Regulation U Definition
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”.
A Little More on What is Regulation U
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.
References for Regulation U
Academic Research on Regulation U
Security loans at banks and nonbanks: Regulation U, Fortune, P. (2002). U. New England Economic Review, (Q 4), 19-40. According to the scholars that worked on this study, data on security loan secured during the 1920s and 1930s was examined and in recent times, the interaction between financial institutions and borrowers (brokers-dealers) often changes the popular belief that the correlation between these two factors is tightly linked is incorrect. This study points out that these observations have recent parallels while the credit absorption view suggests that an increase in the bank security loans should give higher business loan rates relative to other short-term interest rates.
Regulation U-What Is It All About, Eckman, R. P. (2005). Banking LJ, 122, 762. This paper explains the Regulation U and what it is all about. The main aim of this paper is to explain the correlation between Regulation U and the financial institution.
Compliance with Regulation U: A Refresher, Hunter, B. W. (2002). Banking LJ, 119, 438. This research paper explains the compliance of financial institutions and the Regulation U. This compliance is regarded as a Refresher in this study and the financial status of the economy took a new turn.
… to the telegram from the Board of Governors of the Federal Reserve System regarding Amendment No. 4. to Regulation T and Amendment No. 5 to Regulation U …, Sproul, A. According to this study, the telegram got from the Board of Governors of the Federal Reserve System as regards the amendment to the No 4 of the Regulation T and the Amendment to No 5 given to the Regulation U was well explained and studied in this research paper.
Loans to Finance Tender Offers The Bank’s Legal Problems, Herzel, L., & Rosenberg, R. M. (1979). Banking LJ, 96, 676. This paper basically studies the legal problems facing most financial institutions (banks) as regards loan given to finance. There are several problems faced by financial institutions regarding how to go by burrowing lenders loans to finance their operations. This study indicates that tender offers were given to these loaners and the steps taken in achieving this process was well explained.
Regulation of bank capital and portfolio risk, Koehn, M., & Santomero, A. M. (1980). The journal of finance, 35(5), 1235-1244. This paper studies the strategic pricing equilibria under three different market structures and these structures include Upstream-downstream arrangement, over-lapping upstream physician-hospital alliances and the vertically integrated Health Maintenance organizations. This paper shows that as oppose by the public opinion, insurers and providers do not earn maximum net revenue when they are as a monopsony or a monopoly but rather at a midway level of the market power.
Finance and efficiency: do bank branching regulations matter?, Acharya, V. V., Imbs, J., & Sturgess, J. (2010). Review of Finance, 15(1), 135-172. According to this study, the deregulation of the bank branching restrictions in the United State prompted a reallocation in several sectors of the economy with the end result on the state-level volatility. This paper explains that a reallocation effect becomes dormant and according to this study, the mean-variance portfolio theory was applied to the sectorial returns. This reallocation was found to be very firm and rigid in sector characterized by small, young and the external finance dependent firms and also states that possess a larger share in such sector.
Campaign Finance Re-Reform: The Regulation of Independent Political Committees, Buchsbaum, A. P. (1983). Cal. L. Rev., 71, 673. This paper explains the regulation of the independent political committees and the roles these committees play in the financial sector of an economy. This regulation came as a reform in the campaign of the finance sector.
The functional regulation of finance, Schwarcz, S. (2014). This paper explains the less obvious errors in the financial sectors battling most government policies and these errors include; that the financial regulation is mostly tethered to the financial architecture which includes the structure of financial firms, distinctive design and market in place when the regulation is disseminated. This research paper also explains how to implement and design such a “functional” approach to financial regulation. This approach though is primarily normative and it provides ordering principles which have practical utility as a counterweight to prevailing views.