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Testimony: 

Before the Subcommittee on Oversight and Investigations, Committee on 
Financial Services, House of Representatives: 

United States Government Accountability Office: 
GAO: 

For Release on Delivery: 
Expected at 10:00 a.m. EDT:
Thursday, May 6, 2010: 

Financial Markets Regulation: 

Financial Crisis Highlights Need to Improve Oversight of Leverage at 
Financial Institutions and across System: 

Statement of Orice Williams Brown: 
Director, Financial Markets and Community Investment: 

GAO-10-555T: 

GAO Highlights: 

Highlights of GAO-10-555T, a report to Subcommittee on Oversight and 
Investigations, House Committee on Financial Services. 

Why GAO Did This Study: 

In 2009 GAO conducted a study on the role of leverage in the recent 
financial crisis and federal oversight of leverage, as mandated by the 
Emergency Economic Stabilization Act. This testimony presents the 
results of that study, and discusses (1) how leveraging and 
deleveraging by financial institutions may have contributed to the 
crisis, (2) how federal financial regulators limit the buildup of 
leverage; and (3) the limitations the crisis has revealed in 
regulatory approaches used to restrict leverage and regulatory 
proposals to address them. 

To meet these objectives, GAO built on its existing body of work, 
reviewed relevant laws and regulations and academic and other studies, 
and interviewed regulators and market participants. 

What GAO Found: 

Some studies suggested that leverage steadily increased in the 
financial sector before the crisis began in mid-2007 and created 
vulnerabilities that have increased the severity of the crisis. In 
addition, subsequent disorderly deleveraging by financial institutions 
may have compounded the crisis. First, the studies suggested that the 
efforts taken by financial institutions to deleverage by selling 
financial assets could cause prices to spiral downward during times of 
market stress and exacerbate a financial crisis. Second, the studies 
suggested that deleveraging by restricting new lending could slow 
economic growth. However, other theories also provide possible 
explanations for the sharp price declines observed in certain assets. 
As the crisis is complex, no single theory is likely to fully explain 
what occurred or rule out other explanations. Regulators and market 
participants we interviewed had mixed views about the effects of 
deleveraging. Some officials told us that they generally have not seen 
asset sales leading to downward price spirals, but others said that 
asset sales have led to such spirals. 

Federal regulators impose capital and other requirements on their 
regulated institutions to limit leverage and ensure financial 
stability. Federal bank regulators impose minimum risk-based capital 
and leverage ratios on banks and thrifts and supervise the capital 
adequacy of such firms through on-site examinations and off-site 
monitoring. Bank holding companies are subject to similar capital 
requirements as banks, but capital levels of thrift holding companies 
are individually evaluated based on each company’s risk profile. The 
Securities and Exchange Commission uses its net capital rule to limit 
broker-dealer leverage and used to require certain broker-dealer 
holding companies to report risk-based capital ratios and meet certain 
liquidity requirements. Other important market participants, such as 
hedge funds, also use leverage. Hedge funds typically are not subject 
to regulatory capital requirements, but market discipline, 
supplemented by regulatory oversight of institutions that transact 
with them, can serve to constrain their leverage. 

The crisis has revealed limitations in regulatory approaches used to 
restrict leverage. First, regulatory capital measures did not always 
fully capture certain risks, which resulted in some institutions not 
holding capital commensurate with their risks and facing capital 
shortfalls when the crisis began. Federal regulators have called for 
reforms, including through international efforts to revise the Basel 
II capital framework. The planned U.S. implementation of Basel II 
would increase reliance on risk models for determining capital needs 
for certain large institutions. The crisis underscored concerns about 
the use of such models for determining capital adequacy, but 
regulators have not assessed whether proposed Basel II reforms will 
address these concerns. Such an assessment is critical to ensure that 
changes to the regulatory framework address the limitations the crisis 
had revealed. Second, regulators face challenges in counteracting 
cyclical leverage trends and are working on reform proposals. Finally, 
the crisis has revealed that with multiple regulators responsible for 
individual markets or institutions, none has clear responsibility to 
assess the potential effects of the buildup of systemwide leverage or 
the collective effect of institutions’ deleveraging activities. 

What GAO Recommends: 

As Congress considers establishing a systemic risk regulator, it 
should consider the merits of assigning such a regulator with 
responsibility for overseeing systemwide leverage. As U.S. regulators 
continue to consider reforms to strengthen oversight of leverage, we 
recommend that they assess the extent to which reforms under Basel II, 
a new risk-based capital framework, will address risk evaluation and 
regulatory oversight concerns associated with advanced modeling 
approaches used for capital adequacy purposes. In their written 
comments, the regulators generally agreed with GAO’s conclusions and 
recommendation. 

View [hyperlink, http://www.gao.gov/products/GAO-10-555T] or key 
components. For more information, contact Orice Williams Brown at 
(202) 512-8678 or williamso@gao.gov. 

[End of section] 

Chairman Moore, Ranking Member Biggert, and Members of the 
Subcommittee: 

I appreciate the opportunity to participate in today's hearing to 
discuss debt and leverage in financial markets in the context of the 
recent financial crisis. As you know, the buildup of leverage during a 
market expansion and the rush to reduce leverage, or "deleverage," 
when market conditions deteriorated was common to the recent and prior 
financial crises. Leverage traditionally has referred to the use of 
debt, instead of equity, to fund an asset and has been measured by the 
ratio of total assets to equity on the balance sheet. But as witnessed 
in the recent crisis, leverage also can be used to increase an 
exposure to a financial asset without using debt, such as by using 
derivatives.[Footnote 1] In that regard, leverage can be defined 
broadly as the ratio between some measure of risk exposure and capital 
that can be used to absorb unexpected losses from the exposure. 
[Footnote 2] However, because leverage can be achieved through many 
different strategies, no single measure can capture all aspects of 
leverage. Federal financial regulators are responsible for 
establishing regulations that restrict the use of leverage by 
financial institutions under their authority and supervising their 
institutions' compliance with such regulations. 

My statement today is based on our July 2009 report on the role of 
leverage and deleveraging by financial institutions in the recent 
crisis and federal oversight of leverage.[Footnote 3] We completed 
this work in response to a mandate contained in section 117 of the 
Emergency Economic Stabilization Act of 2008.[Footnote 4] 
Specifically, I will discuss (1) how leveraging and deleveraging by 
financial institutions may have contributed to the crisis; (2) how 
federal financial regulators limit the buildup of leverage; and (3) 
the limitations the crisis has revealed in regulatory approaches to 
restrict leverage and regulatory proposals to address them. 

To address our objectives, we reviewed and analyzed (1) academic and 
other studies assessing the buildup of leverage prior to the recent 
financial crisis and the economic mechanisms that possibly helped the 
mortgage-related losses spread to other markets and expand into the 
recent crisis; (2) relevant laws and regulations, and other regulatory 
guidance and materials, related to the oversight of financial 
institutions' use of leverage by the Federal Reserve, Federal Deposit 
Insurance Corporation (FDIC), Office of the Comptroller of the 
Currency (OCC), Office of Thrift Supervision (OTS), and Securities and 
Exchange Commission (SEC); and (3) various data to illustrate leverage 
and other relevant trends. We assessed the reliability of the data and 
found that they were sufficiently reliable for our purposes. We also 
reviewed and analyzed studies done by U.S. and international 
regulators and others identifying limitations in the regulatory 
framework used to restrict leverage and proposals to address such 
limitations. Finally, we reviewed prior GAO work on the financial 
regulatory system. In addition, we interviewed staff from these 
federal financial regulators and officials from two securities firms, 
a bank, and a credit rating agency. 

We conducted our work between February and July 2009 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. 

Summary: 

The causes of the recent financial crisis remain subject to debate and 
additional research. Nevertheless, some researchers and regulators 
have suggested that the buildup of leverage before the financial 
crisis and subsequent disorderly deleveraging have compounded the 
recent financial crisis. In particular, some studies suggested that 
the efforts taken by financial institutions to deleverage by selling 
financial assets could lead to a downward price spiral in times of 
market stress and exacerbate a financial crisis. However, alternative 
theories provide possible explanations; for example, the drop in asset 
prices may reflect prices reverting to more reasonable levels after a 
period of overvaluation or it may reflect uncertainty surrounding the 
true value of the assets. In addition, deleveraging by restricting new 
lending could slow economic growth and thereby contribute to a 
financial crisis. 

Federal financial regulators impose capital and other requirements 
such as leverage measures on their regulated institutions to limit 
leverage and ensure financial stability. Federal banking regulators 
impose minimum risk-based capital and leverage ratios on banks and 
thrifts and supervise the capital adequacy of such firms through on-
site examinations and off-site monitoring. Bank holding companies are 
subject to similar capital requirements as banks, but thrift holding 
companies are not. Capital levels of thrift holding companies are 
individually evaluated based on each company's risk profile. SEC uses 
its net capital rule to limit broker-dealer leverage. Other important 
market participants, such as hedge funds, also use leverage. Hedge 
funds typically are not subject to regulatory capital requirements, 
but market discipline, supplemented by regulatory oversight of 
institutions that transact with them, can serve to constrain their 
leverage. 

The crisis has revealed limitations in the financial regulatory 
capital framework's ability to restrict leverage and to mitigate 
crisis. First, regulatory capital measures did not always fully 
capture certain risks. As a result, these institutions did not hold 
capital commensurate with their risks and some faced capital 
shortfalls when the crisis began. Federal regulators have called for 
reforms, including international efforts to revise the Basel II 
capital framework. The planned U.S. implementation of Basel II would 
increase reliance on risk models for determining capital needs for 
certain large institutions. The crisis underscored concerns about the 
use of such models for determining capital adequacy, but regulators 
have not assessed whether proposed Basel II reforms will address these 
concerns. Such an assessment is critical to help ensure that changes 
to the regulatory framework address the limitations revealed by the 
recent crisis. Second, regulators face challenges in counteracting 
cyclical leverage trends. Finally, with multiple regulators 
responsible for individual markets or institutions, none has clear 
responsibility to assess the potential effects of the buildup of 
systemwide leverage or the collective effects of institutions' 
deleveraging activities. 

Background: 

Many financial institutions use leverage to expand their ability to 
invest or trade in financial assets and to increase their return on 
equity. A firm can use leverage through a number of strategies, 
including by using debt to finance an asset or entering into 
derivatives. Greater financial leverage, as measured by lower 
proportions of capital relative to assets, can increase the firm's 
market risk, because leverage magnifies gains and losses relative to 
equity. Leverage also can increase a firm's liquidity risk, because a 
leveraged firm may be forced to sell assets under adverse market 
conditions to reduce its exposure. Although commonly used as a 
leverage measure, the ratio of assets to equity captures only on-
balance sheet assets and treats all assets as equally risky. Moreover, 
the ratio of assets to equity helps to measure the extent to which a 
change in total assets would affect equity but provides no information 
on the probability of such a change occurring. Finally, a leveraged 
position may not be more risky than a non-leveraged position, when 
other aspects of the position are not equal. For example, a non-
leveraged position in a highly risky asset could be more risky than a 
leveraged position in a low risk asset. 

During the 1980s, banking regulators became concerned that simple 
leverage measures--such as the ratio of assets to equity or debt to 
equity--required too much capital for less-risky assets and not enough 
for riskier assets and that such measures did not require capital for 
growing portfolios of off-balance sheet items. In response to these 
concerns, the Basel Committee on Banking Supervision adopted Basel I, 
an international framework for risk-based capital that required banks 
to meet minimum risk-based capital ratios, in 1988.[Footnote 5] By 
1992, U.S. regulators had fully implemented Basel I; and in 1996, they 
and supervisors from other Basel Committee member countries amended 
the framework to include explicit capital requirements for market risk 
from trading activity (called the Market Risk Amendment).[Footnote 6] 
In response to the views of bankers and many regulators that 
innovation in financial markets and advances in risk management have 
revealed limitations in the existing Basel I risk-based capital 
framework, especially for large, complex banks, the Basel Committee 
released the Basel II international accord in 2004.[Footnote 7] Since 
then, individual countries have been implementing national rules based 
on the principles and detailed framework. In a prior report, we 
discussed the status of efforts by U.S. regulators to implement the 
Basel II accord.[Footnote 8] 

Research Suggests Leverage Increased before the Crisis and Subsequent 
Deleveraging Could Have Contributed to the Crisis: 

Studies we reviewed suggest that leverage within the financial sector 
increased before the crisis and that subsequent deleveraging by 
financial institutions could have contributed to the recent crisis. 
The causes of the recent financial crisis are complex and multifaceted 
and remain subject to debate and ongoing research. Given our mandate, 
our review of the economic literature focused narrowly on deleveraging 
as one of the potential economic mechanisms contributing to the 
crisis. The studies we reviewed do not provide definitive findings 
about the role of deleveraging relative to other mechanisms, and we 
relied on our interpretation and reasoning to develop insights from 
the studies we reviewed. 

Leverage within the Financial Sector Increased before the Financial 
Crisis, and Financial Institutions Sought to Deleverage When the 
Crisis Began: 

Leverage steadily increased in the financial sector before the crisis 
began around mid-2007 and created vulnerabilities that increased the 
severity of the crisis, according to studies we reviewed.[Footnote 9] 
As mentioned earlier, leverage can take many different forms, and no 
single measure of leverage exists. In that regard, the studies we 
reviewed generally identified a range of sources that aided in the 
buildup of leverage before the crisis. One such source was the 
reliance on short-term funding by financial institutions, which made 
them vulnerable to a decline in the availability of such credit. 
Another source of leverage was special purpose entities (SPE), which 
some banks created to buy and hold mortgage-related and other assets 
that the banks did not want to hold on their balance sheets. SPEs 
often borrowed by issuing shorter-term instruments, exposing them to 
the risk of not being able to renew their debt. Other sources of 
leverage included collateralized debt obligations (CDOs) and credit 
default swaps, a type of OTC derivative.[Footnote 10] For securities 
firms, hedge funds, and other financial intermediaries that operate 
mainly through the capital markets, their balance sheet leverage, or 
ratio of total assets to equity, tends to be procyclical.[Footnote 11] 
Historically, such institutions tended to increase their leverage when 
asset prices rose and decrease their leverage when asset prices fell. 
Consistent with this trend, the ratio of assets to equity for five 
large broker-dealer holding companies, in aggregate, increased from an 
average ratio of around 22 to 1 in 2002 to around 30 to 1 in 2007 (see 
figure 1). 

Figure 1: Total Assets, Total Equity, and Leverage (Asset-to-Equity) 
Ratio in Aggregate for Five Large U.S. Broker-Dealer Holding 
Companies, 1998 to 2007: 

[Refer to PDF for image: combined vertical bar and line graph] 

Year: 1998; 
Total assets: $1.14 trillion; 
Total equity: $40 billion; 
Asset-to-equity ratio: 28.1 to 1. 

Year: 1999; 
Total assets: $1.28 trillion; 
Total equity: $51 billion; 
Asset-to-equity ratio: 24.9 to 1. 

Year: 2000; 
Total assets: $1.52 trillion; 
Total equity: $68 billion; 
Asset-to-equity ratio: 22.5 to 1. 

Year: 2001; 
Total assets: $1.66 trillion; 
Total equity: $73 billion; 
Asset-to-equity ratio: 22.8 to 1. 

Year: 2002; 
Total assets: $1.78 trillion; 
Total equity: $79 billion; 
Asset-to-equity ratio: 22.5 to 1. 

Year: 2003; 
Total assets: $2.03 trillion; 
Total equity: $96 billion; 
Asset-to-equity ratio: 21.1 to 1. 

Year: 2004; 
Total assets: $2.60 trillion; 
Total equity: $109 billion; 
Asset-to-equity ratio: 24 to 1. 

Year: 2005; 
Total assets: $2.98 trillion; 
Total equity: $120 billion; 
Asset-to-equity ratio: 24.8 to 1. 

Year: 2006; 
Total assets: $3.65 trillion; 
Total equity: $142 billion; 
Asset-to-equity ratio: 25.8 to 1. 

Year: 2007; 
Total assets: $4.27 trillion; 
Total equity: $140 billion; 
Asset-to-equity ratio: 30.5 to 1. 

Source: GAO analysis of annual report data for Bear Stearns, Goldman 
Sachs, Lehman Brothers, Merrill Lynch, and Morgan Stanley. 

[End of figure] 

In contrast, the ratio of assets to equity for five large bank holding 
companies, in aggregate, was relatively flat during this period (see 
figure 2). As discussed in the background, the ratio of assets to 
equity as a measure of leverage treats all assets as equally risky and 
does not capture off-balance sheet risks. 

Figure 2: Total Assets, Total Equity, and Assets-to-Equity Ratio in 
Aggregate for Five Large U.S. Bank Holding Companies, 1998 to 2007: 

[Refer to PDF for image: combined vertical bar and line graph] 

Year: 1998; 
Total assets: $2.39 trillion; 
Total equity: $169 billion; 
Asset-to-equity ratio: 14.2 to 1. 

Year: 1999; 
Total assets: $2.55 trillion; 
Total equity: $179 billion; 
Asset-to-equity ratio: 14.3 to 1. 

Year: 2000; 
Total assets: $2.82 trillion; 
Total equity: $198 billion; 
Asset-to-equity ratio: 14.3 to 1. 

Year: 2001; 
Total assets: $3.03 trillion; 
Total equity: $227 billion; 
Asset-to-equity ratio: 13.4 to 1. 

Year: 2002; 
Total assets: $3.21 trillion; 
Total equity: $242 billion; 
Asset-to-equity ratio: 13.3 to 1. 

Year: 2003; 
Total assets: $3.56 trillion; 
Total equity: $259 billion; 
Asset-to-equity ratio: 13.7 to 1. 

Year: 2004; 
Total assets: $4.68 trillion; 
Total equity: $400 billion; 
Asset-to-equity ratio: 11.7 to 1. 

Year: 2005; 
Total assets: $4.99 trillion; 
Total equity: $410 billion; 
Asset-to-equity ratio: 12.2 to 1. 

Year: 2006; 
Total assets: $5.89 trillion; 
Total equity: $486 billion; 
Asset-to-equity ratio: 12.1 to 1. 

Year: 2007; 
Total assets: $6.82 trillion; 
Total equity: $508 billion; 
Asset-to-equity ratio: 13.4 to 1. 

Source: GAO analysis of annual report and Federal Reserve Y-9C data 
for Bank of America, Citigroup, JPMorgan Chase, Wachovia, and Wells 
Fargo. 

[End of figure] 

As their mortgage-related and other losses grew after the onset of the 
crisis, banks, securities firms, hedge funds, and other financial 
institutions have attempted to deleverage and reduce their risk. 
Deleveraging can cover a range of strategies, including raising new 
equity, reducing dividend payouts, diversifying sources of funds, 
selling assets, and reducing lending. After the crisis began, U.S. 
banks and securities firms initially deleveraged by raising more than 
$200 billion in new capital from private sources and sovereign wealth 
funds.[Footnote 12] However, raising capital began to be increasingly 
difficult in the subsequent period, and financial institutions have 
deleveraged by selling assets, including financial instruments and 
noncore businesses. For example, in the fourth quarter of 2008, broker-
dealers reduced assets by nearly $785 billion and banks reduced bank 
credit by nearly $84 billion. 

Some Studies Suggested That Deleveraging by Financial Institutions by 
Selling Financial Assets and Restricting New Lending Could Have 
Contributed to the Crisis: 

Some studies we reviewed highlighted the possibility that deleveraging 
through asset sales by financial institutions could trigger downward 
spirals in asset prices and contribute to a financial crisis.[Footnote 
13] In times of market stress, a sharp decline in an asset's price can 
become self-sustaining and lead to a financial market crisis. 
Following a sharp decline in an asset's price, investors normally will 
buy the asset after they deem its price has dropped enough and help 
stabilize the market, but in times of crisis, investors are unable or 
unwilling to buy the asset. As the asset's price declines, more 
investors sell and push the price lower. For leveraged institutions 
holding the asset, the impact of their losses on capital will be 
magnified. To lower their leverage or risk, the institutions may sell 
more of their assets, which can cause the asset's price to drop even 
more and induce another round of selling. In other words, when market 
liquidity is low, namely in times of market stress, asset sales 
establish lower market prices and result in financial institutions 
marking down their positions--potentially creating a reinforcing cycle 
of deleveraging. In the extreme, this downward asset spiral could 
cause the asset's price to be set below its fundamental value, or at a 
"fire sale" price. In addition, a decline in a financial asset's price 
could trigger sales when the asset is used as collateral for a loan. 
In such a case, the borrower could be required to post additional 
collateral for its loan, but if the borrower could not do so, the 
lender could take ownership of the collateral and then sell it, which 
could cause the asset's price to decline further. 

Importantly, other theories that do not involve asset spirals caused 
by deleveraging through asset sales provide possible explanations for 
the sharp price declines in mortgage-related securities and other 
financial instruments. Moreover, as the crisis is complex, no single 
theory likely is to explain in full what occurred or necessarily rule 
out other explanations. First, given the default characteristics of 
the mortgages underlying their related securities and falling housing 
prices, low market prices may result from asset prices reverting to 
more reasonable values after a period of overvaluation. Second, the 
low prices of mortgage-related securities and other financial 
instruments may have resulted from the uncertainty surrounding their 
true value. This theory holds that investors may lack the information 
needed to distinguish between the good and bad securities and, as a 
result, discount the prices of the good securities.[Footnote 14] These 
two theories and the deleveraging hypothesis may provide some insight 
into how the financial crisis has unfolded and are not mutually 
exclusive. Nonetheless, at this juncture, it is difficult to determine 
whether a return to fundamentals, uncertainty, or forced asset sales 
played a larger causal role. 

In addition, some studies we reviewed suggested that deleveraging by 
restricting new lending could contribute to the crisis by slowing 
economic growth. In short, the concern is that banks, because of their 
leverage, will need to cut back their lending by a multiple of their 
credit losses to restore their balance sheets or capital-to-asset 
ratios. The contraction in bank lending can lead to a decline in 
consumption and investment spending, which reduces business and 
household incomes and negatively affects the real economy. Moreover, 
rapidly declining asset prices can inhibit the ability of borrowers to 
raise money in the securities markets. 

Regulators and Market Participants Had Mixed Views about the Effects 
of Deleveraging in the Recent Crisis: 

Officials from federal financial regulators, two securities firms, a 
bank, and a credit rating agency whom we interviewed had mixed views 
about the effects of deleveraging by financial institutions in the 
recent crisis. Nearly all of the officials told us that large banks 
and securities firms generally have sought to reduce their risk 
exposures since late 2007, partly in response to liquidity pressures. 
The institutions have used a number of strategies to deleverage, 
including raising new capital; curtailing certain lines of business; 
and selling assets, including trading assets, loans, and noncore 
businesses. Regulatory officials said that hedge funds and other asset 
managers also deleveraged by selling assets to meet redemptions or 
margin calls. According to officials at a securities firm, raising 
capital and selling financial assets was easier in the beginning of 
the recent crisis, but both became harder to do as the crisis 
continued. Regulatory and credit rating agency officials also said 
that financial institutions have faced challenges in selling mortgages 
and other loans that they planned to securitize, because the 
securitization markets essentially had shut down during the crisis. 

The regulators and market participants we interviewed had mixed views 
on whether sales of financial assets contributed to a downward price 
spiral. Officials from one bank and the Federal Reserve staff we 
interviewed said that due to the lack of market liquidity for some 
instruments and the unwillingness of many market participants to sell 
them, declines in prices that may be attributed to market-driven asset 
spirals generally resulted from the use of models to price assets in 
the absence of any sales. Federal Reserve staff also said that it is 
hard to attribute specific factors as a cause of an observed asset 
spiral because of the difficulty in disentangling the interacting 
factors that can cause financial asset prices to move down. In 
contrast, officials from two securities firms and a credit rating 
agency, and staff from SEC and OCC told us that asset spirals occurred 
in certain mortgage and other debt markets. Officials from one 
securities firm said that financial institutions, such as hedge funds, 
generally sought to sell first those financial assets that were 
hardest to finance, which eventually caused these markets to become 
illiquid. The absence of observable prices for such assets then caused 
their prices to deteriorate even more. According to the securities 
firm officials, firms that needed to sell assets to cover losses or 
meet margin calls helped to drive such asset sales. 

FDIC and OCC staff and officials from a credit rating agency told us 
that some banks tightened their lending standards for certain types of 
loans, namely those with less-favorable risk-adjusted returns. Such 
loans include certain types of residential and commercial mortgages, 
leverage loans, and loans made to hedge funds. According to credit 
rating officials, banks essentially have set a target of slower growth 
for higher-risk loans that have performed poorly and deteriorated 
their loan portfolios. In addition, OCC and credit rating officials 
said that the largest banks rely heavily on their ability to 
securitize loans to help them make such loans. To that end, they said 
that the securitization markets need to open up and provide funding. 

Regulators Limit Financial Institutions' Use of Leverage Primarily 
Through Regulatory Capital Requirements: 

Federal financial regulators (Federal Reserve, FDIC, OCC, and OTS) 
generally have imposed capital and other requirements on their 
regulated institutions as a way to limit excessive use of leverage and 
ensure the stability of the financial system and markets. Federal 
banking and thrift regulators have imposed minimum risk-based capital 
and non-risk-based leverage ratios on their regulated institutions. 
Risk-based capital ratios are broadly intended to require banks to 
hold more capital for higher-risk assets. Leverage ratios provide a 
cushion against risks not explicitly covered in the risk-based capital 
requirements, such as operational weaknesses and model risk. In 
addition, the regulators supervise the capital adequacy of their 
regulated institutions through ongoing monitoring, including on-site 
examinations and off-site tools. Bank holding companies are subject to 
capital and leverage ratio requirements similar to those for 
banks.[Footnote 15] Thrift holding companies are not subject to such 
requirements; rather, capital levels of thrift holding companies are 
individually evaluated based on each company's risk profile. SEC 
primarily uses its net capital rule to limit the use of leverage by 
broker-dealers. According to SEC officials, firms that had 
participated in SEC's now defunct Consolidated Supervised Entities 
program calculated their risk-based capital ratios at the holding 
company level in a manner generally consistent with the method banks 
used.[Footnote 16] 

Other financial institutions, such as hedge funds, use leverage but, 
unlike banks and broker-dealers, typically are not subject to 
regulatory capital requirements; instead, market discipline plays a 
primary role in limiting leverage. Finally, the Federal Reserve 
regulates the use of securities as collateral to finance security 
purchases, but federal financial regulators told us that such credit 
did not play a significant role in the buildup of leverage leading to 
the recent crisis. 

Regulators Are Considering Reforms to Address Limitations the Crisis 
Revealed in Regulatory Framework for Restricting Leverage: 

The financial crisis has revealed limitations in existing regulatory 
approaches that serve to restrict leverage. Although regulators have 
proposed changes to improve the risk coverage of the regulatory 
capital framework, limit cyclical leverage trends and better address 
sources of systemic risk, they have not yet fully evaluated the extent 
to which these proposals would address these limitations. First, 
regulatory capital measures did not always fully capture certain 
risks, particularly those associated with some mortgage-related 
securities held on and off balance sheets. As a result, a number of 
financial institutions did not hold capital commensurate with their 
risks and some lacked adequate capital or liquidity to withstand the 
market stresses of the crisis. Federal financial regulators have 
acknowledged the need to improve the risk coverage of the regulatory 
capital reform and are considering reforms to better align capital 
requirements with risk, but have not formally assessed the extent to 
which these reforms may address risk-evaluation concerns the crisis 
highlighted with respect to Basel II approaches. Such an assessment is 
critical to ensure that Basel II changes that would increase reliance 
on complex risk models and banks' own risk estimates do not exacerbate 
regulatory limitations revealed by the crisis. 

Second, the recent crisis illustrated how the existing regulatory 
framework, along with other factors, might have contributed to 
cyclical leverage trends that potentially exacerbated the recent 
crisis. For example, according to regulators, minimum regulatory 
capital requirements may not provide adequate incentives for banks to 
build loss-absorbing capital buffers in benign markets when it would 
be less expensive to do so. When market conditions deteriorated, 
minimum capital requirements became binding for many institutions that 
lacked adequate buffers to absorb losses and faced sudden pressures to 
deleverage. Regulators are considering several options to counteract 
potentially harmful cyclical leverage trends, but implementation of 
these proposals presents challenges. 

Finally, the financial crisis has illustrated the potential for 
financial market disruptions, not just firm failures, to be a source 
of systemic risk. With multiple regulators primarily responsible for 
individual markets or institutions, none of the financial regulators 
has clear responsibility to assess the potential effects of the 
buildup of systemwide leverage or the collective activities of the 
industry for the financial system. As a result, regulators may be 
limited in their ability to prevent or mitigate future financial 
crises. 

To ensure that there is a systemwide approach to addressing leverage- 
related issues across the financial system, we have asked Congress to 
consider, as it moves toward the creation of a systemic risk 
regulator, the merits of tasking this entity with the responsibility 
for measuring and monitoring systemwide leverage and evaluating 
options to limit procyclical leverage trends. Furthermore, we made a 
recommendation to the financial regulators to assess the extent to 
which Basel II reforms may address risk evaluation and regulatory 
oversight concerns associated with advanced modeling approaches used 
for capital purposes. In their comments on our report, the Federal 
Reserve, FDIC, OCC, and SEC generally agreed with our recommendations. 

Mr. Chairman, Ranking Member Biggert, and Members of the Subcommittee, 
this completes my prepared statement. I am prepared to respond to any 
questions you or other Members of the Subcommittee may have at this 
time. 

Contacts: 

For further information on this testimony, please contact Orice 
Williams Brown on (202) 512-8678 or williamso@gao.gov. Contact points 
for our Congressional Relations and Public Affairs offices may be 
found on the last page of this statement. 

[End of section] 

Footnotes: 

[1] Derivatives are financial products whose value is determined from 
an underlying reference rate (interest rates, foreign currency 
exchange rates); an index (that reflects the collective value of 
various financial products); or an asset (stocks, bonds, and 
commodities). Derivatives can be traded through central locations, 
called exchanges, where buyers and sellers, or their representatives, 
meet to determine prices; or privately negotiated by the parties off 
the exchanges or over the counter (OTC). 

[2] Capital generally is defined as a firm's long-term source of 
funding, contributed largely by a firm's equity stockholders and its 
own returns in the form of retained earnings. One important function 
of capital is to absorb losses. 

[3] GAO, Financial 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.: July 22, 2009). 

[4] 12 U.S.C. § 5227. 

[5] The Basel Committee on Banking Supervision (Basel Committee) seeks 
to improve the quality of banking supervision worldwide, in part by 
developing broad supervisory standards. The Basel Committee consists 
of central bank and regulatory officials from Argentina, Australia, 
Belgium, Brazil, Canada, China, France, Germany, Hong Kong SAR, India, 
Indonesia, Italy, Japan, Korea, Luxembourg, Mexico, the Netherlands, 
Russia, Saudi Arabia, Singapore, South Africa, Spain, Sweden, 
Switzerland, Turkey, the United Kingdom, and the United States. The 
Basel Committee's supervisory standards are also often adopted by 
nonmember countries. 

[6] According to Office of Thrift Supervision (OTS) staff, OTS did not 
adopt the capital requirements for trading book market risk. 

[7] For more information about the limitations of Basel I and the 
three pillars of Basel II, see GAO-09-739. 

[8] GAO, Risk-Based Capital: New Basel II Rules Reduced Certain 
Competitive Concerns, but Bank Regulators Should Address Remaining 
Uncertainties, [hyperlink, http://www.gao.gov/products/GAO-08-953] 
(Washington, D.C.: Sept. 12, 2008). 

[9] See, for example, Financial Services Authority, The Turner Review: 
A Regulatory Response to the Global Banking Crisis (London: March 
2009); Willem H. Buiter, "Lessons from the North Atlantic Financial 
Crisis," paper prepared for presentation at the conference "The Role 
of Money Markets," jointly organized by Columbia Business School and 
the Federal Reserve Bank of New York on May 29-30, 2008 (May 2008); 
Martin Neil Baily, Robert E. Litan, and Matthew S. Johnson, "The 
Origins of the Financial Crisis," Fixing Finance Series-Paper 3, 
(Washington, D.C.: The Brookings Institution, November 2008); and Ben 
Cohen and Eli Remolona, "The Unfolding Turmoil of 2007-2008: Lessons 
and Responses," Proceedings of a Conference, Sydney, Australia, 
Reserve Bank of Australia, Sydney. 

[10] In a basic collateralized-debt obligation (CDO), a group of debt 
securities are pooled, and securities are then issued in different 
tranches (or slices) that vary in risk and return. Through pooling and 
slicing, CDOs can give investors an embedded leveraged exposure. For a 
discussion of embedded leverage in CDOs, see The Joint Forum, Credit 
Risk Transfer, Basel Committee on Banking Supervision (Basel, 
Switzerland: October 2004). 

[11] We use the term "securities firms" generally to refer to the 
holding companies of broker-dealers. 

[12] Sovereign wealth funds generally are pools of government funds 
invested in assets in other countries. 

[13] See, for example, Markus K. Brunnermeier, "Deciphering the 2007-
08 Liquidity and Credit Crunch," Journal of Economic Perspectives 23, 
no. 1 (2009), pp. 77-100; Greenlaw et al. (2008); and Anil K., 
Kashyap, Raghuram G. Rajan, and Jeremy C. Stein, "Rethinking Capital 
Regulation," paper prepared for Federal Reserve Bank of Kansas City 
symposium on "Maintaining Stability in a Changing Financial System," 
Jackson Hole, Wyoming, August 21-23, 2008 (September 2008). 

[14] The seminal paper on this issue is Akerlof, George A., "The 
Market for 'Lemons': Quality Uncertainty and the Market Mechanism," 
Quarterly Journal of Economics, 84(3), pp. 488-500, 1970. 

[15] Bank holding companies are permitted to include certain debt 
instruments in regulatory capital that are impermissible for insured 
banks and, as discussed below, are not subject to statutory Prompt 
Corrective Action. 

[16] Under its Consolidated Supervised Entities (CSE) program, the 
Securities and Exchange Commission (SEC) supervised broker-dealer 
holding companies--Bear Stearns, Lehman Brothers, Merrill Lynch, 
Goldman Sachs, and Morgan Stanley--on a consolidated basis. Following 
the sale of Bear Stearns to JPMorgan Chase, the Lehman Brothers 
bankruptcy filing, and the sale of Merrill Lynch to Bank of America, 
the remaining CSEs opted to become bank holding companies subject to 
Federal Reserve oversight. SEC terminated the CSE program in September 
2008 but continues to oversee these firms' registered broker-dealer 
subsidiaries. 

[End of section] 

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