How and Why the Fed
Regulates Financial Institutions
http://www.kc.frb.org/fed101/supervision/textbook.htm
The health of
the economy and the effectiveness of monetary policy depend on a sound
financial system. By supervising and regulating financial institutions, the
Federal Reserve is better able to make policy decisions. The Federal Reserve System supervises and
regulates a wide range of financial institutions and activities. The Fed works
in conjunction with other federal and state authorities to ensure that
financial institutions safely manage their operations and provide fair and
equitable services to consumers. Bank examiners also gather information on
trends in the financial industry, which helps the Federal Reserve System meet
its other responsibilities, including determining monetary policy.
How a Bank Earns Money
Just like any other business, a bank earns money so
that it can run its operations and provide services. First, customers deposit
their money in a bank account. The bank provides safe storage and pays interest
on customers’ deposits. The bank is required to keep a percentage of deposits
in reserve as cash in its vault or in an account at a Federal Reserve Bank and
can lend the rest to qualified borrowers. Instead of waiting to save the money
to pay for a new house, for example, which could take years, potential
borrowers take out a loan from a bank. They pay interest on the loan – a bank’s
primary source of income. Banks also make money from charging fees for other
financial services, such as debit cards, automated teller machine (ATM) usage
and overdrafts on checking accounts.
Safety and Soundness
/ Compliance
Two major
focuses of banking supervision and regulation are the safety and soundness of
financial institutions, and compliance with consumer protection laws. To
measure the safety and soundness of a bank, an examiner performs an on-site
examination -- reviews the bank's performance based on its management,
financial condition, and its compliance with regulations.
The examiner uses the CAMELS rating system to help
measure the safety and soundness of a bank. Each letter stands for one of the
six components of a bank’s condition: Capital adequacy, Asset
quality, Management, Earnings, Liquidity and Sensitivity
to market risk. When determining a bank's CAMELS rating, instead of reviewing
every detail, the examiner evaluates the overall financial health of the bank
and the ability of the bank to manage risk. A simple definition of risk is
the bank's ability to collect from borrowers and meet the claims of its
depositors. A bank that successfully manages risk has clear, concise
written policies. It also has internal controls, such as separation of duties.
For example, a bank’s management will assign one person to make loans and
another person to collect loan payments.
A safety and
soundness examiner also reviews a bank’s lending activity by rating the quality
of a sample of loans made by the bank. When a bank reviews a loan application,
it uses the "5-Cs" to assess the quality of the applicant:
|
Character |
Capacity |
Condition |
Collateral |
Capital |
|
Measures
the borrower’s willingness to pay, including the borrower’s payment history,
credit report and information from other lenders. |
Measures
the borrower’s ability to pay, including the borrower’s payment source, such
as a job or profits from a business, and amount of income relative to amount
of debt. |
This
refers to the borrower’s circumstances. For example, if a furniture
storeowner was asking for a loan, the banker would be interested in how many
chairs and sofas the store is expected to sell in the area over the next five
years. |
What
are the bank’s options if the loan is not paid? What asset is pledged as
collateral, what is its market value, and can it be sold easily? A valuable
asset might be a house or a car. |
The
applicant’s assets (house, car, savings) minus liabilities (home mortgage,
credit card balance) represent capital. If liabilities outweigh assets, the
borrower might have difficulty repaying a loan if his regular source of
income unexpectedly decreases. |
If you applied for a loan, how would you be sure that you met
the requirements of the "5-Cs"?
Every time a
bank makes a loan, the bank is at some risk that it will not get paid back. A
majority of most banks’ assets are in loans; therefore, a loss of loans could
hurt a bank’s financial condition. After an examiner assesses the quality of a
loan made by a bank, the loan is assigned one of the following ratings: Pass,
Substandard, Doubtful or Loss. Pass, the best rating, is a loan that favorably
meets the conditions set out in all of the 5-Cs. Loss, the worst rating, is a
loan that has significant concerns relating to the 5-Cs and has a history of
late payments. When a loan is classified Loss, the examiner does not expect the
bank to get paid back. When a problem is found within a particular area of a
bank, examiners offer recommendations for improvement; however, penalties can
be assessed for significant noncompliance.
Significant Legislation
Over the years,
legislation has changed what banks can or cannot do. For example, the
Gramm-Leach-Bliley Act of 1999 abolished the core provisions of the Banking Act
of 1933, also known as the Glass-Steagall Act, which restricted banks from
selling insurance and securities. As the impact of the law takes hold,
consumers will be able to purchase a variety of services, such as car insurance
or a checking account, and trade stocks, all at one place. The Federal Reserve
has been given responsibility for regulating these multiple-service providers. Legislation
also regulates both the international activities of
Consumer Protection
Remember that
customers deposit money in a bank, and then the bank makes loans with these
deposits to qualified borrowers. Whether a customer deposits money in a bank or
applies for a loan, there is a lot of information to consider. Let’s say you
deposit money into a savings account at a local bank. What minimum balance are
you required to keep? Also, are you charged a penalty if your account falls
below the minimum amount? When you apply for a loan for a used car, do you know
if the interest rate is allowed to vary, or is it fixed for the life of the
loan? If it is allowed to vary and interest rates go up, the total amount of
interest you owe will increase. Banks are required to provide customers clear
and accurate information about services, such as savings accounts, loans and
credit cards. For example, a bank’s brochure for a savings account should
include information on any minimum balance required, monthly service fee and
the average percentage yield. In addition, the Truth in Lending Act requires
banks to disclose the "finance charge" and the "annual percentage
rate" so that a consumer can compare the prices of credit from different
sources. It also limits liability on lost or stolen credit cards. These laws
ensure that consumers and banks make decisions based on the same information.
Community Reinvestment Act
At the time the
Community Reinvestment Act (CRA) was passed in 1977, the banking industry and
community groups were concerned about "redlining," or the refusal of
a bank to lend money to low-income communities, while, at the same time,
accepting deposits from those areas. CRA requires that financial institutions
help meet the credit needs of their entire communities, including low- and
moderate-income areas. Examiners review the bank’s lending in its community,
such as the number and amount of loans made to low-, middle- and upper-income
borrowers. CRA provides the bank flexibility in meeting requirements, such as
allowing a bank to define its community and how to determine the credit needs
of low- and middle-income neighborhoods. Rebuilding and revitalizing
communities through sound lending and good business judgment benefits both
communities and banks.
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How and Why the
Fed Regulates Financial Institutions
Read the article
about Federal Reserve regulation of banks and take notes below. In each section, take notes about how the
Fed’s regulation in that particular area relates to business owners. In other words, take the big picture given to
you by this article and focus it on what you are trying to learn – how do banks
interact with businesses?