Bank Regulation Explained: FDIC, Basel Accords, and the Financial Reform Act
Book: Financial Markets and Institutions, 11th Edition Author: Jeff Madura Publisher: Cengage Learning, 2015 ISBN: 978-1-133-94788-2
Chapter 18 is all about the rules banks have to follow. The short version: banks hold other people’s money, so governments regulate them to prevent disasters. The longer version involves a complex web of federal and state agencies, capital requirements, and lessons learned from every financial crisis.
The Dual Banking System
The U.S. has a uniquely complicated regulatory setup. Over 6,000 separately owned banks are watched by three federal agencies and 50 state agencies. Banks can get a state charter or a federal charter. National banks must join the Federal Reserve System. The Comptroller of the Currency regulates national banks. The FDIC regulates insured state-chartered banks. The Federal Reserve regulates state-chartered member banks and larger savings institutions.
About 35% of all banks are Fed members, but because they tend to be larger, their combined deposits account for about 70% of all bank deposits.
Deposit Insurance
Federal deposit insurance has been around since 1933 when the FDIC was created. The backstory matters. During 1930-1932, more than 5,000 banks failed. That is over 20% of all existing banks. Depositors panicked and rushed to pull money from banks that were still standing, which caused more failures. A classic death spiral.
The FDIC stops this by guaranteeing deposits. Currently, up to $250,000 per person per bank is insured. That limit was raised from $100,000 during the 2008 crisis as part of the Emergency Economic Stabilization Act. The idea is simple: if you know your money is safe, you will not rush to withdraw it.
Until 1991, all banks paid the same insurance premium regardless of how risky they were. This was a problem. Risky banks could attract depositors just as easily as safe ones because the deposits were insured either way. This is what economists call a moral hazard. Risky banks were essentially subsidized by safe banks. The FDICIA of 1991 fixed this by introducing risk-based premiums. Riskier banks now pay more.
The Deposit Insurance Fund (created by merging the Bank Insurance Fund and the Savings Association Insurance Fund in 2006) currently holds about $45 billion, roughly 1% of all insured deposits. The Dodd-Frank Act requires the fund to maintain at least 1.35% of total insured deposits.
Key Deregulation Milestones
Three big laws gradually opened up competition in banking.
The DIDMCA of 1980 removed interest rate ceilings on deposits and allowed banks to offer NOW accounts (checking accounts that pay interest). Before this, banks could not compete on deposit rates.
The Garn-St. Germain Act of 1982 let banks offer money market deposit accounts and allowed cross-border acquisitions of failing institutions. This was partly a response to savings institutions that were in serious trouble.
The Interstate Banking Act of 1994 removed interstate branching restrictions entirely. Banks could now grow by acquiring competitors in other states. This triggered the massive consolidation we see today.
Regulations on What Banks Can Do
Banks face limits on loans. No more than 15% of a bank’s capital can go to a single borrower (25% if the loan has solid collateral). Foreign loans get extra monitoring. The Community Reinvestment Act requires banks to serve qualified borrowers in their community, including lower-income neighborhoods.
Banks cannot use deposits to buy common stock. They can only buy investment-grade bonds. The Glass-Steagall Act of 1933 originally separated commercial banking from securities activities. That wall came down with the Gramm-Leach-Bliley Act of 1999, which let banks, securities firms, and insurance companies affiliate under one holding company. The result is the financial conglomerates we have today, like JPMorgan Chase, which offers everything from checking accounts to investment banking.
Off-balance-sheet activities like credit default swaps got extra scrutiny after the crisis. By 2008, credit default swaps represented over $30 trillion in coverage. The problem was that nobody really knew how exposed each bank was, or whether the counterparties could actually pay up if things went bad.
Capital Requirements: Basel I, II, and III
Capital requirements are the most important safety mechanism in banking. Capital (equity) acts as a cushion against losses. If a bank has enough capital, it can absorb bad loan losses without failing.
Basel I (1988) established the framework. Twelve major countries agreed to tie capital requirements to risk levels. Safe assets like cash get a zero weight. Risky assets get a 100% weight. Capital is measured as a percentage of risk-weighted assets. Riskier banks need more capital.
Basel II (2004) refined the approach. It improved how credit risk is measured and added explicit accounting for operational risk (losses from failed internal processes or systems). Banks could use their own models to estimate default probability.
Basel III came after the 2008 crisis exposed the weaknesses of Basel II. It raised Tier 1 capital (retained earnings plus common stock) to at least 6% of risk-weighted assets. It added a capital conservation buffer of 2.5%. It introduced liquidity requirements so banks have enough cash on hand during a crisis. And it pushed banks to use scenario analysis instead of relying on credit ratings from agencies that had been overly generous.
Banks commonly use Value-at-Risk (VaR) models to assess risk and determine capital levels. VaR estimates the maximum expected loss over a day with 99% confidence. During the credit crisis, VaR models failed spectacularly because they were built on historical data that did not include anything like 2008.
Regulators now also run stress tests. The 2009 tests asked: what happens to your capital if this recession lasts longer than expected? Banks with heavy real estate exposure looked the worst. These tests are now annual for banks with $50 billion or more in assets.
The TARP Bailout
During 2008-2010, the Troubled Asset Relief Program injected over $300 billion into banks and financial institutions. The Treasury bought preferred stock, purchased toxic assets, and even guaranteed against losses on certain assets. The government took a 36% ownership stake in Citigroup at one point.
By June 2010, more than half the TARP funds had been repaid, and the program had generated over $20 billion in revenue from dividends.
The bailout debate got heated. The Tea Party organized protests against excessive government spending. Occupy Wall Street protested too, though their message was less clear. Some wanted bailouts for ordinary people instead of banks. The sign that captured the mood: “Where’s my bailout?”
The Dodd-Frank Act (2010)
The Financial Reform Act responded to the crisis with several key provisions.
Banks must now verify income, job status, and credit history before approving mortgages. It sounds obvious, but many banks were not doing this during the boom.
Banks that sell mortgage-backed securities must retain 5% of the portfolio to keep skin in the game.
The Financial Stability Oversight Council was created to identify risks to the financial system and recommend higher capital requirements for “too big to fail” institutions.
The Consumer Financial Protection Bureau regulates consumer finance products like credit cards and online banking.
The Volcker Rule limits proprietary trading. Banks cannot invest more than 3% of their capital in hedge funds, private equity, or real estate funds. The argument is straightforward: if you want to gamble like a hedge fund, do not call yourself a bank and do not use depositor money.
Derivative securities must now trade through a clearinghouse or exchange rather than over the counter. This adds transparency and reduces counterparty risk.
How Regulators Monitor Banks: CAMELS
Regulators use the CAMELS rating system to grade banks on six characteristics:
- Capital adequacy
- Asset quality
- Management
- Earnings
- Liquidity
- Sensitivity to market conditions
Each gets a score from 1 (outstanding) to 5 (very poor). Banks with a composite rating of 4.0 or higher are considered problem banks and get extra scrutiny.
Asset quality gets assessed using the “5 Cs”: Capacity (ability to pay), Collateral, Condition, Capital, and Character (payment history). Regulators look at a sample of loans and make a judgment about the overall portfolio.
The system is not perfect. Financial ratios measure past and present performance, not the future. Problems can go undetected until it is too late. And the same system that catches some failing banks early might miss others entirely.
My Take
The history of bank regulation is basically a cycle. Banks push for fewer rules. Regulators loosen restrictions. Some banks take too much risk. Things blow up. New regulations get passed. Then the cycle starts again.
What stands out is the tension between safety and efficiency. More regulation means fewer failures but also less competition and higher costs. Less regulation means more innovation but also more risk. The Dodd-Frank Act is the latest attempt to find the sweet spot, but history says we will be back here again eventually.
The moral hazard problem is real and hard to fix. As long as banks believe the government will bail them out if things go wrong, they have an incentive to take more risk. Risk-based insurance premiums help, but they do not eliminate the problem entirely.