor Protection Corporation SRO Self Regulatory Organization UFIRS Uniform Financial. .. 22 Who Regulates Whom? An Overview of U.S Financial Supervision Regulatory Umbrella Groups The need for coordination and data sharing among regulators has led to the formation of innumerable interagency task forces to study particular market episodes and make recommendations to Congress Three interagency organizations have permanent status Financial Stability Oversight Council Title I of the Dodd-Frank... technically on the bank’s balance sheet Asset quality can include changes in loan default rates, investment performance, exposure to counterparty risk, and all other risks that may affect the value or marketability of an institution’s assets Management Capability The governance of the bank, including management and board of directors, is assessed in relation to the nature and scope of the bank’s activities... Dodd-Frank Wall Street Reform and Consumer Protection Act: Systemic Risk and the Federal Reserve, by Marc Labonte Congressional Research Service 23 Who Regulates Whom? An Overview of U.S Financial Supervision Although the FSOC does not have direct supervisory authority over any financial institution, it plays an important role in regulation, because firms that it designates as systemically important come . three-agency structure: a systemic risk regulator, a markets supervisor, and a consumer regulator. Who Regulates Whom? An Overview of U. S. Financial Supervision. Bureau Consumer businesses of banks with over $10 billion in assets Does not supervise insurers, SEC and CFTC registrants, auto dealers, sellers of