Regulation U

Regulation U is a Federal Reserve Board regulation that governs loans by entities involving securities as collateral and the purchase of securities on margin. Regulation U limits the amount of leverage that can be extended for loans secured by securities for the purpose of buying more securities. Securities involved typically include stocks, mutual funds and other market-traded securities.

Regulation U is designed to mitigate the adherent risks that exist when using margin leverage in securities trading, especially when too much leverage is granted to an individual or business. By limiting the margin amount, Regulation U aims to limit the potential losses that both borrowers and banks or lenders can sustain in instances where leverage can lead to very large losses relative to the physical capital extended.

Regulation U specifically focuses on leverage extended with securities as collateral, for the purchase of additional securities. It applies to entities other than broker dealers such as commercial banks, savings and loan associations, federal savings banks, credit unions, production credit associations, insurance companies and companies that have employee stock option plans.

Regulation U sets a limit on the maximum loan amount an entity can issue to a borrower securing the loan against stock or other securities for the purpose of buying more securities. The maximum loan value that can be offered is 50% of the collateral securities’ market value.

Regulation U has two important requirements that bank lenders must comply with. First, a bank lender must obtain a purpose statement (Form U-1) for loans secured by collateral that exceed $100,000. Second, a bank lender can only extend credit for 50% of the value of the securities used as collateral on the loan if the loan is to be used for securities purchases.

Regulation U specifically applies to secured loans extended for the purpose of buying securities. This is why purpose statements are important for complying with Regulation U. Purpose statements are more strictly enforced for loans exceeding $100,000. A bank lender does not have Federal Reserve Board restrictions when issuing a loan secured with securities that is not intended for the use of buying more securities.

For example, assume a borrower would like to borrow money from a bank for the purpose of buying securities and the borrower plans to use $400,000 in securities as collateral. The loan would require a Form U-1 disclosing the purpose of the loan. Since the loan is for the purpose of buying more securities, the maximum amount of credit the bank can extend to the borrower is $200,000. If the borrower increased the amount of collateral he was willing to use to secure the loan to $500,000 then the bank could offer him a loan for $250,000.

Some exceptions to Regulation U may apply. Nonbank lenders are subject to slightly different oversight when lending with securities as collateral. Additionally, loans offered against employee stock option plans may be exempt from Regulation U requirements.