The Regulatory Thicket

 

Who was minding the store during the period that led up to the breathtaking collapse of financial institutions and the freezing of financial markets?  The answer in the United States is a dizzying array of state and federal regulators each of whom had their one piece of the financial system to look after. This article provides an overview of this regulatory thicket. Knowing where we have been is important for figuring out how the government should regulate financial services in the 21st century and reduce the likelihood of future catastrophic failures.

 

An Overview of the Financial Services Industry

The financial services industry provides a variety of products and services that, broadly speaking, have to do with money. It provides critical services in connecting—that is, acting as an intermediary between—different members of the economy: between borrowers and lenders, between investors and capitalists, and between payers and payees. It can be divided into three main types of businesses: banks, securities firms, and insurance companies.   

Banks are generally in the business of lending money. A significant portion of banks are depository institutions. People and businesses deposit their money at an institution which provides them with check-writing services and some investment possibilities.  Knowing that not everyone will need their deposits at the same time, the institution then lends a multiple of its deposits.  The extent of that leverage is an important variable in bank stability.  Depository institutions include retail and commercial banks, savings and loans, and credit unions.  Retail banks focus on consumers and commercial banks on businesses, although many banks focus on both. Credit unions are owned in effect by the depositors. Savings and loans institutions lend primarily for home mortgages.  A related institution is a mortgage bank which lends money for mortgages based on funds received from Fannie Mae, Freddie Mac, and other providers of mortgage funds. Banks are also in the business of making and receiving payments.  People make deposits at banks in part so they can write checks and make electronic transfers and so they can put money they receive into their accounts.  A number of other businesses are involved in this as well, including those involved in credit, debit and prepaid cards.

Security firms facilitate the buying and selling of stocks and bonds directly or indirectly.  At the center of the stock market are exchanges, such as Nasdaq, which provide venues for offering and taking liquidity.  Dealers such as market markets and specialist companies provide liquidity—that is, they offer to buy or sell equities at particular prices and make their money from the spreads.  Brokers arrange trades for their clients that take that liquidity.  The investment banks are broker-dealers that earn trading profit by offering liquidity as well as commissions for placing orders. Hedge funds and investment funds typically rely on brokers to take liquidity from exchanges.  Similar types of firms buy and sell government and corporate bonds.  These bonds tend to be far more unique than equity—they vary in terms of maturity and risk—and are often exchanged bilaterally rather than on organized exchanges. 

People and businesses can pay insurance companies to take risk off their hands.  Life insurance companies do this by selling annuities, pensions, and life insurance products—all of which are based on bets on how long people will live.  Property and casualty companies insure all other kinds of risk ranging from automobile accidents to hurricanes to various financial products.  Insurance companies make money by pooling risks and charging a premium for doing so.  They also make money by investing these premiums.  Hence insurance companies are significant players on the buy-side of financial markets. Insurance companies try to reduce their risks by themselves buying insurance.  They do this by paying reinsurers to take on some of the risks they have acquired.  The insurance industry is an important player in financial services because they account for a large portion of the money invested in stocks and bonds, and because they insure the complex financial products that have been one of the major sources of the financial calamity.

These businesses are intertwined in a variety of ways.  Some of the large businesses play in all parts of the financial services industry. Citibank does retail and commercial banking, operates an investment bank, and until recently did insurance. AIG insured complex financial products including providing something known as a credit default swaps as well as investing massive amounts of insurance premiums in the financial markets.

Financial Services Regulation in the United States

 
I have not made an exhaustive effort to count all of the regulators in the United States. Roughly speaking, there are at least seven federal regulators and around 150 state regulators of the financial services industry.

Federal Regulation

There are five main regulators for banking, two for securities, and oddly none for insurance. For the banking sector these include:

• The Federal Reserve Board (FRB) which regulates banks that belong to the Federal Reserve System;
• The Office of the Comptroller of the Currency (OCC) of the U.S. Treasury which regulates all national banks;
• The Office of Thrift Supervision (OTS) which regulates savings and loans;
• The National Credit Union Administration (NCUA) which stays on top of credit unions;
• The Federal Deposit Insurance Corporation (FDIC) which regulates and examines banks that are eligible for federal deposit insurance.

In addition, the Securities and Exchange Commission regulates the securities markets and the Commodities Future Trading Commission deals with futures contracts such as commodities futures and stock options.

A large financial institution such as Citi which also has an investment bank would be subject to regulations by all of these with the exception of the OTS and NCUA. The list above isn’t necessarily exhaustive. For example, the Federal Trade Commission’s Bureau of Consumer Protection weighs in on a variety of banking and credit card disclosure issues.

State Regulation

Every state has regulators too.  They have bank regulators for state-chartered banks. They typically have an insurance commission that regulates the activities of all insurance companies in the states regardless of where the company is domiciled. And they usually have laws and often regulations that deal with securities. These may be administered by the State Attorney General or by a separate state agency.

These state agencies have associations that to some extent coordinate their activities. The National Association of Insurance Commissioners is the most important of these because it partly fills in the vacuum left by the lack of any federal authority.  Others include the Conference of State Bank Supervisors and the National Association of Credit Union Supervisors.

The Thicket

   
Thus a lot regulatory authorities oversee the financial services industry. From the standpoint of the regulated companies that means that at least the large ones must deal with multiple regulators. The insurance industry is the extreme. Large insurance companies typically deal with insurance regulators in all 50 states, each of which controls aspects of what the company can do in those states. Large national banks will typically not have to deal with state regulators but they will have to deal with the five major federal bank regulators and possibly the securities regulators as well.

From the standpoint of the regulators, that means that they typically only see a piece of the financial services industry.  No regulator sees more than the state operations of insurance companies.  Several of the national banking regulators only cover a portion of the banks or only a portion of their activities.  Then there are portions of the financial services industry that are largely not subjected to regulation.  That includes hedge funds and private equity firms.

The United States has a far more decentralized and uncoordinated regulatory process than any other country.  The Table shows the situation in several major countries. The United Kingdom, for example, has a single regulator called the Financial Services Authority that oversees banking, insurance, and securities.  The European Community overall, however, also has a decentralized and largely uncoordinated system.  The economy of the European Community is about the same size as the United States. It is partly integrated with many member states having adopted the euro and there ostensibly being free trade and free flow of labor. Each EC member state has one or more regulatory authorities for financial services.  There is no material coordination of these authorities across the EC.

Table: Financial Regulatory Authorities in Selected Countries

 

Country	Banking	Securities	FSA
United Kingdom	FSA	FSA, FRC (for accounting and auditing)	FSA
Japan	JFSA (+BOJ)	JFSA (+SESC)	JFSA
Germany	BaFin (+Buba+LZBs)	BaFin	BaFin
Italy	Banca d’Italia	CONSOB	ISVAP
Canada	OFSI+CDIC	Provisional Securities Commission	OSFI
France	Commission Bancaire (Banque de France)	AMF	CCA

Source: Adapted from Davies & Green, Global Financial Regulation: The Essential Guide, p. 156.

   
The complexity of financial services regulation presents a challenge. It is safe to say that the financial services industry in the United States has not suffered from a lack of regulatory oversight as measured by the sheer number of regulatory authorities and personnel overseeing it.  Whether we had the right regulations and whether the personnel at these agencies exercised their enforcement powers diligently is another matter.

We do not know for a fact that the complexity and lack of coordination among regulatory authorities was the source of the crisis or whether a more centralized approach in the United States would have averted or mitigated the disaster.  A data point, however, is that the United Kingdom’s single FSA seems to have fared no better.

The complexity of the system in the United States does make reform difficult though.  We will need to layer yet more regulatory structures on top of an already seemingly unwieldy system. Or, we will need to simplify and therefore ultimately disable many of the separate regulatory authorities.  Supplanting the state oversight of the insurance industry with a federal regulator is just one example of the restructuring that will need to be considered.