Legal Definitions - Regulation U

Regulation U is a rule established by the U.S. central bank, the Federal Reserve Board. Its primary purpose is to limit the amount of money that banks can lend to customers who want to purchase or hold investment securities, such as stocks or bonds, using a special type of loan known as "margin credit." This regulation helps to prevent excessive borrowing for speculative investments, thereby reducing potential risks and maintaining stability within the financial system.

Here are some examples of how Regulation U applies:

• Individual Investor's Stock Purchase:

  Imagine Maria, an investor, wants to buy $100,000 worth of shares in a promising technology company. Instead of paying the full amount herself, she plans to use $50,000 of her own money and borrow the remaining $50,000 from her bank, using her investment account as collateral. Regulation U would dictate the maximum percentage of the $100,000 purchase price that Maria's bank is legally allowed to lend her for this purpose. If the current margin requirement set by the Federal Reserve is 50%, the bank cannot lend her more than $50,000 for this securities purchase, even if Maria has excellent credit and could theoretically qualify for a larger loan.

• Bank's Lending Practices:

  Consider Horizon Bank, which has a client, Mr. Chen, who wishes to expand his investment portfolio by purchasing additional shares in several companies. Mr. Chen requests a loan from Horizon Bank to cover 65% of the total purchase price of these new securities. Before approving the loan, Horizon Bank's compliance department must ensure that the amount requested by Mr. Chen does not exceed the limits set by Regulation U. If the regulation specifies that banks can only lend up to 50% of the value of the securities being purchased on margin, Horizon Bank would have to inform Mr. Chen that they can only lend him a maximum of 50%, requiring him to provide more of his own capital to complete the purchase.

• Preventing Market Instability:

  During a period of rapid stock market growth, many investors might become overly eager to buy more stocks, hoping for quick profits. They might approach banks to borrow heavily against their existing portfolios to fund these new purchases. Regulation U acts as a crucial safeguard by limiting the amount of credit banks can extend for these margin purchases. Without such limits, banks might lend excessively, creating a situation where a sudden market downturn could lead to widespread defaults on these loans, potentially destabilizing both the banking sector and the broader financial market. The regulation helps to temper speculative excesses by controlling the flow of credit into the securities market.