2.3 Regulation of Financial Institutions and Markets

LG 5 2.3 Regulation of Financial Institutions and Markets

The previous section discussed just how vulnerable modern economies are when financial institutions are in a state of crisis. Partly to avoid these types of prob- lems, governments typically regulate financial institutions and markets as much or more than almost any other sector in the economy. This section provides an overview of the financial regulatory landscape in the United States.

REGULATIONS GOVERNING FINANCIAL INSTITUTIONS As mentioned in the previous section, Congress passed the Glass-Steagall Act in

1933 during the depths of the Great Depression. The early 1930s witnessed a series of banking panics that caused almost one-third of the nation’s banks to fail. Troubles within the banking sector and other factors contributed to the worst economic contraction in U.S. history, in which industrial production fell by more than 50 percent, the unemployment rate peaked at almost 25 percent, and stock prices dropped roughly 86 percent. The Glass-Steagall Act attempted to calm the

Federal Deposit Insurance public’s fears about the banking industry by establishing the Federal Deposit Corporation (FDIC)

Insurance Corporation (FDIC), which provided deposit insurance, effectively

An agency created by the

guaranteeing that individuals would not lose their money if they held it in a bank

Glass-Steagall Act that

that failed. The FDIC was also charged with examining banks on a regular basis provides insurance for deposits to ensure that they were “safe and sound.” The Glass-Steagall Act also prohibited

at banks and monitors banks to ensure their safety and

institutions that took deposits from engaging in activities such as securities

soundness.

underwriting and trading, thereby effectively separating commercial banks from investment banks.

Over time, U.S. financial institutions faced competitive pressures from both domestic and foreign businesses that engaged in facilitating loans or making

CHAPTER 2

The Financial Market Environment

loans directly. Because these competitors either did not accept deposits or were located outside the United States, they were not subject to the same regulations as domestic banks. As a result, domestic banks began to lose market share in their core businesses. Pressure mounted to repeal the Glass-Steagall Act to enable U.S. banks to compete more effectively, and in 1999 Congress enacted and President

Gramm-Leach-Bliley Act Clinton signed the Gramm-Leach-Bliley Act, which allows commercial banks,

An act that allows business

investment banks, and insurance companies to consolidate and compete for busi-

combinations (that is, mergers)

ness in a wider range of activities.

between commercial banks,

In the aftermath of the recent financial crisis and recession, Congress passed

investment banks, and insurance companies, and thus the Dodd-Frank Wall Street Reform and Consumer Protection Act in July 2010. permits these institutions to

In print, the new law runs for hundreds of pages and calls for the creation of sev-

compete in markets that prior

eral new agencies including the Financial Stability Oversight Council, the Office

regulations prohibited them

of Financial Research, and the Bureau of Consumer Financial Protection. The act

from entering.

also realigns the duties of several existing agencies and requires existing and new agencies to report to Congress regularly. As this book was going to press, the var- ious agencies affected or created by the new law were writing rules specifying how the new law’s provisions would be implemented, so exactly how the new leg- islation will affect financial institutions and markets remains unclear.

REGULATIONS GOVERNING FINANCIAL MARKETS Two other pieces of legislation were passed during the Great Depression that had

Securities Act of 1933 an enormous impact on the regulation of financial markets. The Securities Act of

An act that regulates the sale

1933 imposed new regulations governing the sale of new securities. That is, the

of securities to the public via

1933 act was intended to regulate activity in the primary market in which securi-

the primary market.

ties are initially issued to the public. The act was designed to insure that the sellers of new securities provided extensive disclosures to the potential buyers of those securities.

Securities Exchange Act The Securities Exchange Act of 1934 regulates the secondary trading of secu- of 1934

rities such as stocks and bonds. The Securities Exchange Act of 1934 also created

An act that regulates the

the Securities and Exchange Commission (SEC), which is the primary agency

trading of securities such as

responsible for enforcing federal securities laws. In addition to the one-time dis-

stocks and bonds in the secondary market.

closures required of security issuers by the Securities Act of 1933, the Securities Exchange Act of 1934 requires ongoing disclosure by companies whose securities

Securities and Exchange trade in secondary markets. Companies must make a 10-Q filing every quarter Commission (SEC)

and a 10-K filing annually. The 10-Q and 10-K forms contain detailed informa-

The primary government agency responsible for

tion about the financial performance of the firm during the relevant period.

enforcing federal securities

Today, these forms are available online through the SEC’s website known as

laws.

EDGAR (Electronic Data Gathering, Analysis, and Retrieval). The 1934 act also imposes limits on the extent to which corporate “insiders,” such as senior man- agers, can trade in their firm’s securities.