Banking regulation

- To increase the safety of money deposited into bank accounts, governments around the world have imposed regulations on bank operations. - Let's consider an extreme example. Let's say that I bring $1,000 and deposit it into your bank. Now, you immediately take that $1,000 and loan it to my brother here. - And I take that $1,000, use it to start a very risky business. And in just a few months, I'm completely bankrupt. - So I return to the bank and want to withdraw my $1,000. You, the banker, have to tell me that my money is gone. - Now, if stories of people losing money deposited in banks circulate, then two things happen. - [Instructor 2] First, there's a run on the banks. A rush by depositors to get their money out quickly as possible before all the money is gone. - [Instructor 1] If you watch old movies, you've seen a run on the bank. There is one in the original "Mary Poppins" movie, and there is one in the classic Christmas movie, "It's a Wonderful Life." - [Instructor 2] The second thing that happens is that people lose faith in banks and decide to protect their savings the old fashioned way, bury it or hide it under a mattress. - Without savings flowing into banks, serving as the foundations for loans to start and expand businesses, and economy slows down, sometimes dramatically. - The worldwide Great Depression of the 1930s is a classic example. - So governments impose regulations on banks to reduce the likelihood of depositor losses and bank failures. - [Instructor 2] The details of these regulations differ from country to country, but most of these sets of regulations share five common elements, reserve requirements, restrictions on activities that banks can undertake, requirements for a minimum of equity in banks' capital structures, restrictions on loans, and finally, deposit insurance. - The first of these is reserve requirements. Rather than allow a bank to make loans of 100% of its amount of deposits, banking regulators typically require banks to hold some of the amount of deposits in reserve. - [Instructor 2] In the United States, this reserve requirement percentage has recently been 10%. - [Instructor 1] But to spur the economy in the wake of the COVID slowdown in 2020, the United States Federal Reserve temporarily reduced the reserve requirement percentage to 0. - Next, restrictions on non-loan activities that banks can undertake. Now, historically, traditional banks have borrowed from depositors and use the money to make loans to businesses and individuals. - But inevitably, some banks have been attracted to make more adventuresome investments beyond loans. - To control the risky behavior of banks, government regulators frequently impose constraints on what types of banking behavior are allowable. - [Instructor 1] For example, in the United States, the Volcker Rule restricts the ability of banks to invest in high risk investments, such as private equity funds, some derivatives, and hedge funds. - [Instructor 2] Next, minimum equity in banks' capital structures. The Basel standards are a voluntary global standard requiring a minimum amount of shareholder investment in banks. - These shareholder provided funds provide a cushion against depositor losses if some loans go bad. - Determining the Basel standard minimum capital is a complex, risk adjusted computation. But roughly speaking, a bank must have investor provided capital of at least 3% of total assets. - The next item, restriction on loans. Government regulators impose restrictions on the concentration of a bank's loans and the quality of the loan portfolio. - [Instructor 2] For example, in the United States, a national bank may not loan an amount exceeding 15% of its regulatory capital to any one borrower. - In addition, government bank examiners regularly visit banks and evaluate the riskiness of the banks' loan portfolios. - Finally, deposit insurance. Governments around the world provide insurance against loss for deposited amounts in covered banks. - [Instructor 1] For example, in the United States, the Federal Deposit Insurance Corporation, the FDIC, will make sure that depositors receive a replacement of up to $250,000 of deposited amounts in an FDIC insured financial institution that goes bankrupt. - In summary, in countries around the world, governments imposed regulations on banks to reduce the likelihood of depositor losses and bank failures.