Bank Structure and Regulation in the USA - Modern Banking


The central bank and bank supervisory functions in the USA have evolved to create a US banking and financial structure which, by the late 20th century, was notably different from those in other western countries. Several factors explain its unique structure. First, US regulators have been far more inclined to seek statutory remedies in the event of a new problem, resulting in a plethora of legislation. Second, the protection of small depositors has been considered an important objective since the 1930s. Third, concern about potential collusion among banks and between banks and regulators has received as much weight in the USA as measures were put in place to preserve the stability of the banking system.

However, two important financial reforms could result in gradual but major changes in the structure of US banking over the first decade of the new century.

As Table below shows, the most striking feature of the US banking system is the large number of banks, despite recent consolidation. In 2000, there were about 7770 commercial banks, down from approximately 14 500 in 1984. Until the Gramm Leach Bliley Financial Modernisation Act of 1999 (GLB), these banks were severely constrained in the amount of securities related business they could undertake. Unlike most other western economies, the banking system is not highly concentrated. Commercial banks hold over 80% of total US banking assets, 50% of the commercial banking assets are held by 107 banks, and just under 80% of commercial bank assets are controlled by 373 commercial banks. By contrast, in the United Kingdom, the five largest banks21 control up to 80% of the country’s assets.

Table below shows the ‘‘big 6’’ American banks by tier 1 capital. Citicorp has assets in excess of $1 trillion and tier 1 capital of just over $39 billion. By contrast, Wachovia, the

US Banking Structure, 1997 and 2004.

US Banking Structure, 1997 and 2004.

Top US Banks (by tier 1 capital) in 2003

Top US Banks (by tier 1 capital) in 2003

sixth largest, is about a third of Citicorp’s size, measured by assets. Commercial banks with assets of less than $1 billion are known as community banks – controlling just over 20% of commercial bank assets. Commercial banks with assets in excess of $1b are known as regional or super-regional banks. There is virtually no nation-wide banking, i.e. banks with branches throughout the US, but this may change due to recent reforms (see below).

In common with other industrialised nations, the USA has savings banks and ‘‘thrifts’’ – savings and loans associations. Some are mutually owned, others are stock banks. Their original function was to make long-term residential mortgages funded by short-term savings deposits. Changes in regulations in the early 1980s allowed them to offer money market accounts, current or notice of withdrawal (NOW) accounts, flexible rate mortgages (in addition to the traditional fixed rate) and some commercial and personal loans. Mortgages make up just under 80% of their assets.

Serious problems with savings and loans/thrift associations throughout the 1980s led to a sharp reduction in their number, from 2600 in 1987 to 1481 in 1989 and 1230 in 2000. Over 700 were closed by the Resolution Trust Corporation, which operated from 1989 to 1995. Deposits are insured by the FDIC controlled Savings Association Insurance Fund.

In the 1980s and 1990s, most of the mutual savings banks converted to stock banks under state charters, and a few under federal charter. Nearly three-quarters of their assets are in the form of mortgages, though they have been allowed to offer corporate bonds and stocks. In 2004, there were 1413 savings institutions; their deposits are insured by the FDIC. There were just under 10 000 credit unions in 2004, which are owned by members (e.g. employees, police and fire associations, teachers). A member’s salary is paid into the credit union, which provide customers with basic deposit and loan facilities. In common with British building societies, deposits are known as shares. As non-profit maximising firms, net income is tax exempt, allowing them to offer more attractive deposit and loan rates than commercial or savings banks.

Regulatory reforms in the 1980s resulted in just over 4000 new investment banks and securities firms. They numbered about 9500 in October 1987, but the stock market crash (October 1987), together with higher capital requirements, gave rise to mergers so that by 1996 their number had dropped to under 8000. Further consolidation reduced their numbers to 5286 by 2004. There was a correspondingly large increase in concentration. For example, the largest investment bank in 1987 (Salomon’s) had capital of $3.21 billion, but a decade later, the largest is Merrill Lynch with $33 billion of capital.

It is increasingly difficult to distinguish between these firms. US investment banks tend to specialise in underwriting and new issues of bonds and equity (IPOs), though they have expanded into trading, research and consultancy, among other activities. Though Morgan Stanley is often thought of as a typical investment bank, it also offers stock broking services. Securities firms such as Merrill Lynch have a large number of retail outlets, as well as offering investment banking services to corporate clients. Other financial firms in the USA include insurance firms and finance companies. Over the last two decades, the finance company sector has grown rapidly. As in the UK, they are not banks, because they rely on loans from banks to fund short and long-term lending. In 1997, total assets stood at about $900 billion (larger than the thrifts), with the top 20 firms controlling more than 80% of these assets. They consist of sales finance firms which lend to a particular retail or wholesale group (e.g. Sears Roebuck Acceptance Corporation and Ford Motor Credit), personal credit firms such as Household Finance Corporation, which make loans to consumers and business credit firms that specialise in finance to corporations in the form of equipment leasing or factoring. General Motors Acceptance Corporation is involved in several activities. For example, they purchase debt from firms at a discount, then collect the debt. Another one of its subsidiaries is the largest commercial mortgage lender in the USA.

Bank Regulation in the USA

The USA has been inclined to seek statutory remedies whenever a serious problem in the banking/financial sector arises, which is one reason for its somewhat unique financial structure. Given the extensive amount of legislation passed since the 1930s, and related litigation, US regulation is best understood if reviewed under a number of subject headings.

Creation of a central bank and bank supervision

The National Bank Act was passed in 1863 and amended in 1864. It outlined the power, duties and regulations covering national banks, which are federally chartered by the Comptroller of the Currency (and the US Treasury Department). The Federal Reserve Act, 1913, created a central bank for the US banking system, following panics over a number of banks and trust companies, which originated in New York, in October 1907. Concerns about other banks spread to different parts of the USA, causing banks to restrict payments in New York and in other states. The 1913 Act allowed the Federal Reserve Bank to provide an ‘‘elastic’’ currency, that is, to supply liquidity in the event of crises. In 1934, the Federal Reserve Bank (or Fed) was granted the authority to adjust its reserve requirements, independent of the legislators.

In contrast to most other countries, there has always been a great deal of concern that a central bank with lender of last resort/lifeboat functions could add to and/or encourage oligopolistic banking behaviour, going against the American philosophy of free competition in all sectors. As a result, the Federal Reserve System (FRS) had a number of checks and balances built into it to discourage the development of cartel-like tendencies. The emphasis was placed on decentralisation – the FRS consists of 12 regional Federal Reserve Banks and a Board of Governors. The primary function of the Federal Reserve Bank was to pool the reserves of each of these banks.

The Federal Reserve System is one of several regulators of US banks. To operate as a bank, a firm must obtain a national or state charter (hence the term dual banking system), granted by either the Comptroller of the Currency or by a state official, usually called the Superintendent of Banks. The origin of the charter determines the banks’ main regulator. In a national charter, the bank must be regulated by the FRS, which is optional for state chartered banks. Regulations applied to state chartered banks are historically less stringent than for national banks. In 2004, about 2000 banks held national charters, and just under 6000 (75%) were state chartered. The top 10, with national charters controlled 55% of assets; the top 5 controlled 66% of assets.

There are costs and benefits arising from membership of the FRS. The costs are bank examination, conducted by officers from the Comptroller of the Currency at least three times every two years. Bank examiners use composite scores from the CAMEL scores system to evaluate banks. Banks are scored on a scale of 1 (the best) to 5 (the worst), using five criteria.

  • C: capital adequacy
  • A: asset quality
  • M: management quality
  • E: earnings performance
  • L: liquidity

A composite score is produced and banks with scores of 1 or 2 are considered satisfactory. Additional supervision is indicated if the score falls between 3 and 5. Banks scoring 4 or 5 are closely monitored, and a 5 signals that examiners think the bank is likely to fail. The examinations are meant to prevent fraud and to ensure a bank is complying with the various rules and regulations related to its balance sheet and off-balance sheet holdings. For example, banks can be ordered to sell securities if they are considered too risky, or to write off dud loans. Bank examiners may declare a ‘‘problem bank’’ if it is deemed to have insufficient capital, has too many weak loans, an inefficient management or is dishonest. Since the 1991 Federal Deposit Insurance Corporation Act, regulators are obliged to undertake a well-defined set of actions if banks are deemed to be under /significantly /critically under-capitalised.

Three organisations have the authority to examine banks, and the Federal Deposit Insurance Corporation has the right to examine insured banks. To avoid duplication, the Fed, Comptroller of Currency and FDIC normally examine, respectively, state member banks, national member banks and the non-member (of the FRS) insured banks. Banks which are members of the Federal Reserve System must meet a tier 1 capital assets or leverage ratio of at least 5%. An un weighted version of the 1988 Basel ratio, it is defined for a given bank as:

Tier 1 capital (i.e. equity capital+long-term funds)
Total assets

The higher the ratio of capital to assets, the more secure the bank. If a bank’s capital ratio is 5% of its assets, then the bank can afford to lose 5% of these assets (for example, unsound loans) without undermining its ability to repay depositors. Only shareholders will lose. This ratio is one of several banks report; others are used to assess the premium a bank pays for deposit insurance, and are reviewed below.

Federal Reserve membership for larger banks means they can attract deposits from smaller banks, in a correspondent relationship. FRS membership confers an image of quality and reputation, because of the requirements to which all members must conform.

Over the years, the piecemeal legislation has resulted in complex bank supervision in the USA, with a great deal of overlap between supervisory authorities. Table below summarises the key national supervisors and their responsibilities. However, there are also state supervisors, too numerous to list here. They include, for example, the State of New York Banking Department, the different regional reserve banks (e.g. Federal Reserve Bank of Boston, the Federal Reserve Bank of St. Louis, The Federal Reserve Bank of Cleveland), each with some supervisory responsibilities in their respective regions.

Separation of commercial and investment banking

The Glass Steagall sections (20, 32) of the Banking Act (1933), which became known as the Glass Steagall Act, separated commercial and investment banking from 1933

Key Regulators of Financial Firms

Key Regulators of Financial Firms

until it was repealed in 1999. It was largely responsible for the somewhat unique structure of banking that prevailed in the United States for the rest of the 20th century. Under the Act, the securities functions of commercial banks were severely curtailed: they were limited to underwriting and dealing in municipal government debt. Investment banks can engage in securities and underwriting, but are prohibited from taking deposits.

The Glass Steagall Act was passed during the Great Depression, after a special Commission persuaded Congress that separation of commercial and investment banking would prevent another financial crisis arising from the large number of bank failures (over 10 000) between 1929 and 1933.25 The Act also reflects the American obsession with the potential for collusion and anti-competitive practices. In this instance, the Act prevented the possibility of collusion between bank and customer which could arise if a bank both held a firm’s equity and underwrote its securities.

Bank holding companies

Until the 1960s, bank holding companies (BHCs) were a minor part of the US banking scene, controlling about 15% of total bank deposits. By the 1990s, 92% of banks were owned by BHCs. They became popular in the 1950s when banks found they could establish a bank holding company to circumvent the regulations: only wholly owned banking subsidiaries were required to conform to banking regulations.

The Bank Holding Company Act, 1956, defined a BHC as any firm holding at least 25% of the voting stock of a bank subsidiary. It required BHCs to be registered with the Federal Reserve. The purpose of the Act was to restrict BHC activity but by granting them legal status, it actually encouraged their growth. BHCs could circumvent the interstate branching laws, via ‘‘multi-bank’’ holding companies. The BHC organisational framework also meant banks could diversify into non-bank financial activities such as credit card operations, mortgage lending, data processing, investment management advice and discount brokerage.

They were also attractive for tax reasons. However, they could not engage in certain financial businesses (for example, securities) excluded by Glass Steagall, or in businesses not closely related to banking, as specified in the regulations. The Amendment (1970) to the 1956 Act increased control by the Federal Reserve over BHCs, which in turn tried to limit BHCs to offering banking products, and engaging in non-banking financial activities. However, the bank holding company structure continued to expand, with BHCs acquiring domestic and overseas banks.

In 1987, the Supreme Court ruled that section 20 of the Glass Steagall Act did not extend to subsidiaries of commercial banks. It meant they could offer investment banking services, provided they were not ‘‘engaged principally’’ in the said activities. In 1987, the Federal Reserve allowed BHCs (see below) to create section 20 subsidiaries which could undertake securities activities if the revenues generated did not exceed 5% (later raised to 10%, then 25% in 1996) of total BHC revenue. These subsidiaries captured substantial market share in some areas. For example, in 1997, JP Morgan and Chase were in the top 10 underwriters of domestic equity and debt.

Pressure to repeal the Glass Steagall Banking Act increased, especially in the 1990s. In June 1991 a key House of Representatives Committee, considering a Banking Reform Bill, voted in favour of breaking down barriers between banking and commerce. But most aspects of this legislation collapsed in November 1991. In October 1993, Lloyd Bentsen, the Treasury Secretary, set out an agenda for banking reform. Unlike the failed attempt at reform in 1991, the Bentsen agenda did not call for a repeal of Glass Steagall, but did support reforms for interstate banking (see below). The Chairman of the House banking committee (Mr Leach) claimed his top priority was to repeal Glass Steagall. Finally, in November 1999, the Gramm Leach Bliley Financial Modernisation Act (GLB) was signed into law by President Clinton.

The GLB Act was passed at a time when technology and other factors were eroding the boundary between commercial and investment banking. Investment banks had been able to enter retail banking through money market funds, cash management accounts and non-bank banks – though legislation put an end to the latter (see below). Merrill Lynch, an investment bank, owns two thrifts, and together with other subsidiaries engages in a limited amount of deposit taking and lending. From 1987, commercial banks began to offer some investment banking services through section 20 subsidiaries. According to Sweeney (2000), 43% of banks offered insurance products in 1998, a year before the new legislation (see below) was passed. Perhaps the greatest pressure was competitive: it was increasingly difficult for US banks to compete in global markets with the European universal banks.

Financial holding companies

Under the GLB Act, US bank holding companies can convert into financial holding companies (FHCs) which, in turn, can own commercial banking, investment banking and insurance subsidiaries, but are prohibited from cross-share ownership or directorships of non-financial firms.

Supervision of the FHCs is functional, i.e. insurance firms continue to be supervised by the Department of Trade and Industry, investment banks (securities activities) by the Securities and Exchange Commission, and the banking subsidiaries by the Federal Reserve Bank (Fed). However, the Fed acts as an ‘‘umbrella’’ regulator because it has the power to approve the conversion of the bank holding company into a financial holding company.

Nonetheless, for the insurance and securities activities, the Fed is expected to defer to the supervisory authority of the other regulators.

US banks may convert from BHC to FHC status provided the Fed has deemed them to be ‘‘well capitalised’’ and ‘‘well managed’’ – see below. In addition, they must be rated ‘‘satisfactory’’ under the 1977 Community Reinvestment Act. FHCs can engage in a broad range of financial activities listed in the GLB Act; they must seek the permission of the Federal Reserve and Treasury should they wish to offer services not explicitly listed.

However, unlike the German universal banks, FHCs fall into the restricted universal category, for a number of reasons. As subsidiaries, they must be separately capitalised, which is more costly than if they are part of a single legal entity. In addition, the cross-share ownership of non-financial firms is largely prohibited. In the USA, BHC/FHCs may not own more than 5% of a commercial concern. Furthermore, a firewall has been imposed between the commercial and securities subsidiaries – they are prohibited from cross marketing with each other, and a bank can sell but may not underwrite insurance.

As of July 2003, 636 (up by 76 since 2001) BHCs converted to FHCs, leaving thousands of banks that have opted to keep their BHC status, nearly four years after the legislation was passed. Of the 636, 39 are foreign banks – they include the six big Canadian banks, four from the UK, Deutsche Bank, Dresdner Bank, ABN Amro, Credit Suisse Group and Union Bank of Switzerland.

The large American BHCs (e.g. Citigroup, JP Morgan Chase, Bank of America) have converted. Citibank, an insurance firm, Travelers and Salomon Smith Barney, a securities house, began merger talks in 1998 and subsequently merged to form Citigroup. Some insurance firms, such as the State Farm Insurance Company, have set up a bank subsidiary, State Farm Savings Bank, to offer some banking products through their insurance offices, located across the USA.

Merrill Lynch has not converted to a FHC, but was one of the first investment banks to offer a cash management account, that is, a money market account with a cheque book and loan options. Nor has ING (a universal Dutch bank) sought FHC status even though it launched ING Direct in 2000, a savings bank which offers FDIC insured deposit accounts, mortgages and personal loans. Many on-line brokerage houses also offer banking services, and banks offer brokerage services and mutual funds.

Not many insurance firms or securities houses have sought FHC status, for a number of reasons. Unlike the FHC banks, the Fed becomes their umbrella supervisor for the first time, which is a considerable change in the way they are regulated, and compliance costs increase. If they fail to meet the ‘‘well capitalised’’ and other criteria, they are likely to be required to divest of any banks, loan companies and other depository institutions. Also, there are cases where securities or insurance firms engage in banking activities without becoming a FHC, as Merrill Lynch and ING illustrate. There are notable exceptions. The insurance giant MetLife used its new FHC status to purchase a small bank and Charles Schwab (a discount broker) became a FHC after purchasing a firm offering private banking.

The GLB Act has a potential drawback for banks engaged in securities or investment advisory. Before the Act, they were not required to register with the Securities and Exchange Commission as broker dealers or investment advisors. The Act emphasises functional regulation which means any banks which underwrite or broker corporate securities must, or so the SEC claimed, set up separate broker/dealer subsidiaries, subject to SEC regulation, and become members of the National Association of Securities Dealers (NASD). This will raise their compliance costs because they are subject to SEC regulations, and their employees face examinations to acquire the appropriate licences. After complaints from bankers and regulators, the SEC extended the deadline for compliance to May 2002.

To understand the potential complexity of functional regulation, consider Citigroup. It is keeping its banking operations, which means it continues to have a BHC. The BHC is regulated by the Fed, but the various banking subsidiaries, etc. are regulated by state and federal bank authorities including the FDIC and relevant state regulators (for state chartered bank subsidiaries and thrifts), the Office of the Comptroller of the Currency (for nationally chartered bank subsidiaries), and the Office of Thrift Supervision (for federal savings subsidiaries). In the USA, insurance is regulated at state level, which means Citigroup’s insurance subsidiaries must comply with all the state insurance regulators. The broker-dealer subsidiary, Smith Barney, is regulated by the SEC, the exchanges where they trade (e.g. the New York and London stock exchanges), and the National Association of Securities Dealers (NASD). In addition, Citigroup is subject to the regulations of other countries where it has subsidiaries.

Branch banking regulations

To discourage concentration in the banking sector, the United States has a long history of limiting the extent to which banks could set up branches, unlike most of the other banking systems in the industrialised world. Heffernan (1996) reviews the relevant legislation, which discouraged interstate branching, that is the branching across states, and in some states, intrastate branching or branching within the state.

Since 1933, legislation meant the regulation of branching was largely a matter for individual states, and as a result, each state had different degrees of restrictions. Most states prohibited out of state banks from collecting retail deposits, which effectively excluded them from setting up branches. Bank holding companies might establish bank subsidiaries in each state, but each was an individual legal entity, which had to be separately capitalised. In most western countries, such as the UK, Australia, Canada, France and Germany, customers with an account at one branch of a bank can do business in other branches throughout the country. For example, a customer with an account at a London branch of HSBC could also bank at a branch in Manchester or Leeds. Or a customer with an account at the Bank of Montreal in Quebec City could attend one of the branches in Vancouver. However, in the United States, a customer with an account at the subsidiary of a bank holding company in one state cannot bank at another subsidiary of the same bank holding company. There are exceptions. For example, California has a history of liberal intrastate branching laws, and with few branching restrictions. At the other extreme there are states such as Illinois, where no branching was allowed until very recently.

The failure of thousands of banks and thrifts during the 1980s put pressure on individual states to revise their legislation to allow out of state bank entry through the merger of healthy bank holding companies with unsound local banks and thrifts. Also some neighbouring states entered into regional reciprocal agreements to allow branching across state lines. The passage of the Riegle Neal Interstate Banking and Branching Efficiency Act in 1994 (henceforth, the RN Branching Act or Riegle Neal) largely eliminated these restrictions. The Act allowed all US banks to acquire banks in other states from September 1995, and from June 1997 BHCs could convert subsidiaries into branches. Any out of state bank taken over by another bank can be converted into a branch. State laws requiring out of state BHCs to enter by acquisition only continue to apply, though the BHC may opt to take over an existing branch or branches rather than an entire bank. States have the option of passing legislation to stop de novo branching (setting up a new branch) by out of state banks, but the FDIC can override these restrictions if a bank has failed or is failing. The Federal Reserve has a final say over interstate bank acquisitions. To prevent excessive concentration, a BHC/FHC may not hold more than 30% of total deposits in any given state, and 10% nationally. The changes make nation-wide banking possible in the USA for the first time in its history. Nationwide bank, after its merger with Bank of America in 1998, claimed to be America’s first national bank, with branches in 22 states and a share of insured deposits of just over 8%.

The general view of several studies is that the Act conveys benefits such as increased efficiency and lower costs as subsidiaries become branches. Using a sample of bank holding companies, Carrow and Heron (1998) report that the Act had a positive welfare effect. Jayaratne and Strahan (1997) show that the reciprocal/regional agreements (1978–1992) which deregulated branching laws resulted in substantial permanent increases in economic growth in these states. However, Freeman (2002) cautions that the Jayaratne and Strahan findings are over-estimated because, in the sample they used, real incomes in the states that deregulated were on average 4% below trend, and recovered slowly. The states deregulated branching laws to encourage new bank entry because their own state banks were severely troubled or failing as a result of poor economic conditions. The authors conclude Riegle Neal did not have a powerful impact on growth rates. Nippani and Green (2002) looked at the performance of banks (in six different asset categories) pre- and post-Riegle Neal, using measures such as return on equity, return on assets, net interest margins and the ratio of non-performing loans to total loans. Their findings confirm a significant increase in the degree of consolidation in the US banking sector following the RN Act. However, the improvement in most performance measures was largely due to a stronger macro economy, as shown by the significance of real gross domestic product and the bank prime rate in their regression analyses. The finding that the new Act had little impact on the economy or bank performance may be due to a simultaneous increase in consolidation. The reduced competition that accompanies increased consolidation can offset any efficiency gains.

However, the two reforms together, Riegle Neale and GLB, make it highly likely the new century will see a major change in the structure of the American banking system. Universal banking, albeit restricted, together with nation-wide branching, creates new opportunities for financial institutions. But caution should be used when predicting the impact on performance of banks or economic growth rates. Branching across states comes just when banks in other countries are cutting back on bank branches, because new technology makes the remote delivery of most banking services possible. With GLB, financial institutions opting for FHC status face substantial compliance costs, a consequence of functional regulation. Other countries with universal banking tend to have a more concentrated banking system, with all the potential drawbacks arising from reduced competition. However, the reforms make an important contribution: they increase banks’ choice of financial structures within the USA, with greater opportunities for a mixed banking system, ranging from highly specialised banks to mammoth financial supermarkets.

Deposit insurance

Deposit insurance has been an important part of the US system since the Federal Deposit Insurance Corporation (FDIC) was set up after the 1933 US Banking Act. The FDIC was created to protect small depositors from ever experiencing the losses which were a consequence of massive bank failures that occurred between 1929–33. All member banks of the Federal Reserve System are required to join the FDIC; non-members may join if they meet the FDIC admission criteria. Membership is important for any bank if it is to attract depositors, effectively giving the FDIC veto power over the formation of almost any new bank. 97% of US banks, representing 99.8% of deposits, are insured by the FDIC.

The FDIC member banks pay an insurance premium to the FDIC, which is used to purchase securities to provide the insurance fund with a stream of revenue. With these funds, the FDIC insures deposits of up to $100 000.35 Initially, the FDIC was allowed to borrow up to $3 billion from the Treasury, but in the 1980s FDIC resources were seriously threatened because of the increase in bank failures, and for this reason the limit was raised by Congress (see below).

From 1933 until the savings and loans/banking problems in the 1980s, there was little in the way of debate about the need for deposit insurance in the USA. The scheme was devised with a view to protecting small depositors to prevent them from initiating runs on banks thought to be in trouble. It is argued that small personal and business depositors are most inclined to initiate runs, because of the absence of detailed information about the quality of the bank, which is too costly for small depositors to obtain, even if the information were available. Unlike the UK, small depositors do not bear some of the cost of failure through co-insurance.

Large depositors are expected to have the information necessary to make an informed judgement and to impose market discipline on the banks. However, runs are still possible. For example, when Continental Illinois got into trouble in the 1980s, it was the very large depositors who withdrew their money first, because their deposits would not be protected by insurance if the bank failed. Two years earlier, wholesale depositors had lost deposits held at Penn Square bank when the authorities made no attempt to rescue it.

Looking at US commercial bank failures as a percentage of healthy banks in the period 1934–91, the annual average was 0.38% from 1934–39 and did not rise above 0.08% between 1940 and 1981. In 1981 it jumped to 0.29%, rising steadily to peak at 1.68% in 1988. The FDIC tried to reduce demands on its insurance funds by merging problem banks with healthy banks.

The Federal Savings and Loan Insurance Corporation (FSLIC), the insurance fund for the thrift industry, was declared insolvent in early 1987, because of the large number of thrift failures during the 1980s. The FDIC was also on the brink of insolvency. Under the 1989 Financial Institutions Reform, Recovery, and Enforcement Act (FIRREA), the FSLIC was dissolved, as was its regulator, the Federal Home Loan Bank Board. Two new deposit funds were created, the Bank Insurance Fund and the Savings Association Insurance Fund (SAIF) – both administered by the FDIC, even though it, too, was bordering on insolvency. The law also imposed higher deposit premiums for commercial banks and thrifts, to raise the reserves for the respective insurance funds. Under the Act, the regulation of thrifts was tightened by creating the Office of Thrift Supervision, modelled after the Comptroller of the Currency. The Act also authorised $50 billion of government-backed bonds, to help pay off depositors at insolvent thrifts.

A system of 100% deposit insurance is the only way to stop banks being threatened from runs by depositors, but it can create serious moral hazard problems. Protected depositors have no incentive to monitor a bank’s activities, and a bank with difficulties is likely to undertake riskier activities. In fact, the looting hypothesis was developed to explain the behaviour of managers during the US thrift crisis in the 1980s. The experience of costly rescues of banks and thrifts (the rescue of the savings and loans sector alone cost the taxpayer $160–$180 billion in the 1980s) increased the pressure for reform of deposit insurance schemes.

In 1991, the Federal Deposit Insurance Corporation Improvement Act (FDICIA) was passed by Congress to reform the role of the FDIC. The Act requires the FDIC to take prompt corrective action should a bank fail to meet the criteria for being well capitalized (see below). A ‘‘least cost’’ approach (from the standpoint of the taxpayer) must be adopted to resolve bank failures. The FDIC must use a present value approach to evaluate the costs of alternative ways (e.g. closure, merger with a healthy bank, etc.) of dealing with the problem bank. The new changes were introduced to reduce regulatory forbearance and give the FDIC clear rules for dealing with troubled banks. Collusion between banks/thrifts and their regulators and the absence of clear guidelines were thought to be contributory factors in the 1980s bank and thrift crises.

However, if an insured bank’s failure poses a threat to the US financial system (because, for example, it initiates runs on other banks, etc.) then it is exempt from the least cost criteria. Known as the systemic risk exemption, it is really ‘‘too big to fail’’ by the back door. With the rapid rate of consolidation in US banking and reforms allowing restricted universal banks with nation-wide branches, the number of banks qualifying for the exemption is likely to rise. To limit its use, the exemption can only be applied if the boards of the FDIC and the Fed agree by a two-thirds majority, with subsequent approval by the US Treasury Secretary and the US President. The cost of any rescue is funded by higher premia on other FDIC member banks.

Under the FDICIA, the FDIC had to establish a system of risk based deposit insurance premia, based on the risk category of the bank, and the size of the FDIC fund. Three ratios are used to categorise banks:

  • Tier 1 Capital Assets or Leverage Ratio: tier 1 capital/assets
  • Tier 1 Risk Assets Ratio: tier 1 capital/weighted risk assets
  • Total Risk Assets Ratio: tier 1 & 2 capital/weighted risk assets

The different categories include:

Well capitalised banks

Total risk assets ratio ≥ 10%
AND tier 1 risk assets ratio ≥ 6%
AND tier 1 leverage ≥ 5%

Adequately capitalised banks

Total risk assets ratio ≥ 9%
AND tier 1 risk assets ratio ≥ 4%
AND tier 1 leverage ≥ 4%

Under-capitalised banks

Total risk assets ratio < 6%
OR tier 1 risk assets ratio < 4%
OR tier 1 leverage < 4%

Significantly under-capitalised banks

Total risk assets ratio < 6%
OR tier 1 risk assets ratio < 3%
OR tier 1 leverage < 3%

Critically under-capitalised banks
Equity: assets < 2%

Under the Act, a receiver must be brought in if the tier 1 leverage ratio is ≥2%. There is also a list of mandatory and discretionary actions to be taken if any bank falls into a group below well capitalised. For example, brokered deposits39 may only be accepted by well-capitalised banks and, subject to FDIC approval, by adequately capitalised banks. The prompt corrective action clause also requires supervisors to ensure action is taken if capital ratios fall, even if this means re-capitalisation. Capital trigger points were set, but Hawke (2003) identifies a flaw that could give rise to forbearance. The supervisor determines what constitutes capital, which makes it relatively easy to move the goal posts.

In addition to the risk category dimension, banks are also ranked by regulators, based on the supervisor’s view of a bank’s financial health, determined by the quality of assets and other risk indicators. For example, suppose two banks fall into the category ‘‘well capitalised’’. If one is designated a regulatory concern, it will pay a higher premium than the other bank.

Basis points are assigned to determine the premium rates; in January 1996, the premia ranged from 0 to 0.27% of deposits.40 Risk classifications are kept confidential and based on supervisory evaluations, rather than credit ratings from private agencies. It is notable that banks wishing to be in one of the first two categories will have to conform to more stringent requirements than the 8% risk assets ratio laid down in the Basel 1 accord. This may explain why US banks have declared that only ten US mega banks will be required to comply with Basel 2, and the rest with Basel 1. Regulators are confident of their own systems, and do not consider it worth subjecting the majority of banks to the high costs of switching to a new system of risk management.

By the late 1990s, about 92% of insured banks paid no premium to the FDIC – the premia were lowered in 1996 because under FDICIA (1991), the FDIC cannot charge premia to highly rated banks provided their fund reserve exceeds 1.25% of insured deposits.

Effectively, although the USA has a risk based system, the vast majority of banks are exempt from it because the fund reserve is large enough under FIDCIA rules. It means the Act has an element of procyclicality built into it; the fund reserve is likely to fall during a downturn in the economy, and will have to resume its contributions during a period of recession, when credit losses are higher and profits are being squeezed. The FDIC, anxious to have a bigger reserve, has proposed that some premium be paid based on additional measures of banks’ risk levels, such as CAMEL and other financial ratios.

The purpose of these reforms was to reduce moral hazard problems by computing deposit insurance premia on a risk-related basis, thereby effectively curbing bank risk-taking. It is hoped that the ‘‘least cost’’ requirement will expose depositors to greater risks than was true in the past, which in turn should increase their incentive to monitor bank activities. However, explicit co-insurance continues to be absent.

Another proposal to combat the problems created by deposit insurance is to limit coverage to narrow banking activities. Insurance, with no upper limit, would be available for transactions-related purposes or a minimum level of non-transactions deposits (e.g. $250 000). Banks would be required to invest these liabilities in safe government bills and top-rated commercial paper. Any other activities undertaken by banks would not be covered by deposit insurance. Effectively, this would mean banks could become financial conglomerates, but without the special protection of insurance, except for their transactions related deposit business. To date, this proposal has not been implemented.

Regulation of foreign banks

The International Banking Act (1978) eliminated some of the differences in the way domestic and foreign banks were regulated in the US market. For the first time, foreign banks were bound by the McFadden,42 Bank Holding Company and Glass Steagall Acts. Foreign bank branches and agencies were to be regulated by the Fed. Foreign subsidiaries could apply for a federal charter, which would give them access to federal services such as the discount window, cheque collection and clearing.

Reserve requirements were imposed on all federal and state licensed foreign bank branches and agencies which had a parent with more than $1 billion in international assets, thereby covering virtually all foreign banks based in the USA at the time. FDIC insurance was made mandatory for all foreign banks that accepted deposits. Finally, the Act introduced a reciprocity principle for foreign bank entry; foreign banks were only permitted to enter US banking markets to the degree that US banks could enter into the foreign market.

The Foreign Bank Enforcement Supervision Act (1991) was passed to establish uniform federal standards for entry and expansion of foreign banks in the USA. The Act extended the supervisory powers of the Federal Reserve over foreign banks, in response to their rapid growth – their numbers had more than doubled in the 1980s. The Act also ensures that foreign bank operations are regulated, supervised and examined in the same way as US banks. For example, foreign banks wanting to set up state licensed branches/agencies or purchase an existing bank must obtain approval from the Federal Reserve Board, and are subject to examination and supervision by the Board.43 The principle of reciprocity was replaced by equal treatment: foreign and domestic banks receive identical regulation and supervision, provided US banks are treated the same way (i.e. subject to the same regulations as domestic banks) if they have subsidiaries in the foreign bank’s country of origin.

The 1991 Act gave the Fed the right to close any foreign bank which violates US laws or if the bank’s home country regulation is deemed inadequate. In 1996, the Fed used the Act to stop Daiwa Bank from operating in the USA44 after one of its bond dealers lost over $1 billion in bond sales. The trader had concealed the losses from Daiwa for a considerable period of time, but what angered the US authorities was Daiwa’s failure to report the matter until six weeks after the trader owned up. In addition, the bank was fined $340 million. In 2001, the State Bank of India was fined for what the Fed considered unsound practices in some of its branches.

US banking activities overseas are regulated by the Federal Reserve. US banks are required to seek permission to open foreign branches, and may only invest in foreign banks through bank holding companies. Edge Act corporations can invest in financial activities such as leasing, trust businesses, insurance, data processing, securities and dealing in money market funds.

A US National Banking Structure?

US regulatory authorities have largely abandoned trying to regulate bank interest rates or bank products,45 accepting that it is not possible to do so in an environment of rapidly changing technology and financial innovation. Foreign banks can expect to be subject to the same regulations as US domestic banks provided the foreign country applies the principle of equal treatment. More important, the RN Branching (1994) and GLB Financial Modernisation (1999) Acts, taken together, mean that the US banking and financial structure could change beyond all recognition in the 21st century. For the first time, there are few barriers to prevent the development of a nation-wide banking system (e.g. the ceiling on state (30%) and nation-wide (10%) deposits one bank can hold), which has eluded the USA to date, but is taken for granted in most other countries. Now that BHCs (and the banking subsidiaries of FHCs) can have a national branch structure and FHCs can cross-sell some financial services through those branches, there is an increased likelihood that a national banking system could emerge. The large number of mergers and acquisitions among BHCs, commercial banks, investment houses and insurance firms over the last 15 years should bring about a more consolidated national banking system. New technology will mean the scale of national branching is smaller but at the same time, US banks do not have to face the unpopular branch closure programmes witnessed in many countries such as Canada, the UK, France and Germany.

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