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Goal of This Chapter: This chapter is devoted to a study of the complex regulatory
environment that governments around the world have created for banks and other
financial service firms in an effort to safeguard the public’s savings, bring stability to the
financial system, and prevent abuse of financial service customers.

Banking Regulations
Among the most important areas of banking subject to regulation are the adequacy of a
bank's capital, the quality of its loans and security investments, its liquidity position,
fund-raising options, services offered, and its ability to expand through branching and the
formation of holding companies. No new bank can enter the industry without government
approval (in the form of a charter to operate). The types of deposits and other financial
instruments sold to the public to raise funds must be sanctioned by each institutions
principal regulatory agency.

Reasons for the Regulation of Banks

• Protection of the Safety of the Public’s Savings
• Control of the Supply of Money and Credit
• Ensure Equal Opportunity and Fairness in Access to Credit
• Promote Public Confidence in the Financial System
• Avoid Concentration of Power
• Support of Government Activities
• Help for Special Segments of the Economy

Protection of the Safety of the Public’s Savings: Banks are among the leading
depositories of public’s (individuals and families) savings. Savings are placed in short-
term, highly liquid deposits as well as long-term savings in retirement accounts. The loss
of these funds due to bank failure or crime would be catastrophic to many individuals and
families. However, many savers lack the knowledge to correctly evaluate the riskiness of
a bank or financial service provider. Therefore, regulatory agencies are given the
responsibility to asses the true condition of banks and other financial firms to protect the
public against loss. Government agencies are ready to loan to financial firms in need so
that savings are protected.
Control of the Supply of Money and Credit: Banks are one of the players of money
supply process. They can increase or decrease money supply in the country by making
loans and investments. Money creation in turn affects economic conditions (jobs,
inflation etc.). A persistent increase in money supply causes inflation. This is another
reason banks are regulated to have control over the money supply.
Against this some argue that government policy makers can control a country’s money
supply, so there is no need to regulate an individual financial firm about its money
creation.
Ensure Equal Opportunity and Fairness in Access to Credit: Banks and their closest
competitors provide individuals and businesses with loans that support consumption and
investment spending. They are regulated because regulatory authorities want to see an
adequate supply of credit flowing from financial system and make sure that there is no
discrimination in access to credit due to age, sex, race, and national origin.
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Against this regulation some people suggest that discrimination could be eliminated by
promoting more competition rather regulation.
Support of Government Activities: Another reason for bank regulation is that government
can rely on banks in providing government with credit, tax revenues, and other services.
This reason for regulation has come under attack recently, however, because banks
probably would provide financial services to governments if it were profitable to do so,
even in the absence of regulation.

The Impact of Regulation

One argument (by George Stigler) is that firms in regulated industries actually seek out
regulation because it brings monopolistic rents (profits) due to entry block of other firms
to the industry. Another argument (by Samuel Peltman) is that regulation shelters a firm
in terms of lower risk of failure.
More recently, Edward Kane has argued that regulations can increase customer
confidence, which, in turn may create greater loyalty toward regulated firms. Kane also
believes that regulation gives incentive to less-regulated firms to win (take away) the
customers from the regulated firms. This is what is happening recently as less-regulated
firm like mutual funds have stolen away many of banking’s best customers.

Establishing the FDIC under Glass-Steagall Act

Between 1929 and 1933, more than 9,000 banks failed. The legislative response to the
this disappointing performance was to enact stricter rules and regulations in the Glass-
Steagall Act of 1933. One of the Glass-Steagall Act’s most important legacies was to
create the Federal Deposit Insurance Corporation (FDIC) to guarantee the public’s
deposits up to a stipulated maximum amount (initially $2,500, today up to $100,000 per
account holder for most kinds of deposits and upto $250,000 for qualified retirement
deposits).
The FDIC has helped to reduce the number of bank runs, though it has not prevented
bank failures. In fact, it may have contributed to individual bank risk taking and failure in
some instances. Each insured depository institution is required to pay the federal
insurance system an insurance premium based upon its volume of insurance-eligible
deposits and its risk exposure.

Raising the FDIC Insurance Limit

The FDIC pointed out that that the $100,00 limit of protection for depositors was set
nearly 3 decades in 1980 and also inflation raised the cost of living and reduced the
purchasing power. Thus, FDIC and several other groups recommended a significant
coverage hike.
Proponents who want insurance to increase argue that previous decades banks had lost
huge amounts of deposits to mutual funds and other financial institutions. Thus banks
needed a boost to make their deposits more attractive in the race of public savings.
Opponents of insurance increases argue that the original purpose of the insurance
program was to protect the smallest and most vulnerable depositors and $100,000 seems
to fulfill that purpose nicely even with inflation. Moreover, the more deposits that are
protected, the more likely it is that depository institutions will take advantage of higher
insurance limit and high risk loans.
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In response to this Federal Deposit Insurance Reform Act of 2006 raised federal
insurance limits from $100,000 to $250,000 for qualified retirement deposits.

Are Regulations Really Necessary in the Financial-Services Sector?

George Benston suggests that depository institutions should be regulated no differently
from any other corporation with no subsidies or other special privileges. Why? He gives
the historical reasons for regulating the financial sector which are: taxation of monopolies
in supplying money, prevention of centralized power, preservation of solvency to
mitigate the adverse impact of financial firm failures on the economy, and the pursuit of
social goals such as ensuring an adequate supply of viable housing loans for families and
preventing discrimination and unfair dealing. Others argue that these reasons are no
longer relevant today. Moreover, regulations are not free: they impose real costs in the
form of taxes on money users, production inefficiencies, and reduced competition.
In summary, the trend under way all over the globe in recent years has been toward
freeing financial-service firms from rigid boundaries of regulation. However, the failure
of financial institutions and markets during this most recent period in 2008 will be cause
for a thorough review of regulations and the continuation of the debate concerning the
benefits of free competition versus the need for regulation.

The Central Banking System

The Federal Reserve System (the Fed) is the central bank of the US.
What services does the Federal Reserve provide to depository institutions?
Many services needed by banks are provided by the Federal Reserve Banks. Among the
most important services provided by the Fed are checking clearing, the wiring of funds,
shipments of currency and coin, loans from the Reserve banks to qualified depository
institutions, and the supplying of information concerning economic and financial trends
and issues. The Fed began charging for its services in order to help recover the added
costs of deregulation which made more institutions eligible for Federal Reserve services
and also to encourage the private marketplace to develop and offer similar services (such
as check clearing and wire transfers).

What is a primary dealer and why are they important?

A primary dealer is a dealer in U.S. Treasury Bills and other securities that meets the
Federal Reserve System requirements for trading directly with the Fed’s trading desk
inside the New York Federal Reserve. It is through these trades with primary dealers that
the Federal Reserve carries out its monetary policy objectives and influences the
economy including the supply of money and credit and interest rates. Primary dealers
have an integral role to play in the economy of the U.S.

Monetary Policy: A central bank’s primary job is to conduct monetary policy. Monetary
policy consists of regulation and control over the growth of money and credit in an
attempt to pursue broad economic goals such as full employment, avoidance of inflation,
and sustainable economic growth. Its principal tools are (1) open market operations, (2)
changes in the discount (lending) rate, and (3) changes in reserve requirements behind
deposits.
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Open Market Operations (OMO)
Open market operations consist of the buying and selling of securities by the central bank
in an effort to influence and shape the course of interest rates and the growth of money
and credit. Open-market operations, therefore, affect bank deposits -- their volume and
growth -- as well as the volume of lending and the interest rates attached to bank
borrowings and loans as well as the value of bank stock.
When the central bank (Fed) makes open market purchase of securities, bank deposits
and loans (credit) increase. This in turn money supply increases and interest rates tend to
fall. When the central bank (Fed) makes open market sale of securities, bank deposits and
loans (credit) decrease. This in turn money supply decreases and interest rates tend to
rise.
OMO is the preferred tool, because it is also the Central Bank’s most flexible and popular
tool. It can be used every day and any mistakes can be quickly reversed.

Discount Loan
Banks take short-term loans from the central bank for their reserves shortage. The central
bank (Fed) facility or department at which discount loan made to banks for the short
period of time is known as discount window. The rate charged on such loans is called the
discount rate. If the Fed loans $200 million in reserves from the discount window, total
reserves will rise by the amount of the discount window loan, but then will fall when the
loan is repaid.
When discount rate increases, reserves decreases and with it loans and money supply
decrease and interest rates tend to rise. Opposite happens when discount rate decreases.

The Fed has created two new loan types, primary and secondary credit. Primary credit is
extended to sound borrowing institutions at a rate slightly higher than the federal funds
rate. Secondary credit is extended to institutions that do not qualify for primary credit for
temporary funding needs at a rate slightly above the prime rate. These changes were
implemented to encourage greater use of the discount window and to bring greater
stability the federal funds rate and to the money market as a whole.

Reserve Requirements
Reserve requirements are the amount of vault cash and deposits at the Federal Reserve
banks that depository institutions raising funds from sources of reservable liabilities (such
as checking accounts, business CDs, and borrowings of Eurodollars from abroad) must
hold.
Increasing reserve requirement means that depository institutions must keep more vault
cash and reserves with the Federal Reserve for each deposit account they hold. This
would have the effect of making less money available for loans; this means loans and
money supply decrease and interest rates tends to increase. Opposite happens when the
Fed decreases the reserve requirements.

Moral Suasion
Through this policy tool the central bank tries to bring psychological pressure to bear on
individuals and institutions to conform to its policies. Examples of moral suasion include
central bank officials testifying before legislative committees to explain what the bank is
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doing and what its objectives are, letters and phone calls sent to those institutions that
seem to be straying from central bank policies, and press release urging the public to
cooperate with central bank efforts to strengthen the economy.

The European Central Bank (ECB)

Like the Fed the ECB consists of a governing board and a policy making council and just
like the Fed’s board of governors works with the 12 regional Federal Reserve banks the
ECB has a cooperative arrangement with each EU member nation’s central bank. The
policy menu of the ECB however is a lot simpler than its counterpart at the Fed. The
central goal is price stability, which is largely achieved through open market operations
and reserve requirements.

Questions

1. The Trading Desk at the Federal Reserve Bank of New York elects to sell $100
million in U.S. government securities to its list of primary dealers. If other factors are
held constant, what is likely to happen to the supply of legal reserves available? To
deposits and loans? To interest rates?
If the trading desk sold $100 million in U.S. Government securities, the supply of total
legal reserves will decrease by $100 million, some of which will probably be taken from
required reserves behind any new deposits that are created. Deposits and loans will
decrease by a multiple of the new reserves and, initially at least, market interest rates
should rise.

2. Suppose the Federal Reserve's discount rate is 4 percent. This afternoon, the Federal
Reserve Board announces that it is approving the request of several of its Reserve
Banks to raise their discount rates to 4.5 percent. What is likely to happen to other
interest rates tomorrow morning? Carefully explain the reasoning behind your
answer.
Would the impact of the discount rate change described above be somewhat different
if the Fed simultaneously sold $100 million in securities through its Trading Desk at
the New York Fed?
Other interest rates will also rise following a discount rate increase. Of course, if loan
demand were decreasing, market rates could fall despite the upward shift in the discount
rate. If the discount rate were increased when loan demand was rising, market rates
would almost surely rise, ceteris paribus.
If the Fed sold $100 million in securities this would reinforce the discount-rate increase.
Other interest rates would almost certainly rise, other factors held constant. However, a
Fed purchase would encourage lower interest rates, offsetting the discount rate effect.

3. Suppose the Fed purchases $500 million in government securities from a primary
dealer. What will happen to the level of legal reserves in the banking system and by
how much will they change?
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If the Fed purchases $500 million in government securities total bank reserves will
increase by $500 million. If the $500 million represents excess reserves, deposits and
loans will expand by a multiplicative factor related to the reserve requirements of the
various deposits.

4. If the Fed loans depository institutions $200 million in reserves from the discount
windows of the Federal Reserve banks, by how much will legal reserves of the
banking system change? What happens when these loans are repaid by the borrowing
institutions?
If the Fed loans $200 million in reserves from the discount window, total reserves will
rise by the amount of the discount window loan, but then will fall when the loan is repaid.
Correspondingly, loans and deposits should rise by a multiple of the increase in reserves
depending on reserve requirements for deposits and whether the $200 million is excess
reserves or not.