B ANKING R EGULATION Its Purposes, Implementation, and Effects Fifth Edition Kenneth Spong Division of Supervision and Risk Management Federal Reserve Bank of Kansas City 2000 Title page.qxd 12/21/00 4:40 PM Page 1 First Edition, 1983 Second Edition, 1985 Third Edition, 1990 Fourth Edition, 1994 Fifth Edition, 2000 Copies of this book may be obtained from: Public Affairs Department Federal Reserve Bank of Kansas City Kansas City, Missouri64198-0001 This book can be obtained in electronic form from the Federal Reserve Bank of Kansas City 9s website, located at http://www.kc.frb.org , under Publica- tions or Supervision and Risk Management . This service contains a wide array of information and data from the bank 9s Economic Research, Commu- nity Affairs, Supervision and Risk Management, Financial Services, Public Affairs, and Consumer Affairs departments, and the Center for the Study of Rural America. Title page.qxd 12/21/00 4:40 PM Page 2 F OREWORD Throughout U.S.
history, banking regulation has been an important factor in establishing the role of banks within the finan- cial system. This will continue to be true with the pathbreaking banking legislation that was passed in 1999 and with the many rev- olutionary changes that are taking place in our financial system today. ... more. less.
Most notably, the 1999 legislation is opening the door for banking, securities, and insurance activities to be merged together.<br><br> At the same time, technological innovation, new financial theories and ideas, changes in the competitive environment, and expanding international relationships are all leading to a remarkable transfor- mation in how the financial system operates. Among the more sig- nificant and ongoing changes are interstate banking, banking over the Internet, a broad array of new financial services, and a rapid increase in our capacity to process and utilize financial information. As a regional institution and an integral part of the nation 9s cen- tral bank, the Federal Reserve Bank of Kansas City places much emphasis on its role in monitoring developments within banking and promoting a stable and competitive financial system.<br><br> The fifth edition of Banking Regulation: Its Purposes, Implementation, and Effects not only reflects these objectives, but reaffirms our inten- tions to bring about a greater understanding of the U.S. banking system and its supervisory framework. The four previous editions of this book have been widely used by bankers, the general public, colleges and universities, and bank- ing supervisors.<br><br> I trust this fifth edition will continue to be a use- ful source of information on our supervisory process and the challenges we all face in maintaining a sound and innovative finan- cial system. THOMAS M. HOENIG President November 2000 iii Foreword.qxd 12/21/00 4:41 PM Page iii A CKNOWLEDGEMENTS I greatly appreciate the support of the personnel in the Division of Supervision and Risk Management and the Public Affairs Department who provided comments or assisted in writing or producing this book.<br><br> This includes Marge Wagner, Alinda Mur- phy, Jill Conniff, and Jenifer McCormick, who helped draft Chap- ter 7; Jim Hunter, David Klose, Linda Schroeder, and Susan Zubradt, who provided many helpful comments; and Beth Welsh, who assisted in the production of this book. KENNETH SPONG Senior Economist v Acknowledgement.qxd 12/21/00 4:43 PM Page v C ONTENTS Foreword . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .iii Acknowledgements . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .v I NTRODUCTION .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .1 C HAPTER 1W HY R EGULATE B ANKS . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .5 Protection of depositors . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .6 Monetary and financial stability .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .7 Efficient and competitive financial system . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .9 Consumer protection .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .10 What bank regulation is not intended to accomplish . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .11 C HAPTER 2H ISTORYOF B ANKING R EGULATION .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .15 Early American banking . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .16 Development of dual banking and the national bank system .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .18 Development of the Federal Reserve System .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .20 Great Depression and 1930s reform . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .22 A rapidly evolving banking system . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .25 Summary . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .33 C HAPTER 3B ANKS , B ANK H OLDING C OMPANIES , AND F INANCIAL H OLDING C OMPANIES . . .<br><br> . .35 Banks . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .35 Bank holding companies .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .41 Financial holding companies . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .46 C HAPTER 4R EGULATORY A GENCIES . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .51 Comptroller of the Currency . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .51 Federal Reserve System . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .54 Federal Deposit Insurance Corporation . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .55 Federal Financial Institutions Examination Council . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .57 State banking agencies . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .58 Other regulatory agencies . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .59 vii Table of contents.qxd 12/21/00 4:41 PM Page vii C HAPTER 5R EGULATIONFOR D EPOSITOR P ROTECTION AND M ONETARY S TABILITY .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .63 Banking factors and regulations affecting depositor safety . . .<br><br> . . .<br><br> . . .<br><br> . .65 Supervisory compliance procedures . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .116 Summary . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .143 C HAPTER 6R EGULATION C ONSISTENTWITHAN E FFICIENTAND C OMPETITIVE F INANCIAL S YSTEM . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .145 Chartering regulations . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .146 Bank ownership regulations . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .151 Geographic scope of operations . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .161 Changes in the competitive marketplace .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .196 Summary . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .199 C HAPTER 7R EGULATIONFOR C ONSUMER P ROTECTION . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .201 Regulatory considerations .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .202 Disclosure laws .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .204 Civil rights laws . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .224 Other consumer credit laws . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .237 Interrelationship of consumer laws .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .250 Summary .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .252 C HAPTER 8F UTURE T RENDSIN B ANKING R EGULATION . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> .253 Factors influencing future regulation . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .254 Implications for regulatory change . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . .258 Summary . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .267 I NDEX .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .<br><br> . . .269 viii Table of contents.qxd 12/21/00 4:41 PM Page viii I NTRODUCTION Banking and the regulation of banks have both been key ele- ments in the development of the United States and its financial system.<br><br> Banks have attained a unique and central role in U.S. financial markets through their deposit-taking, lending, and other activities. Banks hold the vast majority of deposits that are trans- ferable by check.<br><br> These demand deposit powers have allowed bankers to become the principal agents or middlemen in many financial transactions and in the nation 9s payments system. As a result, most payments in this country involve a bank at some point, and this payments system plays a vital role in enabling goods and services to be exchanged throughout our economy. In terms of deposit activities, banks are also important because indi- viduals have traditionally placed a substantial amount of their funds in bank time and savings deposits.<br><br> On the lending side, banking organizations have significant flexibility in the types of borrowers they can accommodate. Banks are major lenders to the business sector and to individuals, and thus determine how a large portion of credit is to be allocated across the nation. Moreover, through a combination of lending and deposit activities, the banking system can affect the aggregate supply of money and credit, making banks a crucial link in the monetary mechanism and in the overall condition of the economy.<br><br> Other activities of banks are also of major consequence within the financial system and the overall economy. In particular, bank- ing organizations, through the use of bank holding companies, are expanding into many new markets and financial services. In addi- Chap1.qxd 12/21/00 4:53 PM Page 1 tion, banking legislation passed in 1999 allows banking organiza- tions to set up financial holding companies and thereby participate more fully in insurance, securities, and merchant banking activi- ties.<br><br> Consequently, banking organizations can now provide a wide range of services, including insurance and securities brokerage and underwriting, mutual funds, leasing, data processing of financial information, and operation of thrift associations, consumer finance companies, mortgage companies, and industrial banks. Given the overall importance of banks to the economy and the level of trust customers place in banks, few people would be sur- prised to find that governmental regulation and oversight extend to many aspects of banking. In fact, since banks first appeared in the United States, banking has been treated as an industry having strong public policy implications.<br><br> The general public, bankers, and regulators have all played roles in developing the present system of banking laws and supervision. As a consequence, the regulatory sys- tem has been responsive to many different needs and now serves an important function in establishing many of the guidelines and stan- dards under which banking services are provided to the public. There are many reasons to study banking regulation and super- vision, but two general objectives stand out.<br><br> One is practical: we all conduct transactions through the financial system and deal with banks on a frequent basis. Some knowledge of bank regulations is helpful in carrying out these transactions, understanding how the banking system works, and judging the extent of regulatory pro- tection being provided. Moreover, an understanding of banking regulation has assumed added importance with the growing com- plexity of the financial system and the recent passage of major banking legislation.<br><br> The other major reason for studying banking regulation is to ensure that this regulation both protects the public and fosters an efficient, competitive banking system. The actual benefits and costs of banking regulation, in fact, are a concern of many differ- ent groups. This attention originates from a number of factors, 2B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 2 including the overall importance of the banking industry to the economy and the financial problems encountered by some bank and thrift organizations in past years.<br><br> Another concern is whether credit and other banking services flow evenly to different segments of the population. In addition, some contend that banking regu- lation may impose excessive cost burdens that hinder banks in pro- viding services to their customers and in competing with other financial institutions. The benefits and costs of banking regulation are also drawing attention because of many recent industry changes, such as elec- tronic and internet banking, improved communications and data processing systems, and the development of new and more com- plex financial instruments and risk management practices.<br><br> These revolutionary, technological changes are bringing banking closer to its customers, altering the way financial transactions and banking operations are conducted, and expanding the variety of services banks can provide. All of these factors are prompting much debate over the appro- priate regulatory framework for banks and the types of financial services banks should be able to offer. This debate is also focusing attention on what the basic objectives of bank regulation should be and how existing and proposed regulations will affect our finan- cial system in the future.<br><br> The purpose of this book is to describe the current regulatory system and look at its influence on banks and their customers. The book further provides a perspective on how banking regulation developed and the specific reasons or purposes for regulating banks. In addition, it outlines many of the changes taking place in banking today and their implications for banking regulation.<br><br> Chapter 1 addresses the question of why banks are regulated in order to establish the basic purposes, rationale, and goals for bank- ing regulation, and to provide a framework for evaluating bank regulations. Chapter 2 traces the history and development of U.S. banking regulation.<br><br> Examined in this chapter are events that Introduction 3 Chap1.qxd 12/21/00 4:53 PM Page 3 helped create the present regulatory structure and the laws and reg- ulations that were implemented in response to these events. Chapter 3 looks at what banks, bank holding companies, and financial holding companies are, while Chapter 4 discusses who regulates banks and covers the structure, general powers, and func- tions of the bank supervisory authorities. Chapters 5, 6, and 7 examine many of the regulations that cur- rently apply to banks.<br><br> Each of these chapters is organized around one of the basic regulatory purposes presented in Chapter 1. The chapters discuss the major regulations serving each purpose, as well as how these regulations achieve their objectives and what consid- erations led to their implementation. Current issues and possible alternatives to these regulations are also explored.<br><br> While the organ- ization of these chapters provides a convenient means of present- ing the material, the chapters should not be viewed as strict divisions between the various banking regulations. Some regula- tions are discussed in more than one chapter either because they serve more than one purpose or because their purpose has changed over time. These chapters and their organization, consequently, should be viewed as a means of identifying each regulation 9s place in the overall regulatory framework.<br><br> Finally, Chapter 8 reviews ongoing trends and unresolved issues in banking and its regulation. It then discusses what these devel- opments might mean in the future for bank regulation and the supervisory process. Although the book covers major banking regulations and many of their provisions, it provides neither detailed analyses nor specific interpretations of individual regulations themselves.<br><br> In addition, since numerous changes are taking place in banking and its regu- lation, a number of regulations are likely to be revised in coming years. A note is made in the text covering revisions already known or proposed. Otherwise, regulations should be viewed as effective November 2000.<br><br> 4B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 4 Although banks are operated for profit and bankers are free to make many decisions in their daily operations, banking is com- monly treated as a matter of public interest. Banking laws and reg- ulations extend to many aspects of banking, including who can open banks, what products can be offered, and how banks can expand. Consequently, a familiarity with regulatory objectives and goals is essential for understanding how the U.S.<br><br> system of bank regulation and supervision arose and what the purpose of particu- lar regulations might be. 1 Much of the U.S. regulatory system has developed in response to financial crises and other historical and political events.<br><br> No cen- tral architect was assigned to design the overall system or lay out a single set of principles. Instead, many people with many view- points, objectives, and experiences have been responsible for the current supervisory framework. As a consequence, bank regulation has evolved to serve numerous goals 4 goals which have changed over time and on occasion even been in conflict with one another.<br><br> The following sections focus on several of the more commonly accepted goals of bank regulation. Also, because of the potential for conflict among regulatory goals, special attention is given to what banking regulation should not do. C HAPTER 1 Why Regulate Banks 1 Banking regulation in its strictest sense refers to the framework of laws and rules under which banks operate.<br><br> Narrowly defined, supervision refers to the banking agencies 9 monitor- ing of financial conditions at banks under their jurisdiction and to the ongoing enforcement of banking regulation and policies. Throughout this book, however, regulation and supervi- sion will be viewed in a more general sense and, in many cases, will be used interchangeably. Chap1.qxd 12/21/00 4:53 PM Page 5 P ROTECTIONOF D EPOSITORS The most basic reason for regulation of banking is depositor protection.<br><br> Pressure for such regulation arose as the public began making financial transactions through banks, and as businesses and individuals began holding a significant portion of their funds in banks. Banking poses a number of unique problems for customers and creditors. First, many bank customers use a bank primarily when writing and cashing checks and carrying out other financial trans- actions.<br><br> To do so, they must maintain a deposit account. As a con- sequence, bank customers assume the role of bank creditors and become linked with the fortunes of their bank. This contrasts with most other businesses, where customers simply pay for goods or services and never become creditors of the firm.<br><br> A second problem for bank depositors is that under the U.S. fractional reserve system of banking, deposits are only partially backed by the reserves banks hold in the form of cash and balances maintained with the Federal Reserve. As a result, depositor safety is linked to many other factors as well, including the capital in a bank and the condition and value of its loans, securities, and other assets.<br><br> A thorough investigation of these factors is likely to be too complex and costly for the vast majority of depositors, many of whom have accounts too small to justify the scrutiny that might be given to major investments. Even if depositors could accurately assess banks, this condition could change quickly whenever the economy changes or when banks take on new depositors or alter their asset holdings and commitments. In addition, an important part of the information needed to evaluate the condition of a bank may be confidential and unavailable to the public.<br><br> In summary, bank depositors may have more difficulty protect- ing their interests than customers of other types of businesses. While depositors could conceivably make general judgments about the condition of banks, the task would still be difficult, 6B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 6 costly, and occasionally prone to error. These facts, especially when combined with the history of depositor losses before federal deposit insurance, explain much of the public pressure for bank- ing regulation to protect depositors.<br><br> M ONETARYAND F INANCIAL S TABILITY Apart from just being concerned about individual depositors, banking regulation must also seek to provide a stable framework for making payments. With the vast volume of transactions con- ducted every day by individuals and businesses, a safe and accept- able means of payment is critical to the health of our economy. In fact, it is hard to envision how a complex economic system could function and avoid serious disruptions if the multitude of daily transactions could not be completed with a high degree of cer- tainty and safety.<br><br> Ideally, bank regulation should thus keep fluctu- ations in business activity and problems at individual banks from interrupting the flow of transactions across the economy and threatening public confidence in the banking system. Historically, monetary stability became a public policy concern because the most severe economic downturns in U.S history were typically accompanied and accentuated by banking panics. Before the creation of the Federal Reserve System in 1913 and the FDIC in 1933, these panics followed much the same pattern.<br><br> Individual banks and the banking system as a whole held only a limited vol- ume of internal reserves and liquid assets. Consequently, during serious banking and economic problems, these reserves could be quickly exhausted and the value of other bank assets could be put into question, thus giving depositors good reason to fear for the safety of their funds. Such disruptions in the banking system would further hinder financial transactions and the flow of credit, leading to continued slippages in the overall economy and in depositor confidence.<br><br> The Federal Reserve Act sought to prevent such situations by Why Regulate Banks 7 Chap1.qxd 12/21/00 4:53 PM Page 7 providing for a more elastic reserve base and by allowing banks to borrow funds from Reserve banks to meet depositor needs and credit demands. To provide further confidence to depositors, the U.S. Government instituted federal deposit insurance in the 1930s.<br><br> This insurance, by eliminating the link between the fate of small depositors and that of their banks, removed any reason for insured depositors to panic at the first sign of banking problems. Although deposit insurance has not been without cost or risk, it has provided stability in the payments system and given bank reg- ulators greater flexibility in resolving individual bank problems. Several other aspects of state and federal policy have also con- tributed to monetary stability in the United States.<br><br> The Federal Reserve has responsibility for controlling the overall volume of money circulating throughout the economy and thus for provid- ing a stable base for our payments system. Banks play an impor- tant role in this monetary system, since their deposit obligations make them the major issuers of money in the economy. This role is further acknowledged through specific laws and regulations determining which institutions can offer deposit accounts, the level of reserves that must be held against these accounts, and the various deposit reports that must be filed.<br><br> Another policy aspect of monetary stability is supervision and regulation of the banking system. To provide stability, banking reg- ulation should foster the development of strong banks with ade- quate liquidity and should discourage banking practices that might harm depositors and disrupt the payments system. In banking regulation, the objective of monetary stability has been closely linked with the goal of depositor protection.<br><br> Financial crises and unintended fluctuations in the money supply have been prevented primarily by promoting confidence in banks and guar- anteeing the safety of deposits. For that reason, regulations aimed at promoting depositor protection and a stable monetary transac- tions system are examined together in Chapter 5. 8B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 8 E FFICIENTAND C OMPETITIVE F INANCIAL S YSTEM Another aspect of a good banking system is that customers are provided quality services at competitive prices.<br><br> One of the pur- poses of bank regulation, therefore, is to create a regulatory frame- work that encourages efficiency and competition and ensures an adequate level of banking services throughout the economy. Efficiency and competition are closely linked together. In a competitive banking system, banks must operate efficiently and utilize their resources wisely if they are to keep their customers and remain in business.<br><br> Without such competition, individual banks might attempt to gain higher prices for their services by restricting output or colluding with other banks. Competition is also a driv- ing force in keeping banks innovative in their operations and in designing new services for customers. A further consideration is that for resources throughout the economy to flow to activities and places where they are of greatest value, competitive standards should not differ significantly across banking markets or between banking and other industries.<br><br> The promotion of an efficient and competitive banking system carries a number of implications for regulation. Competition and efficiency depend on the number of banks operating in a market, the freedom of other banks to enter and compete, and the ability of banks to achieve an appropriate size for serving their customers. For instance, too few banks in a market could encourage monopoliza- tion or collusion, while banks of a suboptimal size might be unable to serve major customers and might be operating inefficiently.<br><br> Consequently, regulators must be concerned with the concentra- tion of resources in the banking industry and with the opportuni- ties for entry and expansion across individual banking markets. Banking regulation must also take an approach that does not needlessly restrict activities of commercial banks, place them at a competitive disadvantage with less regulated firms, or hinder the Why Regulate Banks 9 Chap1.qxd 12/21/00 4:53 PM Page 9 ability of banks to serve their customers 9 financial needs. Finally, regulation should foster a banking system that can adapt and evolve in response to changing economic conditions and techno- logical advances.<br><br> C ONSUMER P ROTECTION Another goal of banking regulation is to protect consumer interests in various aspects of a banking relationship. The previous regulatory objectives serve to protect consumers in a number of ways, most notably through safeguarding their deposits and pro- moting competitive banking services. However, there are many other ways consumers are protected in their banking activities.<br><br> These additional forms of protection have been implemented through a series of legislative acts passed over the past few decades. Several basic purposes can be found in this legislation. The first is to require financial institutions to provide their customers with a meaningful disclosure of deposit and credit terms.<br><br> The main intent behind such disclosures is to give customers a basis for com- paring and making informed choices among different institutions and financial instruments. The disclosure acts also serve to protect borrowers from abusive practices and make them more aware of the costs and commitments in financial contracts. A second pur- pose of consumer protection legislation is to ensure equal treat- ment and equal access to credit among all financial customers.<br><br> The equal treatment acts can be viewed as the financial industry 9s coun- terpart to civil rights legislation aimed at ensuring equal treatment in such areas as housing, employment, and education. Other pur- poses associated with consumer protection include promoting financial privacy and preventing problems and abusive practices during credit transactions, debt collections, and reporting of per- sonal credit histories. Consumer protection objectives are generally consistent with good banking principles.<br><br> In fact, credit and deposit disclosures and 10B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 10 informed customers should be of most benefit to bankers offering competitive services. Likewise, equal and nondiscriminatory treat- ment of borrowers is necessary for any banker aiming to maximize profits. The growing complexity of financial instruments and the uniqueness of individual customers, though, have made consumer protection a very complicated and detailed regulatory process.<br><br> W HAT B ANK R EGULATION ISNOT I NTENDEDTO A CCOMPLISH Because bank regulation has been extended to cover a range of goals, there is always the possibility that it might be extended to areas that are not a proper concern for public policy. Thus, the lim- its of bank regulation can best be understood in terms of the things it should not try to do. Is it the purpose of banking regulation, for example, to keep banks from failing?<br><br> Provided insured depositors can be protected and adequate banking services can be maintained, preventing the failure of individual banks is not a primary focus of banking regu- lation. In cases where banks are failing, regulatory aid might serve only to protect those responsible for the bank 9s poor performance 4 its management and stockholders. Furthermore, in a dynamic banking system, regulation cannot prevent all banking failures, at least not at an acceptable cost.<br><br> Even if failures could be prevented, the result would be to sacrifice some of the main objectives of reg- ulation. For example, poorly managed banks and their stockhold- ers might have to be protected from competition and the discipline of the marketplace, thus giving them further incentives to take excessive risks and avoid corrective actions. Such protection might also leave the customers of these banks with overpriced, low-quality services.<br><br> Finally, to prevent failures, regulators might have to impose tight restrictions on the entire banking industry, thus keeping well-managed banks from fully meeting the needs of their customers. Why Regulate Banks 11 Chap1.qxd 12/21/00 4:53 PM Page 11 For the most part, the bank regulatory agencies have handled banking problems and failures with little disruption to depositors, other bank customers, and the local economy. Our deposit insur- ance system, for instance, has been able to protect most depositors at failed banks with such means as assumption of deposits by another bank or insured deposit payoffs or transfers.<br><br> Through these actions, failing banks and their management and stockhold- ers can be forced to bear the full consequences of their actions, and the deposits and many of the assets at these banks can be taken over by banks operated in a safer and more efficient manner. Should bank regulation try to substitute government decisions for a banker 9s decisions in operating a bank? When bank examin- ers identify problems at banks, they may offer advice on how the problems could be corrected.<br><br> The examiner is not in a position, however, to determine policy at a bank or to establish particular lending and investment practices. In fact, bank supervisors can often judge a banker 9s decisions only in retrospect. Credit deci- sions, for instance, might be based partly on characteristics of indi- vidual borrowers that only the lending officer understands.<br><br> Also, a bank supervisor or examiner who spends only a few days or weeks in a bank cannot gather all the information available to the banker or fully comprehend all the policy decisions made in the bank. In meeting their own objectives, bank examiners and regulators must therefore be careful not to hinder banks as they serve the needs of their customers and the overall economy. Should banking regulations and government policies favor cer- tain groups over others?<br><br> This kind of intervention in banking, except in cases of obvious distortions, is not desirable for several reasons. In a free society, market forces should be free to allocate credit and resources. Rules that interfere with the market are inconsistent with this principle and may have unforeseen side effects.<br><br> Any such intervention in banking is often likely to be futile, or nearly so, since borrowers and other customers can fre- 12B ANKING R EGULATION Chap1.qxd 12/21/00 4:53 PM Page 12 quently shift their business into cfavored d areas or switch to less regulated entities. Consequently, banking regulation must be evenhanded in its effects on various groups. Regulation should not give preferential treatment to financial institutions or to their customers, and it should not favor one size or type of financial institution over another.<br><br> For example, banks should not be protected from the competition of other institutions 4 nor other institutions from bank competition. In the interest of a competitive and efficient banking system, good bank regulation should have minimal effects on credit and resource allocation decisions and should not encour- age costly efforts at circumvention. Why Regulate Banks 13 Chap1.qxd 12/21/00 4:53 PM Page 13 C HAPTER 2 History of Banking Regulation The U.S.<br><br> banking system, as well as its regulation and regulatory objectives, has undergone many changes during the nation 9s history. The present regulatory system developed as the result of a series of experiments. When regulations were found inadequate, they were changed or discarded for a new regulatory structure.<br><br> Regulations that were judged successful became the more permanent elements in the system. Because the U.S. banking system continues to change rapidly with financial and technological innovation, our regulatory system is still evolving in many significant ways.<br><br> The evolutionary nature of U.S. banking regulation has prompted some to characterize the system as cpatchwork d or ccri- sis-built. d Perhaps if we were starting over to design a comprehen- sive and consistent regulatory structure, some of the features of our current system, such as federal and state bank chartering, the myr- iad of federal and state banking authorities, and the large number of small banks, might not be included. Nevertheless, the current system offers several advantages, such as widespread private own- ership of banks and a diversity of banking services, and it has worked to the general satisfaction of much of the public.<br><br> Because of its gradual development, U.S. banking regulation can best be understood by examining its evolution, its response to financial crises, and the specific reasons why many of its features were orig- inally adopted. Chap2.qxd 12/21/00 4:50 PM Page 15 E ARLY A MERICAN B ANKING Commercial banking in this country developed slowly in the period before the Revolutionary War.<br><br> British merchants wanted to control colonial finances, and the British Parliament cooperated by issuing the Currency Acts, which prohibited paper money of the colonies from being declared legal tender. In addition, banking experience in the colonies was limited, confined primarily to land banks and several early experiments with colonial money. After the war, some states began chartering commercial banks by special acts of their legislatures.<br><br> These banks typically took deposits and engaged in short-term lending. They also issued their own bank notes, which were partially backed by holdings of gold and silver coins. Bank notes were used in everyday business trans- actions and were often put into circulation in exchange for the promissory notes of bank borrowers.<br><br> As a result, the soundness of state bank notes depended largely on their gold and silver backing and on the liquidity and risk in a bank 9s loan portfolio. Most of the early state banks were able to maintain the value of their notes by limiting the amount in circulation and by being selective in their lending operations. In response to such policies, the states played a very limited supervisory role in the early 1800s.<br><br> The federal government first entered into bank regulation in 1791 when, at the urging of Alexander Hamilton, Congress created the Bank of the United States. This bank operated under regular commercial banking principles but also assumed some functions of a central bank. Eighty percent of its stock was privately owned, and most of its income came from commercial banking.<br><br> Under its cen- tral banking functions, the Bank of the United States acted as the principal depository and fiscal agent for the Treasury, as well as the country 9s main gold and silver depository. With a limit on circula- tion and with public confidence in a federal charter, the bank 9s notes usually held their value throughout the country. Since the bank ordinarily received a surplus of state bank notes over its own 16B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 16 notes, it was in a position to present the notes of other banks for redemption and thereby limit their circulation.<br><br> The Bank of the United States further acted as a central bank by making loans to state banks with temporary liquidity problems. Although the Bank of the United States fulfilled its role, con- gressional and state bank opposition kept it from being rechartered in 1811. However, banking problems led to a congressional char- tering of a second Bank of the United States in 1816.<br><br> This bank was organized much the same as the first, but, being much larger, it played an even greater central banking role. Because of political and state bank opposition, the second Bank of the United States met the same fate as its predecessor, and its charter was not renewed in 1836. The federal government thus removed itself from banking regulation and left the Treasury to attend to all fed- eral banking functions until the national banking system was started nearly three decades later.<br><br> With a rapid expansion of state banks after 1836 and an increase in bank note problems and bank failures, states gradually began to assume more regulatory responsibilities. Early state regu- lation had been limited largely to the chartering of banks through special legislative acts. Such acts opened chartering to political favoritism, however, and public opinion eventually led to passage of cfree banking d acts.<br><br> The first free banking acts were passed in Connecticut, Michigan, and New York in 1837 and 1838, and other states later passed similar acts. Essentially incorporation laws, they allowed anyone meeting certain standards and requirements to secure a bank charter. To protect bank customers, states also began supervising bank operations in a limited manner and designing note and deposit insurance systems.<br><br> Between 1836 and 1863, state bank supervision primarily consisted of obtaining and reviewing bank statements of condition. Banks were seldom examined unless they were near insolvency. Most states required that bank notes and deposits be partially backed by gold and silver holdings, but some were lax in History of Banking Regulation 17 Chap2.qxd 12/21/00 4:50 PM Page 17 enforcing these provisions.<br><br> Bank deposit and note insurance plans and security-backed note systems were tried in a number of states before the Civil War. These plans, along with tighter supervision of the participating banks, helped create a more stable banking sys- tem. However, in other states and in many of the frontier territo- ries, inadequate regulation of banks and over-issuance of notes led to a system where many bank notes circulated at a range of dis- counts and could not be readily redeemed for gold or silver specie.<br><br> Nevertheless, even with the costs of circulating and using such notes, banking in this period was important in financing early U.S. development. Moreover, most pre-Civil War bankers oper- ated responsibly, given the difficulties in constructing a new bank- ing system.<br><br> D EVELOPMENTOF D UAL B ANKING ANDTHE N ATIONAL B ANK S YSTEM As commercial trade became more important across the nation and bank note and currency problems continued, proposals for a uniform and stable national currency began to attract public inter- est. Several of the initial proposals for a national currency were strongly opposed by state bankers and others. However, in the early 1860s, political support mounted for a proposal that would provide for a national currency to be secured by U.S.<br><br> Government bonds. The currency would be issued through a new system of national banks. The main appeal of this proposal at the federal level was that it would provide a steady market for the large amount of government bonds sold to finance the Civil War.<br><br> The proposal became part of the National Currency Act of 1863, which was extensively rewritten and strengthened in the National Bank Act of 1864. The National Currency and National Bank Acts brought the federal government into the active supervision of commercial banks. Until then, the only banks chartered at the federal level had 18B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 18 been the first and second Banks of the United States.<br><br> The legisla- tion of the 1860s established the Office of the Comptroller of the Currency, which was given the responsibility for chartering, super- vising, and examining all national banks. Charters for national banks were to be available under the free banking system, provided minimum capital and other organizational requirements were sat- isfied. Every national bank could issue notes backed by U.S.<br><br> bonds deposited with the Comptroller. The National Bank Act also required national banks to hold reserves against their notes and deposits. The reserves could be in the form of vault cash or deposits at national banks in one of 17 central reserve cities.<br><br> Because of tighter supervision and more restrictive lending and investment powers under the National Bank Act, few banks ini- tially switched to national charters. To give banks more incentive to join the national bank system and to foster the development of a national currency, Congress imposed a prohibitive 10 percent tax on state bank notes in 1865. Most state banks soon took out national charters to avoid the earnings disadvantage of state notes.<br><br> The tax on state bank notes thus gave impetus to the national banking system, which was expected to soon supplant the state banking system. Two developments in the 1870s and 1880s, however, led to a resurgence in state bank chartering and firmly established state banks as an alternative to national banks. One was the growing use of checks.<br><br> Checkable deposits increased rapidly in this period rel- ative to bank notes as checks became more widely accepted and proved to be more convenient and safer to use in many transac- tions. This decline in the importance of bank notes served to elim- inate much of the earnings advantage national banks held over state banks. The other development was a decline in the profits national banks could make on notes.<br><br> Note profitability fell in the 1880s as a result of declining yields on bonds eligible for note backing. Because of these factors, the amount of national bank History of Banking Regulation 19 Chap2.qxd 12/21/00 4:50 PM Page 19 notes in circulation fell by half in the 1880s and became a much less significant factor in banking. D EVELOPMENTOF THE F EDERAL R ESERVE S YSTEM Both state and federal regulation increased between 1864 and the early 1900s, but financial panics and bank runs continued to occur.<br><br> The National Bank Act, through its provisions for secured notes, had established the country 9s first uniform currency that circulated nationwide at par. However, as demand deposits became more important, the banking system struggled at times to provide a means for orderly conversions between such deposits and currency. Significant changes in the public 9s deposit holdings 4 whether in response to changes in trade patterns, financial crises, or other factors 4 posed a problem for banks.<br><br> Demand deposits were sup- ported only fractionally by cash reserves, and no outside source of liquid reserves existed for the banking system as a whole. Conse- quently, any excess cash reserves in the banking system were quickly exhausted whenever much of the public sought to convert deposits into currency. Once cash reserves were exhausted, indi- vidual banks had no choice but to try liquidating their loan and investment portfolios in order to obtain the rest of the needed cur- rency.<br><br> Since deposits came to greatly exceed currency in circula- tion, no more than a fraction of the banks in a general panic could obtain enough currency by selling assets. These disruptions in the monetary system and in lending activities, when severe enough, would adversely affect commercial activity. Moreover, such down- turns were likely to continue until the public gained enough con- fidence to return funds to the banking system and banks were again willing to expand their lending.<br><br> Several proposals were advanced during the early 1900s to cor- rect for this cinelastic currency d and the lack of an outside source of reserves for the banking system. After much dispute over the 20B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 20 extent of private versus government control over a bank reserve system, congressional agreement was reached in 1913 with the Federal Reserve Act. This act established the Federal Reserve System, to be headed by a board of seven members.<br><br> To ease the concerns of bankers, busi- nessmen, and others who feared centralized control over the coun- try 9s banking and monetary system, Congress arranged for a Federal Reserve bank to be established in each of 12 districts. Membership in the Federal Reserve System was required for national banks and optional for state banks. Commercial banks that joined the system were required to buy stock in a district bank and could participate in the election of six of the nine reserve bank directors.<br><br> To correct for the inelasticity of currency, the Federal Reserve was given the power to rediscount the eligible paper of member banks. In this manner, a member bank could discount or borrow against its eligible assets and thereby obtain funds to meet a tem- porary cash drain or a rapid increase in credit demand. The admin- istration of the discounting function initially was left to the district banks, with limited supervision by the Federal Reserve Board.<br><br> The Federal Reserve was also given authority to hold the reserves of its member banks and to make open market purchases and sales of government securities. Because of its location near the major bond markets, the Federal Reserve Bank of New York eventually assumed open market operations for the system. In addition, the act gave both the Comptroller of the Currency and the Federal Reserve System authority to supervise and exam- ine member banks.<br><br> This sharing of power caused some confusion, which was resolved in 1917. Since then, the Comptroller has examined and supervised national banks and provided their exam- ination reports to the Federal Reserve, while the Federal Reserve has supervised state member banks. History of Banking Regulation 21 Chap2.qxd 12/21/00 4:50 PM Page 21 G REAT D EPRESSIONAND 1930 S R EFORM After the Federal Reserve System was founded, the nation soon witnessed the deterioration of the international financial system during World War I, followed by postwar inflation, and then a short but severe contraction in the early 1920s.<br><br> However, condi- tions stabilized after that and a long period of prosperity began, bringing with it rising public optimism. Although no major shifts in bank regulation took place during this time, several notable changes occurred in banking services and the number of banks in operation. High business profits after 1921 spurred many banks to increase their commercial lending and securities activities.<br><br> Several major banks, for instance, began expanding their trust operations and promoting affiliates engaged in the underwriting and distribution of securities. In addition, rapid urbanization during the decade prompted many larger banks to begin establishing branch networks wherever allowed by law. While the 1920s were a time of expansion for large banks, many failures and mergers of small banks took place in the rural areas that were forgotten in the prosperity of the 1920s.<br><br> As a result, the number of banks in the United States began to fall from a peak of about 30,000 in 1921. The Great Depression of the 1930s saw the most drastic finan- cial decline in U.S. history.<br><br> Commercial banking was probably affected as much or more than any other business. Bank failures accelerated after the stock market crash of 1929, as the public lost confidence in banks, and continued in waves until 1933. The banking collapse became so widespread that in 1933 President Roosevelt ordered all banks closed, a bank holiday that lasted from March 6 to March 13.<br><br> Banks opened again only after state and federal regulators had examined their condition and issued a license to reopen. Many banks never reopened. By the end of that year, over 4,000 banks suspended operations or were absorbed by 22B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 22 other banks.<br><br> This left fewer than 14,500 banks still in operation, less than half as many as in 1921. After this experience, many regulators and legislators believed the existing regulatory system was still flawed and unable to deal with the basic banking troubles that appeared in the 1930s. Bank- ing, once again, was vulnerable to shifts in public confidence, and instead of withstanding the financial collapse of the 1930s, the banking system was at the forefront of the crisis.<br><br> Many reform measures were proposed during this time. Several of them were first introduced in the Banking Act of 1933 and then imple- mented more fully through the Banking Act of 1935. The most significant change in the banking system incorpo- rated in these acts was the federal insurance of deposits.<br><br> The Fed- eral Deposit Insurance Corporation (FDIC) was organized to carry out this provision, which initially provided insurance cover- age of up to $2,500 per depositor. As a result, insurance has been required of all Federal Reserve member banks since 1934 and extended to nonmember banks at their option and on approval of the FDIC. The insurance system has been funded by premiums paid by the insured banks.<br><br> The FDIC has come to mean several things for bank regulation. Most importantly, once the insurance system was established and began to prove itself, bank panics and the loss of public confidence became much less of a threat to the banking system. With insur- ance, all but the largest depositors were assured that they would not suffer a deposit loss even if their bank failed.<br><br> In addition, since nearly all nonmember banks eventually took out FDIC insurance, federal supervision and examination was extended to almost the entire banking system. The FDIC was empowered to examine all insured banks. However, to prevent regulatory duplication, its supervision has been confined largely to insured state nonmember banks.<br><br> Finally, with deposit insurance came a greater regulatory emphasis on reorganizing or merging a failing bank to maintain banking service and reduce financial disruption in its community. History of Banking Regulation 23 Chap2.qxd 12/21/00 4:50 PM Page 23 Other banking changes were also incorporated into the Bank- ing Acts of 1933 and 1935. First, insured banks were prohibited from paying interest on demand deposits, and provisions were made for the Federal Reserve Board and the FDIC to limit the interest rates banks could pay on time deposits.<br><br> Interest ceilings were advocated under a disputed notion that paying higher deposit rates forced banks to try boosting revenue through riskier investment and lending policies. Second, in response to the stock market crash, investment banks were prohibited from affiliating with commercial banks, and bankers were restricted to a limited range of investment banking activities. Third, after the failure of many small unit banks, the federal banking agencies were required to consider certain factors before allowing a bank to commence operations with deposit insurance.<br><br> Among these factors were capital adequacy, earnings prospects, managerial character, and community need. As a result, the Bank- ing Acts and the economic environment of the 1930s represented the final step in the decline of free banking and the beginning of more restrictive bank chartering. Fourth, the Federal Reserve Board was given authority to change reserve requirements for member banks within certain percentages.<br><br> Finally, to encourage larger and more geographically diversified banks, Congress voted to allow national banks to form branch offices to the same extent as state banks. These provisions and the advent of the FDIC not only changed commercial banking, but also altered the structure and division of power among the regulatory authorities. As many state banks took out federal deposit insurance, state banking agencies lost their posi- tion as sole regulators of state nonmember banks.<br><br> However, in 1939, nonmember banks and the state agencies succeeded in getting a pro- vision in the 1935 act removed, which would have required insured nonmember banks to join the Federal Reserve System. Also, the structure of the Federal Reserve System was changed in the Banking Acts. The acts centralized more power in the Federal Reserve Board, 24B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 24 increased its administrative responsibility in Reserve Bank supervi- sory duties, and established the Federal Open Market Committee to direct open market operations for the system.<br><br> A R APIDLY E VOLVING B ANKING S YSTEM After the banking collapse of the 1930s, federal deposit insur- ance and the conservative attitudes of bankers who had survived the Great Depression helped to restore the banking system and lessen fears of future banking crises and depositor panics. This environment brought about a lengthy period of recovery. The next stage in U.S.<br><br> banking history was initiated in the second half of the twentieth century, when the banking system found itself on the verge of many dramatic and innovative changes. Pathbreaking technological advances in communications and data processing were beginning to pave the way for a vast array of new financial services and instruments. In addition, these advances were breaking down many of the traditional barriers that had effectively limited competition between banks and other parts of the financial system.<br><br> Another result was to make multi-office banking much more feasible and desirable, thus helping to foster rapid banking consolidation and allow banking organizations to expand into new markets 4 either on an intrastate, interstate, or international basis. These recent advances have also enabled bankers to maintain better and more timely information on their operations and risk exposures, while creating a wider set of tools and instruments to address banking risks. Overall, these changes have brought about the most innovative and revolutionary period in U.S.<br><br> banking history. At the same time, they have led to many corresponding changes in banking regula- tion. Although the basic structure of the regulatory agencies has largely remained intact, a number of bank regulatory constraints have undergone significant change.<br><br> As shown by the following events and regulatory changes, much of this period can be charac- History of Banking Regulation 25 Chap2.qxd 12/21/00 4:50 PM Page 25 terized by an ongoing struggle by regulators, bankers, and policy- makers to strike an appropriate balance 4 a balance between allow- ing banks the flexibility to adapt to a rapidly changing environment and maintaining a regulatory framework that will ensure financial stability and adequate protection for bank customers. Growth of bank holding companies One of the first significant changes was the growth of bank holding companies, which are companies that hold stock in one or more banks and may have certain other ownership interests as well. Although such companies were first formed in the early 1900s, most of the growth in holding companies has been fairly recent.<br><br> Outside of some mild restrictions in the Banking Acts of 1933 and 1935, the first time bank holding companies received much legislative attention was in the 1950s. Only a handful of banking organizations were ready to capitalize on the holding company structure then. Several of those organizations, though, were able to use holding companies to create sizeable interstate banking and nonbanking networks, thus circumventing branch- ing and business restrictions imposed on banks.<br><br> This expansion prompted Congress to pass the Bank Holding Company Act in 1956, which placed the formation of multibank holding companies and their acquisition of banking and non- banking interests under the control of the Federal Reserve. Under this act, bank holding companies could not acquire banks in other states unless specifically authorized by state law. Furthermore, any nonbanking activities of a bank holding company had to be closely related to the business of banking.<br><br> Congress did not extend the Bank Holding Company Act to companies owning a single bank in 1956, since such companies were generally small, local organizations. In the late 1960s, how- ever, many large banks saw the one-bank holding company as a vehicle for expanding into financial services banks could not 26B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 26 legally perform, as well as a few nonfinancial activities far removed from banking. By the end of 1970, a third of all commercial bank- ing deposits were controlled by one-bank holding companies.<br><br> To place these companies under federal supervision and control their nonbanking activities, Congress amended the Bank Holding Company Act in 1970 to give the Federal Reserve System author- ity over the formation and operation of one-bank holding compa- nies. The amendments also set public benefits standards for the approval of nonbanking activities and applied the same closely related to banking test to activities performed by one-bank hold- ing companies. With this regulatory framework in place, large bank holding companies continued to expand their banking and permissible nonbanking activities, thereby leading the way to significant con- solidation in the banking industry.<br><br> Small and medium-sized banks also began making greater use of the holding company structure. Much of this interest was prompted by a 1971 tax ruling. This rul- ing permitted stockholders of closely controlled bank holding companies to service bank acquisition indebtedness with tax-free dividends from the bank.<br><br> In response to such factors, holding companies have become, by far, the most common form of bank ownership, with over 96 percent of all bank deposits under hold- ing company control at year-end 1999. With bank holding companies coming under federal supervi- sion, Congress also sought to place decisions on bank expansion through mergers under the control of the regulatory authorities. The Bank Merger Acts of 1960 and 1966 gave the surviving bank 9s primary federal supervisor and the Department of Justice authority over bank mergers.<br><br> To provide a consistent approach to holding company and merger decisions, Congress extended the same com- petitive and public benefits standards to both types of transactions. History of Banking Regulation 27 Chap2.qxd 12/21/00 4:50 PM Page 27 Consumer protection The next step in bank regulation originated with the consumer protection and social concerns that first became prominent in the 1960s and 1970s. At the federal level, legislation has included Truth in Lending, Equal Credit Opportunity, Fair Housing, Fair Credit Billing, Real Estate Settlement Procedures, Home Mort- gage Disclosure, Community Reinvestment, and Truth in Savings.<br><br> These laws were created to deal with many different facets of con- sumer banking services and transactions. The primary objectives behind consumer protection laws have been to ensure that finan- cial customers receive equal treatment, consumer credit and deposit terms are disclosed accurately so the public can understand and compare financial products, and consumers are protected from abusive or deceptive practices. These concerns have been magnified by a very rapid expansion in the use of consumer credit since the 1970s.<br><br> Not only has there been a vast expansion in the variety of consumer credit instruments and lenders, but such fund- ing has also become available to many segments of the population that previously had little access to credit markets. In addition, other consumer laws and regulations have become necessary in order to keep up with recent technological advances that have cre- ated new ways of offering services to consumers. Banking deregulation and other developments Much of the regulatory and legislative change in banking dur- ing the late 1970s and early 1980s emphasized a more open, com- petitive banking environment and a more equal treatment of different types of financial institutions.<br><br> This emphasis reflected the desire of bankers to take advantage of technological developments, meet the growing competition from other financial institutions and from foreign banking organizations, and adapt to a new eco- 28B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 28 nomic environment. Examples of legislation with this and other objectives include: " The International Banking Act of 1978 , which placed foreign and domestic banks on an equal footing in the United States with respect to branching, reserve requirements, and other regulations. The act also increased the ability of U.S.<br><br> banks to compete in inter- national banking. " The Financial Institutions Regulatory and Interest Rate Control Act of 1978 , which was aimed at pre- venting certain financial abuses, but also increased the ability of regulatory agencies to prevent undue concen- trations of bank ownership and management through the Change in Bank Control Act and the Depository Institution Management Interlocks Act. " The Depository Institutions Deregulation and Mone- tary Control Act of 1980 , which sought to place vari- ous financial institutions on a more equal and efficient footing.<br><br> This act equalized reserve requirements across all insured depository institutions; authorized auto- matic transfer services (ATS), negotiable orders of with- drawal (NOW), and share draft accounts nationwide; phased out interest ceilings on time and savings deposits; and broadened the investment and lending powers of savings and loan associations and savings banks. In addition, the act introduced explicit pricing of Federal Reserve services, made these services avail- able to all depository institutions, and opened the Fed- eral Reserve 9s credit facilities to any depository institution offering transaction accounts or nonper- sonal time accounts. History of Banking Regulation 29 Chap2.qxd 12/21/00 4:50 PM Page 29 Bank and thrift industry problems in the 1980s Another focus of regulation and legislation during the remainder of the 1980s and the early 1990s was financial problems in the bank and thrift industries.<br><br> Such problems began with high and fluctuat- ing interest rates in the early 1980s and were magnified further by shortcomings in the thrift supervisory and insurance systems. Also playing a key role were sharp economic declines in the agricultural and energy sectors, many real estate markets, and a number of less developed countries with substantial borrowings from U.S. banks.<br><br> The most severe problems occurred among thrifts, as numerous thrift insolvencies depleted the federal savings and loan insurance fund and necessitated substantial federal funding. In the banking industry, over 1,000 banks failed or required federal assistance dur- ing the 1980s, including several major banking organizations. These failures, along with the level of FDIC insurance reserves thought necessary to cover future failures, brought the bank insurance fund into a deficit position in the early 1990s.<br><br> As a result of such problems, much of the banking legislation during this period focused on dealing with troubled institutions and strengthening the regulatory framework. Among the bills with these objectives are: " The Garn-St Germain Depository Institutions Act of 1982 , which increased the ability of regulators to aid dis- tressed institutions. This act further expanded the lend- ing and investment powers of federal thrift institutions.<br><br> Other provisions of the bill provided for a competitive deposit account at financial institutions and an increase in national bank lending limits to individual borrowers. " The International Lending Supervision Act of 1983 , which strengthened supervision and regulation of U.S. banks engaged in international lending and required 30B ANKING R EGULATION Chap2.qxd 12/21/00 4:50 PM Page 30 banks to maintain special reserves to address debt repayment problems in developing countries.<br><br> " The Competitive Equality Banking Act o