Financial Institutions: Necessary for Prosperity
Financial intermediaries serve a key role in the U.S. economy. They are a central reason why the U.S. economy is as productive as it is.
April 14, 2016 21 min read
Download Report Authors: Norbert Michel and David Burton Financial intermediaries serve a key role in the U.S. economy. They are a central reason why the U.S. economy is as productive as it is. The term financial intermediary includes depository institutions (such as banks and credit unions); insurance companies; investment banks; investment companies (such as mutual funds and exchange-traded funds); and venture capital funds. They pool individuals' funds and channel the money to others who need capital to operate. These intermediaries provide services to both groups. Banks, for instance, effectively allow depositors to loan funds to businesses without having to investigate or monitor those companies' operations and financial health. These businesses, in turn, avoid the trouble of having to find hundreds or thousands of people willing to make loans to them. In return for providing their financial intermediation services, banks earn a profit on the difference between the interest they receive from borrowers and the interest they pay to depositors or creditors. Investment banks serve a similar function by matching investors with companies seeking equity or debt capital. Broker-dealers enable investors who wish to sell a security to find a buyer in an instant. Investment companies take the savings of millions of investors and then invest those savings in the shares of tens of thousands of companies around the world. Venture capital funds take investors' capital and seek out new, dynamic companies to finance. Insurance companies invest premiums to settle future claims, and they sell products, such as variable life insurance and annuities, that have an investment component. The process of financial intermediation, whether carried out by banks, investment banks, or another intermediary, is a vital component of economic growth because it facilitates capital formation and the efficient allocation of scarce capital resources. Without financial intermediation, raising the capital necessary to launch or operate a business, or borrowing to buy or build a home, would be much more difficult and expensive. It would also be harder for capital to find its most productive use. In 2014, the finance and insurance industries generated a value of $1.3 trillion (7.2 percent of gross domestic product), and employed 7 million people. A poorly functioning financial-intermediation sector results in a society with fewer goods and services, fewer employment opportunities, and lower incomes. For at least a century, the U.S. regulatory framework has been increasingly hindering the financial-intermediation process. The current regulatory regime is counterproductive because it seeks to micromanage people's financial risk, a process that inevitably substitutes regulators' judgments for those of the investing public. Financial regulation should not protect people from business or financial risk that they knowingly choose to accept. Instead, financial regulations should focus on punishing and deterring fraud, and fostering the disclosure of information that is material to investment decisions. Overview of Capital Markets This Backgrounder focuses on capital market intermediation, particularly by commercial banks (depository institutions), investment banks, and broker-dealers. While commercial banks typically provide customers with loans, investment banks and broker-dealers intermediate mainly by enabling investors to develop diversified portfolios of businesses' debt and equity securities. Commercial Banks. Historically, the core function of commercial banks has been to accept customers' deposits and provide loans to individuals and businesses. Most people view their bank as a place to store their money, but that view is not completely accurate. While banks must return their customers' deposits on demand, banks do use those deposited funds to finance business investments and consumer purchases. For instance, an individual may open a checking account with $1,000, then regularly withdraw and add funds to the account. The bank is always obligated to make the account balance available to the customer. However, because the bank's customers, in the aggregate, always have some money on deposit, the bank can lend a portion of the money on deposit to borrowers. Banks also use these deposited funds to buy other financial instruments, such as municipal bonds, Treasury bills, and mortgage-backed securities (MBS). While different banks specialize in different types of loans, they generally all make personal, commercial, and industrial loans. Some businesses, for instance, can use commercial loans to finance their inventory and computer purchases, while other companies can use industrial loans to fund new buildings, storage facilities, or manufacturing plants. All banks face a common problem: Their demand deposit customers can ask for their money without any notice. In other words, banks have to make funds available to their deposit customers on demand, even when they have used those funds to make a loan to a borrower. For this reason, banks tend to prefer making short-term loans (no longer than five years). Investment Banks and Broker-Dealers. Investment banks connect investors with companies seeking new equity or debt capital. If the company sells securities to investors, it is called a primary offering. In addition to intermediating primary offerings, broker-dealers connect investors seeking to sell previously issued securities with investors seeking to buy securities, creating a robust secondary market in securities. These broker-dealer secondary-market services enable investors to receive a better price with lower transactions costs and to quickly sell their securities. Moreover, a robust secondary market makes it easier to sell new primary offerings to investors because they know they will be able to sell the purchased securities rapidly and at a reasonable price when they wish to do so. The Current Regulatory Framework For decades, regulators have increasingly taken on a more active role in managing financial firms' risk despite the fact that this approach has repeatedly failed. In the late 1980s, for instance, federal banking regulators introduced the complex Basel capital rules, a purported improvement over the previous capital requirements. While these rules were intended to improve the safety and soundness of the banking system, they clearly did not prevent the 2008 meltdown. In fact, the Basel rules contributed to the crisis because they assigned inappropriate risk weights to certain assets. Federal Deposit Insurance Corporation (FDIC) data even show that U.S. commercial banks exceeded their minimum capital requirements by two to three percentage points (on average) for six years leading up to the crisis. Historically, regulators have not managed nonbanking financial firms' risk-taking as extensively as they have banks' activities, but the approaches have been moving in the same direction for decades. For instance, sections 8(b) and 15(c)(3) of the 1934 Securities Exchange Act introduced a net capital rule for broker-dealers, a rule that dictated the type and amount of liquid assets that broker-dealers had to maintain. The rule has been amended several times, including a major adjustment in 1975 after a series of firm failures in the late 1960s and early 1970s, and again in 2004 just prior to the 2008 financial crisis. The 2004 rule change has been blamed for allowing broker-dealers to raise their leverage, but data shows that major investment banks were more highly levered in 1998 than in 2006. One problem with both sets of capital rules is that they were crafted on the assumption that regulators know exactly which level of capital these firms should use to fund their operations. At the very least, this approach—mandating legally required capital ratios—should not be viewed as superior to allowing market participants to determine which levels of capital are adequate. Empirical research does caution against relying on excessive government supervision and regulation even of bank activities, as doing so does not necessarily promote the development and stabilization of the financial system. Internationally, evidence indicates that, by cultivating large and liquid securities markets, laws that mandate disclosure and enhance enforcement through civil liability rules have a more positive impact than other forms of securities regulations. Some evidence suggests that this type of disclosure and private monitoring works best even in the banking sector. Regardless, there is no reason to think that regulators have superior knowledge compared to other market participants when it comes to measuring financial assets' risk. In fact, regulator-assigned risk weights under the Basel rules proved incorrect and contributed to the 2008 financial crisis. Summary of Bank Regulation. Banks' activities are highly regulated by both state and federal regulators, more so than most types of businesses. These regulatory functions can be broadly grouped as follows: (1) chartering and entry restrictions, (2) regulation and supervision, and (3) examination. Chartering and entry restrictions address issues such as the process that people must follow to start a new bank, as well as how existing banks can expand into new geographic markets through mergers and acquisitions. Supervision and examination authority are complementary, and they cover a much wider range of activities. Supervision involves both the initial publication of rules to implement statutory law, and less formal press releases and circulars known as 'guidance.' Additionally, regulators routinely examine banks' records to ensure that they are following the rules. Sometimes these examinations are informal regulatory sessions, but regulators still use the process to implement changes. Even an increase in capital can be implemented through threatened enforcement actions during informal examinations. Banks tend to comply with regulators' informal suggestions because failure to do so can bring additional regulatory scrutiny or formal enforcement actions. In most cases, banks are supervised and examined by more than one regulator. In general, federally chartered banks are subject to supervision by the Office of the Comptroller of the Currency (OCC). State-chartered banks that are members of the Federal Reserve System are subject to oversight by both the Federal Reserve Board and by state regulators. Non-Fed-member state-chartered banks that are insured by the FDIC are regulated by the FDIC and state regulators. Additionally, the Fed is the primary regulator of all bank holding companies, even though such holding companies are also subject to state regulations. Separately, a statutory formula dictates many specific responsibilities for the various federal banking regulators. For example, the Federal Deposit Insurance Act defines the 'appropriate Federal banking agency' for purposes of which agency regulates which bank, and determines which federal agency is responsible for approving mergers between particular banks. Depending on the banking activity, at least seven federal regulators—(1) the Federal Reserve; (2) the FDIC; (3) the Securities and Exchange Commission (SEC); (4) the Commodity Futures Trading Commission (CFTC); (5) the Consumer Financial Protection Bureau (CFPB); (6) the Federal Housing Finance Agency (FHFA); and (7) various agencies within the U.S. Treasury Department—could supervise, examine, or otherwise regulate a bank. These are, of course, in addition to state regulators. These regulations have imposed enormous costs on banks, and undoubtedly contributed to the decline in the overall number of banks and the increased concentration in the banking industry. In practice, both state and federally chartered banks are subject to state laws governing the basic transactions in which they engage with their customers. For instance, state laws, most notably the Uniform Commercial Code, govern practices such as the transactions in commercial paper and promissory notes, bank deposits, funds transfers, secured transactions, and contracts. Other state laws govern bank chartering, safety, and soundness; securities; insurance; real property; and mortgages. However, federal law governs federally chartered banks' rights and obligations as corporate entities. Moreover, the Truth in Lending Act (TILA) is supposed to provide uniform credit standards, and the Real Estate Settlement Procedures Act (RESPA) governs real estate settlement processes throughout the U.S. Banks are also subject to the Equal Credit Opportunity Act, the Community Reinvestment Act, and the Fair Credit Reporting Act, among many other statutes. Although this dual state–federal system has existed for more than a century, the bank regulatory framework is now more federalized than ever because the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires that any FDIC-insured state bank not engage in any activity impermissible for national banks—and nearly all state banks are FDIC insured. In general, bank regulations are justified on the grounds that they ensure the safety and soundness of the banking system and also promote equitable access to loans. Rather than providing a detailed description of major banking regulations, the goal of this Backgrounder is to provide an overview of the regulatory framework. The following list provides an overview of several key regulations: All bank holding companies with assets of more than $50 billion are subject to heightened supervision by the Fed. These special standards apply to banks' leverage, liquidity, and capital requirements, as well as overall risk-management and resolution processes. Federal law limits how much money a bank can lend to any one customer or to a group of related customers. All banks are subject to the Federal Reserve's deposit reserve requirements. The Dodd–Frank Wall Street Reform and Consumer Protection Act transferred the rulemaking authority for various consumer financial protection laws to the newly created Consumer Financial Protection Bureau (CFPB). Banks are subject to lending limits (and other restrictions) on loans they can provide to insiders (such as officers, directors, and shareholders), as well as to affiliate institutions. The OCC has promulgated rules that determine the minimum amount of capital required to form a bank. The Federal Reserve is the primary regulator of all bank holding companies and, as such, regulates the 'financial condition and operations, management, and intercompany relationships of the bank holding company and its subsidiaries, and related matters.' Federal banking agencies regulate banks' capital adequacy, and have discretion to define what constitutes adequate capital levels. Federal regulators examine banks' capital adequacy every 12 months (every 18 months for small institutions). The Fed's Regulation E covers rules for electronic funds transfers, and Regulation C covers home-mortgage disclosure rules. The Fed's Regulation Z (Truth in Lending) prescribes uniform rules for 'computing the cost of credit, for disclosing credit terms, and for resolving errors on certain types of credit accounts.' Regulation BB 'implements the Community Reinvestment Act and encourages banks to help meet the credit needs of their communities.' Banks and other financial institutions are required to comply with complex anti–money laundering laws and 'know your customer' requirements primarily administered by the Treasury Department's Financial Crimes Enforcement Network. Banks and other financial institutions are required to comply with a complex set of tax-information reporting requirements administered by the IRS. The Senate is considering a treaty that would impose a wide variety of new information-reporting requirements on financial institutions to help