Bank Regulations and Supervision

Banks are an essential component of any modern economy. They provide an easy way for people to save and they provide payment services, primarily in the form of checks, electronic funds transfers, and credit and debit cards. Without payment services, the economy would quickly come to a halt.

Banks are also highly leveraged—most of them have liabilities that are at least 10 times their bank capital, so even small losses can wipe out the bank's capital. Furthermore, the use of leverage is achieved by using other people's money—deposits, loans, and stockholders' equity—which creates the moral hazard inherent in risking other people's money for one's own profit.

Hence, governments have a vested interest to prevent the failure of banks. While deposit insurance protects depositors against losses, it doesn't prevent bank failures, which can still have a devastating effect on the economy. The government tries to prevent bank failures and losses to depositors by strictly regulating the financial system and by close supervision and detailed bank examinations.

The first step in regulating banks is that they must obtain a charter, since no bank can open for business without first obtaining a bank charter, either from the state or from the federal government. The bank charter determines to some extent who the regulators of the new bank will be, and what specific rules and regulations will apply to them. However, there are regulations that apply to all banks to ensure their solvency, including what assets it can own, and the minimum amount of capital that a bank must maintain. Banks are also required periodically to file financial reports.

Regulators of Depository Institutions

Banks are regulated by both state and federal regulators. Virtually all banks are regulated and examined by their deposit insurers, either the Federal Deposit Insurance Corporation (FDIC), which insures most banks, or the National Credit Union, which insures credit unions. Most state banks and all national banks are also members of the Federal Reserve, which oversees and regulates their operation. The Federal Reserve also has some regulatory oversight over nonmember banks.

National banks with a federal charter are also regulated either by the Office of the Controller of the Currency (OCC) or by the Office of Thrift Supervision (OTC). Traditionally, the OCC covered commercial banks and the OTS covered savings banks, but, because most banks are offering the same services, there is little distinction between the two. Hence, banks can choose either regulatory agency by changing their charter, and since these federal agencies collect fees from banks for their oversight, they strive to get more members. This creates a regulatory competition between the OCC and the OTC, where each eases their restrictions to attract more new members. OTC reduced its restrictions so much that during the credit crisis of 2008, IndyMac Bancorp, Washington Mutual, and Downey Savings and Loan Association—all supervised by the OTC—were seized by the federal government; others were taken over by healthier institutions.

State banks are mainly regulated by the states, but the Federal Reserve and the FDIC still have some authority even with state banks, and states also have some authority over national banks. The Supreme Court recently ruled[i] that federal banking regulations do not preempt states from enforcing their own fair-lending laws.

Minimum Capital Requirements

A portion of assets, especially loans, go bad and must be written off. So that a bank can withstand the inevitable losses, it must maintain a minimum ratio of capital to assets. The ratio is determined by the riskiness of its assets—the greater the risk, the greater the amount of capital required. The ratio is determined by complicated, constantly changing rules, for risk adjustments of specific assets.

Reserve Requirements

The Federal Reserve also controls the reserve requirement that banks are required to hold, which is the amount of money that must be held as an average percentage of their loans and demand deposits. Reserves can be used to maintain a cushion against losses and also provides liquidity so that banks can conduct their day-to-day business. Most banks also maintain excess reserves for the same reasons.

In the past, reserve requirements have been a main tool to maintain a bank's safety and liquidity. However, the extensive use of computers has reduced actual or nominal reserve requirements. Since 1994, the Federal Reserve has allowed banks to use sophisticated computer software to reduce the required reserves that they actually hold. Software reclassified banks liabilities by temporarily sweeping the balances of checking accounts, which are subject to reserve requirements, into savings accounts, which are not. These savings accounts are created for each checking account. Savings accounts only allow 6 withdrawals per month, which is why they are not subject to reserve requirements. When banks do this over the weekend, reserve requirements, which are actually calculated as an average, are reduced by treating the checking accounts as savings accounts during the time that the banks are closed over the weekend. Customers can still withdraw their money over the weekend from ATM machines, because the machines are fully loaded with cash before the banks close, and ATM cash counts as part of the reserve requirements.

My Opinion

I don't know how banking software actually sweeps money from savings accounts to checking accounts, but I would guess that, since both checking and savings accounts are simply electronic records in the bank's database, the software simply reclassifies the electronic records as either one or the other. In any case, it is difficult to envision how any reclassification of account information makes the banks safer or more liquid, since the customers can withdraw their money just as before when the bank is open, and when the bank is closed, they cannot withdraw their money anyway, even from their checking account. They can withdraw their money from an ATM or as a debit transaction, but their accounts are not updated until the bank opens.

If computer software can eliminate the need for reserve requirements, then maybe the Federal Reserve should just do as Canada did in the 1990s — eliminate reserve requirements.

Asset Restrictions

Banks are restricted in what assets they can own. They cannot own bonds that are below investment grade nor any bonds by a single issuer that is greater than 25% of the bank's capital. Likewise, a bank cannot have more than 25% of its capital in another bank.

Banks in the United States also cannot own stocks, because of the risk. In other countries, such as Japan, banks can own stocks, which caused many of them to fail in the 1990's when the Japanese stock market collapsed.

Ironically, while U.S. banks can't own stocks, they can own derivatives, which are potentially much riskier. Bank ownership of stocks was forbidden by the Banking Act of 1933, which occurred soon after the 1929 stock market crash and long before the development of derivatives. However, derivatives, mostly mortgage-backed securities, based on bad loans caused the 2007 – 2009 credit crisis, when banks had to contract credit to shore up capital against the huge losses they were suffering from mortgage-backed securities that they held.

Public Disclosure Requirements

Since most banks are corporations, they are required to issue financial reports periodically so that investors can assess the financial health of the bank, which complements the assessment by regulatory authorities.

Bank Supervision and Examinations

Bank supervision consists of monitoring and on-site examinations. Banks must file call reports (Consolidated Reports of Conditions and Income) with bank regulators, which includes details of a bank's income, assets, and liabilities. Call reports are analyzed using statistical models that highlight industry trends and allow quick comparison of financial tests among many banks to see which banks are becoming financially troubled.

Bank examinations are done onsite, at least annually, and sometimes more frequently, if the bank shows signs of financial distress. The bank examiner comes to the bank unannounced and examines every aspect of the bank, which includes calling customers at random to verify that loans were actually made and their amount. At large banks, bank examiners are always onsite doing a continuous examination where the examiners start at one part of the bank's operations, then sequentially cover every other part until everything has been examined. Then it starts over.

Some of the things that bank examiners note are whether the bank has enough capital for its assets, whether the assets are too risky or that they are carried on the books at a conservative value, and whether bad loans have been written off. Bank managers are obviously reluctant to sell bad assets at a loss, or to reduce the book value of its assets or to write off bad loans since this reduces the market value of the bank and the bank may be required to raise additional capital to remedy any deficiencies below reserve requirements.

To rate banks, supervisors use a scoring system called CAMELS, which stands for Capital adequacy, Asset quality, Management, Earnings, Liquidity, and Sensitivity to risk. A score of 1(highest) to 5 is assigned to each category, which is then used to select banks for greater scrutiny. However, CAMELS scores are not publicly disclosed since they are only the opinions of bank examiners. Bank examiners also consult with managers on how to do better, especially since most of them examine multiple banks and learn the best practices of the different banks.

Since a bank examination is based on the opinion of the bank examiner, disputes do arise, and, often, the bank examiner will defer to the bank's managers if the dispute is questionable. Sometimes, the bank will even go to court to dispute any actions required by the examiners that would significantly lower its market value or have some other adverse effect.

Each regulatory agency of a bank has the right to examine the bank, but the regulators will usually cooperate with each other, and accept the examinations of other authorities. So, although the FDIC wants an examination at least annually, it will often accept a recent examination by the Federal Reserve, the OCC, or the OTC. Even the states often accept the reviews of federal regulators rather than doing their own.

International Banking Regulations — Basel Accord

As the recent credit crisis has revealed, banking is becoming more international in scope, and banks shop around for the most permissive laws. For instance, many of the derivatives that have created havoc in recent times were packaged by special purpose entities located in Denmark.

Although there is no international agency that regulates international banking, there have been 3 Basel Accord agreements to set minimum international standards for banking, not only to reduce global risk but to also level the playing field so that banks can compete under the same regulatory requirements. The thrust of the evolving Basel Accord is to establish minimum capital requirements that are adjusted for the risks of the bank's assets. The Basel Accords have no legal force, but they serve as a guide for governments, especially in developing countries.

What does have the force of law are the new rules being enacted by governments that apply to banks headquartered in other countries. For instance, the European Union is restricting the sale of debt instruments to those where the debt issuer maintains at least a 5% stake and it is also establishing solvency requirements for the parent companies of any insurers selling insurance in Europe. It may also require managers of hedge funds to register in Europe if they want to sell there.

No doubt these de facto international regulations will only increase as international banking becomes more pervasive, to prevent the fiasco of a worldwide credit crisis that has just occurred.