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Home > Regulation Best Practice > US Financial Regulation: A Hopeless Tangle, or Complexity for a Purpose?

Regulation Best Practice

US Financial Regulation: A Hopeless Tangle, or Complexity for a Purpose?

by Lawrence J. White

Executive Summary

  • The US financial services sector is heavily regulated.

  • The regulatory structure is quite complicated, with a myriad of regulatory agencies and overlapping responsibilities.

  • This structure is daunting and confusing, and it has its costs and complications.

  • However, a great advantage to this complicated and duplicative system is that it gives someone with an innovative idea more than one place to turn; there is no monopoly regulator.

  • Although there are periodic calls for simplifying the system, a major cost from simplification would be this reduced choice, and consequent reduced innovation.

Introduction

The US system of financial regulation has received heightened scrutiny recently, because of the financial debacle of 2007–2009. No observer can come away from that scrutiny without being overwhelmed by the complexity of financial regulation in the United States. Many are convinced that this system’s complexity is somehow responsible, at least in part, for the debacle; and, in any event, they would argue that the system must be reformed and simplified.

Any enterprise that enters the US financial services industry must immediately confront this regulatory system and its complexity. The reasons for having financial regulation—and at least some of the reasons for the system’s complexity—are certainly worth understanding. That there are actually strengths and advantages to that complexity should be understood as well.

Finance Is Special

Finance is special, for at least four reasons.

  1. Finance is ubiquitous. Every individual, enterprise, organization, or government requires finance, even if it is self-finance, to smooth income and expenditure flows, and to provide the basis for investment. The payments system of a modern economy—cash, checks, credit and debit cards, electronic transfers—involves finance as well.

  2. Finance involves an unavoidable time sequencing that creates special problems: Finance always involves an initial conveyance of funds—a loan, an investment—and then a later reversal of the flow of funds—the loan repayment (plus interest), a stream of dividends, etc.1 Because of this time sequencing, the lender or investor has to be worried about the prospects of being repaid. But asymmetric information problems between the lender and the borrower (or between the investor and the enterprise) will adversely affect the lender’s (investor’s) ability to determine the prospects for repayment.

  3. Many individuals have difficulties understanding finance and its complexities.

  4. At least partly because of reasons 1, 2, and 3, the financial sector is heavily and extensively regulated;2 financial regulation, too, is ubiquitous.

Categories of Regulation

Despite its ubiquity, financial regulation is not an undifferentiated mass of governmental intervention in the provision of financial services. There are a few important categories that can help in the understanding of the whys and the wherefores of financial regulation.

  • Prudential regulation. This type of regulation is reserved primarily for depository institutions (i.e., commercial banks, savings institutions, and credit unions), insurance companies, and defined-benefit pension plans (i.e., those in which a company has promised a retiree a specified monthly or annual sum).3 The goal of prudential regulation of these institutions is to maintain their solvency, so that their claimants will remain whole4 and so that the institutions themselves can function as major providers of credit to the rest of the US economy. The important comparison between a healthy (solvent) bank and an insolvent bank, shown in Tables 1 and 2, illustrates the goal of prudential regulation: maintain banks in the condition shown in Table 1, and avoid having banks incur losses so as to arrive in the condition shown in Table 2.

Table 1. The balance sheet of a solvent (healthy) bank or thrift

Assets Liabilities
US$100 (loans, bonds, investments) US$92 (deposits)
US$8 (net worth, owners’ equity, capital)

Table 2. The balance sheet of an insolvent bank or thrift

Assets Liabilities
US$80 (loans, bonds, investments) US$92 (deposits)
−US$12 (net worth, owners’ equity, capital)

  • Consumer safety regulation. This encompasses prudential regulation (as consumers often have their savings in banks, etc.) but goes substantially beyond, and includes disclosure requirements, limits on what can and cannot be sold, and licensing requirements for who can do the selling. Such requirements can apply to financial advisors, brokers, dealers, and accountants, as well as to the banks and other financial institutions.

  • “Economic” regulation. This usually involves limits on prices and/or profits and/or entry or exit. Examples include usury limits (i.e., a maximum interest rate that can be charged on a loan), limitations on where a bank can establish locations, and restrictions on what kinds of products or services a bank (or other financial institution) can offer. The motives underlying “economic” regulation are usually complex, sometimes encompassing antitrust and consumer protection considerations, but sometimes also just reflecting the successful lobbying of incumbents who fear competition (but who usually “dress up” their arguments in the language of consumer protection).

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Further reading

Books:

  • Acharya, Viral V., and Matthew Richardson. Restoring Financial Stability: How to Repair a Failed System. Hoboken, NJ: Wiley, 2009.
  • White, Lawrence J. “The partial deregulation of banks and other depository institutions.” In Leonard W. Weiss, and Michael W. Klass (eds). Regulatory Reform: What Actually Happened. Boston, MA: Little, Brown, 1986: 169–204.
  • White, Lawrence J. The S&L Debacle: Public Policy Lessons for Bank and Thrift Regulation. New York: Oxford University Press, 1991.

Articles:

  • Gramm, Wendy L., and Gerald D. Gray. “Scams, scoundrels, and scapegoats: A taxonomy of CEA regulation over derivative instruments.” Journal of Derivatives 1 (Spring 1994): 6–24.
  • White, Lawrence J. “Bank regulation in the US: Understanding the lessons of the 1980s and 1990s.” Japan and the World Economy 14 (April 2002): 137–154.

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