The Fed adopts a tiered approach to banking regulation

The importance of the banking sector in US

Banks play a crucial role in an economy. They provide valuable credit, risk-management, and liquidity services to businesses and households, which also makes them the pulse of the financial system. Though most banks are designed to take on risks and to operate with leverage, they too can falter as we learned during the credit crisis of 2008–09.

Banks in the US rode the housing boom all the while making housing loans to people with the worst credit. But the housing bubble soon burst, and banks were left with declining capitalization and rising delinquencies.

Investors can get exposure to the financial sector of the US economy by investing in ETFs such as the Financial Select Sector SPDR Fund (XLF) and the iShares U.S. Financials ETF (IYF), which have up to 21.5% and 16% of their holdings in financial firms Wells Fargo (WFC), JPMorgan Chase (JPM), and Bank of America Corporation (BAC).

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The Fed to adopt a tiered approach to bank regulation

Since the credit crisis, the Federal Reserve has bailed out some banks. Others, it’s helped recapitalize by pumping more money into the economy, easing credit availability. Recognizing the critical role that the banking sector plays in the US, Loretta Mester, President and CEO of the Fourth District Federal Reserve Bank of Cleveland, recently highlighted additional steps that the Fed is ready to take to help the sector.

Consistent with the Dodd-Frank Wall Street Reform and Consumer Protection Act of 2010, the Federal Reserve and other federal banking agencies are taking a tiered approach to banking regulation and supervision.The tiered approach categorizes institutions based on their complexity and the level of risk they pose to the overall financial system. Oversight is then appropriately tailored to the level of risk and complexity.

Currently, the Fed has organized its supervision according to four groups of banks:

1. community banks – institutions with $10 billion or less in assets
2. regional banking organizations – with assets between $10 billion and $50 billion
3. large banking organizations
4. systemically important institutions

How a tiered approach could help

The tiered approach should help cost-effectively manage banks according to the different levels of risk  presented to the financial system. For example, community and regional banks are not subject to a quantitative minimum liquidity requirement or the enhanced prudential standards. And stronger capital positions are only required of systemically important banks.

The Fed is being careful that the new regulatory environment does not put undue burden on community banks. Rather, it wants to foster a healthier and more resilient financial system that will benefit banks of all sizes as well as the overall economy.