INTRODUCTION

There are multiple U.S. financial regulators with a wide range of regulatory objectives and approaches. Further, both the architecture and approach of the U.S. regulatory regime differ from those of other international regulatory regimes. This chapter provides an introduction to U.S. financial regulation and the approaches of the various U.S. regulators, and compares the U.S. approach to that of international financial regulatory regimes. This chapter also introduces the Dodd-Frank Act.

After you read this chapter you will be able to:

• Identify the U.S. financial regulators.
• Understand the approach of U.S. financial regulators.
• Compare the U.S. financial regulatory regime to international financial regulatory regimes.
• Identify international financial institutions.
• Understand the objectives of the Dodd-Frank Act.
• Describe each of the titles of the Dodd-Frank Act.

WHO ARE THE REGULATORS?

Table 7.1 details the various U.S. federal financial regulators and organizations. In a Congressional Research Service article authored by Edward Murphy, regulators are described as focused on either certain types of financial institution, a particular financial market or activity, or systemic risk.¹ The focus of each of the regulatory entities is as follows:

• Focus on certain types of financial institutions: The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the National Credit Union Administration (NCUA), and the Federal Reserve Board (FRB) regulate lending institutions. The regulation of lending institutions is coordinated by the Federal Financial Institutions Examinations Council (FFIEC). The OCC is the primary prudential regulator of national banks and thrifts. The FDIC provides deposit insurance and is the primary prudential regulator of certain state-chartered banks. The NCUA is the prudential regulator of credit unions. The FRB (also known, colloquially, as “the Fed”) is the primary prudential regulator of bank holding companies, certain U.S. branches of foreign banks, and certain state-chartered banks. The Federal Housing Finance Agency (FHFA) regulates government-sponsored enterprises (GSEs).
• Focus on a particular financial market or activity: The Securities and Exchange Commission (SEC) regulates corporations that sell securities to the public and securities markets while the Commodities Futures Trading Commission (CFTC) regulates derivatives markets. The President's Working Group on Financial Markets (PWG) (colloquially known as the “plunge protection team”) studies and provides recommendations related to financial markets. The Consumer Financial Protection Bureau (CFPB) regulates financial activity related to consumers.
• Focus on systemic risk: The Financial Stability Oversight Council (FSOC) monitors systemic risk and coordinates the systemic risk–related activities of financial regulatory authorities.

Due to the way that regulation is organized, a given organization will often find itself regulated by multiple regulatory agencies. For example, a bank is regulated as a financial institution, its activities in securities markets and derivatives markets are regulated, its activities related to consumers are regulated, and there is careful monitoring of the financial institution as a source of systemic risk. Further, in addition to the federal financial regulators there are state financial regulators, including state banking supervisors, state insurance supervisors, and state securities regulators.

U.S. REGULATORY APPROACHES

All regulatory agencies do not share the same approach toward regulation. The differences in the approaches across regulatory agencies are driven by their distinct goals. The Group of Thirty, a consultative group on international economic and monetary affairs, describes four policy goals of regulation:³

1. The safety and soundness of financial institutions
2. Mitigation of systemic risk
3. Fairness and efficiency of markets
4. The protection of customers and investors

Financial regulation can be broadly categorized as either prudential regulation that is focused on the health of financial institutions or conduct of business regulation that is focused on protecting users of financial services and increasing confidence in markets. The Group of Thirty describes four regulatory approaches through which regulation can be organized:⁴

1. Institutional approach: Financial institutions are regulated based on the type of institution that represents its legal status.
2. Functional approach: Financial institutions are regulated based on the type of activity they undertake.
3. Integrated approach: A single regulator oversees all financial institutions, markets, and activities.
4. Twin peaks approach: One regulator oversees prudential regulation while another regulator oversees business conduct.

The U.S. financial regulatory approach combines the institutional and functional approaches. The OCC, FDIC, NCUA, FRB, and the FHFA focus on certain types of financial institutions while the SEC, CFTC, and the CFPB focus on certain types activities. Clearly, the financial regulatory architecture in the United States is decentralized, with multiple regulators providing a variety of regulatory functions rather than a single regulatory agency. In an article authored for the Pew Economic Policy Department's Financial Reform Project, authors Adriane Fresh and Martin Neil Baily note some of the pros and cons of the decentralized U.S. approach.⁵ On the one hand, competition among multiple regulators encourages innovation and specialization. On the other hand, competition can lead a given regulator to be lenient so as to attract more customers (i.e., regulated financial institutions). This can lead to regulatory arbitrage whereby financial institutions shop for the most lenient regulator. As an example of regulatory arbitrage, Fresh and Baily provide the example of AIG's choice of a thrift institution through which to expand its credit default swap unit. This allowed AIG's credit default swap activity to fall under the regulation of the Office of Thrift Supervision (OTS), which was ill-suited to appropriately regulate the credit default swap activity.⁶

The approach of regulators and politicians toward regulation evolves over time, reflective of changing attitudes towards the role of regulation in financial markets. In our discussion in subsequent chapters, we will see how the evolution of changing attitudes greatly influenced—and continues to influence—financial regulation.

COMPARISON OF U.S. VERSUS INTERNATIONAL FINANCIAL REGULATORY REGIMES

We've seen that the U.S. financial regulatory approach combines the institutional and functional approaches and does not use the integrated or twin peaks approaches. The approaches used in other jurisdictions vary widely. Table 7.2 presents the approaches of a number of international jurisdictions.

The European Union has extensive supervisory authority as well. Three European Union Supervisory Authorities (ESAs) are as follows:

1. The European Banking Authority (EBA): A prudential regulator of the EU's banking sector.
2. The European Securities and Market Authority (ESMA): A conduct-of-business regulator of the EU's securities sector that works to protect investors and promote stable and orderly financial markets.
3. The European Insurance and Occupational Pensions Authority (EIOPA): A regulator of the EU's insurance and occupational pensions sector.

In addition, the European Systemic Risk Board (ESRB) provides macroprudential oversight of the EU's financial system and works to mitigate systemic risk.⁸ Further, the European System of Financial Supervision (ESFS) is a decentralized system consisting of European and national supervisors, including the three ESAs (the EBA, ESMA, and EIOPA), the ESRB, and national supervisors. The objectives of the ESFS are to develop a common supervisor culture and to facilitate a single European market.

There are also a wide range of international financial institutions, consisting of membership across jurisdictions. Table 7.3 presents a list of such organizations.⁹

INTRODUCTION TO THE DODD-FRANK ACT

On July 21, 2010, the Dodd-Frank Wall Street Reform and Consumer Protection Act, typically referred to as the “Dodd-Frank Act,” was signed into law. The Dodd-Frank Act is quite extensive and its impact on financial institutions and the financial system in the United States is enormous. The preamble of the Dodd-Frank Act encapsulates the objectives of the Dodd-Frank Act as follows:¹⁸

To promote the financial stability of the United States by improving accountability and transparency in the financial system, to end “too big to fail,” to protect the American taxpayer by ending bailouts, to protect consumers from abusive financial services practices, and for other purposes.

We see that the core objectives of the Dodd-Frank Act are fourfold:

1. To promote financial stability
2. To end “too big to fail”
3. To end bailouts
4. To protect consumers from abusive financial services practices

The Dodd-Frank Act is organized into 16 titles, listed in Table 7.4.

The following is a brief summary of each title of the Dodd-Frank Act.

• Title I: Financial Stability: Establishes the Financial Stability Oversight Council (FSOC) and the Office of Financial Research (OFR). Establishes regulation and supervision of systemically important non-bank financial institutions. We discuss the FSOC in Chapter 9 and the OFR in Chapter 15.
• Title II: Orderly Liquidation Authority: Establishes processes through which systemically important financial institutions in distress can be liquidated by the FDIC in an orderly fashion.
• Title III: Transfer of Powers to the Comptroller of the Currency, the Corporation, and the Board of Governors: Eliminates the Office of Thrift Supervision (OTS) and transfers its authorities to the Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), and the Federal Reserve Board (FRB). Establishes other changes to the FDIC.
• Title IV: Regulation of Advisers to Hedge Funds and Others: Establishes a registration requirement for private funds.
• Title V: Insurance: Creates the Federal Insurance Office, which monitors certain elements of the insurance industry and makes recommendations to the FSOC. Establishes other insurance industry reforms.
• Title VI: Improvements to Regulation of Bank and Savings Association Holding Companies and Depository Institutions: Reforms the regulation of Bank and Saving Association Holdings. Notably, includes the “Volcker Rule,” which prohibits banks from engaging in proprietary trading or owning or sponsoring a private fund. We discuss the Volcker Rule extensively in Chapter 10.
• Title VII: Wall Street Transparency and Accountability: Heavily regulates over-the-counter (OTC) derivatives markets. We discuss Title VII extensive in Chapter 12.
• Title VIII: Payment, Clearing and Settlement Supervision: Establishes regulation and supervision of systemically important financial market utilities that provide payment, clearing, and settlement services.
• Title IX: Investor Protections and Improvements to the Regulation of Securities: Establishes a wide range of investor protections and reform of securities regulation. Impacts broker-dealers, credit rating agencies, and those engaged in securitization and collateralization. Also reforms executive compensation and corporate governance.
• Title X: Bureau of Consumer Financial Protection: Establishes the Consumer Financial Protection Bureau (CFPB).
• Title XI: Federal Reserve System Provisions: Establishes limits and audits related to the FRB's ability to engage in emergency lending. We discuss the role of the FRB as a lender of last resort in Chapter 14.
• Title XII: Improving Access to Mainstream Financial Institutions: Encourages initiatives to provide access to financial products and services to underserved Americans who are “not fully incorporated into the financial mainstream.”
• Title XIII: Pay It Back Act: Sets limits to the Troubled Asset Relief Program (TARP) established under the Emergency Economic Stabilization Act of 2008 and other acts in response to the financial crisis.
• Title XIV: Mortgage Reform and Anti–Predatory Lending Act: Establishes reforms of the mortgage market.
• Title XV: Miscellaneous Provisions: Contains a variety of additional provisions. These include restrictions on the use of U.S. funds for foreign governments; provisions related to conflict minerals; reporting requirements for coals or other mine safety; payment disclosure requirements for resource extraction issuers; and certain studies.
• Title XVI: Section 1256 Contracts: Section 1256 contracts are marked to market for tax purposes. Title XVI establishes that certain swaps, such as an interest rate swap, currency swap, basis swap, interest rate cap, interest rate floor, commodity swap, equity swap, equity index swap, credit default swap, or similar agreements, are not deemed Section 1256 contracts.

In the subsequent chapters of this book we will delve deeply into various ways through which the Dodd-Frank Act works to reduce exposure to systemic risk. In Chapter 9 we will learn that the Dodd-Frank Act enables the designation of certain financial institutions as “systemically important.” In Chapter 10 we will learn about the Volcker Rule, which has greatly curtailed certain trading and investing activities of certain financial institutions. In Chapter 11 we will learn about counterparty credit risk and in Chapter 12 we will learn how the Dodd-Frank Act addresses the counterparty credit risk that financial institutions face due to their participation in over-the-counter derivatives markets.

The Dodd-Frank Act is obviously not the first U.S. financial legislation—indeed, there is an extensive history of U.S. financial legislation before the Dodd-Frank Act, key examples of which are provided in Table 7.5. In subsequent chapters, we will learn that many aspects of the Dodd-Frank Act alter or overturn previous legislation. Our emphasis on the Dodd-Frank Act is due to its recency; its focus on systemic risk; and its tremendous impact on financial institutions and the financial system. However, in the context of exploring the Dodd-Frank Act, we will also learn about earlier legislation and the evolution of financial regulation over time.

KEY POINTS

• There are multiple U.S. financial regulators and organizations. The Office of the Comptroller of the Currency (OCC) is the primary prudential regulator of national banks and thrifts. The Federal Deposit Insurance Corporation (FDIC) provides deposit insurance and is the primary prudential regulator of certain state-chartered banks. The National Credit Union Administration (NCUA) is the prudential regulator of credit unions. The Federal Reserve Board (FRB) is the primary prudential regulator of bank holding companies, certain U.S. branches of foreign banks, and certain state chartered banks. The regulation of lending institutions is coordinated by the Federal Financial Institutions Examinations Council (FFIEC).
• The Federal Housing Finance Agency (FHFA) regulates GSEs. The Securities and Exchange Commission (SEC) regulates corporations that sell securities to the public and securities markets while the Commodities Futures Trading Commission (CFTC) regulates derivatives markets. The President's Working Group on Financial Markets (PWG) studies and provides recommendations related to financial markets. The Consumer Financial Protection Bureau (CFPB) regulates financial activity related to consumers. The Financial Stability Oversight Council (FSOC) monitors systemic risk and coordinates the systemic risk–related activities of financial regulatory authorities.
• Four policy goals of regulation are the safety and soundness of financial institutions; mitigation of systemic risk; fairness and efficiency of markets; and the protection of customers and investors. Financial regulation can be broadly categorized as either prudential regulation that is focused on the health of financial institutions or conduct-of-business regulation that is focused on protecting users of financial services and increasing confidence in markets.
• Four regulatory approaches through which regulation can be organized include an institutional approach where financial institutions are regulated based on the type of institution that represents its legal status; a functional approach where financial institutions are regulated based on the type of activity they undertake; an integrated approach where a single regulator oversees all financial institutions, markets, and activities; and a twin peaks approach where one regulator oversees prudential regulation while another regulator oversees business conduct. The U.S. financial regulatory approach combines the institutional and functional approaches. Other jurisdictions use alternative approaches.
• Three European Union supervisory authorities are the European Banking Authority (EBA), the European Securities and Market Authority (ESMA), and the European Insurance and Occupational Pensions Authority (EIOPA). The European Systemic Risk Board (ESRB) oversees the EU's financial system and works to mitigate systemic risk. The European System of Financial Supervision (ESFS) is a decentralized system consisting of European and national supervisors.
• Notable international financial institutions include the Basel Committee on Banking Supervision; the Committee on the Global Financial System; the Committee on Payment and Settlement Systems; the Financial Action Task Force; the Financial Stability Board; the International Association of Deposit Insurers; the International Association of Insurance Supervisors; the International Organization of Securities Commissions; and the Joint Forum.
• The Dodd-Frank Act is recent U.S. legislation with extensive impact. Its objectives are to promote financial stability; to end “too big to fail”; to end bailouts; and to protect consumers from abusive financial services practices. The Dodd-Frank Act is organized into 16 titles, a number of which will be explored in detailed in subsequent chapters. While the Dodd-Frank Act is not the first U.S. financial legislation, it is of central importance due to its recency; its focus on systemic risk; and its tremendous impact on financial institutions and the financial system.