Financial regulations are laws that govern banks, investment firms, and insurance companies. They protect youfrom financial risk and fraud. But they must be balanced with the need to allow capitalism to operate efficiently.
Learn about financial regulations, how they help and sometimes hamper economic growth, and the regulators that ensure these laws are enforced.
Key Takeaways
- Financial regulations protect consumers’ investments.
- Regulations prevent financial fraud and limit the risks financial institutions can take with their investors’ money.
- Financial regulators oversee three main financial sectors: banking, financial markets, and consumers.
Why Financial Regulations Are Important
Regulations protect consumers from financial fraud. These include unethical mortgages, credit cards, and other financial products.
Effective government oversight prevents companies from taking excessive risks. Some have concluded, for example, that tighter regulations would have stopped Lehman Brothers from engaging in risky behavior, a change that could have prevented or curbed the 2008 financial crisis.
Laws like the Sherman Anti-Trust Act prevent monopolies from taking over and busing their power. Unregulated monopolies have the freedom to gouge prices, sell faulty products, and stifle competition.
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Without regulation, a free market creates asset bubbles. That occurs when speculators bid up the prices of stocks, houses, and gold. When the bubbles burst, they create crises andrecessions.
Government protection can help some critical industries get started. Examples include the electricity and cable industries. Companies wouldn't invest in high infrastructure costs without governments to shield them.In other industries, regulations can protect small or new companies. Proper rules can foster innovation, competition, and increased consumer choice.
Regulations protect social concerns. Without them, businesses will ignore damage to the environment. They will also ignore unprofitable areas such as rural counties.
When Regulations Pose a Threat
Regulations are a problem when they inhibit thefree market. The market is the most efficient way to set prices. It improves corporate efficiency and lowers costs for consumers. In the 1970s, wage-price regulations distorted the market and were one significant factor behind stagflation.
Regulations can damp economic growth. Companies must use their capital to comply with federal rules instead of investing in plants, equipment, and people.
Businesses createprofitableproducts inunforeseen areas. Regulations aren't effective against new types of products likecredit default swaps, but regulators keep up with the dangers these innovative products often introduce.
Finally, some industry leaders become too cozy with their regulators. They influence them to create rules that benefit them and stifle competition.
Who Regulates the Financial Industry?
There are three types of financial regulators.
Banking
Bank regulators perform four functions that help to strengthen and maintain trust in the banking system—and trust is critical to a functioning system. First, they examine banks' safety and soundness. Second, they make sure the bank has adequate capital. Third, they insure deposits. Fourth, they evaluate any potential threats to the entire banking system.
TheFederal Deposit Insurance Corp. (FDIC) examines and supervises more than 5,000 banks, a significant portion of the banks in the U.S. When a bank fails, the FDIC brokers its sale to another bank and transfers depositors to the purchasing bank. The FDIC also insures savings, checking, and other deposit accounts.
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The Federal Reserve oversees bankholding companies, members of theFed Banking System, and foreign bank operations in the U.S.
TheDodd-Frank Wall Street Reform and Consumer Protection Actstrengthened theFed's power over financial firms.If any becometoo big to fail, they can be turned over to the Federal Reserve for supervision. The Fed is also responsible for the annualstress testof major banks.
The Office of the Comptroller of the Currency supervises all national banks and federal savings associations. It also oversees national branches of foreign banks. The National Credit Union Administration regulates credit unions.
Financial Markets
TheSecurities and Exchange Commission (SEC)is at the center of federal financial regulations.It maintains the standards that govern thestock markets, reviews corporate filing requirements, and oversees the Securities Investor Protection Corporation.
The SEC also regulates investment management companies, including mutualfunds. It reviews documents submitted under theSarbanes-Oxley Act of 2002. Most important, the SEC investigates and prosecutes violations of securities laws and regulations.
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Another regulating body, the Securities Investor Protection Corporation (SIPC) helps protect financial investments. The SIPC insures customers' investment accounts in case a brokerage company goes bankrupt.
The Commodity Futures Trading Commission regulates the commodities futures and swaps markets. Commodities include food, oil, and gold. The most common swaps are interest-rate swaps. The unregulated use of credit default swaps helped cause the 2008 financial crisis.
The Federal Housing Finance Agency was established by theHousing and Economic Recovery Act of 2008. It supervises the secondary mortgage market and oversees Fannie Mae, Freddie Mac, and theFederal Home Loan Bank System.
The Farm Credit Administration is the largest U.S. farm lender and oversees the Farm Credit System.
Consumers
The Consumer Financial Protection Bureau (CFPB) isunder theU.S. Treasury Department.It makes sure banks don't overcharge for creditcards, debit cards, and loans. It requires banks to explainrisky mortgages to borrowers. Banks must also verify that borrowers have an income.
List of Major Financial Regulations
In 1933, the Glass-Steagall Act regulated banks after the1929 stock market crash. In 1999, the Gramm-Leach-Bliley Act repealed it. The repeal allowed banks to invest in unregulated derivatives and hedge funds, making it possible for banks to use depositors' funds for their own gains.
In return, the banks promised to invest only in low-risksecurities. They said these woulddiversifytheir portfolios and reduce the risk for their customers. Instead, financial firms invested in riskyderivativesto increase profit and shareholder value.
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Many have argued that it was because of such deregulations that financial firms such as Bear Stearns, Citigroup, and American International Group Inc.required billions in bailout funds in 2008.
TheSarbanes-Oxley Act of 2002 was a regulatory reaction to the corporate scandals at Enron, WorldCom, and Arthur Anderson. Sarbanes-Oxley required top executives to personally certify corporate accounts. If fraud was uncovered, these executives could face criminal penalties. At the time, many were afraid this regulation would deter qualified managers from seeking top positions.
Dodd-Frank was put in place to prevent a repeat of the 2008 financial crisis.It creates an agency to review risks threatening the financial industry and gives the Federal Reserve the authority to regulate large banks before they become "too big to fail." It regulates hedge funds,derivatives,and mortgage brokers. The Volcker Rule bans banks from owning hedge funds or using investors' funds to trade derivatives for their own profit. Dodd-Frank also created the CFPB.
How Regulations Affect the Markets
One of the arguments against regulations is that they can have unintended consequences. For example, in October 2013, theFederal Reserverequired big banks to add more liquid assets. That forced them to buy U.S. Treasury bonds so they could quickly sell them if another financial crisis loomed.
As a result, banks increased their holdings of bonds. In 2014, the increase in demand pushed yields on long-term Treasuriesdown.Lower interest rates spurred lending but reduced demand for stocks. Bonds compete with the stock marketfor investors' dollars. Although their returns are lower, they offer more security.
Trump's Regulatory Rollbacks
In 2018, President Donald Trump signed the Economic Growth, Regulatory Relief, and Consumer Protection Act, which eased regulations on small banks.
The rollback meant the Fed can't designate these banks as too big to fail. They also aren't subject to the Fed's "stress tests." And they no longer have to comply with the Volcker Rule. Now banks with less than $10 billion in assets can, once again, use depositors' funds for risky investments.
What are some different types of financial regulations?
The Congressional Research Service found that financial regulations fall into several different categories: safety and soundness, transparency and disclosure, setting standards, competition, and price and rate regulations.
Where do the two major political parties stand on financial regulations?
As a matter of policy, Democrats generally advocate more regulations. Republicans typically promote deregulation.
Do states have their own financial regulations?
Yes, states have their own financial laws and regulators in place. For example, each state has an insurance commissioner who oversees the insurance industry in the state.
