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The U.S. Financial Regulatory System

Author: Lee Hudson Teslik
October 2, 2008
This publication is now archived.

Introduction

The sweeping credit crunch of 2008 triggered several high-profile financial failures and prompted widespread debate about how the U.S. government regulates financial markets. Beyond efforts to resolve an immediate liquidity crisis, policymakers are considering longer-term efforts to significantly reorganize the rules governing financial markets and the regulatory agencies charged with enforcing them. Treasury Secretary Henry M. Paulson has pushed for the implementation of a series of reforms he initially proposed in March 2008. Paulson's plan would shut down one regulatory agency, the Office of Thrift Supervision (OTS), and merge two others, the Securities and Exchange Commission (SEC) and the Commodities Futures Trading Commission (CFTC). Overall, many analysts interpreted the plan as a broad move to empower yet another regulator, the U.S. Federal Reserve. Other policymakers and analysts advocate different approaches. Many Democrats in Congress aim to repeal or revise the Gramm-Leach-Bliley Act of 1999, which discarded financial safeguards applied during the Great Depression and opened the way for banks and insurance companies to compete with brokerage houses in offering complex investment products. Others stress major operational reforms at the SEC. Still others insist that federal intervention in markets is a mistake and that investment houses and other financial institutions which took undue risks should be allowed to collapse.

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The following is an outline of the U.S. financial regulatory system as it currently stands, delineating the different regulatory bodies and their respective roles.

Federal Reserve System

The Federal Reserve, commonly referred to as the Fed, is the central bank of the United States. The Fed is responsible for regulating the U.S. monetary system (i.e. how much money is printed, and how it is distributed), as well as monitoring the operations of holding companies, including traditional banks and banking groups. Broadly speaking, its mandate is to promote stable prices and economic growth.

The Federal Reserve exerts regulatory oversight in a few different ways:

  • Board of Governors: The national component of the federal reserve system is run by a seven-person Board of Governors, commonly called the Federal Reserve Board. This group is managed by a chairman (currently Ben S. Bernanke) and vice chairman (Donald L. Kohn). Its main responsibility is to guide monetary policy by coordinating with the Federal Open Markets Committee (FOMC) and regional reserve banks. Toward this end, the board organizes a wide range of research and analytical operations. The board is also charged with overseeing the U.S. government's system of payments; supervising the financial services industry, including approving bank presidents and setting requirements for the amount of cash banks must hold in reserve; and coordinating and overseeing the actions of regional reserve banks.
  • Federal Open Markets Committee: The FOMC is the Fed's primary monetary policymaking body. It consists of twelve members, including the seven members of the Board of Governors, the president of the Federal Reserve Bank of New York, and the presidents of four other regional banks (who serve on a rotating basis). The FOMC typically meets eight times a year and is charged with assessing the economic and financial landscape and setting the "federal funds rate," the benchmark interest rate at which the Fed loans money to banks.
  • Reserve banks: The federal reserve banking system encompasses twelve regional banks with twenty-five total branches. These banks are regional arms of the U.S. central bank that act as intermediaries between local banks and the U.S. reserve banking system. They store and distribute reserves, process checks and other forms of interbank payments, and generally supervise the operations of commercial banks in their region. Reserve banks have additional regulatory authority over the 38 percent of U.S. commercial banks (mainly larger banks, including all national banks) that are members of the Federal Reserve system. These banks are considered stockholders of their local reserve bank and thus are required to hold 3 percent of their total capital at that bank.

Amidst the financial crisis of 2008, the Fed sought to use policy statements and its control of interest rates to influence legislative policy and calm capital markets. Chairman Bernanke has also encouraged lawmakers to pass a plan aimed at stimulating liquidity in financial markets, and has supported moves by the U.S. Treasury to make money available to some failing U.S. financial institutions.

Department of the Treasury

The U.S. Department of the Treasury, originally created specifically to manage government revenues (whereas the Federal Reserve manages payments), has evolved to encompass several different duties. It recommends and influences fiscal policy; regulates U.S. imports and exports; collects all U.S. revenues, including taxes; and designs and mints all U.S. currency.

In terms of financial regulation, the Treasury Department functions primarily through the operations of two agencies it oversees, the Office of the Comptroller of the Currency and the Office of Thrift Supervision, which regulate banks and savings and loans:

  • Office of the Comptroller of the Currency: The Office of the Comptroller of the Currency, or OCC, is the primary means through which the Treasury regulates U.S. banks. It is headed by the comptroller of the currency (currently John Dugan). The OCC is responsible for chartering all U.S. banks and, more broadly, for ensuring the stability of the banking system. According to the OCC's website, it attempts the latter task by monitoring: "a bank's loan and investment portfolios, funds management, capital, earnings, liquidity, sensitivity to market risk, and compliance with consumer banking laws." Its responsibilities thus overlap, to a degree, with those of the Federal Deposit Insurance Corporation (FDIC), which must also monitor banks' capital reserves and sensitivity to risk. If a bank doesn't comply with OCC standards, the agency holds the authority to take a variety of actions. It can force the ouster of senior bank personnel, force the bank to change certain practices, issue fines or penalties, and ultimately issue orders for the bank to close its operations.
  • Office of Thrift Supervision: The Office of Thrift Supervision (OTS) is tasked with supervising federally-chartered savings and loan associations, also known as "thrifts." (Thrifts generally specialize in managing large savings deposits and issuing mortgages, and are often mutually held, meaning that involved borrowers and lenders have the ability to guide the association's management and financial practices.) The OTS regulates the formation and management of thrifts. It is also responsible for regulating savings and loan holding companies-firms that buy up rights to all the loans held by various thrifts-which gives it purview over several major U.S. banks and financial firms.

Treasury Secretary Henry M. Paulson has taken a very active role amidst the financial turmoil of 2008. He has pressed the need for a plan aimed at stimulating liquidity in financial markets and has made Treasury money available to some failing U.S. financial institutions on the grounds that their failure would severely damage the U.S. economy. He also devised and recommended a series of reforms aimed at reorganizing the manner in which the United States regulates financial institutions.

Securities and Exchange Commission

The Securities and Exchange Commission (SEC) is an independent government agency tasked with overseeing U.S. securities markets, enforcing securities law, and monitoring exchanges for stocks, options, and other securities. The commission was created by Congress in 1934 and is also responsible for overseeing corporate takeovers. One of the primary tasks assigned to the commission is the promotion of transparency in securities markets and thus the protection of investors from fraud or corporate malfeasance, in part through requiring that firms file quarterly and annual financial reports. The SEC is tasked with providing guidance to corporations regarding U.S. accounting rules, and Congress authorizes the commission to bring civil charges against firms thought to have committed fraud or other accounting wrongdoings. The commission has subdivisions focused on regulating: corporate finance, trading and markets, investment management, and enforcement. The agency is governed by five commissioners, though all decisions ultimately run through the chairman. The current chairman, Christopher Cox, is a conservative former California representative and an advocate of market deregulation. In late September 2008, Cox moved to shut down the Consolidated Supervised Entities program, a largely voluntary regulatory program that oversaw investment banks like Bear Stearns and Lehman Brothers, saying it was "fundamentally flawed" and that the financial turmoil of 2008 "made it abundantly clear that voluntary regulation does not work."

The SEC administers the body of financial law established through seven major acts governing the financial industry, including most recently the Sarbanes-Oxley Act of 2002 and the Credit Rating Agency Reform Act of 2006 (PDF). As a means of regulating market behavior, the SEC polices and licenses stock exchanges, and is responsible for regulating credit ratings agencies, which also have taken criticism during the current crisis. The SEC has enforcement authority in that it can bring civil charges against individuals or companies thought to have violated securities law (violations include trading on insider information, committing accounting fraud, providing false information to the SEC, etc.). When criminal charges are involved, the commission recommends to the Justice Department whether to prosecute a case. The Justice Department has little direct oversight over financial market regulation, other than the ability to prosecute these cases sent to it by the SEC. In terms of direct jurisdiction, the Justice Department's main purview in terms of corporate governance is limited to anti-trust cases-it cannot independently pursue charges in cases involving securities market violations.

In some cases, state and local officials get involved in regulating markets and companies, independent of the SEC. For instance, in New York, which has extensive state law on securities regulation, the state attorney general has historically undertaken and prosecuted criminal legislation in fraud cases and other securities cases. New York State Attorney General Andrew Cuomo and former Attorney General Elliot Spitzer, for instance, pressed to prosecute several high-profile executive-pay cases.

Federal Deposit Insurance Corporation

Created in 1933 following a wave of bank closures, the Federal Deposit Insurance Corporation, or FDIC, was intended as a financial backstop to provide the broader U.S. population a guarantee that individual savings wouldn't evaporate when a bank did. The agency insures holdings in checking and savings accounts at member banks, currently guaranteeing up to $100,000 per person per bank, and up to $250,000 in retirement accounts.

The FDIC exerts regulatory authority in that, to qualify for FDIC insurance, member banks must meet certain requirements. Banks are categorized based on the extent of their reserves and liquidity. Typically, a U.S. bank holding less than 8 percent of the assets it is managing in reserves is considered "undercapitalized." A bank holding less than 6 percent becomes subject to FDIC regulation-the agency can oust the bank's management or call for other corrective measures.

Commodities Futures Trading Commission

The Commodities Futures Trading Commission, or CFTC, was founded as an independent agency in 1974 to provide a regulatory framework for the increasingly complex market in futures contracts (through which traders agree to buy or sell a good at a specific time in the future for a specific price). At the time of the commission's founding, the vast majority of futures trading involved commodities in the agricultural sector. Traders now speculate on the future prices of any number of financial entities-from currencies, to government securities like Treasury bonds, to the valuation of different stock indices-and the CFTC has come to regulate all futures contracts, not just those involving commodities.

Among other oversight roles, the CFTC regulates the derivatives clearinghouses that bring together buyers and sellers of futures contracts; approves and regulates the organizations responsible for actually executing futures trades; and monitors buyers and sellers in an attempt to ensure against fraud and other violations.

National Credit Union Administration

The National Credit Union Administration, or NCUA, in some ways functions both like the FDIC and the OCC, though it regulates credit unions rather than banks (credit unions are nonprofit savings and loan institutions that pool the money of members in order to provide credit and banking services to one another, theoretically at lower rates than for-profit banks). The NCUA is responsible for chartering and supervising U.S. credit unions. It also insures savings in all federal- and most state-chartered unions through a fund called the National Credit Union Share Insurance Fund.

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