Comprehensive Guide to Financial Institutions and Banking Regulations

Financial institution (FI)

An organization offering financial services; includes both banks and nonbank financial institutions (NBFIs).

Nonbank financial institution (NBFI)

A financial institution that is not a bank, such as a broker-dealer, asset manager, or insurance company.

Primary role of FIs in the economy

Intermediation of funds — providing a mechanism for savers of capital to transfer that capital to parties who need capital.

Commercial bank

An FI that accepts deposits and makes commercial loans; ranges from small community banks to large global institutions with trillions in assets.

Depository institution

A term for a bank based on its primary criteria: acceptance of deposits and provision of loans.

Global commercial bank

A commercial bank that operates in multiple countries, providing services to domestic and multinational corporations; must generally follow the regulations of the country in which it operates, regardless of where it is headquartered.

Four main services of commercial banks

Depository accounts, credit services, transaction processing, and information reporting.

Term loan (term note)

A loan in which a business borrows a specific amount to be repaid by a specific date.

Revolving line of credit (revolver)

A credit facility in which a business can borrow up to a specified amount, repay all or part of the balance, and borrow again in the future.

Cleanup (resting) period

A provision in a revolver requiring the borrower to pay down the balance on the credit line for a relatively short period of time.

Overdraft facility

A facility allowing a business to borrow from a bank by withdrawing funds from an account so that it has a debit balance, usually repayable on demand and usually unsecured.

Commercial paper (CP)

Unsecured, discounted, short-term promissory notes issued by companies or commercial bank holding companies; rated for default risk by credit rating agencies.

Municipal securities (munis)

Bonds or notes issued by city, county, or state government entities (sub-sovereign securities), generally with some income tax exemption on interest paid.

Loan sales

Structuring of lending facilities so that short-term loans can be sold to other banks and investors.

Private placements

Direct sales of long-term notes to institutional investors, such as insurance companies and hedge funds.

Open banking

Technology and regulations that enable banking clients to aggregate data from multiple banks via an application programming interface (API).

PSD2

The second Payment Services Directive (EU); enables account information service providers (AISPs) to access bank account information, with customer consent, to aggregate bank account positions via API.

Letter of credit (L/C)

A trade service instrument used to facilitate the payment and collection of trade obligations, often for international business.

Foreign currency accounts

Accounts in which deposit balances are held in a currency other than that of the country of location, typically in major international currencies (CAD, EUR, GBP, JPY, USD).

Multicurrency account

An account allowing a customer to make and receive payments in several currencies, typically operated via a series of virtual accounts by a payment service provider.

Financial derivatives

Instruments (forwards, futures, swaps, and options) whose market value is derived from an underlying asset, such as a currency, commodity, or security.

Investment bank

An FI providing broad financial services related to the issuance and trading of securities, including underwriting, custodial services, M&A facilitation, and broker/advisor services for institutional clients.

Universal bank

A bank offering both commercial and investment banking services, typically through the investment banking arm of a commercial bank's holding company.

Glass-Steagall Act (1933)

Law that prohibited banks from providing both commercial and investment banking services; fully repealed by the Gramm-Leach-Bliley Act of 1999.

Gramm-Leach-Bliley Act (1999)

Act that fully repealed the Glass-Steagall Act's separation of commercial and investment banking (except FDIC deposit insurance).

Volcker rule

Part of the 2010 Dodd-Frank Act; partially reinstated restrictions on banks combining commercial and investment banking activities by limiting proprietary trading.

UK Financial Services (Banking Reform) Act (2013)

Law requiring the largest UK banks to separate ("ring-fence") their commercial and investment banking activities.

Industrial bank (industrial loan company)

An FI with a limited scope of services (e.g., no checking accounts) that sells investment shares, accepts deposits, and lends via installment loans to consumers and small businesses; locally chartered and not under general banking regulatory authority.

Central bank (reserve bank)

An institution that provides banking services to a country's government and banking sector, usually responsible for issuing currency and implementing monetary policy.

Seigniorage

Income derived by a central bank from issuing currency in exchange for government bonds; used to fund central bank operations or remitted to the government.

Lender of last resort

A role in which a central bank provides loans to FIs unable to raise funds in the interbank market.

Monetary policy

The management of money supply and interest rates to target inflation and, indirectly, economic growth.

Monetary policy transmission mechanism

The process by which changes in interest rates, reserve requirements, and central bank money market operations affect the size of a country's money supply.

Fractional reserve banking

The process of banks recycling deposits into new loans (after holding required reserves), which creates money and increases the money supply.

Open market operations

Central bank activity of buying or selling government securities to reduce or increase market interest rates.

Quantitative easing

Central bank purchase of a range of money market assets to keep interest rates low and boost economic activity, notably used after the 2007-2009 financial crisis.

Export credit bank / export credit agency (ECA)

An institution that provides companies with financing and insurance products to support exporting of goods, especially into emerging markets; can be government-owned or private.

Savings bank

A bank that primarily manages consumer deposits; typically community-based, not-for-profit, or cooperative.

Systemic failure

The collapse of the entire banking system, which bank regulators aim to prevent through oversight of credit and liquidity risks.

Two stages of bank supervision

(1) Initial chartering/licensing and (2) ongoing supervision and surveillance of chartered banks.

Dual banking system

The US system in which banks are either federally or state chartered.

Capital requirements

Regulations determining how much capital (usually equity funds) the owners of a bank must contribute, typically expressed as a ratio of capital to risk-weighted assets.

Tiered capital

A regulatory concept in which common equity is the first (most stable) tier and preferred stock/long-term debt form a second (less stable) tier.

Net interest margin

The difference between the interest rate at which a bank lends to borrowers and the interest rate it pays to depositors for funds on deposit; a primary source of bank earnings.

Basel Committee on Banking Supervision (BCBS)

The committee that published the initial Basel Capital Accord in 1988, setting minimum capital requirements for banks.

Basel I (1988)

The first Basel Accord; established minimum capital ratios for large banks based on the credit risk of each bank's assets.

Basel II (2004)

Accord that expanded Basel I's risk ratings and added an operational risk assessment; based on three pillars — minimum capital requirements, supervisory review, and market discipline.

Basel III (2011)

Accord developed in response to the 2007-2009 financial crisis; extended Basel II to address stress testing and market liquidity risk, and increased capital adequacy requirements.

Basel III minimum capital levels

Common Equity Tier 1 (CET1) capital of 4.5% of risk-weighted assets (RWA), plus a 2.5% capital conservation buffer, plus a countercyclical buffer of 0%-2.5% of RWA.

Basel III leverage ratio

A minimum of 3% Tier 1 equity that all banks must maintain against all on- and off-balance-sheet exposures.

Liquidity coverage ratio (LCR)

A Basel III requirement that banks hold sufficient high-quality liquid assets to cover net cash outflows over a stressed 30-day period.

Net stable funding ratio

A Basel III requirement that banks closely match the maturities of their assets and liabilities.

Deposit insurance

Protection of the assets of smaller deposit customers (mainly consumers) up to a set limit in the event of a bank failure.

FDIC (Federal Deposit Insurance Corporation)

US entity that insures $250,000 per depositor, per FDIC-insured bank, per ownership category.

EU deposit guarantee schemes

National schemes in the EU that offer insurance up to EUR 100,000 (or currency equivalent) per depositor, per bank.

Moral hazard (deposit insurance context)

The reduced incentive for depositors to investigate a bank's creditworthiness, and increased incentive for banks to take on risk, because deposits are insured regardless of bank choice.

Bank run

A situation in which a large number of depositors demand the return of their deposits all at once, potentially forcing a bank out of business.

Federal Reserve Act (1913)

Act that established the Federal Reserve System (the Fed) and provided the foundation for the current US banking system; required nationally chartered banks to become Fed member banks.

Regulation D

Fed regulation implementing the reserve requirement provision of the Federal Reserve Act of 1913, imposing uniform reserve requirements on depository institutions.

Regulation Q (original)

Implemented the interest-bearing account restriction of the Glass-Steagall Act of 1933, barring interest on corporate demand deposit accounts.

Regulation Q (current, 2013)

Implements the Basel III minimum capital requirements and capital adequacy standards for banks regulated by the Federal Reserve.

Regulation Y

Implements provisions of the Bank Holding Company Act of 1956 and the Change in Bank Control Act of 1978, covering acquisition of control of banks and bank holding companies.

Regulation BB

Implements the Community Reinvestment Act of 1977 (revised 1995), requiring banks to help meet the credit needs of their entire community.

Regulation W

Implements the Volcker rule, Section 619 of the Dodd-Frank Act.

Regulation WW

Imposes minimum liquidity requirements on large, internationally active banking organizations, based on the liquidity coverage ratio (LCR) from Basel III.

Banking Act of 1933 (Glass-Steagall)

Prohibited commercial banks from underwriting most securities and prohibited securities firms from bank-like activities; created the FDIC.

Anti-tying Amendments to the Bank Holding Company Act (1970)

Prohibits an FI from conditioning credit extension on the borrower obtaining other services from the FI, subject to a traditional bank product exception.

Traditional bank product exception

Exception allowing banks to condition offer terms on a customer purchasing other bank products, as long as all products are also available separately.

Gramm-Leach-Bliley Act key provisions

Permits creation of financial holding companies (FHCs), establishes the Fed as primary FHC regulator, allows easier entry by foreign banks, and includes consumer nonpublic personal information protections.

Financial holding company (FHC)

An entity created under Gramm-Leach-Bliley that can engage in any activity the Fed considers financial in nature or incidental to it.

Dodd-Frank Wall Street Reform and Consumer Protection Act (2010)

Law that formed the Financial Stability Oversight Council and Consumer Financial Protection Bureau, required annual Fed stress tests, introduced the Volcker rule, and implemented clawback rules.

Financial Stability Oversight Council

Body formed under the Dodd-Frank Act (discussed further in Chapter 2) to monitor systemic financial risk.

Consumer Financial Protection Bureau

Body formed under the Dodd-Frank Act (discussed further in Chapter 2) to protect consumers in financial services.

Clawback rules (Dodd-Frank Section 954)

SEC rule requiring listed companies to adopt a policy enabling recovery of executive compensation in certain situations.