Financial Regulation
Recent Crisis Reaffirms the Need to Overhaul the U.S. Regulatory System Gao ID: GAO-09-1049T September 29, 2009This testimony discusses issues relating to efforts to reform the regulatory structure of the financial system. In the midst of the worst economic crisis affecting financial markets globally in more than 75 years, federal officials have taken unprecedented steps to stem the unraveling of the financial services sector. While these actions aimed to provide relief in the short term, the severity of the crisis has shown clearly that in the long term, the current U.S. financial regulatory system was in need of significant reform. Our January 2009 report presented a framework for evaluating proposals to modernize the U.S. financial regulatory system, and work we have conducted since that report further underscores the urgent need for changes in the system. Given the importance of the U.S. financial sector to the domestic and international economies, in January 2009, we also added modernization of its outdated regulatory system as a new area to our list of high-risk areas of government operations because of the fragmented and outdated regulatory structure. We noted that modernizing the U.S. financial regulatory system will be a critical step to ensuring that the challenges of the 21st century can be met. This testimony discusses (1) how regulation has evolved and recent work that further illustrates the significant limitations and gaps in the existing regulatory system, (2) the experiences of countries with other types of varying regulatory structures during the financial crisis, and (3) how certain aspects of proposals would reform the U.S. regulatory system.
The current U.S. financial regulatory system is fragmented due to complex arrangements of federal and state regulation put into place over the past 150 years. It has not kept pace with major developments in financial markets and products in recent decades. Today, almost a dozen federal regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies share responsibility for overseeing the financial services industry. Several key changes in financial markets and products in recent decades have highlighted significant limitations and gaps in the existing U.S. regulatory system. For example, regulators have struggled, and often failed, both to identify the systemic risks posed by large and interconnected financial conglomerates and to ensure these entities adequately manage their risks. In addition, regulators have had to address problems in financial markets resulting from the activities of sometimes less-regulated and large market participants--such as nonbank mortgage lenders, hedge funds, and credit rating agencies--some of which play significant roles in today's financial markets. Further, the increasing prevalence of new and more complex financial products has challenged regulators and investors, and consumers have faced difficulty understanding new and increasingly complex retail mortgage and credit products. Our recent work has also highlighted significant gaps in the regulatory system and the need for an entity responsible for identifying existing and emerging systemic risks. Various countries have implemented changes in their regulatory systems in recent years, but the current crisis affected most countries regardless of their structure. All of the countries we reviewed have more concentrated regulatory structures than that of the United States. Some countries, such as the United Kingdom, have chosen an integrated approach to regulation that unites safety and soundness and business conduct issues under a single regulator. Others, such as Australia, have chosen a "twin peaks" approach, in which separate agencies are responsible for safety and soundness and business conduct regulation. However, regardless of regulatory structure, each country we reviewed was affected to some extent by the recent financial crisis. One regulatory approach was not necessarily more effective than another in preventing or mitigating a financial crisis. However, regulators in some countries had already taken some actions that may have reduced the impact on their institutions. These and other countries also have taken or are currently contemplating additional changes to their regulatory systems to address weaknesses identified during this crisis. The Department of the Treasury's recent proposal to reform the U.S. financial regulatory system includes some elements that would likely improve oversight of the financial markets and make the financial system more sound, stable, and safer for consumers and investors. For example, under this proposal a new governmental body would have responsibility for assessing threats that could pose systemic risk. This proposal would also create an entity responsible for business conduct, that is, ensuring that consumers of financial services were adequately protected. However, our analysis indicated that additional opportunities exist beyond the Treasury's proposal for additional regulatory consolidation that could further decrease fragmentation in the regulatory system, reduce the potential for differing regulatory treatment, and improve regulatory independence.
GAO-09-1049T, Financial Regulation: Recent Crisis Reaffirms the Need to Overhaul the U.S. Regulatory System
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Testimony:
Before the Committee on Banking, Housing, and Urban Affairs, U.S.
Senate:
United States Government Accountability Office:
GAO:
For Release on Delivery:
Expected at 2:00 p.m. EDT:
Tuesday, September 29, 2009:
Financial Regulation:
Recent Crisis Reaffirms the Need to Overhaul the U.S. Regulatory
System:
Statement of Richard J. Hillman, Managing Director:
Financial Markets and Community Investment:
GAO-09-1049T:
[End of section]
Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss issues relating to efforts to
reform the regulatory structure of the financial system. In the midst
of the worst economic crisis affecting financial markets globally in
more than 75 years, federal officials have taken unprecedented steps to
stem the unraveling of the financial services sector. While these
actions aimed to provide relief in the short term, the severity of the
crisis has shown clearly that in the long term, the current U.S.
financial regulatory system was in need of significant reform. Our
January 2009 report presented a framework for evaluating proposals to
modernize the U.S. financial regulatory system, and work we have
conducted since that report further underscores the urgent need for
changes in the system.[Footnote 1] Given the importance of the U.S.
financial sector to the domestic and international economies, in
January 2009, we also added modernization of its outdated regulatory
system as a new area to our list of high-risk areas of government
operations because of the fragmented and outdated regulatory structure.
[Footnote 2] We noted that modernizing the U.S. financial regulatory
system will be a critical step to ensuring that the challenges of the
21ST century can be met. In my statement today, which is based on our
reports and additional work we have completed, I will discuss (1) how
regulation has evolved and recent work that further illustrates the
significant limitations and gaps in the existing regulatory system, (2)
the experiences of countries with other types of varying regulatory
structures during the financial crisis, and (3) how certain aspects of
proposals would reform the U.S. regulatory system.
To do this work, we synthesized existing GAO work and other studies on
the financial crisis, such as those from the Department of Treasury,
Group of Twenty (G20), Group of Thirty (G30), and the Committee on
Capital Markets Regulation, among others. We also selected a judgmental
sample of countries--Australia, Canada, The Netherlands, Sweden, and
the United Kingdom--because they each had advanced financial markets
and were illustrative of regulatory changes made internationally. We
compiled information from publicly available sources on the individual
countries' regulatory systems and the countries' experiences during the
crisis. Finally, we used our framework of regulatory reform elements
that was developed for our January 2009 report to analyze the strengths
and weaknesses of legislative proposals on regulatory reform. Our work
was conducted in accordance with generally accepted government auditing
standards. Those standards require that we plan and perform the audit
to obtain sufficient, appropriate evidence to provide a reasonable
basis for our findings and conclusions based on our audit objectives.
We believe that the evidence obtained provides a reasonable basis for
our findings and conclusions based on our audit objectives. This work
was conducted between August 2009 and September 2009.
Summary:
The current U.S. financial regulatory system is fragmented due to
complex arrangements of federal and state regulation put into place
over the past 150 years. It has not kept pace with major developments
in financial markets and products in recent decades. Today, almost a
dozen federal regulatory agencies, numerous self-regulatory
organizations, and hundreds of state financial regulatory agencies
share responsibility for overseeing the financial services industry.
Several key changes in financial markets and products in recent decades
have highlighted significant limitations and gaps in the existing U.S.
regulatory system. For example, regulators have struggled, and often
failed, both to identify the systemic risks posed by large and
interconnected financial conglomerates and to ensure these entities
adequately manage their risks. In addition, regulators have had to
address problems in financial markets resulting from the activities of
sometimes less-regulated and large market participants--such as nonbank
mortgage lenders, hedge funds, and credit rating agencies--some of
which play significant roles in today's financial markets. Further, the
increasing prevalence of new and more complex financial products has
challenged regulators and investors, and consumers have faced
difficulty understanding new and increasingly complex retail mortgage
and credit products.
Our recent work has also highlighted significant gaps in the regulatory
system and the need for an entity responsible for identifying existing
and emerging systemic risks. For example, our July 2009 report on
oversight of banks' fair lending practices revealed that the fragmented
financial regulatory system limited the consistency and effectiveness
of regulators' oversight of these practices. In addition, our recent
reports on regulators' oversight of risk management systems found that
regulators were not sufficiently focused on looking across institutions
to identify factors that could affect the overall financial system was
in part responsible for the failure to detect problems that
significantly contributed to the crisis. Reports from a variety of
international groups have identified similar weaknesses in regulatory
systems globally and have called for a number of reforms.
Various countries have implemented changes in their regulatory systems
in recent years, but the current crisis affected most countries
regardless of their structure. All of the countries we reviewed have
more concentrated regulatory structures than that of the United States.
Some countries, such as the United Kingdom, have chosen an integrated
approach to regulation that unites safety and soundness and business
conduct issues under a single regulator. Others, such as Australia,
have chosen a "twin peaks" approach, in which separate agencies are
responsible for safety and soundness and business conduct regulation.
However, regardless of regulatory structure, each country we reviewed
was affected to some extent by the recent financial crisis. One
regulatory approach was not necessarily more effective than another in
preventing or mitigating a financial crisis. However, regulators in
some countries had already taken some actions that may have reduced the
impact on their institutions. These and other countries also have taken
or are currently contemplating additional changes to their regulatory
systems to address weaknesses identified during this crisis.
The Department of the Treasury's recent proposal to reform the U.S.
financial regulatory system includes some elements that would likely
improve oversight of the financial markets and make the financial
system more sound, stable, and safer for consumers and investors. For
example, under this proposal a new governmental body would have
responsibility for assessing threats that could pose systemic risk.
This proposal would also create an entity responsible for business
conduct, that is, ensuring that consumers of financial services were
adequately protected. However, our analysis indicated that additional
opportunities exist beyond the Treasury's proposal for additional
regulatory consolidation that could further decrease fragmentation in
the regulatory system, reduce the potential for differing regulatory
treatment, and improve regulatory independence.
U.S. Financial Regulatory System's Failure to Keep Pace with Market
Developments Underscores the Need for Reforms:
As a result of 150 years of changes to financial regulation in the
United States, the regulatory system has become complex and fragmented.
Today, responsibilities for overseeing the financial services industry
are shared among almost a dozen federal banking, securities, futures,
and other regulatory agencies, numerous self-regulatory organizations,
and hundreds of state financial regulatory agencies. For example:
* Insured depository institutions are overseen by five federal
agencies--the Federal Deposit Insurance Corporation (FDIC), the Board
of Governors of the Federal Reserve System (Federal Reserve), the
Office of the Comptroller of the Currency (OCC), the Office of Thrift
Supervision (OTS), and the National Credit Union Administration (NCUA)--
and states supervise state-chartered depository and certain other
institutions.
* Securities activities and markets are overseen by the Securities and
Exchange Commission (SEC) and state government entities, and private
sector organizations performing self-regulatory functions.
* Commodity futures markets and activities are overseen by the
Commodity Futures Trading Commission (CFTC) and also by industry self-
regulatory organizations.
* Insurance activities are primarily regulated at the state level with
little federal involvement.
Other federal regulators also play important roles in the financial
regulatory system, such as the Federal Trade Commission, which acts as
the primary federal agency responsible for enforcing compliance with
federal consumer protection laws for financial institutions such as
finance companies that are not overseen by another financial regulator.
Much of this structure has developed as the result of statutory and
regulatory measures taken in response to financial crises or
significant developments in the financial services sector. For example,
the Federal Reserve was created in 1913 in response to financial panics
and instability around the turn of the century, and much of the
remaining structure for bank and securities regulation was created as
the result of the Great Depression turmoil of the 1920s and 1930s.
Changes in the types of financial activities permitted for financial
institutions and their affiliates have also shaped the financial
regulatory system over time. For example, under the Glass-Steagall
provisions of the Banking Act of 1933, financial institutions were
prohibited from simultaneously offering commercial and investment
banking services, but with the passage of the Gramm-Leach-Bliley Act of
1999, Congress permitted financial institutions to fully engage in both
types of activities, under certain conditions.
Various Market Developments Have Revealed Limitations in the Existing
Regulatory Structure:
Several key developments in financial markets and products in the past
few decades have significantly challenged the existing financial
regulatory structure.[Footnote 3] (See figure 1.)
Figure 1: Key Developments and Resulting Challenges That Have Hindered
the Effectiveness of the Financial Regulatory System:
[Refer to PDF for image: illustrated table]
Developments in financial markets and products: Emergence of large,
complex, globally active, interconnected financial conglomerates;
Examples of how developments have challenged the regulatory system:
* Regulators sometimes lack sufficient authority, tools, or
capabilities to oversee and mitigate risks.
* Identifying, preventing, mitigating, and resolving systemic crises
has become more difficult.
Developments in financial markets and products: Less-regulated entities
have come to play increasingly critical roles in financial system;
Examples of how developments have challenged the regulatory system:
* Nonbank lenders and a new private-label securitization market played
significant roles in the subprime mortgage crisis that led to broader
market turmoil.
* Activities of hedge funds have posed systemic risks.
* Overreliance on credit ratings of mortgage-backed products
contributed to the recent turmoil in financial markets.
* Financial institutions‘ use of off-balance sheet entities led to
ineffective risk disclosure and exacerbated recent market instability.
Developments in financial markets and products: New and complex
products that pose challenges to financial stability and investor and
consumer understanding of risks;
Examples of how developments have challenged the regulatory system:
* Complex structured finance products have made it difficult for
institutions and their regulators to manage associated risks.
* Growth in complex and less-regulated over-the-counter derivatives
markets have created systemic risks and revealed market infrastructure
weaknesses.
* Investors have faced difficulty understanding complex investment
products, either because they failed to seek out necessary information
or were misled by improper sales practices.
* Consumers have faced difficulty understanding mortgages and credit
cards with new and increasingly complicated features, due in part to
limitations in consumer disclosures and financial literacy efforts.
* Accounting and auditing entities have faced challenges in trying to
ensure that accounting and financial reporting requirements
appropriately meet the needs of investors and other financial market
participants.
Developments in financial markets and products: Financial markets have
become increasingly global in nature, and regulators have had to
coordinate their efforts internationally;
Examples of how developments have challenged the regulatory system:
* Standard setters and regulators also face new challenges in dealing
with global convergence of accounting and auditing standards.
* Fragmented U.S. regulatory structure has complicated some efforts to
coordinate internationally with other regulators, such as negotiations
on Basel II and certain insurance matters.
Sources: GAO (analysis); Art Explosion (images).
[End of figure]
Regulators have struggled, and often failed, to identify the systemic
risks posed by large and interconnected financial conglomerates, as
well as new and complex products, and to adequately manage these risks.
These firms' operations increasingly cross financial sectors, but no
single regulator is tasked with assessing the risks such an institution
might pose across the entire financial system. In addition, regulators
have had to address problems in financial markets resulting from the
activities of sometimes less-regulated and large market participants--
such as nonbank mortgage lenders, hedge funds, and credit rating
agencies--some of which play significant roles in today's financial
markets. Further, the increasing prevalence of new and more complex
financial products has challenged regulators and investors, and
consumers have faced difficulty understanding new and increasingly
complex retail mortgage and credit products. Standard setters for
accounting and financial regulators have also faced growing challenges
in ensuring that accounting and audit standards appropriately respond
to financial market developments. And despite the increasingly global
aspects of financial markets, the current fragmented U.S. regulatory
structure has complicated some efforts to coordinate internationally
with other regulators.
Because of this hearing's focus on prudential regulation of the banking
industry, I would like to reinforce that our prior work has repeatedly
identified limitations of the fragmented banking regulatory structure.
For example:
* In 1996, we reported that the division of responsibilities among the
four federal bank oversight agencies in the United States was not based
on specific areas of expertise, functions or activities, either of the
regulator or the banks for which they are responsible, but based on
institution type and whether the banks were members of the Federal
Reserve System. Despite their efforts to coordinate, this multiplicity
of regulators was cited as resulting in inconsistent treatment of
banking institutions in examinations, enforcement actions, and
regulatory decisions.[Footnote 4]
* In a 2007 report we noted that having bank holding company affiliates
supervised by multiple banking regulators increased the potential for
conflicting information to be provided to the institution, such as when
a large, complex banking organization initially received conflicting
information from the Federal Reserve, its consolidated supervisor, and
OCC, its primary bank supervisor, about the firm's business continuity
provisions.[Footnote 5]
* In 2005, we reported that a difference in authority across the
banking regulators could lead to problems in oversight. For example,
FDIC's authority over the holding companies and affiliates of
industrial loan corporations was not as extensive as the authority that
the other supervisors have over the holding companies and affiliates of
banks and thrifts. For example, FDIC's authority to examine an
affiliate of an insured depository institution exists only to disclose
the relationship between the depository institution and the affiliate
and the effect of that relationship on the depository institution.
Therefore, any reputation or other risk from an affiliate that has no
relationship with the industrial loan corporation could go undetected.
[Footnote 6]
* In a 2004 report, we noted cases in which interagency cooperation
between bank regulators has been hindered when two or more agencies
share responsibility for supervising a bank. For example, in the
failure of Superior Bank of West Virginia problems between OTS,
Superior's primary supervisor, and FDIC hindered a coordinated
supervisory approach, including OTS refusing to let FDIC participate in
at least one examination. Similarly, disagreements between OCC and FDIC
contributed to the 1999 failure of Keystone Bank.[Footnote 7]
* In a 2007 report, we expressed concerns over the appropriateness of
having OTS oversee diverse global financial firms given the size of the
agency relative to the institutions for which it was responsible.
[Footnote 8]
Our recent work has further revealed limitations in the current
regulatory system, reinforcing the need for change and the need for an
entity responsible for identifying existing and emerging systemic
risks. In January 2009, we designated modernizing the outdated U.S.
financial regulatory system as a new high-risk area to bring focus to
the need for a broad-based systemwide transformation to address major
economy, efficiency, and effectiveness challenges.[Footnote 9] We have
found that:
* Having multiple regulators results in inconsistent oversight. Our
February 2009 report on the Bank Secrecy Act found that multiple
regulators are examining for compliance with the same laws across
industries and, for some larger holding companies, within the same
institution.[Footnote 10] However, these regulators lack a mechanism
for promoting greater consistency, reducing unnecessary regulatory
burden, and identifying concerns across industries. In July 2009, we
reported many violations by independent mortgage lenders of the fair
lending laws intended to prevent lending discrimination could go
undetected because of less comprehensive oversight provided by various
regulators.[Footnote 11]
* Lack of oversight exists for derivatives products. In March 2009, we
reported that the lack of a regulator with authority over all
participants in the market for credit default swaps (CDS) has made it
difficult to monitor and manage the potential systemic risk that these
products can create.[Footnote 12]
* Gaps in the oversight of significant market participants. We reported
in May 2009 on the issues and concerns related to hedge funds, which
have grown into significant market participants with limited regulatory
oversight.[Footnote 13] For example, under the existing regulatory
structure, SEC's ability to directly oversee hedge fund advisers is
limited to those that are required to register or voluntarily register
with the SEC as an investment advisor. Further, multiple regulators
(SEC, CFTC, and federal banking regulators) each oversee certain hedge
fund-related activities and advisers. We concluded that given the
recent experience with the financial crisis, regulators should have the
information to monitor the activities of market participants that play
a prominent role in the financial system, such as hedge funds, to
protect investors and manage systemic risk.
* Lack of appropriate resolution authorities for financial market
institutions. We recently reported that one of the reasons that federal
authorities provided financial assistance to at least one troubled
institution--the insurance conglomerate AIG--in the crisis stemmed from
concerns that a disorderly failure by this institution would have
contributed to higher borrowing costs and additional failures, further
destabilizing fragile financial markets. According to Federal Reserve
officials, the lack of a centralized and orderly resolution mechanism
presented the Federal Reserve and Treasury with few alternatives in
this case. The lack of an appropriate resolution mechanism for non-
banking institutions has resulted in the federal government providing
assistance and having significant ongoing exposure to AIG.
* Lack of a focus on systemwide risk. In March 2009 we also reported on
the results of work we conducted at some large, complex financial
institutions that indicated that no existing U.S. financial regulator
systematically looks across institutions to identify factors that could
affect the overall financial system.[Footnote 14] While regulators
periodically conducted horizontal examinations on stress testing,
credit risk practices, and risk management, they did not consistently
use the results to identify potential systemic risks and have only a
limited view of institutions' risk management or their
responsibilities. Our July 2009 report on approaches regulators used to
restrict the use of financial leveraging--the use of debt or other
products to purchase assets or create other financial exposures--by
financial institutions also found that regulatory capital measures did
not always fully capture certain risks and that none of the multiple
regulators responsible for individual markets or institutions had clear
responsibility to assess the potential effects of the buildup of
systemwide leverage.[Footnote 15]
Recognition of the need for regulatory reform extends beyond U.S.
borders. Various international organizations such as the G20, G30, Bank
for International Settlements, and Committee on Capital Markets
Regulation have all reported that weaknesses in regulation contributed
to the financial crisis.[Footnote 16] Specifically, among other things,
these reports pointed to the fragmented regulatory system, the lack of
a systemwide view of risks, and the lack of transparency or oversight
of all market participants as contributing to the crisis. Further, the
reports noted that sound regulation and a systemwide focus were needed
to prevent instability in the financial system, and that recent events
have clearly demonstrated that regulatory failures had contributed to
the current crisis.
Other Countries Have Adopted Various Structures for Their Regulatory
Systems, but the Recent Crisis Is Prompting Additional Changes:
In response to consolidation in the financial services industry and
past financial crises, other countries have previously made changes to
their financial regulatory systems in the years before the most recent
crisis. For the purposes of our study, we selected five countries--
Australia, Canada, Sweden, the Netherlands, and the United Kingdom--
that had sophisticated financial systems and different regulatory
structures. Each of these countries restructured their regulatory
systems within the last 20 years in response to market developments or
financial crises (see table 1).
Table 1: Examples of Regulatory Changes:
Country & Regulatory Structure: Australia - Separate regulator for
prudential oversight and a separate consumer protection agency that
oversees conduct of business. Responsibility for systemic stability,
the payment system, and monetary policy is with the central bank;
Response to the Crisis: The government expressed willingness to
purchase residential mortgage backed securities. Retail deposits up to
AUD $1 million were guaranteed--previously the limit was AUD $20,000;
Examples of Actions Taken or Contemplated:
* Reviewing liquidity standards and risk management approaches for
banks.
Country & Regulatory Structure: Canada - Single prudential supervisor
for banks insurance companies, and pension plans. A separate agency
oversees consumer protection for banking. Securities regulation is
conducted at the provincial level. The central bank is the lender of
last resort;
Response to the Crisis: Banks have accessed liquidity facilities
provided by the central bank. Government agency has purchased
residential mortgages from banks;
Examples of Actions Taken or Contemplated:
* Reexamining the quality of bank capital, the effect of relying on
wholesale funding, the risks posed by off balance sheet exposures, the
role of credit rating agencies, and the need for improved international
solvency resolution.
Country & Regulatory Structure: The Netherlands - The prudential and
systemic risk supervisor of all financial services is the central bank.
A separate conduct of business regulator also is responsible for
consumer protection;
Response to the Crisis: The government took over the Dutch operations
of an internationally active bank. Other banks were given solvency
assistance and the government also took on the high risk mortgage
portfolios of other banks;
Examples of Actions Taken or Contemplated:
* Will strengthen capital requirements;
* Will strengthen supervisory authorities;
* Will address systemic risk nationally.
Country & Regulatory Structure: Sweden - A single regulator covers
banking, securities, and insurance. Sweden's central bank conducts
monetary policy and is entrusted with promoting safe and efficient
payment systems;
Response to the Crisis: The government approved a debt guarantee scheme
for the medium term borrowing of banks and mortgage institutions. Bank
deposit insurance limits were increased. One domestic bank failed and
was resolved;
Examples of Actions Taken or Contemplated:
* The government enacted legislation giving it the power to grant
credit guarantees if there is a serious systemic risk and bank capital
falls below a regulatory threshold;
* Changes are being contemplated in the prompt corrective action
framework, the deposit insurance scheme, cross border crisis
resolution.
Country & Regulatory Structure: United Kingdom - A single agency deals
with banking, insurance, asset management and market supervision and
regulation. The central bank exercised informal oversight over the
banking sector;
Response to the Crisis: The government created a bank recapitalization
fund, a credit guarantee scheme, and special liquidity scheme, and an
asset protection scheme;
Examples of Actions Taken or Contemplated: Reform of the regulatory and
legislative framework will:
* reform the corporate governance of banking institutions;
* change the amount of capital firms will need;
* reduce their leverage;
* more intensive regulation of financial firms, and;
* new powers for authorities to deal with failing banks.
Source: GAO analysis.
[End of table]
The countries we reviewed chose one of two models--with some
implementing an integrated approach, in which responsibilities for
overseeing safety and soundness issues and business conduct issues are
centralized and unified in usually a single regulator, and with others
implementing what is commonly referred to as a "twin peaks" model, in
which separate regulatory organizations are responsible for safety and
soundness and business conduct regulation.[Footnote 17] A single
regulator is viewed by some as advantageous because, with financial
firms not being as specialized as they used to be, a single regulator
presents economies of scale and efficiency advantages, can quickly
resolve conflicts that arise between regulatory objectives, and the
regulatory model increases accountability. For example, the United
Kingdom moved to a more integrated model of financial services
regulation because it recognized that major financial firms had
developed into more integrated full services businesses. As a result,
this country created one agency (Financial Services Authority) to deal
with banking, insurance, asset management and market supervision and
regulation. Similarly, Canada and Sweden integrated their regulatory
systems prior to the current global financial crisis.
In contrast, other countries chose to follow a twin peaks model. The
twin peaks model is viewed by some as advantageous because they view
the two principal objectives of financial regulation--systemic
protection and consumer protection--as being in conflict. Putting these
objectives in different agencies institutionalizes the distinction and
ensures that each agency focuses on one objective. For example, in
order to better regulate financial conglomerates and minimize
regulatory arbitrage, Australia created one agency responsible for
prudential soundness of all deposit taking, general and life insurance,
and retirement pension funds (Australian Prudential Regulatory
Authority) and another for business conduct regulation across the
financial system including all financial institutions, markets, and
market participants (Australian Securities and Investment Commission).
In the Netherlands, regulators were divided along the lines of banking,
insurance, and securities until the twin peaks approach was adopted.
Under the revised structure, the prudential and systemic risk
supervisor of all financial services including banking, insurance,
pension funds, and securities is the central bank (DNB). Another agency
(Netherlands Authority for Financial Markets) is responsible for
conduct of business supervision and promoting transparent markets and
processes to protect consumers.
However, regardless of the regulatory system structure, these and many
other countries were affected to some extent by the recent financial
crisis. For example, the United Kingdom experienced bank failures, and
the government provided financial support to financial institutions.
Further, in the Netherlands, where the twin peaks approach is used, the
government took over the operations of one bank, provided assistance to
financial institutions to reinforce their solvency positions, and took
on the risk of a high-risk mortgage portfolio held by another bank,
among other actions.
However, regulators or financial institutions in some of these
countries took steps that may have reduced the impact of the crisis on
their institutions. For example, according to a testimony that we
reviewed, the impact on Australian institutions was mitigated by the
country's relatively stricter prudential standards compared to other
countries. The Australian prudential regulator had also conducted a
series of stress tests on its five largest banks that assessed the
potential impact of asset price changes on institutions. According to
Canadian authorities, the positive performance of Canadian banks
relative to banks in other countries in the recent crisis was the
result of a more conservative risk appetite that limited their
activities in subprime mortgages, and exotic financial instruments.
However, both countries still experienced some turbulence, requiring
among other actions, some government purchases of mortgage-backed
securities by the Australian government and some Canadian banks taking
advantage of liquidity facilities provided by the Bank of Canada.
Authorities in these five countries have taken actions or are
contemplating additional changes to their financial regulatory systems
based on weaknesses identified during the current financial crisis.
These changes included strengthening bank capitalization requirements,
enhancing corporate governance standards, and providing better
mechanisms for resolving failed financial institutions. For example, in
the United Kingdom, in response to its experience dealing with one
large bank failure (Northern Rock) the government has called for
strengthening the role of the central bank. The Banking Act of 2009
formalized a leading role for the Bank of England in resolving
financial institution and provided it statutory authority in the
oversight of systemically important payment and settlement systems.
Reform Proposals Would Enhance U.S. Regulatory System, but Additional
Opportunities to Improve System Appear to Exist:
With a clear need to improve regulatory oversight, our January 2009
report offered a framework for crafting and evaluating regulatory
reform proposals.[Footnote 18] This framework includes nine
characteristics that should be reflected in any new regulatory system,
including:
* goals that are clearly articulated and relevant, so that regulators
can effectively conduct activities to implement their missions.
* appropriately comprehensive coverage to ensure that financial
institutions and activities are regulated in a way that ensures
regulatory goals are fully met;
* a mechanism for identifying, monitoring, and managing risks on a
systemwide basis, regardless of the source of the risk or the
institution in which it is created;
* an adaptable and forward-looking approach allows regulators to
readily adapt to market innovations and changes and evaluate potential
new risks;
* efficient oversight of financial services by, for example,
eliminating overlapping federal regulatory missions, while effectively
achieving the goals of regulation;
* consumer and investor protection as part of the regulatory mission to
ensure that market participants receive consistent, useful information,
as well as legal protections for similar financial products and
services, including disclosures, sales practices standards, and
suitability requirements;
* assurance that regulators have independence from inappropriate
influence; have sufficient resources and authority, and are clearly
accountable for meeting regulatory goals;
* assurance that similar institutions, products, risks, and services
are subject to consistent regulation, oversight, and transparency; and:
* adequate safeguards that allow financial institution failures to
occur while limiting taxpayers' exposure to financial risk.
Various organizations have made proposals to reform the U.S. regulatory
system, and several proposals have been introduced to the Congress.
Among these proposals are the administration's proposal, which is
specified in its white paper and draft legislation, and another
proposal that has been introduced as legislation in the House of
Representatives (H.R. 3310).[Footnote 19]
The administration's proposal includes various elements that could
potentially improve federal oversight of the financial markets and
better protect consumers and investors. For example, it establishes a
council consisting of federal financial regulators that would, among
other things, advise Congress on financial regulation and monitor the
financial services market to identify the potential risks systemwide.
Under H.R. 3310, a board consisting of federal financial regulators and
private members, would also monitor the financial system for exposure
to systemic risk and advise Congress. The creation of such a body under
either proposal would fill an important need in the current U.S.
regulatory system by establishing an entity responsible for helping
Congress and regulators identify potential systemic problems and making
recommendations in response to existing and emerging risks. However,
such an entity would also need adequate authority to ensure that
actions were taken in response to its recommendations. As discussed,
the inability of regulators to take appropriate action to mitigate
problems that posed systemic risk contributed to the current crisis.
The administration's proposal also contains measures to improve the
consistency of consumer and investor protection. First, the
administration proposes to create a new agency, the Consumer Financial
Protection Agency (CFPA). Among other things, this agency would assume
the consumer protection authorities of the current banking regulators
and would have broad jurisdiction and responsibility for protecting
consumers of credit, savings, payment and other consumer financial
products and services. Its supervisory and enforcement authority
generally would cover all persons subject to the financial consumer
protection statutes it would be charged with administering. However,
the SEC and CFTC would retain their consumer protection role in
securities and derivatives markets. As our January report described,
consumers have struggled with understanding complex products and the
multiple regulators responsible for overseeing such issues have not
always performed effectively. We urged that a new regulatory system be
designed to provide high-quality, effective, and consistent protection
for consumers and investors in similar situations. The administration's
proposal addresses this need by charging a single financial regulatory
agency with broad consumer protection responsibilities. This approach
could improve the oversight of this important issue and better protect
U.S. consumers. However, separating the conduct of consumer protection
and prudential regulation can also create challenges. Therefore, having
clear requirements to coordinate efforts across regulators responsible
for these different missions would be needed.
Although the Administration's proposal would make various improvements
in the U.S. regulatory system, our analysis indicated that additional
opportunities exist to further improve the system exist. Unlike H.R.
3310, which would combine all five federal depository institution
regulators, the Administration's proposal would only combine the
current regulators for national banks and thrifts into one agency,
leaving the three other depository institution regulators--the Federal
Reserve, the FDIC, and NCUA--to remain separate. As we reported in our
January 2009 report, having multiple regulators performing similar
functions presents challenges.[Footnote 20] For example, we found that
some regulators lacked sufficient resources and expertise, that the
need to coordinate among multiple regulators slowed responses to market
events, and that institutions could take advantage of regulatory
arbitrage by seeking regulation from an agency more likely to offer
less scrutiny. Regulators that are funded by assessments on their
regulated entities can also become overly dependent on individual
institutions for funding, which could potentially compromise their
independence because such firms have the ability to choose to be
overseen by another regulator.
Finally, regardless of any regulatory reforms that are adopted, we urge
Congress to continue to actively monitor the progress of such
implementation and to be prepared to make legislative adjustments to
ensure that any changes to the U.S. financial regulatory system are as
effective as possible. In addition, we believe that it is important
that Congress provides for appropriate GAO oversight of any regulatory
reforms to ensure accountability and transparency in any new regulatory
system. GAO stands ready to assist the Congress in its oversight
capacity and evaluate the progress agencies are making in implementing
any changes.
Mr. Chairman and Members of the Committee, I appreciate the opportunity
to discuss these critically important issues and would be happy to
answer any questions that you may have. Thank you.
Staff Contributions and Acknowledgments:
For further information on this testimony, please contact Orice
Williams Brown at (202) 512-8678 or williamso@gao.gov, or Richard J.
Hillman at (202) 512-8678 or hillmanr@gao.gov. Contact points for our
Offices of Congressional Relations and Public Affairs may be found on
the last page of this statement. Individuals making key contributions
to this testimony include Cody J. Goebel, Assistant Director; Sonja J.
Bensen; Emily R. Chalmers, Patrick S. Dynes; Marc W. Molino; Jill M.
Naamane; and Paul Thompson.
[End of section]
Appendix I: Framework for Crafting and Evaluating Regulatory Reform:
As a result of significant market developments in recent decades that
have outpaced a fragmented and outdated regulatory structure,
significant reforms to the U.S. regulatory system are critically and
urgently needed. The following framework consists of nine elements that
should be reflected in any new regulatory system. This framework could
be used to craft proposals, or to identify aspects to be added to
existing proposals to make them more effective and appropriate for
addressing the limitations of the current system.
Table:
Characteristic: Clearly defined regulatory goals;
Description: Goals should be clearly articulated and relevant, so that
regulators can effectively carry out their missions and be held
accountable. Key issues include considering the benefits of re-
examining the goals of financial regulation to gain needed consensus
and making explicit a set of updated comprehensive and cohesive goals
that reflect today's environment.
Characteristic: Appropriately comprehensive;
Description: Financial regulations should cover all activities that
pose risks or are otherwise important to meeting regulatory goals and
should ensure that appropriate determinations are made about how
extensive such regulations should be, considering that some activities
may require less regulation than others. Key issues include identifying
risk-based criteria, such as a product's or institution's potential to
create systemic problems, for determining the appropriate level of
oversight for financial activities and institutions, including closing
gaps that contributed to the current crisis.
Characteristic: Systemwide focus;
Description: Mechanisms should be included for identifying, monitoring,
and managing risks to the financial system regardless of the source of
the risk. Given that no regulator is currently tasked with this, key
issues include determining how to effectively monitor market
developments to identify potential risks; the degree, if any, to which
regulatory intervention might be required; and who should hold such
responsibilities.
Characteristic: Flexible and adaptable;
Description: A regulatory system that is flexible and forward looking
allows regulators to readily adapt to market innovations and changes.
Key issues include identifying and acting on emerging risks in a timely
way without hindering innovation.
Characteristic: Efficient and effective;
Description: Effective and efficient oversight should be developed,
including eliminating overlapping federal regulatory missions where
appropriate, and minimizing regulatory burden without sacrificing
effective oversight. Any changes to the system should be continually
focused on improving the effectiveness of the financial regulatory
system. Key issues include determining opportunities for consolidation
given the large number of overlapping participants now, identifying the
appropriate role of states and self-regulation, and ensuring a smooth
transition to any new system.
Characteristic: Consistent consumer and investor protection;
Description: Consumer and investor protection should be included as
part of the regulatory mission to ensure that market participants
receive consistent, useful information, as well as legal protections
for similar financial products and services, including disclosures,
sales practice standards, and suitability requirements. Key issues
include determining what amount, if any, of consolidation of
responsibility may be necessary to streamline consumer protection
activities across the financial services industry.
Characteristic: Regulators provided with independence, prominence,
authority, and accountability;
Description: Regulators should have independence from inappropriate
influence, as well as prominence and authority to carry out and enforce
statutory missions, and be clearly accountable for meeting regulatory
goals. With regulators with varying levels of prominence and funding
schemes now, key issues include how to appropriately structure and fund
agencies to ensure that each one's structure sufficiently achieves
these characteristics.
Characteristic: Consistent financial oversight;
Description: Similar institutions, products, risks, and services should
be subject to consistent regulation, oversight, and transparency, which
should help minimize negative competitive outcomes while harmonizing
oversight, both within the United States and internationally. Key
issues include identifying activities that pose similar risks, and
streamlining regulatory activities to achieve consistency.
Characteristic: Minimal taxpayer exposure;
Description: A regulatory system should foster financial markets that
are resilient enough to absorb failures and thereby limit the need for
federal intervention and limit taxpayers' exposure to financial risk.
Key issues include identifying safeguards to prevent systemic crises
and minimizing moral hazard.
Source: GAO.
[End of table]
[End of section]
Related GAO Products:
Financial Markets Regulation: Financial Crisis Highlights Need to
Improve Oversight of Leverage at Financial Institutions and across
System. [hyperlink, http://www.gao.gov/products/GAO-09-739].
Washington, D.C.: Jul. 22, 2009.
Fair Lending: Data Limitations and the Fragmented U.S. Financial
Regulatory Structure Challenge Federal Oversight and Enforcement
Efforts. [hyperlink, http://www.gao.gov/products/GAO-09-704].
Washington, D.C.: Jul. 15, 2009.
Hedge Funds: Overview of Regulatory Oversight, Counterparty Risks, and
Investment Challenges. [hyperlink,
http://www.gao.gov/products/GAO-09-677T]. Washington, D.C.: May 7,
2009.
Financial Regulation: Review of Regulators' Oversight of Risk
Management Systems at a Limited Number of Large, Complex Financial
Institutions. [hyperlink, http://www.gao.gov/products/GAO-09-499T].
Washington, D.C.: Mar. 18, 2009.
Federal Financial Assistance: Preliminary Observations on Assistance
Provided to AIG. [hyperlink, http://www.gao.gov/products/GAO-09-490T].
Washington, D.C.: Mar. 18, 2009.
Systemic Risk: Regulatory Oversight and Recent Initiatives to Address
Risk Posed by Credit Default Swaps. [hyperlink,
http://www.gao.gov/products/GAO-09-397T]. Washington, D.C.: Mar. 5,
2009.
Bank Secrecy Act: Federal Agencies Should Take Action to Further
Improve Coordination and Information-Sharing Efforts. [hyperlink,
http://www.gao.gov/products/GAO-09-227]. Washington, D.C.: Feb. 12,
2009.
Financial Regulation: A Framework for Crafting and Assessing Proposals
to Modernize the Outdated U.S. Financial Regulatory System. [hyperlink,
http://www.gao.gov/products/GAO-09-216]. Washington, D.C.: Jan. 8,
2009.
Troubled Asset Relief Program: Additional Actions Needed to Better
Ensure Integrity, Accountability, and Transparency. [hyperlink,
http://www.gao.gov/products/GAO-09-161]. Washington, D.C.: December 2,
2008.
Hedge Funds: Regulators and Market Participants Are Taking Steps to
Strengthen Market Discipline, but Continued Attention Is Needed.
[hyperlink, http://www.gao.gov/products/GAO-08-200]. Washington, D.C.:
January 24, 2008.
Information on Recent Default and Foreclosure Trends for Home Mortgages
and Associated Economic and Market Developments. [hyperlink,
http://www.gao.gov/products/GAO-08-78R]. Washington, D.C.: October 16,
2007.
Financial Regulation: Industry Trends Continue to Challenge the Federal
Regulatory Structure. [hyperlink,
http://www.gao.gov/products/GAO-08-32]. Washington, D.C.: October 12,
2007.
Financial Market Regulation: Agencies Engaged in Consolidated
Supervision Can Strengthen Performance Measurement and Collaboration.
[hyperlink, http://www.gao.gov/products/GAO-07-154]. Washington, D.C.:
March 15, 2007.
Alternative Mortgage Products: Impact on Defaults Remains Unclear, but
Disclosure of Risks to Borrowers Could Be Improved. [hyperlink,
http://www.gao.gov/products/GAO-06-1021]. Washington, D.C.: September
19, 2006.
Credit Cards: Increased Complexity in Rates and Fees Heightens Need for
More Effective Disclosures to Consumers. [hyperlink,
http://www.gao.gov/products/GAO-06-929]. Washington, D.C.: September
12, 2006.
Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure. [hyperlink,
http://www.gao.gov/products/GAO-05-61]. Washington, D.C.: October 6,
2004.
Consumer Protection: Federal and State Agencies Face Challenges in
Combating Predatory Lending. [hyperlink,
http://www.gao.gov/products/GAO-04-280]. Washington, D.C.: January 30,
2004.
Long-Term Capital Management: Regulators Need to Focus Greater
Attention on Systemic Risk. [hyperlink,
http://www.gao.gov/products/GAO/GGD-00-3]. Washington, D.C.: October
29, 1999.
Financial Derivatives: Actions Needed to Protect the Financial System.
[hyperlink, http://www.gao.gov/products/GAO/GGD-94-133]. Washington,
D.C.: May 18, 1994.
[End of section]
Footnotes:
[1] GAO, Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory System,
[hyperlink, http://www.gao.gov/products/GAO-09-216] (Washington, D.C.:
Jan. 8, 2009).
[2] GAO, High Risk Series: An Update, [hyperlink,
http://www.gao.gov/products/GAO-09-271] (Washington, D.C.: Jan. 2009).
[3] [hyperlink, http://www.gao.gov/products/GAO-09-216].
[4] GAO, Bank Oversight Structure: U.S. and Foreign Experience May
Offer Lessons for Modernizing U.S. Structure, [hyperlink,
http://www.gao.gov/products/GAO/GGD-97-23] (Washington D.C.: Nov. 20,
1996).
[5] GAO, Financial Market Regulation: Agencies Engaged in Consolidated
Supervision Can Strengthen Performance Measurement and Collaboration,
[hyperlink, http://www.gao.gov/products/GAO-07-154] (Washington, D.C.:
Mar. 15, 2007).
[6] GAO, Industrial Loan Corporations: Recent Asset Growth and
Commercial Interest Highlight Differences in Regulatory Authority,
[hyperlink, http://www.gao.gov/products/GAO-05-621] (Washington, D.C.:
Sept. 15, 2005).
[7] GAO, Financial Regulation: Industry Changes Prompt Need to
Reconsider U.S. Regulatory Structure, [hyperlink,
http://www.gao.gov/products/GAO-05-61] (Washington, D.C.: Oct. 6,
2004).
[8] [hyperlink, http://www.gao.gov/products/GAO-07-154].
[9] [hyperlink, http://www.gao.gov/products/GAO-09-227].
[10] GAO, Bank Secrecy Act: Federal Agencies Should Take Action to
Further Improve Coordination and Information-Sharing Efforts,
[hyperlink, http://www.gao.gov/products/GAO-09-227] (Washington, D.C.:
Feb. 12, 2009).
[11] GAO, Fair Lending: Data Limitations and the Fragmented U.S.
Financial Regulatory Structure Challenge Federal Oversight and
Enforcement Efforts, [hyperlink,
http://www.gao.gov/products/GAO-09-704] (Washington, D.C.: Jul. 15,
2009).
[12] GAO, Systemic Risk: Regulatory Oversight and Recent Initiatives to
Address Risk Posed by Credit Default Swaps, [hyperlink,
http://www.gao.gov/products/GAO-09-397T] (Washington, D.C.: Mar. 5,
2009).
[13] GAO, Hedge Funds: Overview of Regulatory Oversight, Counterparty
Risks, and Investment Challenges, [hyperlink,
http://www.gao.gov/products/GAO-09-677T] (Washington, D.C.: May 7,
2009).
[14] GAO, Financial Regulation: Review of Regulators' Oversight of Risk
Management Systems at a Limited Number of Large, Complex Financial
Institutions, [hyperlink, http://www.gao.gov/products/GAO-09-499T]
(Washington, D.C.: Mar. 18, 2009).
[15] GAO, Financial Markets Regulation: Financial Crisis Highlights
Need to Improve Oversight of Leverage at Financial Institutions and
across System, [hyperlink, http://www.gao.gov/products/GAO-09-739]
(Washington, D.C.: Jul. 22, 2009).
[16] G-20 Working Group 1, Enhancing Sound Regulation and Strengthening
Transparency, March 25, 2009 and Bank for International Settlements,
79th Annual Report (Basel, Switzerland, Jun. 12, 2009). The Group of
30, Financial Reform: A Framework for Financial Stability (Washington,
D.C.: Jan. 15, 2009). Committee on Capital Markets Regulation, The
Global Financial Crisis, A Plan for Regulatory Reform (May 2009).
[17] While we chose countries that use the integrated and twin peaks
approaches, other approaches to financial regulation exist.
[18] [hyperlink, http://www.gao.gov/products/GAO-09-216].
[19] A New Foundation: Rebuilding Financial Supervision and Regulation
provides outlines the Administration's proposal and draft legislation
provides additional specific information. Mr. Spencer Bachus and others
introduced H.R. 3310, the Consumer Protection and Regulatory
Enhancement Act of 2009--a proposal on behalf of House Republicans--on
July 23, 2009.
[20] [hyperlink, http://www.gao.gov/products/GAO-09-216].
[End of section]
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