Regulation U - Explained
What is Regulation U?
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What is Regulation U?
Regulation U was promulgated by the Board of Governors of the Federal Reserve System for preventing the excessive use of credit for the purchase or carrying of securities. The regulation was adopted in the response of the stock market crash in 1929. After the crash, the Federal Reserve System was authorized under Section 7 of the Securities Exchange Act of 1934 to regulate margin lending and the body devised the Federal Margin Regulations. Regulation U is one such regulation applicable to the credit extended by the U.S. banks and other non-broker lenders against margin-stock as collateral. It imposes substantive limits when it is purpose credit.
How Does Regulation U Work?
The regulation aims at limiting the risks involved in security trading using margin leverage. When loans are guaranteed by securities, too much leverage may harm the interest of both the lender and borrower. Especially, when those loan amounts are used for buying more securities the risk level increases exponentially. The securities include stocks, mutual funds and other securities traded in the market. If too much leverage is granted to an individual or company both the lender and the borrower may have to face a huge loss. Regulation U is particularly applied to leverage extended with securities as collaterals, for purchasing more securities. Federal savings banks, commercial banks, credit unions, savings and loan associations, production credit associations, companies having employee stock options plans and any other institutions who are not registered as broker-dealer are obliged to adhere to the provisions of Regulation U. Any such entity is allowed to extend loan support to a borrower for buying securities against stocks and other securities as collateral but there is an upper limit set by the regulation. The regulation states, the lenders are allowed to lend up to 50% of the collateral securities market value. According to the regulation, if a loan amount is used for purchasing securities and the borrower is providing stocks and securities as collateral, the lender bank can extend a credit amount only up to 50% of the total value of the collaterals. The regulation also makes it mandatory for the banks to obtain a 'purpose of statement' (Form U-1) from the borrowers who are taking a loan exceeding the value of $100,000 and providing securities as collateral. The 'purpose of statement' is important because this regulation is only applied to the loans taken out for buying additional securities. This restriction is not valid for the loans obtained for any other purposes. The 'purpose of statement' ensures if a loan is used for buying more securities or not. If a borrower provides securities worth the value of $200,000 as collateral and intends to buy additional securities with the loan, the bank can extend a credit up to $100,000. If the borrower states in the 'purpose of statement' that they are going to use the loan amount for any other purposes this limit is not applicable. There are certain exemptions of this regulation. The rule is slightly different for the non-bank lenders who are approving loans for buying additional securities against securities as collateral. Also, the loans provided against employee stock option plans as collateral may take advantage of exemptions from the requirements of Regulation U.