Financial Markets Regulation:

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

GAO-09-739: Published: Jul 22, 2009. Publicly Released: Jul 22, 2009.

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The Emergency Economic Stabilization Act directed GAO to study the role of leverage in the current financial crisis and federal oversight of leverage. GAO's objectives were to review (1) how leveraging and deleveraging by financial institutions may have contributed to the crisis, (2) regulations adopted by federal financial regulators to limit leverage and how regulators oversee compliance with the regulations, and (3) any limitations the current 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.

Some studies suggested that leverage steadily increased in the financial sector before the crisis, and deleveraging by financial institutions may have contributed to the crisis. First, the studies suggested that deleveraging by selling financial assets could cause prices to spiral downward during times of market stress. 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 thrift holding companies are not. 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, 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. For example, many financial institutions applied risk models in ways that significantly underestimated certain risk exposures. 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 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. Although the crisis underscored concerns about the use of such models for determining capital adequacy, regulators have not assessed whether proposed Basel II reforms will address these concerns. However, such an assessment is critical to ensure that changes to the regulatory framework address the limitations revealed by the crisis. Second, regulators face challenges in counteracting cyclical leverage trends and are working on reform proposals. Finally, the crisis has reinforced the need to focus greater attention on systemic risk. 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 activities of institutions to deleverage.

Matter for Congressional Consideration

  1. Status: Closed - Implemented

    Comments: Congress passed the Dodd-Frank Act in 2010, which created the (1) Financial Stability Oversight Council (FSOC) and (2) Office of Financial Research (OFR). FSOC is charged with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the U.S. financial system. On behalf of FSOC, OFR is responsible for, among other things, developing and maintaining metrics and reporting systems for risks to U.S. financial stability and monitoring and reporting changes in systemwide risk levels and patterns to FSOC.

    Matter: As Congress considers assigning a single regulator, a group of regulators, or a newly created entity with responsibility for overseeing systemically important firms, products, or activities to enhance the systemwide focus of the financial regulatory system, Congress may wish to consider the merits of tasking this systemic regulator with: (1) identifying ways to measure and monitor systemwide leverage and (2) evaluating options to limit procyclical leverage trends.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: In a comment letter to the report, FDIC said that the agency strongly endorses the report's recommendation that regulators undertake a fundamental review of Basel II to assess whether the framework would adequately address concerns about the use of banks' internal models to determine capital requirements. It further noted that it would consider this matter as part of the interagency review of Basel II that the agencies committed by regulation to undertake, and would propose suitable remedies as needed. In 2010, the regulators proposed revisions to the Market Risk Capital Framework. These revisions placed additional prudential requirements on the use of banks' internal models for measuring market risk and require enhanced qualitative and quantitative disclosures, particularly with respect to banks' securitization activities. To help prevent a recurrence of the dramatic increase in losses from trading activities during the recent crisis, the proposals include an incremental capital charge to augment the existing Value at Risk (VAR) capital charge.

    Recommendation: The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted.

    Agency Affected: Federal Deposit Insurance Corporation

  2. Status: Closed - Implemented

    Comments: OTS has been terminated. Thrifts that were supervised by OTS are now under the supervision of OCC. OCC has implemented this recommendation.

    Recommendation: The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted.

    Agency Affected: Department of the Treasury: Office of Thrift Supervision

  3. Status: Closed - Implemented

    Comments: In a comment letter to the report, the Federal Reserve agreed that the financial crisis has revealed weaknesses in both the Basel-I and Basel-II based risk-based capital standards and concurred with the recommendation for a more fundamental review of the Basel II capital framework to assess whether this new framework would address concerns about the use of using banks' internal models to determine capital requirements. In 2010 the bank regulators jointly proposed revisions to the Basel II Market Risk Framework. The revisions placed additional prudential requirements on banks' internal models for measuring market risk and required enhanced qualitative and quantitative disclosures, particularly with respect to banks' securitization activities. To help prevent a recurrence of the dramatic increase in leverage that contributed to the losses from trading activities during the recent crisis, the proposals include an incremental capital charge to augment the existing Value at Risk capital charge.

    Recommendation: The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted.

    Agency Affected: Federal Reserve System

  4. Status: Closed - Implemented

    Comments: OCC is working with the other U.S. banking agencies to implement the Basel Committee's amendments to the Basel II framework to address weaknesses in the treatment of securitization exposures and to prevent a recurrence of the dramatic increase in leverage that contributed to recent losses. They also are implementing the Basel Committee's enhancements to the capital requirements for trading activities--an area not updated at the time the Basel II framework was published but where significant losses occurred during the crisis. According to OCC, the modifications for trading activities better capture the credit risk that the more complex activities present. In addition, the risk weights for complex re-securitizations were increased to better reflect the risk inherent in these transactions. OCC noted that the modifications also include a stressed value-at-risk requiement that will help reduce the cyclicality of the regulatory capital framework. These changes are being implemented through rulemaking.

    Recommendation: The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted.

    Agency Affected: Department of the Treasury: Office of the Comptroller of the Currency

 

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