What Is Regulation U?
Let me explain Regulation U directly to you—it's a Federal Reserve Board regulation that controls loans where securities serve as collateral, especially when those loans are for buying more securities on margin. This rule caps the leverage lenders can offer for such purposes, and the securities involved are things like stocks, mutual funds, and other traded assets.
Key Takeaways
- Regulation U is a Federal Reserve requirement for lenders who extend credit secured by margin stock—excluding securities brokers and dealers.
- Margin stock includes equity security registered on a national exchange, such as the NYSE, over-the-counter (OTC) security trading on the Nasdaq, debt security that can be converted into a margin stock, and most mutual funds.
- The regulation applies to commercial banks, savings and loan associations, federal savings banks, credit unions, production credit associations, insurance companies, and companies with employee stock option plans.
- Regulation U puts limits on entities that give out credit for the purpose of buying or carrying margin stock, using securities as collateral for the loans.
Understanding Regulation U
You need to know that Regulation U exists to reduce the risks tied to using margin leverage in securities trading, particularly when too much leverage goes to an individual or business. By capping the margin amount, it helps limit potential losses for both borrowers and lenders in cases where leverage causes huge losses compared to the actual capital provided.
This regulation targets leverage given with securities as collateral for buying more securities. It covers entities beyond broker-dealers, including commercial banks, savings and loan associations, federal savings banks, credit unions, production credit associations, insurance companies, and companies with employee stock option plans.
Regulation U establishes a ceiling on the maximum loan an entity can provide to a borrower who secures it with stock or other securities to buy more securities. The top loan value is 50% of the market value of those collateral securities.
Important Note on Regulation U
Remember, Regulation U sets a baseline to cap potential losses that borrowers and lenders might face when leverage results in significant losses relative to the available capital.
Bank Lender Requirements
If you're a bank lender, Regulation U imposes two key requirements you must follow. First, you have to get a purpose statement (Form U-1) for loans secured by collateral over $100,000. Second, you can only extend credit up to 50% of the securities' value used as collateral if the loan is for buying securities.
This rule specifically deals with secured loans for purchasing securities, which is why purpose statements are crucial for compliance. They're enforced more rigorously for loans above $100,000. If the loan secured by securities isn't for buying more securities, the Federal Reserve Board doesn't impose restrictions on you as a lender.
The Origins of Regulation U
Regulation U started in 1936, when it first covered securities credit extended by commercial banks.
Example of Regulation U Limits
Consider this scenario: suppose you want to borrow from a bank to buy securities, using $400,000 in securities as collateral. You'd need to provide a Form U-1 stating the loan's purpose. Since it's for buying more securities, the bank can lend you a maximum of $200,000. If you up the collateral to $500,000, the bank could then offer $250,000.
Regulation U Exemptions
There are some exemptions to Regulation U you should be aware of. Nonbank lenders face slightly different rules when lending with securities as collateral. Also, loans against employee stock option plans might not have to follow Regulation U requirements.
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