Chapter 02 – The Impact of Government Policy and Regulation on the Financial-Services Industry
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CHAPTER 2
THE IMPACT OF GOVERNMENT POLICY AND REGULATION ON THE
FINANCIAL-SERVICES INDUSTRY
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.
Key Topics Presented in This Chapter
• The Principal Reasons for Banking and Financial-Services Regulation
• Major Financial-Services Regulators and Laws
• The Riegle-Neal and Gramm-Leach-Bliley (GLB) Acts
• The Check 21, FACT, Patriot, Sarbanes-Oxley, Bankruptcy Abuse, Federal Deposit
Insurance Reform, and Financial-Services Regulatory Relief Acts
• Emergency Economic Stabilization Act and the Global Credit Crisis
• FINREG is passed into law to avoid severe disruption in the financial system and deal
with systemic risk
• Some Key Regulatory Issues Left Unresolved
• The Central Banking System
• Organization and Structure of the Federal Reserve System and Leading Central Banks of
Europe and Asia
• Financial-Services Industry Impact of Central Bank Policy Tools
Chapter Outline
I. Introduction: Nature and Importance of Bank Regulation
II. Banking Regulation
A. Pros and Cons of Strict Rules
1. To protect the safety of the public’s savings
2. To control the supply of money and credit
3. To ensure adequate supply of loans and to ensure fairness in the public’s
access to credit & other vital financial services
4. To provide support for government activities
5. To support sectors of the economy that have special credit needs
B. The Impact of Regulation—The Arguments for Strict Rules versus Lenient Rules
1. Maintain confidence in the financial system
2. Avoid monopoly powers
III. Major Banking Laws—Where and When the Rules Originated
A. Meet the “Parents”: The Legislation That Created Today’s Bank Regulators
1. National Currency and Bank Acts (1863-64)
2. The Federal Reserve Act (1913)
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3. The Banking Act of 1933 (Glass-Steagall)
4. Establishing the FDIC under Glass-Steagall Act
a. Criticisms of the FDIC and Responses via New Legislation: The
FDIC Improvement Act (1991)
b. Raising the FDIC Insurance Limit?
B. Instilling Social Graces and Morals-Social Responsibility Laws
C. Legislation Aimed at Allowing Interstate Banking: Where Can the “Kids” Play?
1. The Riegle-Neal Interstate Banking Law (1994)
2. Bank Expansion Abroad
D. The Gramm-Leach-Bliley Act (1999): What Are Acceptable Activities for
Playtime?
E. The USA Patriot and Bank Secrecy Acts: Fighting Terrorism and Money
Laundering
F. Telling the Truth and Not Stretching It—The Sarbanes-Oxley Accounting
Standards Act (2002)
IV. The 21st Century Ushers In an Array of New Laws and Regulations—FINREG, The
Basel Agreement, and Other Rules Around the Globe
A. The FACT Act
B. Check 21
C. New Bankruptcy Rules
D. Federal Deposit Insurance Reform
E. 2008 “Bailout Bill” and Strengthening Bank Capital
F. The 2009 CARD Act and Greater Disclosure of Information
G. Financial Reform With FINREG: The Swing Back from Deregulation to More
Regulation
H. New Regulatory Strategies in a New Century
1. Using Capital as a Regulator
2. Market Data as a Regulatory Warning Device
3. The Role Played by Public Disclosure in Regulating Financial-Service
Firms
4. Unresolved Regulatory Issues
V. The Regulation of Nonbank Financial-Service Firms Competing with Banks
A. Regulating the Thrift (Savings) Industry
1. Credit Unions
2. Savings and Loans and Savings Banks (“Thrifts”)
3. Money Market Funds
B. Regulating Other Nonbank Financial Firms
1. Life and Property/Casualty Insurance Companies
2. Finance Companies
3. Mutual Funds
4. Security Brokers and Dealers and Investment Banks
5. Hedge Funds, Private Equity Funds, and Venture Capital Companies
C. Are Regulations Really Necessary in the Financial-Services Sector?
VI. The Central Banking System: Its Impact on the Decisions and Policies of Financial
Institutions
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A. Organizational Structure of the Federal Reserve System
B. The Central Bank’s Principal Task: Making and Implementing Monetary Policy
1. The Open Market Policy Tool of Central Banking
2. Other Central Bank Policy Tools
3. A Final Note on Central Banking’s Impact on Financial Firms
VII. Summary of the Chapter
Concept Checks
2-1. What key areas or functions of a bank or other financial firm are regulated today?
Among the most important areas of banking subject to regulation are the adequacy of a bank’s
2-2. What are the reasons for regulating each of these key areas or functions?
These areas are regulated, first of all, to primarily protect the safety of the depositors’ funds so
that the public has some assurance that its savings and transactions balances are secure. Thus,
2-3. What is the principal role of the Comptroller of the Currency?
The Comptroller of the Currency charters and supervises the activities of national banks through
2-4. What is the principal job performed by the FDIC?
The Federal Deposit Insurance Corporation (FDIC) insures the deposits of bank customers, up to
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2-5. What key roles does the Federal Reserve System perform in the banking and financial
system?
The Federal Reserve System supervises and examines the activities of state-chartered banks that
2-6. What is the Glass-Steagall Act, and why was it important in banking history?
The Glass-Steagall Act, passed by the U.S. Congress in 1933, was one of the most
comprehensive pieces of banking legislation in American history. It created the Federal Deposit
Insurance Corporation to insure smaller-size bank deposits, imposed interest-rate ceilings on
2-7. Why did the federal insurance system run into serious problems in the 1980s and 1990s?
Can the current federal insurance system be improved? In what ways?
The FDIC, which insures U.S. bank deposits up to a certain level, was not designed to deal with
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2-8. How did the Equal Credit Opportunity Act and the Community Reinvestment Act address
discrimination?
2-9. How does the FDIC deal with most failures?
Most bank failures are handled by getting another bank to take over the deposits and clean assets
2-10. What changes have occurred in U.S. banks’ authority to cross state lines?
In 1994, the Riegle-Neal Interstate Banking and Efficiency Act was passed. This law is
complicated but allows bank holding companies with adequate capital to acquire banks or bank
2-11. How have bank failures influenced recent legislation?
Recent bank failures have caused huge losses to federal insurance reserves and damaged public
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The most important aspect of the law is to allow U.S. banks, insurance companies, and securities
2-13. What new regulatory issues remain to be resolved now that interstate banking is possible
and security and insurance services are allowed to commingle with banking?
There are several key issues that remain to be resolved. One issue is concerned with what we
should do about the governmental safety net. We need to balance risk taking by financial firms
2-14 Why must we be concerned about privacy in the sharing and use of a financial-service
customer’s information? Can the financial system operate efficiently if sharing nonpublic
information is forbidden? How far, in your opinion, should we go in regulating who gets access
to private information?
2-15. Why were the Sarbanes-Oxley, Bank Secrecy, and USA Patriot Acts enacted in the
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The Bank Secrecy Act (passed originally in 1970 to combat money laundering) requires any cash
transaction of $10,000 or more be reported to the government and was passed to prevent money
laundering by criminal organizations. The USA Patriot Act was enacted after the attacks of
2-16 Explain how the FACT, Check 21, 2005 Bankruptcy, Financial Services Regulatory
Relief, and Federal Deposit Insurance Reform Acts are likely to affect the revenues and costs of
financial firms and their services to customers.
FACT requires the Federal Trade Commission to make it easier for individuals victimized by
identity theft to file a theft report and requires credit bureaus to help victims resolve the
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The Federal Deposit Insurance Reform Act raised the deposit insurance limit for certain
retirement accounts and allowed regulators to periodically adjust deposit insurance limits for
2-17 In what ways is the regulation of nonbank financial institutions different from the
regulation of banks in the United States? How are they similar?
2-18 Which financial-service firms are regulated primarily at the federal level and which at the
state level? Can you see problems in this type of regulatory structure?
Federal Credit Unions: They are supervised and examined by the National Credit Union
Administration (NCUA).
Savings and Loans and Savings Banks (“Thrifts”): State-chartered associations are supervised
fund.
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Security Brokers and Dealers and Investment Banks: These are regulated at both federal and
state levels. The chief federal regulator is the SEC and requires the firms to submit periodic
2-19 Can you make a case for having only one regulatory agency for financial-service firms?
Yes, a case can easily be made for financial service firms. Problems in one area such as security
2-20 What is monetary policy?
Monetary policy consists of regulation and control over the growth of money and credit in an
2-21 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
2-22 How does the Fed affect the banking and financial system through open market
operations (OMO)? Why is OMO the preferred tool for many central banks around the globe?
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2-23 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
2-24 How can changes in the central bank loan (discount) rate and reserve requirements affect
the operations of depository institutions? What happens to the legal reserves of the banking
system when the Fed grants loans through the discount window? How about when these loans
are repaid? What are the effects of an increase in reserve requirements?
2-25 How did the Federal Reserve change the policy and practice of the discount window
recently? Why was this change made?
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In 2003, the Fed began setting the discount rate slightly above its target federal funds rate to
2-26 How do the structures of the European Central Bank (ECB), the Bank of Japan, and the
People’s Bank of China appear to be similar to the structure of the Federal Reserve System?
How are these powerful and influential central banks different from one another?
Like the Fed, the ECB consists of a governing council and a policy making council. The ECB
also has a cooperative arrangement with each EU member nation’s central bank like the Fed’s
2-27 How did the Federal Reserve and selected other central banks expands their policy tools
to deal with the great credit crisis of 2007–2009? Did their efforts work satisfactorily?
Besides the traditional policy tools of open market operations, discount rates, reserve
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Problems
2-1. For each of the actions described, explain which government agency or agencies a
financial manager must deal with and what laws are involved:
A. Chartering a new bank.
B. Establishing new bank branch offices.
C. Forming a bank holding company (BHC) or financial holding company (FHC).
2-2. See if you can develop a good case for and against the regulation of financial institutions
in the following areas:
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D. Restrictions on the geographic expansion of banks and other financial firms, such
as limits on branching and holding company acquisitions across state and
international borders.
E. Regulations on the failure process, defining when banks and other financial firms
confidence in the financial system.
C. Limits on underwriting securities reduce a bank’s revenue potential and will probably
result in losing some of the largest corporate customers to foreign banks who face more
lenient regulations.
On the hand, underwriting securities is inherently risky and limiting this may limit the
2-3. Consider the issue of whether or not the government should provide a system of deposit
insurance. Should it be wholly or partly subsidized by the taxpayers? What portion of the cost
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If taxpayers subsidize the cost of deposit insurance, depository institutions will be encouraged to
take on added risk. Ideally more risky banks should be compelled to pay more for deposit
insurance; some of this cost would probably be passed on to depositors who would begin to shift
2-4. 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
2-5. 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.
change?
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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.
2-7. If the Fed loans depository institutions $200 million in reserves from the discount
windows of the Federal Reserve banks, by how much will the legal reserves of the banking
system change? What happens when these loans are repaid by the borrowing institutions?
The Discount Window is the department in each Federal Reserve Bank that receives requests to
2-8. What happens when a central bank like the Federal Reserve expands its assets? Is there
any upper limit to a central bank’s assets? Why?
Central banks, just like the Federal Reserve, occasionally uses changes in reserve requirements
as a monetary policy tool. Institutions selling deposits must place a small percentage of each