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Banking On Failure: Regulation of Banks

WORLDWORKS by Joe PimbleyEditor’s Note: This is the next in a Continuing Series of Articles by Joe, as excerpted from his Book;“Banking on Failure” co-authored by Laurel McDevitt.

In virtually every country there exists strong and explicit government regulation of the banks. Chapter 8 noted that central banks include regulation of the financial sector as one critical activity. Yet government entities other than the central bank also regulate a nation’s banks.

Chapter 5 described several forms of government support (e.g., deposit insurance, central bank lending, possible bailouts) for banks. It is entirely natural that a government providing such support will recognize that it bears risk of loss if and when Banking on Failurebanks fail. Recognition of the loss possibility compels the government to attempt to “control” this possibility through regulation. This chapter presents a brief overview of government regulation of banking sectors with focus on the U.S.

Resource material for this chapter includes (i) S. Bair, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, Free Press, 2012, (ii) D. Wessel, In Fed We Trust: Ben Bernanke’s War on the Great Panic, Crown Business, 2009, (iii) G. Morgenson and J. Rosner, Reckless Endangerment: How Outsized Ambition, Greed, and Corruption Led to Economic Armageddon, Time Books, 2011, (iv) A. Ross Sorkin, Too Big to Fail, Viking Adult, 2009, (v) H. Paulson, On the Brink: Inside the Race to Stop the Collapse of the Global Financial System, Business Plus, 2010, (vi) K. Grind, The Lost Bank: The Story of Washington Mutual – The Biggest Bank Failure in American History, Simon & Schuster, 2012, and (vii) R. Apostolik, C. Donohue, and P. Went, Foundations of Banking Risk: An Overview of Banking, Banking Risks and Risk-Based Banking Regulation, John Wiley & Sons, 2009.

Bank Regulators

The primary regulators of U.S. banks are the Fed (Federal Reserve System), the FDIC (Federal Deposit Insurance Corporation), the OCC (Office of the Comptroller of the Currency), and the NCUA (National Credit Union Administration).[1] These four agencies are prudential bank regulators in the sense that they focus on monitoring and regulating banking risk.[2] The Fed regulates bank holding companies, state banks that are members of the Federal Reserve System, U.S. branches of foreign banks, and foreign branches of U.S. banks.[3] The FDIC oversees federally insured depository institutions.[4] The OCC regulates national banks and federally chartered thrift institutions.[5] The NCUA has responsibility for federally chartered or insured credit unions.[6] There is a great deal of overlap and coordination between and among the Fed, FDIC, and OCC in the oversight of banks.[7]

In the United Kingdom, the PRA (Prudential Regulatory Authority) supervises and regulates banks, building societies, credit unions, insurers, and major investment firms.[8] The BoE owns the PRA. The FCA (Financial Conduct Authority) is part of the UK Treasury and regulates financial services firms, advisors, and individuals primarily for purposes of consumer protection.[9]

Mission and Purpose of Bank Regulation

As we noted in chapter 8, the mission of the U.S. Fed “is to foster stability, integrity, and efficiency of the nation’s monetary, financial, and payment systems so as to promote optimal macroeconomic performance.”[10] Specifically with regard to regulation, the Fed adopts the mission of “supervising and regulating banking institutions to ensure the safety and soundness of the nation’s banking and financial system and to protect the credit rights of customers.”[11]

The mission of the FDIC is “to maintain stability and public confidence in the nation’s financial system by: insuring deposits; examining and supervising financial institutions for safety and soundness and consumer protection; and managing receiverships.”[12] The FDIC maintains and is accountable for the Deposit Insurance Fund (DIF) – the source of payment to depositors upon the failure of an FDIC-insured bank.

The OCC mission is “to charter, regulate, and supervise all national banks and federal savings associations … and … to ensure that they operate in a safe and sound manner and in compliance with laws requiring fair treatment of their customers and fair access to credit and financial products.”[13] The mission of the NCUA is “to facilitate the availability of credit union services to all eligible consumers, especially those of modest means, through a safe and sound credit union system.”[14] The UK’s PRA describes itself as having a single objective: “to promote the safety and soundness of [its] regulated firms.”[15]

The clear theme here is “safety and soundness” – alternatively, “safe and sound” – in stated regulatory goals. Yet there must be more specificity in regulatory practice. All banks have leverage in the sense that they use borrowed money, including deposits, to lend to borrowers. Since virtually all borrowers have some non-zero risk of defaulting on the loan repayment, then the bank clearly has risk of defaulting on its own borrowing (from depositors, for example). For a leveraged lender, the only “regulatory rule” that provides zero risk of bank default is “no lending permitted.” Such an exaggerated rule, of course, defeats the purpose of banks as lenders. It is therefore at the discretion of each regulator how to implement “safety and soundness” as its mission in a world of risky lending.

There also exist numerous laws and regulations to govern or direct bank activities outside the motive of “safety and soundness.” With focus on the U.S., banks must assist governments in detecting money laundering,[16] enforcing tax compliance,[17] and imposing economic sanctions.[18] We choose not to elaborate on these ancillary regulatory mandates.

The next excerpt for Chapter 9 will discuss “Regulatory Tools” and “Moral Hazard”

[1] See, for example, E. V. Murphy, “Who Regulates Whom and How? An Overview of U.S. Financial Regulatory Policy for Banking and Securities Markets,” Congressional Research Service, May 2013.

[2] Id.

[3] Id.

[4] Id. An act of Congress created the FDIC in 1933.

[5] Id. The OCC is a bureau within the Department of Treasury of the Executive branch of the U.S. government.

[6] Id. An act of Congress created the NCUA in 1934.

[7] S. Bair, Bull by the Horns: Fighting to Save Main Street from Wall Street and Wall Street from Itself, Free Press, 2012.

[8] “The Bank of England, Prudential Regulation Authority – Our approach to banking supervision,” Bank of England, May 2011.

[9] See, for example, http://www.fca.org.uk/about and “UK financial regulation overhauled,” BBC News, March 31, 2013.

[10] See http://www.federalreserve.gov/publications/gpra/2011-mission-values-and-goals-of-the-board-of-governors.htm .

[11] See http://www.federalreserve.gov/aboutthefed/mission.htm .

[12] See http://www.fdic.gov/about/mission/ .

[13] See http://www.occ.gov/about/what-we-do/mission/index-about.html .

[14] See http://www.ncua.gov/about/Pages/default.aspx .

[15] “The Bank of England, Prudential Regulation Authority – Our approach to banking supervision,” Bank of England, May 2011.

[16] See, for example, http://www.investopedia.com/exam-guide/finra-series-6/customer-accounts/anti-money-laundering-regulations.asp for a description of Anti-Money Laundering (AML) regulations.

[17] See, for example, the discussion of the Foreign Account Tax Compliance Act (FATCA) of http://www.irs.gov/Businesses/Corporations/Foreign-Account-Tax-Compliance-Act-FATCA .

[18] See the Mission Statement of the Office of Foreign Assets Control (OFAC) at http://www.treasury.gov/about/organizational-structure/offices/Pages/Office-of-Foreign-Assets-Control.aspx .

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Joe Pimbley
Joe Pimbleyhttp://www.maxwell-consulting.com/
Joe is Principal of Maxwell Consulting, a firm he founded in 2010. Joe is expert in complex financial instruments, financial risk management (certified as FRM by the Global Association of Risk Professionals), valuation, structured products, derivatives, and quantitative algorithms. His recent and current engagements include financial risk management advisory, valuation and credit underwriting for structured and other financial instruments, and litigation testimony and consultation. In a prominent engagement from 2009 to 2010, Joe served as a lead investigator for the Examiner appointed by the Lehman bankruptcy court to resolve numerous issues pertaining to history’s largest bankruptcy. Joe and his colleagues discovered Repo 105 and also reported the critical importance of pledged collateral mishaps and mischaracterizations to the Lehman failure. Joe holds a Ph.D. in Theoretical Physics and is a co-author of Banking on Failure (2014), Simple Money (2013), and Advanced CMOS Process Technology (1989). He serves on several corporate and academic Boards, has written more than thirty finance articles, presented more than sixty finance seminars, and holds numerous patents for engineering inventions.

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