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.

When large banks fail, they can pose a substantial risk to the financial system of any economy. Because banks are highly leveraged, large loan losses may cause instability in the financial system. If a large bank fails, then the loans that it has acquired from other banks may cause those banks to fail also. Additionally, banks may stop lending to other banks because the cause of the large bank's losses may be affecting other banks, which can cause many of those banks to fail, since they often rely on loans from other banks to cover shortfalls. Such was the case during the Great Recession of 2007 - 2009. In that recession, banks were failing because many of them were holding mortgage-backed securities (MBSs), which were based on the mortgages of subprime borrowers. Because many banks were holding these MBSs, credit dried up, because banks could not know the financial viability of other banks, so they would not lend to them. Moreover, when banks fail, depositors lose faith in the system and start withdrawing their money, leading to another cascading effect, where more banks fail, one after the other. Thus, governments must prevent the failure of big banks by bailing them out, which is why these banks are considered too big to fail. But, by being too big to fail, bank managers have an incentive to offer riskier loans or undertake riskier investments, to potentially increase profits for the bank's owners or increase bonuses for its managers, since the owners and managers expect that the government will bail them out if their bets do not pay off. They benefit from asymmetric information, because they have greater knowledge of the riskiness of their loans and other assets than bank regulators have.

Hence, governments have a vested interest to prevent the failure of banks, which is achieved partly by limiting the amount of risk that banks may acquire. 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. Banks are required to maintain deposit insurance, minimum capital requirements, and to restrict their holdings to less riskier assets, such as government bonds. Moreover, banks must adhere to standard accounting procedures and disclose certain information that may affect their viability.

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. State banks must get their charter from the state banking authority; national banks must get their charter from the Comptroller of the Currency. The bank charter somewhat determines 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 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 Great Recession 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.

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 exceeds 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 Great Recession, 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, including 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, including 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 Great Recession 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. Consequently, several international organizations have been created to address international banking regulations and risks. The most prominent of these organizations is the Basel Committee on Banking Supervision (BCBS), located in the Bank for International Settlements in Basel, Switzerland, composed of representatives from central banks of about 28 countries. Its goal is to improve bank supervision, although it has no formal legal powers. However, bank regulators do adopt many of the recommendations, including regulatory standards for securities trading, insurance, and banking.

The BCBS was formed in 1974 by the central bank governors of the G10 countries, to provide recommendations for international regulation of banking, to reduce international banking risks, prompted by the international currency problems created by the failure of Bankhaus Herstatt in West Germany.

One of the 1st agreements was the Basel Concordant, revised several times over several decades, that helped to establish home country supervision for foreign branches of domestic banks. For international institutions, foreign branches are regulated by their home country rather than by the countries where the branches are located. However, the risk with home country supervision became evident during the Great Recession in 2008. If the supervision is inadequate, businesses and citizens in other countries can suffer. Such was the case with Icelandic banks in 2008, during the Great Recession, when Iceland suffered the largest banking crisis in history, relative to the size of its economy. The Icelandic Financial Supervisory Authority (IFSA) supervised the Icelandic banks and its foreign branches, but failed to prevent the collapse of its banking system, thus causing taxpayers in the United Kingdom and the Netherlands to lose about €4 billion.

Additionally, 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.

Another transgovernmental network is the Financial Stability Board (FSB), originally known as the Financial Stability Forum, which includes 50 regulatory agencies from about 25 countries and other international agencies, whose objective is to promote international financial stability. Like the BCBS, it has no formal legal powers, but it does provide regulatory recommendations based on its expertise.