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Regulation U limits the amount of credit banks can offer for the purchase of margin stocks, with exceptions for collateral and emergency expenses. It aims to minimize risk and regulate the use of leverage.
Regulation U is a regulation of the United States Federal Reserve Board that pertains to loans made by banks for the purchase of margin stocks. It applies to investments such as stocks, over-the-counter securities, and most mutual funds. First adopted in 1936, this regulation specifies the maximum amount a bank can lend for margin shares.
The amount that can be borrowed under Regulation U has changed several times since the policy was first adopted. As of 2010, the maximum value of a loan to purchase margin shares is set at 50 percent of the value of the margin shares at the time the loan is made. The maximum loan is not affected if the value of the margin shares falls after the issuance of the initial loan. This regulation applies to banks and all other lenders that make credit secured by margin shares.
Regulation U also requires transaction participants to register and complete documentation. When loans exceed $100,000 United States Dollars (USD), banks are responsible for submitting U-1s, a form issued by the Federal Reserve Board. This form contains a “statement of purpose” that describes the purpose for which the loan will be used. Non-bank lenders should always obtain statements of purpose.
The regulation lists several exceptions to your maximum credit stipulation. For example, margin shares used solely for collateral are not covered by Regulation U. Banks are not required to comply when they issue loans to other banks, employee share ownership plans, or plan lenders. The regulation also allows banks to issue larger amounts of credit if the loans are used only for the temporary purchase of securities or to allow clients to cover unforeseeable emergency expenses. Non-bank lenders are exempt if they issue less than $200,000 in margin share-backed loans in any given quarter or have margin share loans worth less than $500,000 in any given quarter.
Regulation U is designed to minimize the risk assumed by customers whose loans are collateralized on margin stock. In particular, the regulation aims to regulate the use of a technique called “leverage”, in which borrowed capital is used to finance investments. This regulation arose from the adoption of Regulation T, which governs credit issued by brokerage firms and brokers, and was issued to ensure loopholes left open by the previous regulation.
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