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Course: Law of Banking and Financial Institutions (Benchmark Assignment #1) *Most Recent Writing Sample (November 2014)
Law of Banking and Financial Institutions
Unit 1 – Benchmark #1 Assignment
THE U.S. BANKING SYSTEM
I. The Nature of Banking and Legislation Regulating Banking
As the business of banking grew more complex so did the laws governing banking. Such that, regulations on financial institutions (i.e. banks), required legislation that would permit or prohibit certain activities associated to the business of banking and the services they perform (Banking Law §1.03, 4-5, Matthew Bender & Company, Inc., 2013, LexisNexis).
A.Important Banking Acts
A significant piece of legislation was The Banking Act of 1933. “The Act required all banks to choose whether to conduct business activities in the field of commercial banking or investment banking” (5-6). This was during a time when “banking ventures were viewed as inherently risky and speculative” (6). Legislation such as The Banking Act of 1933, have been needed from time to time, especially during the depression. At the time the Act was created, “Congress passed The Glass-Steagall Act in 1933 in response to perceived abuses in bank operations which had occurred during the depression” (6). Thus, new legislation concerning the commercial banking system, was sparked by the Great Depression, and the effect it had on the financial system in the United States.
One of the issues of “congressional Concern about the commercial banking system” in the 1980s was the “floundering of commercial banks,” “corporate takeovers, the placement of junk bonds, and the like” (6). Due to this “intertwining [of] commercial and investment activities,” of congressional concern, resulted in The Bank Holding Company Act of 1956. This Act was important because “it made the approval of The Federal Reserve Board a requirement for formation of a new bank holding company (6). Other requirements established by legislation, included, “a type of ‘demand deposit’ that could be used by savings and loan associations,” which the FDIC and FSLIC “placed on depositors’ accounts,” which “led to effective deregulation,” such as “the gradual removal of the interest rate ceilings that the insuring entities . . . placed on depositors accounts” (6). This was the “Depository Institutions Deregulation and Monetary Control Act of 1980,” (6) described above.
In other times, legislation in the banking finance industry, has been needed in response to an emergency, and during the crisis in the 1980’s (i.e. thrift crisis) –and The Financial Institutions Reform, Recovery, and Enforcement Act of 1989 (FIRREA) was created (7). This is an example of an Act (i.e. legislation) that prohibited certain banking activities. In fact, the “FIRREA gave the FDIC authority to examine savings associations as necessary for insurance purposes and to issue regulations barring associations from engaging in certain activities” (7). In doing so, funds were transferred and managed by the FDIC. The “FIRREA created the FSLIC Resolution Fund” to serve the purpose of “enhance[ing] the capital requirements of savings associations and applied the national bank lending limits to the savings associations . . .” to the same extent they applied to national banks (7).
B.Need for Government Intervention & Remedies
Government intervention has been needed, from time to time, during instances when “supervisory and regulatory process[es] in the U.S. banking system, needed to be strengthened (8). In other times, new banking legislation has been needed when “banking law enforcement” (8) has been needed. –The Crime Control Act of 1990 was created for the purpose of “plac[ing] prohibitions on control or participation in depository instituions by certain convicted persons, protected assets of the FDIC as conservator or receiver from wrongful disposition” (8). This legislation was important, because it also served to “amen[d] The Bankruptcy Code,” regarding debts arising from breach of a fiduciary duty to insured institutions” (8).
Legislation such as The Crime Control Act, is an example of a need for government intervention, because it brought up banking law enforcement on areas of banking to prevent “benefits which may be subject to misuse” from arising (8). This in turn gave “additional authority to the federal banking agencies, the Justice Department, and in particular, the FDIC to help resolve the continuing financial institution crisis” (8).
Today the Comptroller “supervis[es] the operation of national banks . . . and trust activities” (Banking Law §1.06, 2). The Comptroller charters those institutions, and can convert state banks to national ones, while “regulat[ing] permissible . . . activities of national banking association” (2). This is a good example of government intervention, whereby guidelines are set, and banks supervised to insure quality “management and compliance with applicable laws and regulations” (Banking Law § 1.06, 2).
The Board of Governors, is another example of government intervention, which sets “monetary policy and regulate[s] and supervise[s] [the] Federal Reserve Banks, member banks, bank holding companies, and . . . other depository institutions” (§ 1.06, 2). –In addition, the government also sets monetary policy “to influence or control the costs and availability of money and credit” (3). Monetary policies including discount rates and rescue requirements are set when government intervention is needed and money is borrowed from the Federal Reserve System (§ 1.06, 3). This regulatory authority, exercised by the Board, supervises, approves, examines, gathers reports on assets and liabilities, and may approve or deny banking holding company acquisitions of additional banks, and performs other administrative roles (§ 1.06, 4).
Another example of government intervention is the establishment of insurance funds through the FDIC, “to provide for the resolution of liabilities incurred” (9). So that, “in the event [that] an insured institution fails,” that bank may be acquired by another institution who will assume the deposit liabilities of the failed association” (§ 1.06, 9). How so? The FDIC exercises government intervention, in the form of establishing a “risk based assessment system” (§ 1.06, 12) designed to evaluate capital measures of institutions, to determine what type of supervision (and subsequent intervention) is needed to accommodate those “that pose substantial probability of loss . . . unless corrective action is taken” (12).
In addition, government intervention has been needed with regards to consumer protection whereby, federal regulation –equally applies to all types of depository institutions (Banking Law § 2.04, 36). Consumer safeguards, mandated by federal regulation, apply to: home mortgage settlements, and all depository institutions –state or federally chartered (36).
C.Aspects of Banking –Inherently Unstable
An aspect of banking that was inherently unstable, occurred in 1863 during the passage of the National Bank Act, and National Currency Act (Banking Law § 1.04, 17). During that time, was when the federal governments ability to charter banks was established (17). It took more than 40 years, “before a procedure for chartering privately owned federal financial institutions was put in place” (17).
When Congress first passed the National Bank Act of 1863, during the “proliferation of new state financial institution charters,” “bank failures were common in times of economic downturn” (Banking Law § 1.04, 17). Although “states [were given the power] to charter financial institutions” (17) these “free banking Acts” “authorized the formation of banks upon compliance with certain requirements.” (17) However, “states made little to no attempt to regulate the conduct and business of these institutions” (17). –Which brings up another inherently unstable quality of private banking is the “dangerous tendency toward a ‘race of laxity’ in bank supervision” (Banking Law § 1.04, 19) thought to “lead [to] an accelerating rate, to deterioration of the standards of sound banking,” a function of bank supervision to maintain” (19).
Banking law is complex and confusing, comprised of an “array of financial institutions, regulatory agencies and statutes” (Banking Law § 1.02, 3). This evolving banking system, changed based on the financial needs of the nation, and thus provides a complex system of statutes, regulatory agencies, and financial institutions (Banking Law § 1.02, 3).
II. Instability of the U.S. Banking System in Comparison to European Crisis
During the early years of the U.S. Banking System there was no chartering system for “privately owned federal financial institutions,” (Banking Law § 1.04, 17). This occurred during the “passage of the National Bank Act . . . [and] the National Currency Act” (17).
Much of the instability in the U.S. Banking System, is a product of the dual banking system. (*See also discussion under III.) During the passage of The National Bank Act it was believed that taxing state bank notes to eliminate them, “would end the pervasive problem of financial panics,” through the “regulation of the national banks by the Comptroller of the Currency” (18). However, the “reserve requirements” and regulation of national banks, did not protect these banks from “bank runs” (Banking Law §1.04, 18). Bank runs may “cause a bank to fail” (18) during times when there was no available currency to cover deposits and more currency needed to meet withdrawal demands (18). In sum, during times of these bank fails due to banks runs and lack of “available currency” meant that “the National Bank Act had failed to provide . . . a “lender of last resort” (18).
This is why the Federal Reserve Act was created, to combat interference between the state and federal systems, by creating “an effective safety net under the entire banking system,” leaving “financial institutions subject to multiple regulators” (18). This overlap created by the dual banking system and conversion of state to national charters’ means that there is also a “tremendous overlap between each of the state and federal regulatory institutions” (18).
However, despite these concern a pro is that “whether federally or state chartered they are “FDIC insured” (19). With the FDIC’s power to “a wide range of examination and enforcement functions . . . applied to any insured depository institution,” means that the dual banking system disburses tremendous power of chartering such institutions more equitably” (19).
A.The US in the Past (Compared to Cyprus)
Historically, the U.S. Banking System, has evolved based on “the particular financial needs of different segments of the nation and to the concepts of Federalism basic to the American political system” (Banking Law § 1.02, 3). For instance, the Dual Banking System was created in response to the “dangerous laxity” (19), which posed a threat to sound banking practices (as discussed above). That is why they set up an insurance framework, whether “federally or state charters,” by the FDIC, for the purposes of “examination and enforcement functions” (19).
The “management or policies” (Banking Law § 1.05, 31) of institutions has also been under scrutiny, historically in the U.S. In order to implement “various regulatory improvements and changes to various aspects of financial regulation” the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, was created (Banking Law § 1.05, 31). The Dodd-Frank Act was comprised of “16 titles that deal with various regulatory improvements and changes to various aspects of financial regulation aimed at insuring consumer protection, [and] preventing further financial crises, and providing stability within the financial system” (Banking Law § 1.05, 31). The Dodd-Frank Act enhanced federal regulation to non-bank financial companies, thus creating this new classification of “non-bank financial companies,” which were “supervised by the Federal Reserve in cooperation with the FDIC” (31).
In addition, the FDIC, regulates compliance of banks, and evaluates any “adverse effects on economic conditions or financial stability . . . [of] the operating institution . . [to] manipulate these adverse effects” (Banking Law § 1.06, 11). In order to avoid situations, or remedy emergencies, like what happened in Cyprus, the FDIC has the power to “suspend or remove” anyone from engaging in “unsafe or unsound” practices (Banking Law §1.06, 11).
Currently, with respect to the mortgage crisis in the U.S., The Federal Home Loan Bank System was established by the Federal Home Loan Act of 1932, and presented a “reserve credit system for thrift institutions” (Banking Law §1.06, 13). –In the event of a crisis, the Federal Home Loan Bank System and the Federal Housing Finance Board (FHFB) were created to ensure “banks carry out their housing finance mission, remain adequately capitalized and operate in a safe and sound manner” (Banking Law §1.06, 13).
(See also discussion under I.-B).
If there is a banking failure, depository institutions may pay back that liability and obligation to depositors, others general creditors, shareholders, and other members (Banking Law § 1.06, 10). –Reports and other are created to ensure “orderly resolution of the institution “as well as determine “the administrative expenses, necessary expenses . . . [and those] unpaid at the time of failure” (10).
The FDIC, oversees federally-chartered state banks and in the event of bank failure, may liquidate assets to pay depositors and other creditors (10). It therefore has the “authority to provide for emergency interstate or interindustry acquisitions under certain conditions” (10).
III. Pros and Cons of the Dual Banking System in the United States
A pro of the dual banking system, is that “banks may be regulated by the federal government” (16). The overlapping regulatory power of the “many different varieties of state [and federal] regulatory schemes” grows out of the “need for a strong central bank [and] . . . a strong central government” (Banking Law § 1.04, 16). Another pro of the dual banking system is that “dual regulation and dual chartering extends to the thrift industry, as well as the banking system” (16). Under the dual banking system, both state and federal governments have the “power to charter financial institutions” (16). –However, the Dual Banking System had a very unintended result, by enacting “legislation to provide for the charter of national banks,” (e.g. Con) (18); the number of state banks dropped during the passage of the National Bank Act, until state banks “discovered deposits as a source of funds” (18).
The Federal Reserve Act in 1913, came about with the “idea of federal charters of financial institutions,” when “there were twice as many state banks as federal banks” (17). This act was important because it “specifically provided for the conversion of state banks to national banks” (Banking Law § 1.04, 18). The “ability to switch from state to federal charters continues to exist today” and has continued to give “the dual banking system great vitality” (18). This ability to convert freely from state to federal charters, allows “existing institutions [to] make choices about their regulatory authorities” (18). –(For continued Con discussion see II.)
Today “the dual banking system” can be “best described as two interrelated systems in which most state-chartered institutions [may be] subject to some federal regulation and in which federally-chartered institutions are governed, to some extent, by state laws” (Banking Law § 1.04, 19).
IV. The Four Main Types of Depository Institutions & How They Differ
“The four main types of depository institutions in the United States are: (1) Commercial Banks, (2) Savings and Loan Associations, (3) Savings Banks, and (4) Credit Unions (Banking Law § 1.05, 22).
The four main types of financial depository institutions provide services that vary with specialties ranging from: short term business credit, home finance, consumer loans, to mutually owned thrift institutions (22). –In addition it is important to note that the four major types of depository institutions are further subdivided, depending on whether they are “bank, thrift, or financial holding companies that fall under federal banking regulation” (22).
Commercial Banks are synonymous with stock corporations, “specializ[ing] in short-term business credit (Banking Law § 1.01, 1). Of the four major types of financial depository institutions, “commercial banks are the most important” (Banking Law § 1.05, 22). They have a “broad range of financial powers” (§1.05, 22) consider the “bulwarks of the depository industry” (§1.05, 22). Commercial banks are “organized as stock associations” (§1.05, 22) offering “deposit accounts, [that] include time and savings accounts” (§1.05, 22). They “accommodate all types of borrowers,” and may make: commercial loans, business loans, consumer loans, and mortgage loans (§1.05, 22). They may also invest in “government securities” (§1.05, 22). –It is important to also note that commercial banks may be further subdivided “into four categories based upon the chartering authority and their relationship with the major federal regulatory bodies” (Banking Law §1.05, 22).
Savings and Loan Associations are described as “the most prominent type of thrift institution” (Banking Law §1.05, 25). They have “historically specialized in home mortgages and savings accounts for small savers” (Banking Law §1.05, 25). “Prior to 1933, all savings and loan associations were chartered by the states either as mutual organizations or stock companies” (25). –Raising capital, through stock associations, similar to the structure of a corporation or by mutual association, increasing capital “only through retention of operating profits” (25).
Savings associations are governed by a dual system, which means they are either “state or federally chartered” (25). As a result of the Home Owners Loan Actin 1933, Congress enacted this dual system for purposes of establishing supervision by the Federal Home Loan Board, or by state authorities (25). Enabling “state-chartered savings associations” to apply for membership to Federal Home Loan Bank system and “insurance coverage with the FDIC” (25). This membership also allowed “state-chartered savings associations” to “convert to federal charter, and federal associations [to] . . . state charter if state law permits such a conversion” (25). That described the supervision imposed in 1933, and dual system governing savings and loan associations in the U.S. Banking System.
Savings and Loan Associations may be further subdivided as “federal savings and loan associations (26). These types of associations were “primarily limited to mortgage lending” and given almost “equivalent powers” as federal savings banks. Overtime, especially during the Depository Institutions and Monetary Control Act of 1980 (26), those powers of federal savings and loan associations were expanded to include: NOW (interest bearing checking) accounts, authorization to issue credit cards and extend credit to cardholders, trust powers (given by federal regulator by special permit),” and “permitted to invest and hold commercial paper and certain debt instruments,” make loans secured by commercial real estate and commercial loans, may be “designated a depository of public money . . . [and] be employed as a fiscal agent of the United States” (Banking Law §1.05, 26).
Savings Banks “are depository institutions established for the primary purpose fo encouraging thrift among persons of modest means” (26) with a “primary objective of . . . promot[ing] –thrift among the general public” (26). There are federal savings banks, state-chartered mutual savings banks, and state-chartered mutual or stock savings banks (Banking Law §1.05, 27). -Savings Banks are “organized in two ways”: (1) a “stock savings bank (or guaranty savings bank) [with] capital stock . . . managed by a board of directors,” (26) or (2) as a “mutual savings ban[k], which are more common . . . [and] technically owned by their depositors” (Banking Law §1.05, 26).
Prior to 1978, “no federal provisions existed for chartering savings banks” and they “were all organized under state law,” primarily “concentrate[ing] their lending activities in the home mortgage market,” and once “only accepted savings deposits” (27). –Authorized by state law, savings banks may: “rent safe deposit boxes, make educational and consumer loans, administer estates, and perform other fiduciary duties and even to offer low-cost term life insurance” (27). Recently, powers have been expanded to “federally-chartered savings banks” and under federal law, “federal savings banks may make commercial loans, offer transaction accounts and lease personal property” (27).
Savings banks are regulated, federally by the Comptroller of the Currency (with membership to the Federal Home Loan Bank System, insured by The Federal Deposit Insurance Corporation), and state (savings banks) regulated by state regulators (with eligible membership to the FDIC for insurance, and membership to The Federal Reserve System) (27).
Credit Unions “are mutually owned thrift institutions, chartered by either state or the federal government” (Banking Law § 1.05, 27). Credit Unions are described as being “typically democratic” with members having the “same vote regardless of the size of their deposits” (27). There are federal savings banks, state-chartered mutual savings banks, and state-chartered mutual or stock savings banks (Banking Law §1.05, 27). Credit Unions primarily serve “predominantly low-income members” (28), “specializ[ing] in short-term personal loans for members, and . . . is –their primary lending activity” (28). Credit Unions are required to share some common bond whether it be “having the same employer, belonging to the same labor or social association[,] or living within the same neighborhood” (27).
There are federal credit unions and state-chartered credit unions. “Under the Financial Institutions Reform, Recovery, and Enforcement Act of 1989, insured credit unions are required to have an outside independent audit by a certified public accountant” (Banking Law § 1.05, 28). Whereby, their supervisory committee must annually provide a “complete and satisfactory” audit (28). Credit Unions differ from other depository institutions, in that they are “exempt from federal, state, and local taxation, other than real and personal property taxes” (29).
Credit Unions may be federal and state chartered, “federal credit unions are regulated by the National Credit Union Administration . . . [and] under the supervision of The National Credit Union Administration Board (N.C.U.A. Board)” (28). (Note: The NCUA may also regulate “state chartered associations on an optional basis” (28)). Federal Credit Unions “are empowered to lend funds for a wide variety of purposes” (i.e. mortgages, and condominium, mobile home, home improvement, automobile, and business loans) (Banking Law § 1.05, 28).
There are also state credit unions and corporate credit unions. “Credit Unions are restricted [to] investments . . . approved by law” (Banking Law § 1.05, 29). They may also be “federally-insured . . . under the regulatory authority of the Secretary of Treasury” (29). Those which operate to serve other credit unions [are] designated corporate and the services they provide to their members, “unless otherwise prohibited by the Board” or by state law (i.e. if a state chartered institution), and must reflect policies that “address the risk of diversification” and other factors, while “adopt[ing] strategic and business plans . . . acceptable to the NCUA (regulatory agency) (Banking Law § 1.05, 29).
V. Bank Holding Companies vs. Depository Institutions
Bank holding companies differ from depository institutions in that “depository institutions [are] controlled by holding company[ies]” Holding Companies help to “safeguard insured depository institutions” (Banking Law § 1.05, 30). Furthermore, the Gramm-Leach-Bliley Act “specified complex rules on where financial activities must be located in the holding company structure” (Banking Law § 1.05, 30).
There are “bank” holding companies and “financial” holding companies. To “qualify as a financial holding company”: “bank holding companies must meet heightened standards” such that they are “well capitalized and well-managed” (30). –There are also “savings and loan” holding companies, whereby “any company that acquires direct or indirect control of a savings association or of another savings and loan holding company, therefore “becomes a holding company” (30). –“Beginning in 1989, bank holding companies have been specifically authorized to acquire savings associations as subsidiaries” (Banking Law § 1.01, 2). Whereby through that acquisition, control of that savings association therefore becomes a holding company (as stated above) (2).
Agencies regarding holding companies include The Office of the Comptroller of the Currency, the FDIC, and The Federal Reserve (Banking Law § 1.05, 30). Depository Institutions, on the other hand, are regulated by the Comptroller of the Currency, The Board of Governors of The Federal Reserve System, the Federal Deposit Insurance Corporation, and the National Credit Union Administration Board (Banking Law § 1.06, 1). (For more on Depository Institutions, see IV).
Of the major regulatory agencies, the Comptroller of the Currency has jurisdiction over depository institutions that include: national banks and savings and loan associations (Banking Law § 1.01, 1). Other regulatory agencies with jurisdiction over depository institutions are: The Board of Governors of The Federal Reserve System, Federal Deposit Insurance Corporation, and the National Credit Unions Administration Board (Banking Law § 1.01, 1) & (Banking Law § 1.06, 1).
Banking Law (Matthew Bender & Company, Inc., 2013) (LexisNexis).