1.5 Financial Regulators
There are many government agencies at the federal and state levels that regulate financial markets. These agencies primarily exist to establish trust. If people lack confidence in the functionality and integrity of a financial market, then it will not last. Consider the story of Confucius and his disciple Zigong:
Zigong asked about government. The Master said, You need enough good, enough weaponry, and the trust of the common people.
Zigong said, If you had to do without one of these, which of the three would you do without first?
Do without weapons.
And if you had to do without one of the other two, which would it be?
The Master said, Do without food. From times past, everyone has to die. But without the trust of the common people, you get nowhere.1
Federal Reserve Board
The Federal Reserve Board, more commonly referred to as the “Fed,” is the central bank of the U.S., and it is involved with the regulation of depository institutions, such as commercial banks. The Federal Reserve Act of 1913 gave the Fed responsibility for setting monetary policy, which includes actions that influence the money supply in the economy. There are seven Boards of Governors that serve 14-year terms, which includes the chair, who serves a 4-year term. The chair, or head of the Fed, may serve multiple terms, either consecutively or non-consecutively, during service on the Board of Governors. There are 12 Fed district banks that service different geographic areas.
Image from the Board of Governors of the Federal Reserve System 2015 Annual Report.
The Federal Open Market Committee (FOMC) consists of 12 members—the 7 members of the Board of Governors, the president of the New York Fed district bank, and then 4 of the remining 11 Fed district bank presidents on a rotational basis. The FOMC meets eight times per year to discuss current economic and financial conditions and determine appropriate monetary policy action. The Fed has two primary objectives: maintain full employment and ensure stable prices. The three tools of monetary policy that the Fed can use to achieve its objectives are open market operations, adjusting the discount rate, and setting the reserve requirements.
Office of the Comptroller of the Currency
A well-functioning banking system is critical for economic growth. Accordingly, in addition to the Fed, there are many other regulatory agencies that oversee deposit institutions. The Office of the Comptroller of the Currency (OCC) was established in the National Currency Act of 1863, making it one of the oldest federal agencies. The OCC operates as an independent branch of the U.S. Department of the Treasury and is charged with chartering, regulating, and supervising all national banks and federal savings associations. As of 2022, the OCC supervised over 1,100 banks that controlled more than $15 trillion in assets.
Federal Deposit Insurance Corporation
The Federal Deposit Insurance Corporation (FDIC) was created to maintain stability and public confidence in the banking system. The rise in bank failures around the Great Depression left people lacking trust in deposit institutions. In response, the FDIC was created by the Glass-Steagall Act of 1933. The FDIC provides protection, or insurance, on deposit accounts, such as checking and savings accounts. If you were to deposit money into your local bank, the FDIC would ensure that your money would not disappear even if the bank failed. Each depositor is protected up to $250,000. The FDIC also supervises financial institutions to ensure financial safety and soundness.
Securities and Exchange Commission
The principal regulator of financial markets in the U.S. is the Securities and Exchange Commission (SEC). Ever since the SEC was established by the Securities Exchange Act of 1934, it has operated with the same three-part commitment: (1) protect investors; (2) maintain fair, orderly, and efficient markets; and (3) facilitate capital formation. How does the SEC accomplish this? For one, everyone should have access to timely, accurate, and complete information on both financial assets and entities that sell them. The SEC ensures that participants in financial markets, such as institutions, professional money managers, and corporations, regularly disclose financial and other relevant information so that all people can make informed investment decisions. Secondly, the SEC proposes and enforces federal securities laws that prohibit certain types of conduct (e.g., deceit and misrepresentation) in financial markets. An example of both deceit and misrepresentation is a Ponzi scheme, which is a type of fraud that pays existing investors with money obtained from new investors. The scheme works until no new investors join the pyramid. Essentially, no new wealth is being accumulated, but rather, money is just transferring hands.
Bernie Madoff, the former chairman of NASDAQ and a long-time stock broker and financial advisor on Wall Street, successfully ran a Ponzi scheme like the one depicted above, allegedly for decades. It has been estimated that Madoff defrauded thousands of investors out of billions of dollars. On June 29, 2009, Madoff, age 71, was sentenced to 150 years in prison with restitution of $170 billion.2 Interestingly, the SEC was highly criticized over this scandal, as they were tipped about potential wrongdoings as early as 1999. Thus, even with regulation in place, it is still important as the investor to do your own due diligence!
Financial Industry Regulatory Authority
The Financial Industry Regulatory Authority (FINRA) was formed in 2007 and oversees more than 600,000 U.S. broker-dealers. The primary goal of FINRA is to create a fair financial market for everyone by protecting the public against illegal or bad practices. An example of a bad broker practice is churning, which is the excessive trading of financial assets within a customer’s investment account with the sole intent of generating commissions. Now, sometimes a good amount of trading is necessary to achieve certain investment goals, but if the intent is wrong, then the practice can lead to great financial loss. FINRA helps write and enforce rules by investigating brokerage firms and individuals for non-compliance and unethical behavior.