Why are financial institutions among the most heavily regulated sectors in the world?

The topic of financial deregulation is once again generating news stories. It raises a foundational question: “Why is the U.S. banking system so heavily regulated?”

Banking regulation has existed in some form since the chartering of banks and its goals have evolved over time. Today, banking regulation serves four main purposes.

Financial Stability

Instability in the financial system can have material ripple effects into other parts of the domestic and international financial sectors. Supervision that is focused on financial stability (often called macro-prudential supervision) looks at trends and analyzes the likelihood for financial contagion and the possible impacts across firms that pose systemic risks.

Protection of the Federal Deposit Insurance Fund

Since Jan. 1, 1934, the Federal Deposit Insurance Corp. has insured the deposits held in U.S. banks up to a defined amount (currently $250,000 per depositor per bank). The federal government serves as a backstop to the insurance fund.

In exchange for this insurance guarantee, banks pay an insurance premium and are also subject to safety and soundness examinations by state and/or federal regulators. Oversight of individual financial institutions by banking regulators is called micro-prudential supervision.

While the insurance fund protects depositors, it does not protect shareholders of banks. When inappropriate risks are taken and prove unsuccessful, banks will fail and be liquidated.

Consumer Protection

Since the creation of the Federal Trade Commission in 1914, the federal government has had a formal obligation to protect consumers across industries. Since that time, numerous laws and regulations have been crafted by various agencies to protect bank customers and promote fair and equal access to credit.

Banks conduct financial transactions with consumers either directly (lending to consumers and taking consumer deposits) or indirectly (through financial technology on the front end, for example). Banking regulators enforce consumer protection regulations by conducting comprehensive reviews of bank lending and deposit operations and investigating consumer complaints.

Competition

A competitive banking system is a healthy banking system. Banking regulators actively monitor U.S. banking markets for competitiveness and can deny bank mergers that would negatively affect the availability and pricing of banking services.

Although fewer than 40 banks account for more than 70 percent of all U.S. banking assets, as shown in the table below, there are nearly 6,000 institutions of all sizes operating in communities across the country.

While all banks are regulated, not all regulations apply to every bank. We’ll discuss some of these differences in future posts. In my next post, I’ll discuss how the banking system has changed over time—especially over the past 25 years—adding to the complexity and scope of banking regulation in the U.S.

Financial regulation is part of ensuring the safety and soundness of the financial system and protecting consumers. But what does financial regulation mean in practice?

What is financial regulation?

Financial regulation refers to the rules and laws firms operating in the financial industry, such as banks, credit unions, insurance companies, financial brokers and asset managers must follow. However financial regulation is more than just having rules in place - it's also about the ongoing oversight and enforcement of these rules.

The Central Bank of Ireland regulates and supervises over 10,000 financial service providers operating in Ireland. Since 2014, the responsibility for supervising banks is shared between the Central Bank of Ireland and the European Central Bank (ECB).

Most of the laws governing the financial system are made by politicians in the House of the Oireachtas or the European Union. The Central Bank then oversees how these rules are complied with, sometimes issuing additional guidance. These rules have strengthened significantly since the financial crisis

Why is financial regulation important?

All of us depend on the financial system in one way or another. For example, savers rely on banks to have their money available when they need it. Businesses need to be able to borrow to maintain and develop their business. Consumers taking out a mortgage or insurance may need to get advice on the best product for them. In the case of insurance companies, policyholders rely on getting claims paid when something goes wrong.

Poorly regulated financial institutions have the potential to undermine the stability of the financial system, harm consumers and can damage the prospects for the economy. That's why strong financial regulation is important - to put rules in place to stop things from going wrong, and to safeguard the wider financial system and protect consumers if they do go wrong.

How does financial regulation work?

Ensuring firms have the funding to trade safely, have the appropriate risk controls in place and are appropriately governed is known as "prudential regulation".

Ensuring firms treat customers fairly from the sales process to how complaints are managed, is known as "consumer protection".

An important part of prudential regulation is authorisation. We call this our "gatekeeper role" and means we only allow firms to operate in the financial system once they have fulfilled a number of criteria, including governance and risk control.

Consumer protection rules are also in place. These spell out how firms must treat their customers when selling them financial products. So for example, a regulated firm must ensure that it "acts honestly, fairly and professionally in the best interests of its customers and the integrity of the market".

What about supervision?

To make sure firms abide by the rules of regulation, they have to be supervised. Our supervision work is intrusive, and allows us to monitor financial service providers to make sure they are following the rules.

Central Bank staff review and report on all aspects of firms' businesses to judge whether they are being run in a safe and sound manner. They also go on-site in firms to meet key decision-makers and inspect aspects of the business. The number of Central Bank staff doing this job has increased rapidly in recent years, leading to more in-depth supervision.

How closely firms are supervised is based on how much risk they present to the financial system or to consumers. The greater the potential harm, the closer the supervision. This is why we call it "risk-based supervision".

Enforcement and resolution

Having rules and laws, and making sure financial services providers follow them, are the first two pieces to understanding financial regulation. Enforcement and resolution is the third.

Where a firm is found not to be in compliance with the rules, we can take a number of steps. In serious cases, this can lead to the firm facing enforcement proceedings. Having the credible threat of enforcement is essential to deter poor behaviour in the financial services sector.

Finally, there are times when resolution is the only outcome. Resolution is the process of winding down or restructuring a financial institution in a way that minimises harm to the economy.

Why is the banking system much more heavily regulated than other areas of the economy?

What is the most highly regulated industry in the world?

What kind of institution is most heavily regulated?

What are some reasons that banks are highly regulated?