Banking Supervision & Regulation
The health of the economy and the effectiveness of monetary policy depend on a sound financial system. Through supervising and regulating financial institutions, the Federal Reserve is better able to make policy decisions. Bank supervision involves monitoring and examining the condition of banks and their compliance with laws and regulations. If a bank under the Federal Reserve’s jurisdiction is found to have problems or be noncompliant, the Federal Reserve may use its authority to request that the bank correct the problems. Bank regulation includes issuing specific regulations and guidelines to govern the operations, activities and acquisitions of banking organizations.
The Federal Reserve System supervises and regulates a wide range of financial institutions and activities. The Federal Reserve works in conjunction with other federal and state authorities to ensure that financial institutions safely manage their operations and provide fair and equitable services to consumers. Bank examiners also gather information on trends in the financial industry, which helps the Federal Reserve System meet its other responsibilities, including determining monetary policy.
How a Bank Earns a Profit
Just like any other business, a bank earns money so that it can run its operations and provide services. First, customers deposit their money in a bank account. The bank provides safe storage and pays interest on customers’ deposits. The bank is required to keep a percentage of deposits in reserve as cash in its vault or in an account at a Federal Reserve Bank. The bank can lend the rest to qualified borrowers. Potential borrowers may wish to buy a house or a new car; however, they may not have enough money to pay the full price at one time. Instead of waiting to save the money to pay for a new house, which could take years, they take out a loan from a bank. Borrowers are charged interest on the loan – a bank’s primary source of income. Banks also make money from charging fees for other financial services, such as debit cards, automated teller machine (ATM) usage and overdrafts on checking accounts.
Safety and Soundness
Two major focuses of banking supervision and regulation are the safety and soundness of financial institutions and compliance with consumer protection laws. To measure the safety and soundness of a bank, an examiner performs an on-site examination review of the bank's performance based on its management and financial condition, and its compliance with regulations.
The examiner uses the CAMELS rating system to help measure the safety and soundness of a bank. Each letter stands for one of the six components of a bank’s condition: capital adequacy, asset quality, management, earnings, liquidity and sensitivity to market risk. When performing an examination to determine a bank’s CAMELS rating, instead of reviewing every detail, the examiner evaluates the overall health of the bank and the ability of the bank to manage risk. A simple definition of risk is the bank’s ability to collect from borrowers and meet the claims of its depositors. A bank that successfully manages risk has clear and concise written policies. It also has internal controls, such as separation of duties. For example, a bank’s management will assign one person to make loans and another person to collect loan payments.
A safety and soundness examiner also reviews a bank’s lending activity by rating the quality of a sample of loans made by the bank. When a bank reviews a loan application, it uses the "5-Cs" to assess the quality of the applicant. The 5-Cs stand for:
- Capacity - measures the borrower’s ability to pay, including borrower’s payment source and amount of income relative to debt.
- Collateral - what are the bank’s options if the loan is not paid? What asset can be turned over to the bank, what is its market value, and can it be sold easily? A valuable asset might be a house or a car.
- Condition - this refers to the borrower’s circumstances. For example, if a furniture storeowner is asking for a loan, the banker would be interested in how many chairs and sofas the store is expected to sell in the area over the next five years.
- Capital - the applicant’s assets (house, car, savings) minus liabilities (home mortgage, credit card balance) represent capital. If liabilities outweigh assets, the borrower might have difficulty repaying a loan if his regular source of income unexpectedly decreases.
- Character - measures the borrower’s willingness to pay, including the borrower’s payment history, credit report and information from other lenders.
Other Bank Regulators
Several federal and state authorities regulate banks along with the Federal Reserve. The Office of the Comptroller of the Currency (OCC), the Federal Deposit Insurance Corporation (FDIC), the Office of Thrift Supervision (OTS) and the banking departments of various states also regulate financial institutions. The OCC charters, regulates and supervises nationally chartered banks. The FDIC, the Federal Reserve and state banking authorities regulate state-chartered banks. Bank holding companies and financial services holding companies, which own or have controlling interest in one or more banks, are also regulated by the Federal Reserve. The OTS examines federal and many state-chartered thrift institutions, which include savings banks and savings and loan associations.
Remember that customers deposit money in a bank, and then the bank makes loans with these deposits to qualified borrowers. Whether a customer deposits money in a bank or applies for a loan, there is a lot of information to consider. Suppose you deposit money into a savings account at a local bank. What minimum balances are you required to keep? Are you charged a penalty if your account falls below the minimum amount? When you apply for a loan for a used car, do you know if the interest rate is allowed to vary, or is it fixed for the life of the loan? If it is allowed to vary and interest rates go up, the total amount of interest you owe will increase. Banks are required to provide customers clear and accurate information about services, such as savings accounts, loans and credit cards. For example, a bank’s brochure for a savings account should include information on any minimum balance required, monthly service fee and the average percentage yield. In addition, the Truth in Lending Act requires banks to disclose the finance charge and the annual percentage rate so that a consumer can compare the prices of credit from different sources. It also limits liability on lost or stolen credit cards. These laws ensure that consumers and banks make decisions based on the same information.
If consumers have a complaint about a financial institution they can contact the Federal Reserve. Together with the twelve Federal Reserve Banks, the Board of Governors can answer questions about banking practices and investigate complaints about specific banks under the Fed’s supervisory jurisdiction. For more information, visit Federal Reserve Consumer Help - http://federalreserveconsumerhelp.gov/.
Congress passed the Community Reinvestment Act (CRA) in 1977 in response to the banking industry and community groups concerns about “redlining”, or the refusal of a bank to lend money in low-income communities, while at the same time, accepting deposits from those areas. In accordance with the CRA, the Federal Reserve reviews a bank’s attempt to meet the credit and development needs of its entire community, sometimes including its efforts to lend in including low- and moderate- income areas. When deciding whether to approve an application for a bank acquisition or merger or for the formation of a bank holding company, the Federal Reserve takes into account an institution’s performance under the CRA.