Financial intermediaries serve a key role in the U.S. economy. They are a central reason why the U.S. economy is as productive as it is. The term financial intermediary includes depository institutions (such as banks[1] and credit unions[2]); insurance companies;[3] investment banks;[4] investment companies (such as mutual funds and exchange-traded funds);[5] and venture capital funds.[6] They pool individuals’ funds and channel the money to others who need capital to operate. These intermediaries provide services to both groups.

Banks, for instance, effectively allow depositors to loan funds to businesses without having to investigate or monitor those companies’ operations and financial health. These businesses, in turn, avoid the trouble of having to find hundreds or thousands of people willing to make loans to them. In return for providing their financial intermediation services, banks earn a profit on the difference between the interest they receive from borrowers and the interest they pay to depositors or creditors.

Investment banks serve a similar function by matching investors with companies seeking equity or debt capital. Broker-dealers enable investors who wish to sell a security to find a buyer in an instant. Investment companies take the savings of millions of investors and then invest those savings in the shares of tens of thousands of companies around the world. Venture capital funds take investors’ capital and seek out new, dynamic companies to finance. Insurance companies invest premiums to settle future claims, and they sell products, such as variable life insurance and annuities, that have an investment component.[7]

The process of financial intermediation, whether carried out by banks, investment banks, or another intermediary, is a vital component of economic growth because it facilitates capital formation and the efficient allocation of scarce capital resources. Without financial intermediation, raising the capital necessary to launch or operate a business, or borrowing to buy or build a home, would be much more difficult and expensive. It would also be harder for capital to find its most productive use. In 2014, the finance and insurance industries generated a value of $1.3 trillion (7.2 percent of gross domestic product),[8] and employed 7 million people.[9]

A poorly functioning financial-intermediation sector results in a society with fewer goods and services, fewer employment opportunities, and lower incomes. For at least a century, the U.S. regulatory framework has been increasingly hindering the financial-intermediation process. The current regulatory regime is counterproductive because it seeks to micromanage people’s financial risk, a process that inevitably substitutes regulators’ judgments for those of the investing public. Financial regulation should not protect people from business or financial risk that they knowingly choose to accept. Instead, financial regulations should focus on punishing and deterring fraud, and fostering the disclosure of information that is material to investment decisions.

Overview of Capital Markets

This Backgrounder focuses on capital market intermediation, particularly by commercial banks (depository institutions),[10] investment banks, and broker-dealers. While commercial banks typically provide customers with loans, investment banks and broker-dealers intermediate mainly by enabling investors to develop diversified portfolios of businesses’ debt and equity securities.

Commercial Banks. Historically, the core function of commercial banks has been to accept customers’ deposits and provide loans to individuals and businesses. Most people view their bank as a place to store their money, but that view is not completely accurate. While banks must return their customers’ deposits on demand, banks do use those deposited funds to finance business investments and consumer purchases.

For instance, an individual may open a checking account with $1,000, then regularly withdraw and add funds to the account. The bank is always obligated to make the account balance available to the customer. However, because the bank’s customers, in the aggregate, always have some money on deposit, the bank can lend a portion of the money on deposit to borrowers. Banks also use these deposited funds to buy other financial instruments, such as municipal bonds, Treasury bills, and mortgage-backed securities (MBS).[11]

While different banks specialize in different types of loans, they generally all make personal, commercial, and industrial loans. Some businesses, for instance, can use commercial loans to finance their inventory and computer purchases, while other companies can use industrial loans to fund new buildings, storage facilities, or manufacturing plants. All banks face a common problem: Their demand deposit customers can ask for their money without any notice.[12] In other words, banks have to make funds available to their deposit customers on demand, even when they have used those funds to make a loan to a borrower. For this reason, banks tend to prefer making short-term loans (no longer than five years).

Investment Banks and Broker-Dealers. Investment banks[13] connect investors with companies seeking new equity or debt capital. If the company sells securities to investors, it is called a primary offering. In addition to intermediating primary offerings, broker-dealers connect investors seeking to sell previously issued securities with investors seeking to buy securities, creating a robust secondary market in securities.[14] These broker-dealer secondary-market services enable investors to receive a better price with lower transactions costs and to quickly sell their securities. Moreover, a robust secondary market makes it easier to sell new primary offerings to investors because they know they will be able to sell the purchased securities rapidly and at a reasonable price when they wish to do so.

The Current Regulatory Framework

For decades, regulators have increasingly taken on a more active role in managing financial firms’ risk despite the fact that this approach has repeatedly failed. In the late 1980s, for instance, federal banking regulators introduced the complex Basel capital rules, a purported improvement over the previous capital requirements. While these rules were intended to improve the safety and soundness of the banking system, they clearly did not prevent the 2008 meltdown. In fact, the Basel rules contributed to the crisis because they assigned inappropriate risk weights to certain assets.[15] Federal Deposit Insurance Corporation (FDIC) data even show that U.S. commercial banks exceeded their minimum capital requirements by two to three percentage points (on average) for six years leading up to the crisis.[16]

Historically, regulators have not managed nonbanking financial firms’ risk-taking as extensively as they have banks’ activities, but the approaches have been moving in the same direction for decades. For instance, sections 8(b) and 15(c)(3) of the 1934 Securities Exchange Act introduced a net capital rule for broker-dealers, a rule that dictated the type and amount of liquid assets that broker-dealers had to maintain.[17] The rule has been amended several times, including a major adjustment in 1975 after a series of firm failures in the late 1960s and early 1970s, and again in 2004 just prior to the 2008 financial crisis.[18]

The 2004 rule change has been blamed for allowing broker-dealers to raise their leverage, but data shows that major investment banks were more highly levered in 1998 than in 2006.[19] One problem with both sets of capital rules is that they were crafted on the assumption that regulators know exactly which level of capital these firms should use to fund their operations. At the very least, this approach—mandating legally required capital ratios—should not be viewed as superior to allowing market participants to determine which levels of capital are adequate. Empirical research does caution against relying on excessive government supervision and regulation even of bank activities, as doing so does not necessarily promote the development and stabilization of the financial system.[20]

Internationally, evidence indicates that, by cultivating large and liquid securities markets, laws that mandate disclosure and enhance enforcement through civil liability rules have a more positive impact than other forms of securities regulations.[21] Some evidence suggests that this type of disclosure and private monitoring works best even in the banking sector.[22] Regardless, there is no reason to think that regulators have superior knowledge compared to other market participants when it comes to measuring financial assets’ risk.[23] In fact, regulator-assigned risk weights under the Basel rules proved incorrect and contributed to the 2008 financial crisis.[24]

Summary of Bank Regulation. Banks’ activities are highly regulated by both state and federal regulators, more so than most types of businesses. These regulatory functions can be broadly grouped as follows: (1) chartering and entry restrictions, (2) regulation and supervision, and (3) examination.[25] Chartering and entry restrictions address issues such as the process that people must follow to start a new bank, as well as how existing banks can expand into new geographic markets through mergers and acquisitions. Supervision and examination authority are complementary, and they cover a much wider range of activities. Supervision involves both the initial publication of rules to implement statutory law, and less formal press releases and circulars known as “guidance.”

Additionally, regulators routinely examine banks’ records to ensure that they are following the rules. Sometimes these examinations are informal regulatory sessions, but regulators still use the process to implement changes. Even an increase in capital can be implemented through threatened enforcement actions during informal examinations. Banks tend to comply with regulators’ informal suggestions because failure to do so can bring additional regulatory scrutiny or formal enforcement actions.[26]

In most cases, banks are supervised and examined by more than one regulator. In general, federally chartered banks are subject to supervision by the Office of the Comptroller of the Currency (OCC). State-chartered banks that are members of the Federal Reserve System are subject to oversight by both the Federal Reserve Board and by state regulators. Non-Fed-member state-chartered banks that are insured by the FDIC are regulated by the FDIC and state regulators.

Additionally, the Fed is the primary regulator of all bank holding companies, even though such holding companies are also subject to state regulations.[27] Separately, a statutory formula dictates many specific responsibilities for the various federal banking regulators. For example, the Federal Deposit Insurance Act[28] defines the “appropriate Federal banking agency” for purposes of which agency regulates which bank,[29] and determines which federal agency is responsible for approving mergers between particular banks.[30]

Depending on the banking activity, at least seven federal regulators—(1) the Federal Reserve; (2) the FDIC; (3) the Securities and Exchange Commission (SEC);[31] (4) the Commodity Futures Trading Commission (CFTC); (5) the Consumer Financial Protection Bureau (CFPB); (6) the Federal Housing Finance Agency (FHFA); and (7) various agencies within the U.S. Treasury Department[32]—could supervise, examine, or otherwise regulate a bank. These are, of course, in addition to state regulators. These regulations have imposed enormous costs on banks, and undoubtedly contributed to the decline in the overall number of banks and the increased concentration in the banking industry.[33]

In practice, both state and federally chartered banks are subject to state laws governing the basic transactions in which they engage with their customers. For instance, state laws, most notably the Uniform Commercial Code, govern practices such as the transactions in commercial paper and promissory notes, bank deposits, funds transfers, secured transactions, and contracts.[34] Other state laws govern bank chartering, safety, and soundness; securities; insurance; real property; and mortgages.[35] However, federal law governs federally chartered banks’ rights and obligations as corporate entities.

Moreover, the Truth in Lending Act (TILA)[36] is supposed to provide uniform credit standards, and the Real Estate Settlement Procedures Act (RESPA) governs real estate settlement processes throughout the U.S.[37] Banks are also subject to the Equal Credit Opportunity Act,[38] the Community Reinvestment Act,[39] and the Fair Credit Reporting Act,[40] among many other statutes. Although this dual state–federal system has existed for more than a century, the bank regulatory framework is now more federalized than ever because the 1991 Federal Deposit Insurance Corporation Improvement Act (FDICIA) requires that any FDIC-insured state bank not engage in any activity impermissible for national banks—and nearly all state banks are FDIC insured.[41]

In general, bank regulations are justified on the grounds that they ensure the safety and soundness of the banking system and also promote equitable access to loans. Rather than providing a detailed description of major banking regulations, the goal of this Backgrounder is to provide an overview of the regulatory framework. The following list provides an overview of several key regulations:

• All bank holding companies with assets of more than $50 billion are subject to heightened supervision by the Fed. These special standards apply to banks’ leverage, liquidity, and capital requirements, as well as overall risk-management and resolution processes.[42]
• Federal law limits how much money a bank can lend to any one customer or to a group of related customers.[43]
• All banks are subject to the Federal Reserve’s deposit reserve requirements.[44]
• The Dodd–Frank Wall Street Reform and Consumer Protection Act transferred the rulemaking authority for various consumer financial protection laws to the newly created Consumer Financial Protection Bureau (CFPB).[45]
• Banks are subject to lending limits (and other restrictions) on loans they can provide to insiders (such as officers, directors, and shareholders), as well as to affiliate institutions.[46]
• The OCC has promulgated rules that determine the minimum amount of capital required to form a bank.[47]
• The Federal Reserve is the primary regulator of all bank holding companies and, as such, regulates the “financial condition and operations, management, and intercompany relationships of the bank holding company and its subsidiaries, and related matters.”[48]
• Federal banking agencies regulate banks’ capital adequacy, and have discretion to define what constitutes adequate capital levels.[49] Federal regulators examine banks’ capital adequacy every 12 months (every 18 months for small institutions).[50]
• The Fed’s Regulation E covers rules for electronic funds transfers,[51] and Regulation C covers home-mortgage disclosure rules.[52]
• The Fed’s Regulation Z (Truth in Lending) prescribes uniform rules for “computing the cost of credit, for disclosing credit terms, and for resolving errors on certain types of credit accounts.”[53]
• Regulation BB “implements the Community Reinvestment Act and encourages banks to help meet the credit needs of their communities.”[54]
• Banks and other financial institutions are required to comply with complex anti–money laundering laws and “know your customer” requirements primarily administered by the Treasury Department’s Financial Crimes Enforcement Network.[55]
• Banks and other financial institutions are required to comply with a complex set of tax-information reporting requirements administered by the IRS.[56] The Senate is considering a treaty that would impose a wide variety of new information-reporting requirements on financial institutions to help foreign governments collect their taxes.[57]

Summary of Securities Regulation. The regulation of securities issued by companies to investors (primary offerings) and sales between investors (secondary offerings or secondary market) has become monstrously complex. The Securities Act of 1933 (as amended)[58] governs the offering of securities to the public by companies. In general, the 1933 act requires companies to register the securities they sell, and mandates disclosure of a great deal of information. It creates various exceptions. It prohibits fraud. In addition, the Trust Indenture Act of 1939 regulates the issuance of bonds and other debt securities.[59]

The Securities Exchange Act of 1934 (as amended)[60] governs secondary markets and securities firms. In general, the 1934 act governs stock exchanges, underwriters (investment banks), and broker-dealers. It requires broker-dealers and exchanges to register with the SEC. It prohibits fraud, and the SEC has exercised its authority under the act to prohibit insider trading. Investment companies such as mutual funds and closed-end funds are regulated by the Investment Company Act of 1940 (as amended),[61] and investment advisers are regulated by the Investment Advisers Act of 1940 (as amended).[62] The Sarbanes–Oxley Act of 2002[63] and the Dodd–Frank Act[64] made major changes in corporate governance and auditing rules for public companies.

These laws are enforced by the SEC, but the Treasury Department also regulates financial (including securities) markets, particularly the activities of broker-dealers.[65] Additionally, the U.S. Commodity Futures Trading Commission (CFTC), created in 1974, enforces the Commodities Exchange Act[66] and regulates commodities futures and foreign exchange. The CFTC’s regulatory authority can overlap with that of the SEC with respect to certain derivatives.[67] Finally, state “blue sky” laws and state regulators also regulate securities (both primary and secondary offerings) and broker-dealers. For firms seeking to raise capital or do business in more than one state, these laws add substantial costs and delays. Similarly, blue sky laws are a major impediment to small broker-dealers seeking to operate across state lines.

Much of the regulation of broker-dealers has been effectively delegated to the Financial Industry Regulatory Authority (FINRA), a private not-for-profit organization.[68] Similarly, the Public Company Accounting Oversight Board (PCAOB) has been delegated regulatory authority over the auditing of public companies and broker-dealers.[69] The SEC is charged with oversight of the activities of FINRA and the PCAOB. The overall approach to securities regulation has gone well beyond the traditional focus of deterring and punishing fraud, and requiring reasonable, limited, scaled disclosure of material information by widely held firms.[70] The regulatory framework has reduced the competitiveness and effectiveness of the U.S. financial system, and it is time to move to a more market-based regulatory system where private actors—not taxpayers—absorb losses when they take unwarranted risks.

A New Approach

The process of financial intermediation, whether carried out by banks, investment banks, or another intermediary, is a vital component of economic growth because it facilitates capital formation and the efficient allocation of scarce capital resources. A great deal of evidence supports this proposition.[71] Furthermore, evidence indicates that a regulatory framework that mandates disclosure and improves enforcement through civil liability is superior to one that relies on excessive government supervision and regulation.[72]

U.S. banks have dealt with some form of risk management from regulatory agencies since the early republic. Securities market regulation was originally focused on fraud prevention and disclosure. Particularly at the state level, but increasingly at the federal level, regulations in both areas have become more concerned with active risk management. Essentially every sort of panic, crisis, or downturn has been met with added regulation in the name of preventing the next calamity, a goal that can never be reached. Worse, the new regulations often fail to address the underlying cause of the problem and typically exacerbate the situation. The 2010 Dodd–Frank Act is the latest example of this flawed approach.

Title I of Dodd–Frank creates the Financial Stability Oversight Council (FSOC) and charges these regulators with the ill-defined task of maintaining financial stability as well as identifying so-called systemically important firms (that is, companies deemed too big to fail).[73] Title II creates a government-backed resolution process for these firms,[74] Title VIII provides Federal Reserve access to a new group of financial firms identified as financial market utilities,[75] and Title XI codifies the types of emergency lending the Fed conducted during the 2008 crisis.[76] Finally, Title III extends the FDIC deposit insurance limit to $250,000.[77] This approach has reduced the competitiveness and effectiveness of the U.S. financial system, and has undermined financial intermediation and stability.

To reverse these trends, policymakers should take an entirely different approach to regulating capital markets. The main goals of a financial market reform program should be to reduce impediments to capital formation and market efficiency, to reduce unwarranted regulatory costs, to eliminate policies that socialize private investors’ losses, and to protect taxpayers from bailing out failed financial firms. In both the banking and securities industries, the main goal of regulations should be to provide reasonable, scaled disclosure, enforce contracts, and deter fraud.

In many cases, the current disclosure rules have become overly burdensome and so voluminous that they obfuscate rather than inform.[78] For example, over the past 20 years, the average number of pages in annual reports devoted to footnotes and “Management’s Discussion and Analysis” has quadrupled.[79] Other so-called disclosure laws have also expanded in scope. For instance, although TILA is supposed to promote uniform disclosure of credit terms to relatively unsophisticated consumers, the rules are so complex that regulators monitor banks’ training programs to ensure that employees are properly trained in TILA requirements.[80]

The new framework should be grounded in the following principles:

• Private markets do a better job of allocating capital than the government.
• The government exists to protect individuals’ property, to prevent fraud, and to enforce contracts. It is not a proper function of government to protect people from making poor business or investment decisions, or from bad luck.
• Government regulators do not have better investment judgment than private citizens investing their own money.
• The socialization of the risk of loss via government backing increases the willingness to take unwarranted risk, reduces rather than enhances stability, increases concentration in the financial services industry, rewards politically connected actors, and imposes an unfair burden on taxpayers.

Broadly, regulations directed at restricting investor choice and substituting regulators’ investment judgment for that of investors should be discarded. To promote freedom, improve the economy, and enhance the stability of the financial system, a new regulatory framework should be adopted for both banking and securities markets.

Bank Regulation. Throughout U.S. history, banking regulations have increasingly focused on risk management conducted by regulatory agencies rather than on disclosure and fraud prevention. Yet, data show that the U.S. has had 15 banking crises since 1837, a total that ranks among the highest of developed countries.[81] Similarly, among severe economic contractions in six developed nations from 1870 to 1933, banking crises occurred only in the U.S.[82] More recently, the U.S. is one of only three developed countries with at least two banking crises between 1970 and 2010.[83] Furthermore, as federal interventions, such as central banking, deposit insurance, and loan guarantees, became more widespread internationally, banking crises occurred relatively more frequently.[84] Evidence also suggests that government policies have not greatly improved overall macroeconomic stability in the U.S. during the post WWII era.[85]

The safety and soundness regulations imposed on U.S. banks are consistently justified by citing systemic-risk concerns (financial and macroeconomic stability), as well as the necessity of protecting the FDIC insurance fund.[86] In the 1980s, regulators forced the Basel capital rules on virtually all banks, even though these rules were originally meant only for internationally active financial institutions. Banks are now dealing with the third iteration of these rules, known as Basel III.[87] Under this system, banks must maintain various capital ratios and liquidity buffers based partly on regulators’ subjective risk assessments. These rules impose needlessly complex requirements. They impose lower capital requirements for assets that regulators deem safe, and higher capital requirements for assets that regulators deem riskier.[88]

Rather than forcing banks to adhere to arbitrary standards set by regulatory fiat, policymakers should introduce more market discipline into the system so that, ultimately, market participants can set their own capital rules. While allowing market participants to determine the appropriate equity levels for funding still fails to guarantee a stable banking system and macroeconomy, evidence clearly shows that allowing regulators to set statutory capital requirements fails as well. What’s more, both theory and evidence suggest that the banking system will perform better when banks’ capital suppliers face more market discipline.[89]

Imposing more market discipline in the banking sector will require major changes to the FDIC bank-resolution process, the FDIC deposit-insurance scheme, and the Federal Reserve’s lending authority. It is critical that banks’ capital suppliers are no longer protected from loss by taxpayers. Allowing banks to fail, just as other types of businesses are allowed to fail, is integral to bringing market discipline to the financial sector.

The fear that a bank failure could freeze a large amount of customer deposits, thus disrupting the economy, has been a main contributing factor to the existing FDIC bank-resolution process. There are, however, many market-based options used around the world that could replace the FDIC process and bring much-needed market discipline to the banking sector. New Zealand, for instance, uses an open-bank-resolution policy that freezes a portion of a failed bank’s assets but allows the bank to remain open to conduct limited business in a way that minimizes economic disruptions.[90]

There is no doubt that the taxpayer-backed deposit insurance provided by the FDIC insulates banks from market discipline. To mitigate this problem, FDIC deposit insurance should be reduced, at least to the pre-Dodd–Frank limit of $100,000 per account. Even lowering the value to the pre-1980 limit of $40,000 per account would insure a level (based on 2014 data) nearly 10 times the average transaction account balance of approximately $4,000.[91] Another major improvement would be to require that banks acquire private deposit insurance from well-capitalized insurance company syndicates. At the very least, a private system that mutualizes deposit insurance losses—as in other countries—should be developed.[92] Research shows that countries with more government involvement in a deposit insurance system, and with higher levels of deposit insurance coverage, tend to have more bank failures and financial crises.[93]

Taxpayer backing in the current framework also comes indirectly from the Federal Reserve, which has a long history of using its emergency lending and discount-window loan policies to support failing firms.[94] This type of lending perpetuates the too-big-to-fail problem, so Congress should eliminate the Fed’s ability to provide such lending, and limit the Fed to providing system-wide liquidity (instead of allocating credit to individual institutions). The Fed can expand system-wide liquidity by, for example, temporarily expanding its open-market purchases as it did during the Y2K scare and after the 9/11 terrorist attacks. Banks can then use the temporary expansion in liquid reserves to lend to each other as needed in the federal funds market, presumably only to sound banks.[95] Combined, these improvements will introduce more market discipline into financial markets with minimum economic disruption.

Securities Regulation. Current securities laws are a complex morass. They impede capital formation, disproportionately harm small and start-up businesses, and reduce innovation and economic growth. Securities laws should focus primarily on the core mission of deterring and punishing fraud, as well as requiring reasonable, limited, scaled disclosure by widely held firms.[96] That is, public firms should disclose material information required by investors to make informed investment decisions, such that larger and more widely held firms are subject to greater disclosure requirements.

The modern securities market is generally interstate in character and therefore most primary offerings, secondary markets, and broker-dealers should be subject only to the federal regulatory regime. State securities regulation should be limited to intrastate offerings and anti-fraud enforcement rather than offering registration and qualification.

The law should allow the development of robust secondary markets in the securities of smaller companies by improving existing secondary markets for small public companies, establishing a regulatory environment that enables venture exchanges, and reasonably regulating the secondary sales of private securities. Regulators should not engage in “merit review” or mandate particular portfolio choices where regulators seek to substitute their investment or business judgment for that of investors.

Conclusion

Historically, the U.S. has one of the worst financial-stability records among developed nations. Virtually every crisis period has been followed with the same response: more invasive federal regulation. This response has not improved stability, but it has made the financial sector less competitive because younger, smaller firms find it more difficult to comply with voluminous, complex regulations. Currently, more than ever before, federal oversight of U.S. capital markets relies on regulators to plan, protect, and maintain the safety of the financial system. Furthermore, the federal government now stands ready to absorb private financial firms’ losses to an even greater degree than prior to the 2008 crisis.

For decades, regulators—undaunted by their past failures—have taken a more active role in managing financial firms’ risk-taking. It is time to move to a more market-based regulatory system where private actors—not taxpayers—absorb losses when they take unwarranted risks, and poorly managed banks are allowed to fail. Such an approach would have the added benefit of reducing the regulatory burden on smaller financial institutions, increasing their competitiveness and reducing concentration in the industry.

Securities laws should focus primarily on the core mission of deterring and punishing fraud, as well as requiring reasonable, limited, scaled disclosure by widely held firms of information material to investors’ investment decisions. The modern securities market is generally interstate in character and therefore, in order to reduce barriers to small-firm capital formation, most primary offerings, secondary markets, and broker-dealers should be subject only to the federal regulatory regime. Moreover, the law should allow the development of robust secondary markets in the securities of smaller companies. Finally, regulators should not seek to substitute their investment or business judgment for that of investors.

—David R. Burton is Senior Fellow in Economic Policy in the Thomas A. Roe Institute for Economic Policy Studies, of the Institute for Economic Freedom and Opportunity, at The Heritage Foundation. Norbert J. Michel, PhD, is a Research Fellow in Financial Regulations in the Roe Institute.