This is the accessible text file for GAO report number GAO-09-739
entitled 'Financial Crisis Highlights Need to Improve Oversight of
Leverage at Financial Institutions and Across System' which was
released on July 22, 2009.
This text file was formatted by the U.S. Government Accountability
Office (GAO) to be accessible to users with visual impairments, as part
of a longer term project to improve GAO products' accessibility. Every
attempt has been made to maintain the structural and data integrity of
the original printed product. Accessibility features, such as text
descriptions of tables, consecutively numbered footnotes placed at the
end of the file, and the text of agency comment letters, are provided
but may not exactly duplicate the presentation or format of the printed
version. The portable document format (PDF) file is an exact electronic
replica of the printed version. We welcome your feedback. Please E-mail
your comments regarding the contents or accessibility features of this
document to Webmaster@gao.gov.
This is a work of the U.S. government and is not subject to copyright
protection in the United States. It may be reproduced and distributed
in its entirety without further permission from GAO. Because this work
may contain copyrighted images or other material, permission from the
copyright holder may be necessary if you wish to reproduce this
material separately.
Report to Congressional Committees:
United States Government Accountability Office:
GAO:
July 2009:
Financial Markets Regulation:
Financial Crisis Highlights Need to Improve Oversight of Leverage at
Financial Institutions and across System:
GAO-09-739:
GAO Highlights:
Highlights of GAO-09-739, a report to congressional committees.
Why GAO Did This Study:
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.
What GAO Found:
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.
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 our conclusions and recommendation.
View [hyperlink, http://www.gao.gov/products/GAO-09-739] or key
components. For more information, contact Orice Williams Brown at (202)
512-8678 or williamso@gao.gov.
[End of section]
Contents:
Letter:
Results in Brief:
Background:
Research Suggests Leverage Increased before the Crisis and Subsequent
Deleveraging Could Have Contributed to the Crisis:
Regulators Limit Financial Institutions' Use of Leverage Primarily
Through Regulatory Capital Requirements:
Regulators Are Considering Reforms to Address Limitations the Crisis
Revealed in Regulatory Framework for Restricting Leverage, but Have Not
Reevaluated Basel II Implementation:
Conclusions:
Matter for Congressional Consideration:
Recommendation for Executive Action:
Agency Comments and Our Evaluation:
Appendix I: Scope and Methodology:
Appendix II: Briefing to Congressional Staff:
Appendix III: Transition to Basel II Has Been Driven by Limitations of
Basel I and Advances in Risk Management at Large:
Appendix IV: Three Pillars of Basel II:
Appendix V: Comments from the Board of Governors of the Federal Reserve
System:
Appendix VI: Comments from the Federal Deposit Insurance Corporation:
Appendix VII: Comments from the Office of the Comptroller of the
Currency:
Appendix VIII: Comments from the Securities and Exchange Commission:
Appendix IX: Letter from the Federal Reserve Regarding Its Authority to
Regulate Leverage and Set Margin Requirements:
Appendix X: GAO Contact and Staff Acknowledgments:
Bibliography:
Related GAO Products:
Tables:
Table 1: Comparison of Various Regulatory Reform Proposals to Address
Systemic Risk:
Table 2: U.S. Basel I Credit risk Categories:
Figures:
Figure 1: Supervisors for a Hypothetical Financial Holding Company:
Figure 2: Effect of a Gain or Loss on a Leveraged Institution's Balance
Sheet:
Figure 3: Nominal GDP, Real GDP, Total Debt, and Ratio of Total Debt to
Nominal GDP, 2002 to 2007:
Figure 4: Total Assets, Total Equity, and Leverage (Assets-to-Equity)
Ratio in Aggregate for Five Large U.S. Broker-Dealer Holding Companies,
1998 to 2007:
Figure 5: Total Assets, Total Equity, and Assets-to-Equity Ratio in
Aggregate for Five Large U.S. Bank Holding Companies, 1998 to 2007:
Figure 6: Ratio of Total Assets to Equity for Four Broker-Dealer
Holding Companies, 1998 to 2007:
Figure 7: Margin Debt and Margin Debt as a Percentage of the Total
Capitalization of the NYSE and NASDAQ Stock Markets, 2000 through 2008:
Figure 8: Foreclosures by Year of Origination--Alt-A and Subprime Loans
for the Period 2000 to 2007:
Figure 9: Example of an Off-Balance Sheet Entity:
Figure 10: Key Developments and Resulting Challenges That Have Hindered
the Effectiveness of the Financial Regulatory System:
Figure 11: Computation of Wholesale and Retail Capital Requirements
under the Advanced Internal Ratings-based Approach for Credit Risk:
Abbreviations:
CAMELS: capital, asset quality, management, earnings, liquidity,
sensitivity to market risk:
CDO: collateralized debt obligations:
CORE: capital, organizational structure, risk management, and earnings:
CSE: Consolidated Supervised Entity:
CFTC: Commodity Futures Trading Commission:
FDIC: Federal Deposit Insurance Corporation:
FINRA: Financial Industry Regulatory Authority:
FSOC: Financial Services Oversight Council:
GAAP: Generally Accepted Accounting Principles:
GDP: gross domestic product:
IG: inspector general:
MRA: Market Risk Amendment:
NYSE: New York Stock Exchange:
OCC: Office of the Comptroller of the Currency:
OTC: over the counter:
OTS: Office of Thrift Supervision:
PCA: Prompt Corrective Action:
SEC: Securities and Exchange Commission:
SPE: special purpose entity:
SRC: systemic risk council:
SRO: self-regulatory organization:
VaR: value-at-risk:
[End of section]
United States Government Accountability Office:
Washington, DC 20548:
July 22, 2009:
Congressional Committees:
The United States is in the midst of the worst financial crisis in more
than 75 years. To date, federal regulators and authorities have taken
unprecedented steps to stem the unraveling of the financial services
sector by committing trillions of dollars of taxpayer funds to rescue
financial institutions and restore order to credit markets. Although
the current crisis has spread across a broad range of financial
instruments, it was initially triggered by defaults on U.S. subprime
mortgage loans, many of which had been packaged and sold as securities
to buyers in the United States and around the world. With financial
institutions from many countries participating in these activities, the
resulting turmoil has afflicted financial markets globally and has
spurred coordinated action by world leaders in an attempt to protect
savings and restore the health of the markets.
The buildup of leverage during a market expansion and the rush to
reduce leverage, or "deleverage," when market conditions deteriorated
was common to this and other financial crises. Leverage traditionally
has referred to the use of debt, instead of equity, to fund an asset
and been measured by the ratio of total assets to equity on the balance
sheet. But as witnessed in the current 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.
On October 3, 2008, the Emergency Economic Stabilization Act of 2008
(the act) was signed into law.[Footnote 3] The act's purpose is to
provide the Secretary of the Department of the Treasury (Treasury) with
the authority to restore liquidity and stability to the U.S. financial
system and to ensure the economic well-being of Americans. To that end,
the act established the Office of Financial Stability within Treasury
and authorized the Troubled Asset Relief Program. The act provided
Treasury with broad, flexible authorities to buy or guarantee up to
$700 billion in "troubled assets," which include mortgages and mortgage-
related instruments, and any other financial instrument the purchase of
which Treasury determines is needed to stabilize the financial markets.
[Footnote 4]
The act also established several reporting requirements for GAO. One of
these requires the U.S. Comptroller General to "undertake a study to
determine the extent to which leverage and sudden deleveraging of
financial institutions was a factor behind the current financial
crisis."[Footnote 5] Additionally, the study is to include an analysis
of the roles and responsibilities of federal financial regulators for
monitoring leverage and the authority of the Board of Governors of the
Federal Reserve System (Federal Reserve) to regulate leverage.[Footnote
6] To address this mandate, we sought to answer the following
questions:
1. How have leveraging and deleveraging by financial institutions
contributed to the current financial crisis, according to primarily
academic and other studies?
2. What regulations have federal financial regulators adopted to try to
limit the use of leverage by financial institutions, and how do the
regulators oversee the institutions' compliance with the regulations?
3. What, if any, limitations has the current financial crisis revealed
about the regulatory framework used to restrict leverage, and what
changes have regulators and others proposed to address these
limitations?
To satisfy our responsibility under the act's mandate to report the
results of this work by June 1, 2009, we provided an interim report on
the results of this work in the form of a briefing to the committees'
staffs on May 27, 2009. Appendix II contains the full briefing. This
letter represents the final report.
To address our objectives, we reviewed and analyzed academic and other
studies assessing the buildup of leverage prior to the current
financial crisis and the economic mechanisms that possibly helped the
mortgage-related losses spread to other markets and expand into the
current crisis. We reviewed and analyzed 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). We also collected and
analyzed 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. In addition, we interviewed
staff from these federal financial regulators and officials from two
securities firms, a bank, and a credit rating agency. 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.
The work upon which this report is based 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 February
and July 2009. A more extensive discussion of our scope and methodology
appears in appendix I.
Results in Brief:
According to studies we reviewed, leverage steadily increased within
the financial sector before the crisis began around mid-2007, and
banks, securities firms, hedge funds, and other financial institutions
have sought to deleverage and reduce their risk since the onset of the
crisis. Some studies suggested that the efforts taken by financial
institutions to deleverage by selling financial assets and restricting
new lending could have contributed to the current crisis. First, some
studies we reviewed suggested that deleveraging through asset sales
could trigger downward spirals in financial asset prices. In times of
market crisis, a sharp drop in an asset's price can lead investors to
sell the asset, which could push the asset's price even lower. For
leveraged institutions holding the asset, the impact of their losses on
capital will be magnified. The subsequent price decline could induce
additional sales that cause the asset's price to fall further. 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. However, other theories, such as that the current
market prices are the result of asset prices reverting to their
fundamental values after a period of overvaluation, provide possible
explanations for the sharp price declines in mortgage-related
securities and other financial instruments. As the crisis is complex,
no single theory likely is to explain in full what occurred. Second,
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.
Moreover, rapidly declining asset prices can inhibit the ability of
borrowers to raise money in the securities markets. Financial
regulators and market participants we interviewed had mixed views about
the effects of deleveraging by financial institutions in the current
crisis. Some regulatory officials and market participants told us that
they generally have not seen asset sales leading to downward price
spirals, but others said that asset sales involving a variety of debt
instruments have contributed to such spirals. Regulatory and credit
rating agency officials told us that banks have tightened their lending
standards for some loans, such as ones with less favorable risk-
adjusted returns. They also said that some banks rely on the securities
markets to help them fund loans and, thus, need conditions in the
securities markets to improve. As we have discussed in our prior work,
since the crisis began, federal regulators and authorities have
undertaken a number of steps to facilitate financial intermediation by
banks and the securities markets.[Footnote 7]
Federal financial regulators generally impose capital and other
requirements on their regulated institutions as a way to limit the use
of leverage and ensure the stability of the financial system and
markets. Specifically, federal banking and thrift regulators have
imposed minimum risk-based capital and leverage ratios on their
regulated institutions. The risk-based capital ratios generally are
designed to require banks and thrifts to hold more capital for more
risky assets. Although regulators have imposed minimum leverage ratios
on regulated institutions, some regulators told us that they primarily
focus on the risk-based capital ratios to limit the use of leverage. In
addition, they supervise the capital adequacy of their regulated
institutions through on-site examinations and off-site monitoring. Bank
holding companies are subject to capital and leverage ratio
requirements similar to those imposed on banks, but thrift holding
companies are not subject to such requirements. Instead, 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. The rule serves to protect
market participants from broker-dealer failures and to enable broker-
dealers that fail to meet the rule's minimum requirements to be
liquidated in an orderly fashion. For the holding companies of broker-
dealers that participated in SEC's discontinued Consolidated Supervised
Entity (CSE) program, they calculated their risk-based capital ratios
in a manner designed to be consistent with the method used by
banks.[Footnote 8] In addition to the capital ratio, SEC imposed a
liquidity requirement on CSE holding companies. Other financial
institutions, such as hedge funds, have become important participants
in the financial markets, and many use leverage. But, unlike banks and
broker-dealers, hedge funds typically are not subject to regulatory
capital requirements that limit their use of leverage. Rather, their
use of leverage is to be constrained primarily through market
discipline, supplemented by regulatory oversight of banks and broker-
dealers that transact with hedge funds as creditors and counterparties.
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 in the current crisis.
The financial crisis has revealed limitations in existing regulatory
approaches that serve to restrict leverage. Federal financial
regulators have proposed reforms, but have not yet fully evaluated the
extent to which these proposals would address these limitations. First,
although large banks and broker-dealers generally held capital above
the minimum regulatory capital requirements prior to the crisis,
regulatory capital measures did not always fully capture certain risks,
particularly those associated with some mortgage-related securities
held on and off their balance sheets. As a result, a number of these
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
framework and are considering reforms to better align capital
requirements with risk. Furthermore, the crisis highlighted past
concerns about the approach to be taken under Basel II, a new risk-
based capital framework based on an international accord, such as the
ability of banks' models to adequately measure risks for regulatory
capital purposes and the regulators' ability to oversee them. Federal
financial regulators have not formally assessed the extent to which
Basel II reforms proposed by U.S. and international regulators may
address these concerns. Such an assessment is critical to ensure that
Basel II reforms, particularly those that would increase reliance on
complex risk models for determining capital needs, do not exacerbate
regulatory limitations revealed by the crisis. Second, the crisis
illustrated how the existing regulatory framework, along with other
factors, might have contributed to cyclical leverage trends that
potentially exacerbated the current crisis. For example, minimum
regulatory capital requirements may not provide adequate incentives for
banks to build loss-absorbing capital buffers in benign markets when it
is relatively 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. As discussed, actions taken by
individual institutions to deleverage by selling assets in stressed
markets may exacerbate a financial crisis. 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. As some studies we reviewed suggested, ensuring the
solvency of individual institutions may not be sufficient to protect
the stability of the financial system, in part because of the potential
for deleveraging by institutions to have negative spillover effects. In
our prior work, we have noted that a regulatory system should focus on
risk to the financial system, not just institutions.[Footnote 9] 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 leverage and
deleveraging by a few institutions or by 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 are providing a matter
for congressional consideration. In particular, as Congress moves
toward the creation of a systemic risk regulator, it should consider
the merits of tasking this entity with the responsibility for measuring
and monitoring systemwide leverage and evaluating options to limit
procyclical leverage trends. Furthermore, to address concerns about the
Basel II approach highlighted by the current financial crisis, we are
making one recommendation to the heads of the Federal Reserve, FDIC,
OCC, and OTS. Specifically, these regulators should assess the extent
to which Basel II reforms may address risk evaluation and regulatory
oversight concerns associated with advanced modeling approaches used
for capital adequacy purposes.
We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and
Treasury with a draft of this report for their review and comment. We
received written comments from the Federal Reserve, FDIC, OCC, and SEC,
which are reprinted in appendices V through VIII, respectively. The
regulators generally agreed with our conclusions and recommendation. We
did not receive written comments from OTS and Treasury. Except for
Treasury, the agencies also provided technical comments that we
incorporated in the report where appropriate.
Background:
The financial services industry comprises a broad range of financial
institutions--including broker-dealers, banks, government-sponsored
enterprises, hedge funds, insurance companies, and thrifts. Moreover,
many of these financial institutions are part of a holding company
structure, such as a bank or financial holding company.[Footnote 10] In
the United States, large parts of the financial services industry are
regulated under a complex system of multiple federal and state
regulators, and self-regulatory organizations (SRO) that operate
largely along functional lines (see figure 1).[Footnote 11] Such
oversight serves, in part, to help ensure that the financial
institutions do not take on excessive risk that could undermine their
safety and soundness. Primary bank supervisors--the Federal Reserve,
FDIC, OCC, and OTS--oversee banks and thrifts according to their
charters. Functional supervisors--primarily SEC, the Commodity Futures
Trading Commission (CFTC), SROs, and state insurance regulators--
oversee entities engaged in the securities and insurance industries as
appropriate. Consolidated supervisors oversee holding companies that
contain subsidiaries that have primary bank or functional supervisors-
-the Federal Reserve oversees bank holding companies and OTS oversees
thrift holding companies.[Footnote 12] In the last few decades, nonbank
lenders, hedge funds, and other firms have become important
participants in the financial services industry but are unregulated or
less regulated.
Figure 1: Supervisors for a Hypothetical Financial Holding Company:
[Refer to PDF for image: organizational chart]
Top level:
Financial holding company (regulated by Federal Reserve).
Second level, reporting to the Financial holding company:
National bank (regulated by OCC);
State member bank (regulated by Federal Reserve, State regulator);
State nonmember bank (regulated by FDIC, State regulator);
National thrift (regulated by OTS);
State thrift (regulated by OTS, State regulator);
Special financing entity (unregulated);
Bank holding company (regulated by Federal Reserve);
Broker/dealer (regulated by SEC, SRO, State Regulator);
Futures commission merchant (regulated by CFTC, SRO);
National bank (regulated by OCC);
Life insurance company (broker/agent/underwriter) (regulated by State
regulator).
Third level, reporting to Bank holding company:
Commercial paper funding corporation (unregulated);
Non-U.S. commercial bank (regulated by Non-U.S. regulator);
National bank (regulated by OCC).
Third level, reporting to Broker/dealer:
Asset management company (regulated by SEC, State regulator);
Non-U.S. investment bank (regulated by Non-U.S. regulator).
Third level, reporting to National bank:
Futures commission merchant (regulated by CFTC, SRO);
Insurance agencies (regulated by State regulator);
U.S. securities broker/dealer/underwriter (regulated by SEC, SRO, State
regulator).
Fourth level, reporting to U.S. securities broker/dealer/underwriter:
Non-U.S. securities broker/dealer/underwriter (regulated by Non-U.S.
regulator).
Source: GAO.
[End of figure]
To varying degrees, all financial institutions are exposed to a variety
of risks that create the potential for financial loss associated with:
* failure of a borrower or counterparty to perform on an obligation--
credit risk;
* broad movements in financial prices--interest rates or stock prices--
market risk;
* failure to meet obligations because of inability to liquidate assets
or obtain funding--liquidity risk;
* inadequate information systems, operational problems, and breaches in
internal controls--operational risk;
* negative publicity regarding an institution's business practices and
subsequent decline in customers, costly litigation, or revenue
reductions--reputation risk;
* breaches of law or regulation that may result in heavy penalties or
other costs--legal risk;
* risks that an insurance underwriter takes in exchange for premiums--
insurance risk; and:
* events not covered above, such as credit rating downgrades or factors
beyond the control of the firm, such as major shocks in the firm's
markets--business/event risk.
In addition, the industry as a whole is exposed to systemic risk, the
risk that a disruption could cause widespread difficulties in the
financial system as a whole.
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. As illustrated in figure 2, a 10
percent decline in the value of assets of an institution with an assets-
to-equity ratio of 5-to-1 would deplete the institution's equity by 50
percent. 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.
Figure 2: Effect of a Gain or Loss on a Leveraged Institution's Balance
Sheet:
[Refer to PDF for image: illustrated bar graph]
Illustrative balance sheet:
$100 assets:
* $20 equity;
* $80 debt.
Leverage = 100/20 = 5x.
Impact of loss on leverage:
$90 assets:
* $10 equity;
* $80 debt.
Leverage = 90/10 = 9x.
-10% in assets yields -50% in equity.
Impact of gain on leverage:
$110 assets:
* $30 equity;
* $80 debt.
Leverage = 110/30 = 3.7x.
+10% in assets yields +50% in equity.
Source: GAO.
[End of figure]
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. Another concern was 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 13] 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 14] 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. (Appendix
III discusses limitations of Basel I, and appendix IV describes the
three pillars of Basel II.) 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 15]
The dramatic decline in the U.S. housing market precipitated a decline
in the price of financial assets around mid-2007 that were associated
with housing, in particular mortgage assets based on subprime loans
that lost value as the housing boom ended and the market underwent a
dramatic correction. Some institutions found themselves so exposed that
they were threatened with failure--and some failed--because they were
unable to raise the necessary capital as the value of their portfolios
declined. Other institutions, ranging from government-sponsored
enterprises such as Fannie Mae and Freddie Mac to large securities
firms, were left holding "toxic" mortgages or mortgage-related assets
that became increasingly difficult to value, were illiquid, and
potentially had little worth. Moreover, investors not only stopped
buying securities backed by mortgages but also became reluctant to buy
securities backed by many types of assets. Because of uncertainty about
the financial condition and solvency of financial entities, the prices
banks charged each other for funds rose dramatically, and interbank
lending effectively came to a halt. The resulting liquidity and credit
crunch made the financing on which businesses and individuals depend
increasingly difficult to obtain as cash-strapped banks held on to
their assets. By late summer of 2008, the potential ramifications of
the financial crisis ranged from the continued failure of financial
institutions to increased losses of individual savings and corporate
investments and further tightening of credit that would exacerbate the
emerging global economic slowdown that was beginning to take shape.
Research Suggests Leverage Increased before the Crisis and Subsequent
Deleveraging Could Have Contributed to the Crisis:
The current financial crisis is complex and multifaceted; and likewise,
so are its causes, which remain subject to debate and ongoing research.
Before the current crisis, leverage broadly increased across the
economy. For example, as shown in figure 3, total debt in the United
States increased from $20.7 trillion to $31.7 trillion, or by nearly 53
percent, from year-end 2002 to year-end 2007, and the ratio of total
debt to gross domestic product (GDP) increased from 1.96 to 1 to 2.26
to 1, or by 15 percent, during the same period. In general, the more
leveraged an economy, the more prone it is to crisis generated by
moderate economic shocks.
Figure 3: Nominal GDP, Real GDP, Total Debt, and Ratio of Total Debt to
Nominal GDP, 2002 to 2007 (Dollars in trillions):
[Refer to PDF for image: combination line and multiple vertical bar
graph]
Year: 2002;
Nominal GDP: $10,591.1;
Real GDP: $10,095.8;
Total debt: $20,732.1;
Ratio of total debt to GDP: 1.96 to 1.
Year: 2003;
Nominal GDP: $11,219.5;
Real GDP: $10,467;
Total debt: $22,441.9;
Ratio of total debt to GDP: 2 to 1.
Year: 2004;
Nominal GDP: $11,948.5;
Real GDP: $10,796.4;
Total debt: $24,450.2;
Ratio of total debt to GDP: 2.05 to 1.
Year: 2005;
Nominal GDP: $12,696.4;
Real GDP: $11,086.1;
Total debt: $26,776.8;
Ratio of total debt to GDP: 2.11 to 1.
Year: 2006;
Nominal GDP: $13,370.1;
Real GDP: $11,356.4;
Total debt: $29,166.3;
Ratio of total debt to GDP: 2.18 to 1.
Year: 2007;
Nominal GDP: $14,031.2;
Real GDP: $11,620.7;
Total debt: $31,672.8;
Ratio of total debt to GDP: 2.26 to 1.
Source: GAO analysis of the Federal Reserve’s Flow of Funds data and
the Bureau of Economic Analysis’s GDP data.
[End of figure]
According to many researchers, the crisis initially was triggered by
defaults on U.S. subprime mortgages around mid-2007. Academics and
others have identified a number of factors that possibly helped fuel
the housing boom, which helped set the stage for the subsequent
problems in the subprime mortgage market. These factors include:
* imprudent mortgage lending that permitted people to buy houses they
could not afford;
* securitization of mortgages that reduced originators' incentives to
be prudent;
* imprudent business and risk management decisions based on the
expectation of continued housing price appreciation;
* faulty assumptions in the models used by credit rating agencies to
rate mortgage-related securities;
* establishment of off-balance sheet entities by banks to hold
mortgages or mortgage-related securities that allowed banks to make
more loans during the expansion; and:
* economic conditions, characterized by permissive monetary policies,
ample liquidity and availability of credit, and low interest rates that
spurred housing investment.[Footnote 16]
Around mid-2007, the losses in the subprime mortgage market triggered a
reassessment of financial risk in other debt instruments and sparked
the current financial crisis. Academics and others have identified a
number of economic mechanisms that possibly helped to cause the
relatively small subprime mortgage-related losses to become a financial
crisis. However, given our mandate, our review of the economic
literature focused narrowly on deleveraging by financial institutions
as one of the potential mechanisms.[Footnote 17] (See the bibliography
for the studies included in our literature review.) 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
reviewed. Other theories that do not involve deleveraging may provide
possible explanations for the sharp price declines in mortgage-related
securities and other financial instruments. Because such theories are
largely beyond the scope of our work, we discuss them only in brief.
Leverage within the Financial Sector Increased before the Financial
Crisis, and Financial Institutions Have Sought to Deleverage Since the
Crisis Began:
Leverage steadily increased in the financial sector during the
prolonged rise in housing and other asset prices and created
vulnerabilities that have increased the severity of the crisis,
according to studies we reviewed.[Footnote 18] Leverage can take many
different forms, and no single measure of leverage exists; in that
regard, the studies generally identified a range of sources that aided
in the buildup of leverage before the crisis. One such source was the
use of short-term debt, such as repurchase agreements, by financial
institutions to help fund their assets.[Footnote 19] The reliance on
short-term funding made the institutions vulnerable to a decline in the
availability of such credit.[Footnote 20] 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.[Footnote 21] To obtain the funds to
purchase their assets, SPEs often borrowed by issuing shorter-term
instruments, such as commercial paper and medium-term notes, but this
strategy exposed the SPEs to the risk of not being able to renew their
debt. Similarly, to expand their funding sources or provide additional
capacity on their balance sheets, financial institutions securitized
mortgage-backed securities, among other assets, to form collateralized
debt obligations (CDO). In a basic 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.[Footnote 22]
Finally, the growth in credit default swaps, a type of OTC derivative,
was another source of leverage. Credit default swaps aided the
securitization process by providing credit enhancements to CDO issuers
and provided financial institutions with another way to leverage their
exposure to the mortgage market.
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 23] Historically, such institutions tended to increase their
leverage when asset prices rose and decrease their leverage when asset
prices fell.[Footnote 24] One explanation for this behavior is that
they actively measure and manage the risk exposure of their portfolios
by adjusting their balance sheets. For a given amount of equity, an
increase in asset prices will lower a firm's measured risk exposure and
allow it to expand its balance sheet, such as by increasing its debt to
buy more assets. Because measured risk typically is low during booms
and high during busts, the firm's efforts to control its risk will lead
to procyclical leverage. Another possible factor leading financial
institutions to manage their leverage procyclically is their use of
fair value accounting to revalue their trading assets periodically at
current market values.[Footnote 25] When asset prices rise, financial
institutions holding the assets recognize a gain that increases their
equity and decreases their leverage ratio. In turn, the institutions
will seek profitable ways to use their increase in equity by expanding
their balance sheets and thereby increasing their leverage. Consistent
with this research, 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 4).
[Footnote 26] In contrast, the ratio of assets to equity for five large
bank holding companies, in aggregate, was relatively flat during this
period (see figure 5). As discussed in the background, the ratio of
assets to equity treats all assets as equally risky and does not
capture off-balance sheet risks.
Figure 4: Total Assets, Total Equity, and Leverage (Assets-to-Equity)
Ratio in Aggregate for Five Large U.S. Broker-Dealer Holding Companies,
1998 to 2007 (Dollars in trillions):
[Refer to PDF for image: combination line and multiple vertical bar
graph]
Year: 1998;
Total assets: $1.14;
Total equity: $0.04;
Assets-to-equity ratio: 28.6 to 1.
Year: 1999;
Total assets: $1.282;
Total equity: $0.051;
Assets-to-equity ratio: 24.9 to 1.
Year: 2000;
Total assets: $1.52;
Total equity: $0.068;
Assets-to-equity ratio: 22.5 to 1.
Year: 2001;
Total assets: $1.664;
Total equity: $0.073;
Assets-to-equity ratio: 22.8 to 1.
Year: 2002;
Total assets: $1.778;
Total equity: $0.079;
Assets-to-equity ratio: 22.5 to 1.
Year: 2003;
Total assets: $2.027;
Total equity: $0.096;
Assets-to-equity ratio: 21.1 to 1.
Year: 2004;
Total assets: $2.604;
Total equity: $0.109;
Assets-to-equity ratio: 24 to 1.
Year: 2005;
Total assets: $2.984;
Total equity: $0.120;
Assets-to-equity ratio: 24.8 to 1.
Year: 2006;
Total assets: $3.654;
Total equity: $0.142;
Assets-to-equity ratio: 25.8 to 1.
Year: 2007;
Total assets: $4.272;
Total equity: $0.140;
Assets-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]
Figure 5: Total Assets, Total Equity, and Assets-to-Equity Ratio in
Aggregate for Five Large U.S. Bank Holding Companies, 1998 to 2007
(Dollars in trillions):
[Refer to PDF for image: combination line and multiple vertical bar
graph]
Year: 1998;
Total assets: $2.391;
Total equity: $0.169;
Assets-to-equity ratio: 14.2 to 1.
Year: 1999;
Total assets: $2.551;
Total equity: $0.179;
Assets-to-equity ratio: 14.3 to 1.
Year: 2000;
Total assets: $2.816;
Total equity: $0.198;
Assets-to-equity ratio: 14.3 to 1.
Year: 2001;
Total assets: $3.033;
Total equity: $0.227;
Assets-to-equity ratio: 13.4 to 1.
Year: 2002;
Total assets: $3.208;
Total equity: $0.242;
Assets-to-equity ratio: 13.3 to 1.
Year: 2003;
Total assets: $3.560;
Total equity: $0.259;
Assets-to-equity ratio: 13.71 to 1.
Year: 2004;
Total assets: $4.675;
Total equity: $0.400;
Assets-to-equity ratio: 11.7 to 1.
Year: 2005;
Total assets: $4.990;
Total equity: $0.410;
Assets-to-equity ratio: 12.2 to 1.
Year: 2006;
Total assets: $5.889;
Total equity: $0.486;
Assets-to-equity ratio: 12.1 to 1.
Year: 2007;
Total assets: $6.829;
Total equity: $0.508;
Assets-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]
The securitization of subprime mortgages and other loans can enable
banks and securities firms to transfer credit risk from their balance
sheets to parties more willing or able to manage that risk. However,
the current crisis has revealed that much of the subprime mortgage
exposure and losses have been concentrated among leveraged financial
institutions, including banks, securities firms, and hedge funds.
[Footnote 27] For example, some banks and securities firms ended up
with large exposures because they (1) were holding mortgages or
mortgage-related securities for trading or investment purposes, (2)
were holding mortgages or mortgage-related securities in inventory, or
warehouses, that they planned to securitize but could not do so after
the crisis began, or (3) brought onto their balance sheets mortgage-
related securities held by SPEs. According to an equity analyst report,
10 large banks and securities firms had over $24 billion and $64
billion in writedowns in the third and fourth quarters of 2007,
respectively.[Footnote 28] Importantly, higher leverage magnifies
market risk and can magnify liquidity risk if leveraged firms
experiencing losses are forced to sell assets under adverse market
conditions.
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 29] 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 Could Have Led to Downward
Spirals in Asset Prices, but Other Theories also May Explain Price
Declines:
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
30] These studies generally build on a broader theory that holds a
market disruption, such as a sharp drop in asset prices, can be a
source of systemic risk under certain circumstances.[Footnote 31]
Today, the securities markets, rather than banks, are the primary
source of financial intermediation--the channeling of capital to
investment opportunities. For example, in 1975, banks and thrifts held
56 percent of the total credit to households and businesses; by 2007,
they held less than 30 percent.[Footnote 32] To function efficiently,
the securities markets need market liquidity, generally defined as the
ability to buy and sell a particular asset without significantly
affecting its price. According to the theory, 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. At the extreme,
the asset market's liquidity dries up and market gridlock takes hold.
However, not all academics subscribe to this theory, but because the
alternative theories are largely beyond the scope of our work, we only
discuss them briefly.
Some studies we reviewed suggested that deleveraging through asset
sales can lead to a downward asset spiral during times of market stress
when market liquidity is low. Following a drop in an asset's price, one
or more financial institutions may sell the asset. As noted above,
certain financial institutions tend to adjust their balance sheets in a
procyclical manner and, thus, may react in concert to a drop in an
asset's price by selling the asset. When market liquidity is low, asset
sales may cause further price declines. Under fair value accounting,
financial institutions holding the asset will revalue their positions
based on the asset's lower market value and record a loss that reduces
their equity. 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 asset holdings, 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.
Some studies we reviewed also suggested that deleveraging through asset
sales could lead to a downward asset spiral when funding liquidity is
low. In contrast to market liquidity, which is an asset-specific
characteristic, funding liquidity generally refers to the availability
of funds in the market that firms can borrow to meet their obligations.
For example, financial institutions can increase their leverage by
using secured or collateralized loans, such as repurchase agreements,
to fund assets. Under such transactions, borrowers post securities with
lenders to secure their loans. Lenders typically will not provide a
loan for the full market value of the posted securities, with the
difference called a margin or haircut. This deduction protects the
lenders against default by the borrowers. When the prices of assets
used to secure or collateralize loans decline significantly, borrowers
may be required to post additional collateral, for example, if the
value of the collateral falls below the loan amount or if a lender
increased its haircuts.[Footnote 33] Leveraged borrowers may find it
difficult to post additional collateral, in part because declining
asset prices also could result in losses that are large relative to
their capital. If borrowers faced margin calls, they could be forced to
sell some of their other assets to obtain the cash collateral. If the
borrowers cannot meet their margin calls, the lenders may take
possession of the assets and sell them. When market liquidity is low,
such asset sales may cause the asset prices to drop more. If that
occurred, other firms that have borrowed against the same assets could
face margin calls to post more collateral, which could lead to another
round of asset sales and subsequent price declines. Moreover, asset
spirals stemming from reduced market or funding liquidity can reinforce
each other.
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. Because such theories are largely beyond the scope
of our work, we discuss them only in brief. First, given the default
characteristics of the mortgages underlying their related securities
and falling housing prices, the current valuations of such securities
may reflect their true value, not "fire sale" prices. While there may
have been some overreaction, this theory holds that 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 34] In the extreme, investors may price the
good securities far below their true value, leading to a collapse of
the market. 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.
Studies Suggested That Deleveraging Could Have a Negative Effect on
Economic Growth:
In addition to deleveraging by selling assets, banks and broker-dealers
can deleverage by restricting new lending as their own financial
condition deteriorates, such as to preserve their capital and protect
themselves against future losses. However, the studies we reviewed
stated that this deleveraging strategy raises concerns because of the
possibility it may slow economic growth.[Footnote 35] 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.
One study suggested that the amount by which banks reduce their overall
lending will be many times larger than their mortgage-related losses.
[Footnote 36] For example, the study estimated that if leveraged
institutions suffered about $250 billion in mortgage-related losses, it
would lead them to reduce their lending by about $1 trillion. However,
these results should be interpreted with caution given that such
estimates are inherently imprecise and subject to great uncertainty.
Moreover, a portion of any reduction in bank lending could be due to
reasons independent of the need to deleverage, such as a decline in the
creditworthiness of borrowers, a tightening of previously lax lending
standards, or the collapse of securitization markets.[Footnote 37] In
commenting on the study, a former Federal Reserve official noted that
banks are important providers of credit but a contraction in their
balance sheets would not necessarily choke off all lending.[Footnote
38] Rather, he noted that a key factor in the current crisis is the
sharp decline in securities issuances, and the decline has to be an
important part of the story of why the current financial market turmoil
is affecting economic activity. In summary, the Federal Reserve
official said that the mortgage credit losses are a problem because
they are hitting bank balance sheets at the same time that the
securitization market is experiencing difficulties. As mentioned above,
the securities markets have played an increasingly dominant role over
banks in the financial intermediation process.
Regulators and Market Participants Had Mixed Views about the Effects of
Deleveraging in the Current 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
current 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
based on a reassessment of their risk and return; and selling assets,
including trading assets, consumer and commercial loans, and noncore
businesses. Regulatory officials said that hedge funds and other asset
managers, such as mutual funds, also have 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 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 have 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 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. The securities firm officials said that margin calls forced
sales in illiquid markets and caused the spirals. 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 their 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. OCC staff attributed
some of the downward price spirals to the loss of liquidity in the
securitization markets. They said that traditional buyers of
securitized assets became sellers, causing the securitization markets
to become dislocated.
As suggested in an April 2008 testimony by the former president of the
Federal Reserve Bank of New York, reduced funding liquidity may have
resulted in a downward price spiral during the current crisis:
Asset price declines--triggered by concern about the outlook for
economic performance--led to a reduction in the willingness to bear
risk and to margin calls. Borrowers needed to sell assets to meet the
calls; some highly leveraged firms were unable to meet their
obligations and their counterparties responded by liquidating the
collateral they held. This put downward pressure on asset prices and
increased price volatility. Dealers raised margins further to
compensate for heightened volatility and reduced liquidity. This, in
turn, put more pressure on other leveraged investors. A self-
reinforcing downward spiral of higher haircuts forced sales, lower
prices, higher volatility and still lower prices.[Footnote 39]
Similarly, in its white paper on the Public-Private Investment Program,
Treasury has indicated that deleveraging through asset sales has led to
price spirals:
The resulting need to reduce risk triggered a wide-scale deleveraging
in these markets and led to fire sales. As prices declined further,
many traditional sources of capital exited these markets, causing
declines in secondary market liquidity. As a result, we have been in a
vicious cycle in which declining asset prices have triggered further
deleveraging and reductions in market liquidity, which in turn have led
to further price declines. While fundamentals have surely deteriorated
over the past 18-24 months, there is evidence that current prices for
some legacy assets embed substantial liquidity discounts.[Footnote 40]
FDIC and OCC staff and officials from a credit rating agency told us
that some banks have 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. OCC staff
said that some banks began to tighten their lending standards in 2007,
meaning that they would not be making as many marginal loans, and such
action corresponded with a decline in demand for loans. 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.
As we have discussed in our prior work, since the crisis began, federal
regulators and authorities have undertaken a number of steps to
facilitate financial intermediation by banks and the securities
markets.[Footnote 41] To help provide banks with funds to make loans,
Treasury, working with the regulators, has used its authority under the
act to inject capital into banks so that they would be stronger and
more stable. Similarly, the Federal Reserve has reduced the target
interest rate to close to zero and has implemented a number of programs
designed to support the liquidity of financial institutions and foster
improved conditions in financial markets. These programs include
provision of short-term liquidity to banks and other financial
institutions and the provision of liquidity directly to borrowers and
investors in key credit markets. To support the functioning of the
credit markets, the Federal Reserve also has purchased longer-term
securities, including government-sponsored enterprise debt and mortgage-
backed securities. In addition, FDIC has created the Temporary
Liquidity Guarantee Program, in part to strengthen confidence and
encourage liquidity in the banking system by guaranteeing newly issued
senior unsecured debt of banks, thrifts, and certain holding companies.
Regulators Limit Financial Institutions' Use of Leverage Primarily
Through Regulatory Capital Requirements:
Federal financial regulators 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. In addition, they 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 42] 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. Firms that had participated in SEC's now
defunct CSE program calculated their risk-based capital ratios at the
holding company level in a manner generally consistent with the method
banks used.[Footnote 43] 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 current crisis.
Federal Banking and Thrift Regulators Have Imposed Minimum Capital and
Leverage Ratios on Their Regulated Institutions to Limit the Use of
Leverage:
Federal banking and thrift regulators (Federal Reserve, FDIC, OCC, and
OTS) restrict the excessive use of leverage by their regulated
financial institutions primarily through minimum risk-based capital
requirements established under the Basel Accord and non-risk based
leverage requirements. If a financial institution falls below certain
capital requirements, regulators can impose certain restrictions, and
must impose others, and thereby limit a financial institution's use of
leverage. Under the capital requirements, banks and thrifts are
required to meet two risk-based capital ratios, which are calculated by
dividing their qualifying capital (numerator) by their risk-weighted
assets (denominator).[Footnote 44] Total capital consists of core
capital, called Tier 1 capital, and supplementary capital, called Tier
2 capital.[Footnote 45] Total risk-weighted assets are calculated using
a process that assigns risk weights to the assets according to their
credit and market risks. This process is broadly intended to assign
higher risk weights and require banks to hold more capital for higher-
risk assets. For example, cash held by a bank or thrift is assigned a
risk weight of 0 percent for credit risk, meaning that the asset would
not be counted in a bank's total risk-weighted assets and, thus, would
not require the bank or thrift to hold any capital for that asset. OTC
derivatives also are included in the calculation of total risk-weighted
assets. Banks and thrifts are required to meet a minimum ratio of total
capital to risk-weighted assets of 8 percent, with at least 4 percent
taking the form of Tier 1 capital. However, regulators told us that
they can recommend that their institutions hold capital in excess of
the minimum requirements, if warranted (discussed in more detail
below).
Banks and thrifts also are subject to minimum non-risk-based leverage
standards, measured as a ratio of Tier 1 capital to total assets. The
minimum leverage requirement to be adequately capitalized is between 3
and 4 percent, depending on the type of institution and a regulatory
assessment of the strength of its management and controls.[Footnote 46]
Leverage ratios have been part of bank and thrift regulatory
requirements since the 1980s, and regulators continued to use the
leverage ratios after the introduction of risk-based capital
requirements to provide a cushion against risks not explicitly covered
in the risk-based capital requirements, such as operational weaknesses
in internal policies, systems, and controls or model risk or related
measurement risk. The greater level of capital required by the risk-
based or leverage capital calculation is the binding overall minimum
requirement on an institution.
Federal banking regulators are required to take increasingly severe
actions as an institution's capital deteriorates under Prompt
Corrective Action (PCA).[Footnote 47] These rules apply to banks and
thrifts but not to bank holding companies. Under PCA, regulators are to
classify insured depository institutions into one of five capital
categories based on their level of capital: well-capitalized,
adequately capitalized, undercapitalized, significantly
undercapitalized, and critically undercapitalized.[Footnote 48]
Institutions that fail to meet the requirements to be classified as
well or adequately capitalized generally face several mandatory
restrictions or requirements. Specifically, the regulator will require
an undercapitalized institution to submit a capital restoration plan
detailing how it is going to become adequately capitalized. Moreover,
no insured institution may pay a dividend if it would be
undercapitalized after the dividend. When an institution becomes
significantly undercapitalized, regulators are required to take more
forceful corrective measures, including requiring the sale of equity or
debt, restricting otherwise allowable transactions with affiliates, or
restricting the interest rates paid on deposits. After an institution
becomes critically undercapitalized, regulators have 90 days to place
the institution into receivership or conservatorship or to take other
actions that would better prevent or reduce long-term losses to the
insurance fund.[Footnote 49]
Regulators Can Use Various Oversight Approaches to Monitor and Enforce
Capital Adequacy:
Federal bank and thrift regulators can supervise the capital adequacy
of their regulated institutions by tracking the financial condition of
their regulated entities through on-site examinations and continuous
monitoring for the larger institutions.[Footnote 50] According to
Federal Reserve officials, the risk-based capital and leverage measures
are relatively simple ratios and are not sufficient, alone, for
assessing overall capital adequacy. In that regard, the supervisory
process enables examiners to assess the capital adequacy of banks at a
more detailed level. On-site examinations serve to evaluate the
institution's overall risk exposure and focus on an institution's
capital adequacy, asset quality, management and internal control
procedures, earnings, liquidity, and sensitivity to market risk
(CAMELS).[Footnote 51] For example, the examination manual directs
Federal Reserve examiners to evaluate the internal capital management
processes and assess the risk and composition of the assets held by
banks. Similarly, OCC examiners told us that they focused on the
capital levels of large banks in their examinations during the current
crisis and raised concerns about certain banks' weak results from the
stress testing of their capital adequacy.
Federal bank and thrift regulatory officials told us that they also can
encourage their regulated institutions to hold more than the minimum
required capital, if warranted. For example, if examiners find that an
institution is exceeding its capital ratios but holding a large share
of risky assets, the examiners could recommend that the bank enhance
its capital. As stated in the Federal Reserve's examination manual,
because risk-based capital does not take explicit account of the
quality of individual asset portfolios or the range of other types of
risks to which banks may be exposed, banks generally are expected to
operate with capital positions above the minimum ratios. Moreover,
banks with high levels of risk also are expected to maintain capital
well above the minimum levels. According to OTS officials, under
certain circumstances, OTS can require an institution to increase its
capital ratio, whether through reducing its risk-weighted assets,
boosting its capital, or both. For example, OTS could identify through
its examinations that downgraded securities could be problematic for a
firm. OTS can then require a troubled institution under its supervisory
authority, through informal and formal actions, to increase its capital
ratio. Moreover, the charter application process for becoming a thrift
institution can provide an opportunity to encourage institutions to
increase their capital. Bank and thrift regulators also can use their
enforcement process, if warranted, to require a bank or thrift to take
action to address a capital-adequacy weakness.
Federal bank and thrift regulators told us that they also use off-site
tools to monitor the capital adequacy of institutions. For example,
examiners use Consolidated Reports of Condition and Income (Call
Report) and Thrift Financial Report data to remotely assess the
financial condition of banks and thrifts, respectively, and to plan the
scope of on-site examinations.[Footnote 52] Regulators also use
computerized monitoring systems that use Call Report data to compute,
for example, financial ratios, growth trends, and peer-group
comparisons. OCC officials with whom we spoke said that they review
Call Reports to ensure that banks are calculating their capital ratios
correctly. FDIC officials also told us that they used the data on
depository institutions to conduct informal analyses to assess the
potential impact a credit event or other changes could have on banks'
capital adequacy. They said that FDIC has performed such analyses on
bank holdings of various types of mortgage-related securities.
In addition, federal bank and thrift regulators also can conduct
targeted reviews, such as those related to capital adequacy of their
regulated entities. For example, in 2007, a horizontal study led by the
Federal Reserve Bank of New York examined how large banks determined
their economic capital, which banks use to help assess their capital
adequacy and manage risk. Federal Reserve examiners told us that they
typically do not conduct horizontal studies on leverage, because they
cover the institutions' use of leverage when routinely supervising
their institutions' capital adequacy. Federal Reserve officials told us
supervisors believe that capital adequacy is better reviewed and
evaluated through continuous monitoring processes that evaluate capital
adequacy against the individual risks at a firm and compare capital and
risk levels across a portfolio of institutions, rather than through the
use of horizontal exams that would typically seek to review banks'
processes.
Bank Holding Companies Are Subject to Capital and Leverage Ratio
Requirements Similar to Those for Banks, but Thrift Holding Companies
Are Not:
Bank holding companies are subject to risk-based capital and leverage
ratio requirements, which are similar to those applied to banks except
for the lack of applicability of PCA and the increased flexibility
afforded to bank holding companies to use debt instruments in
regulatory capital. The Federal Reserve requires that all bank holding
companies with consolidated assets of $500 million or more meet risk-
based capital requirements developed in accordance with the Basel
Accord. In addition, it has required, with the other bank supervisors,
revised capital adequacy rules to implement Basel II for the largest
bank holding companies.[Footnote 53] To be considered well-capitalized,
a bank holding company with consolidated assets of $500 million or more
generally must have a Tier 1 risk-based capital ratio of 4 percent, and
a minimum total risk-based capital ratio of 8 percent, and a leverage
ratio of at least 4 percent.[Footnote 54]
According to OTS officials, thrift holding companies generally are not
subject to minimum capital or leverage ratios because of their
diversity. Rather, capital levels of thrift holding companies are
individually evaluated based on each company's risk profile. OTS
requires that thrift holding companies hold a "prudential" level of
capital on a consolidated basis to support the risk profile of the
holding company.[Footnote 55] For its most complex firms, OTS requires
a detailed capital calculation that includes an assessment of capital
adequacy on a groupwide basis and identification of capital that might
not be available to the holding company or its other subsidiaries,
because it is required to be held by a specific entity for regulatory
purposes. Under this system, OTS benchmarks thrift holding companies
against peer institutions that face similar risks.
In supervising the capital adequacy of bank and thrift holding
companies, the Federal Reserve and OTS are to focus on those business
activities posing the greatest risk to holding companies and
managements' processes for identifying, measuring, monitoring, and
controlling those risks. The Federal Reserve's supervisory cycle for
large complex bank holding companies generally begins with the
development of a systematic risk-focused supervisory plan, which it
then implements, and ends with a rating of the firm. The rating
includes an assessment of holding companies' risk management and
controls; financial condition, including capital adequacy; and impact
on insured depositories.[Footnote 56] In addition, the Federal Reserve
requires that all bank holding companies serve as a source of financial
and managerial strength to their subsidiary banks. Similarly, OTS
applies the CORE (Capital, Organizational Structure, Risk Management,
and Earnings) rating system for large complex thrift holding companies.
CORE focuses on consolidated risks, internal controls, and capital
adequacy rather than focusing solely on the holding company's impact on
subsidiary thrifts. In reviewing capital adequacy, particularly in
large, complex thrift holding companies, OTS considers the risks
inherent in the enterprise's capital to absorb unexpected losses,
support the level and composition of the parent company's and
subsidiaries' debt, and support business plans and strategies.
The Federal Reserve and OTS have a range of formal and informal actions
they can take to enforce their regulations for holding companies.
Federal Reserve officials noted that the law provides explicit
authority for any formal actions that may be warranted and incentives
for bank holding companies to address concerns promptly or through less
formal enforcement actions, such as corrective action resolutions
adopted by the company's board of directors or memoranda of
understanding in which the relevant Federal Reserve bank
enters.[Footnote 57] Similarly, OTS also has statutory authority to
take enforcement actions against thrift holding companies and any
subsidiaries of those companies.[Footnote 58]
Both the Federal Reserve and OTS also monitor the capital adequacy of
their respective regulated holding companies using off-site tools. For
example, the Federal Reserve noted that it obtains financial
information from bank holding companies in a uniform format through a
variety of periodic regulatory reports and uses the data to conduct
peer analysis, including a comparison of their capital adequacy ratios.
Similarly, according to a June 2008 testimony by an OTS official, OTS
in 2008 conducted an extensive review of capital levels at the thrift
holding companies and found that savings and loan holding company peer
group averages were strong.[Footnote 59]
SEC Has Regulated the Use of Leverage by Broker-Dealers Primarily
through Its Net Capital Rule:
According to SEC staff, the agency regulates the use of leverage by
registered broker-dealers primarily through the risk-based measures
prescribed in its net capital and customer protection rules.[Footnote
60] SEC adopted these rules pursuant to its broad authority to adopt
rules and regulations regarding the financial responsibility of broker-
dealers that it finds necessary in the public interest or for the
protection of customers.[Footnote 61]
Under the net capital rule, broker-dealers are required to maintain a
minimum amount of net capital at all times. Net capital is computed in
several steps. A broker-dealer's net worth (assets minus liabilities)
is calculated using U.S. Generally Accepted Accounting Principles
(GAAP). Certain subordinated liabilities are added back to GAAP equity
because the net capital rule allows them to count toward capital,
subject to certain conditions. Deductions are taken from GAAP equity
for assets that are not readily convertible into cash, such as
unsecured receivables and fixed assets. The net capital rule further
requires prescribed percentage deductions from GAAP equity, called
"haircuts." Haircuts provide a capital cushion to reflect an
expectation about possible losses on proprietary securities and
financial instruments held by a broker-dealer resulting from adverse
events. The amount of the haircut on a position is a function of, among
other things, the position's market risk liquidity. A haircut is taken
on a broker-dealer's proprietary position because the proceeds received
from selling assets during liquidation depend on the liquidity and
market risk of the assets.
Under the net capital rule, a broker-dealer must at all times have net
capital equal to the greater of two amounts: (1) a minimum amount based
on the type of business activities conducted by the firm or (2) a
financial ratio.[Footnote 62] The broker-dealers must elect one of two
financial ratios: the basic method (based on aggregate indebtness) or
the alternative method (based on aggregate debit items). That is,
broker-dealers must hold different minimum levels of capital based on
the nature of their business and whether they handle customer funds or
securities. According to SEC staff, most broker-dealers that carry
customer accounts use the alternative method. Under this method, broker-
dealers are required to have net capital equal to the greater of
$250,000 or 2 percent of aggregate debit items, which generally are
customer-related receivables, such as cash and securities owned by
customers but held by their broker-dealers.[Footnote 63] This amount
serves to ensure that broker-dealers have sufficient capital to repay
creditors and pay their liquidation expense if they fail.
According to SEC staff, the customer protection rule, a separate but
related rule, requires broker-dealers to safeguard customer property,
so that they can return such property if they failed.[Footnote 64] The
rule requires a broker-dealer to take certain steps to protect the
credit balances and securities it holds for customers. Under the rule,
a broker-dealer must, in essence, segregate customer funds and fully
paid and excess margin securities held by the firm for the accounts of
customers. The intent of the rule is to require a broker-dealer to hold
customer assets in a manner that enables their prompt return in the
event of an insolvency, which increases the ability of the firm to wind
down in an orderly self-liquidation and thereby avoid the need for a
proceeding under the Securities Investor Protection Act of 1970.
[Footnote 65]
SEC oversees U.S. broker-dealers but delegates some of its authority to
oversee broker-dealers to one or more of the various self-regulatory
organizations, including the Financial Industry Regulatory Authority
(FINRA), an SRO that was established in 2007 through the consolidation
of NASD and the member regulation, enforcement, and arbitration
functions of the New York Stock Exchange (NYSE). SEC and the SROs
conduct regularly scheduled target examinations that focus on the risk
areas identified in their risk assessments of firms and on compliance
with relevant capital and customer protection rules.[Footnote 66] SEC's
internal control risk-management examinations, which started in 1995,
cover the top 15 wholesale and top 15 retail broker-dealers and a
number of mid-sized broker-dealers with a large number of customer
accounts. SEC conducts examinations every 3 years at the largest
institutions, while the SROs conduct more frequent examinations of all
broker-dealers. For instance, FINRA examines all broker-dealers that
carry customer accounts at least once annually. According to SEC and
FINRA, they receive financial and risk area information on a regular
basis from all broker-dealers. In addition, the largest brokers and
those of financial concern provide additional information through
monitoring programs and regular meetings with the firms.
SEC Regulated the Use of Leverage by Selected Broker-Dealers under an
Alternative Net Capital Rule from 2005 to 2008:
From 2005 to September 2008, SEC implemented the voluntary CSE program,
in which five broker-dealer holding companies had participated. In
2004, SEC adopted the program by amending its net capital rule to
establish a voluntary, alternative method of computing net capital. A
broker-dealer became a CSE by applying for an exemption from the net
capital rule and, as a condition of the exemption, the broker-dealer
holding company consented to consolidated supervision (if it was not
already subject to such supervision). According to SEC staff, a broker-
dealer electing this alternative method is subject to enhanced net
capital, early warning, recordkeeping, reporting, liquidity, and
certain other requirements, and must implement and document an internal
risk management system. Under the new alternative net capital rule, CSE
broker-dealers were permitted to use their internal mathematical risk
measurement models, rather than SEC's haircut structure, to calculate
their haircuts for the credit and market risk associated with their
trading and investment positions. Expecting that firms would be able to
lower their haircuts and, in turn, capital charges by using their
internal risk models, SEC required as a safeguard that CSE broker-
dealers maintain at least $500 million in net capital and at least $1
billion in tentative net capital (equity before haircut deductions).
According to SEC staff, because of an early warning requirement set at
$5 billion for tentative net capital, CSE broker-dealers effectively
had to maintain a minimum of $5 billion in tentative net capital. If a
firm fell below that level, it would need to notify SEC, which could
require the firm to take remedial action. Recognizing that capital is
not synonymous with liquidity, SEC also expected each CSE holding
company to maintain a liquid portfolio of cash and highly liquid and
highly rated debt instruments in an amount based on its liquidity risk
management analysis, which includes stress tests that address, among
other things, illiquid assets.[Footnote 67]
In addition to consenting to consolidated regulation, the CSE holding
companies agreed to calculate their capital ratio consistent with the
Basel II capital standards. SEC expected CSE holding companies to
maintain a risk-based capital ratio of not less than 10 percent.
According to SEC staff, the 10-percent risk-based capital ratio was the
threshold that constituted a well-capitalized institution under the
Basel standards and was consistent with the threshold used by banking
regulators, but it was not a regulatory requirement. The CSE holding
companies were required to notify SEC if they breached or were likely
to breach the 10-percent capital ratio. According to SEC staff, if it
received such a notification, the staff would have required the CSE
holding company to take remedial action. Moreover, SEC staff said that
they received and monitored holding company capital calculations on a
monthly basis. SEC staff also said that the CSE holding companies were
holding capital above the amount needed to meet the 10-percent risk-
based capital ratio during the current crisis, except for one
institution that later restored its capital ratio.
The holding companies and their broker-dealers that participated in the
CSE program were not subject to explicit non-risk based leverage limits
before or after SEC created the program. According to SEC staff, the
broker-dealers' ability to increase leverage was limited through the
application of haircuts on their proprietary positions under the net
capital rule. To the extent that the use of their internal models
(instead of SEC's haircut structure) by the broker-dealers enabled them
to reduce the amount of their haircuts, they could take on larger
proprietary positions and increase their leverage. However, SEC staff
told us that the broker-dealers generally did not take such action
after joining the CSE program. The staff said that the primary sources
of leverage for the broker-dealers were customer margin loans,
repurchase agreements, and stock lending. According to the staff, these
transactions were driven by customers and counterparties, marked daily,
and secured by collateral--exposing the broker-dealers to little, if
any, market risk. In addition, SEC did not seek to impose a non-risk
based leverage limit on CSE holding companies, in part because such a
leverage ratio treated all on-balance sheet assets as equally risky and
created an incentive for firms to move exposures off-balance sheet.
Officials at a former CSE told us that their firm's decision to become
a CSE was to provide the firm with another way to measure its capital
adequacy. They said the firm did not view the CSE program as a strategy
to increase its leverage, although it was able to reduce its broker-
dealer's haircuts. According to the officials, the firm's increase in
leverage after becoming a CSE likely was driven by market factors and
business opportunities. In our prior work on Long-Term Capital
Management (a hedge fund), we analyzed the assets-to-equity ratios of
four of the five broker-dealer holding companies that later became CSEs
and found that three had ratios equal to or greater than 28-to-1 at
fiscal year-end 1998, which was higher than their ratios at fiscal year-
end 2006 before the crisis began (see figure 6).[Footnote 68]
Figure 6: Ratio of Total Assets to Equity for Four Broker-Dealer
Holding Companies, 1998 to 2007:
[Refer to PDF for image: multiple line graph]
Year: 1998;
Company: Goldman Sachs: 34.5 to 1;
Company: Morgan Stanley: 22.5 to 1;
Company: Lehman Brothers: 28.4 to 1;
Company: Merrill Lynch: 30.9 to 1.
Year: 1999;
Company: Goldman Sachs: 24.7 to 1;
Company: Morgan Stanley: 21.6 to 1;
Company: Lehman Brothers: 30.6 to 1;
Company: Merrill Lynch: 23.8 to 1.
Year: 2000;
Company: Goldman Sachs: 17.5 to 1;
Company: Morgan Stanley: 22.1 to 1;
Company: Lehman Brothers: 28.9 to 1;
Company: Merrill Lynch: 22.2 to 1.
Year: 2001;
Company: Goldman Sachs: 17.1 to 1;
Company: Morgan Stanley: 23.3 to 1;
Company: Lehman Brothers: 29.3 to 1;
Company: Merrill Lynch: 21.8 to 1.
Year: 2002;
Company: Goldman Sachs: 18.7 to 1;
Company: Morgan Stanley: 24.2 to 1;
Company: Lehman Brothers: 29.1 to 1;
Company: Merrill Lynch: 19.6 to 1.
Year: 2003;
Company: Goldman Sachs: 18.7 to 1;
Company: Morgan Stanley: 24.2 to 1;
Company: Lehman Brothers: 23.7 to 1;
Company: Merrill Lynch: 17.2 to 1.
Year: 2004;
Company: Goldman Sachs: 21.2 to 1;
Company: Morgan Stanley: 27.5 to 1;
Company: Lehman Brothers: 23.9 to 1;
Company: Merrill Lynch: 21.8 to 1.
Year: 2005;
Company: Goldman Sachs: 25.2 to 1;
Company: Morgan Stanley: 30.8 to 1;
Company: Lehman Brothers: 24.4 to 1;
Company: Merrill Lynch: 19.1 to 1.
Year: 2006;
Company: Goldman Sachs: 23.4 to 1;
Company: Morgan Stanley: 31.7 to 1;
Company: Lehman Brothers: 26.2 to 1;
Company: Merrill Lynch: 21.6 to 1.
Year: 2007;
Company: Goldman Sachs: 26.2 to 1;
Company: Morgan Stanley: 33.4 to 1;
Company: Lehman Brothers: 30.7 to 1;
Company: Merrill Lynch: 31.9 to 1.
Source: GAO analysis of the firms' annual report data.
[End of figure]
SEC's Division of Trading and Markets had responsibility for
administering the CSE program. According to SEC staff, the CSE program
was modeled on the Federal Reserve's holding company supervision
program. SEC staff said that continuous supervision was usually
conducted through regular monthly meetings on-site with CSE firm risk
managers to monitor liquidity and funding and to review how market and
credit risks are identified, quantified, and communicated to senior
management and whether senior managers have approved of the risk
exposures. Quarterly meetings were held with senior managers from
treasury and internal audit. According to SEC staff, these regularly
scheduled risk meetings were frequently supplemented by additional on-
site meetings and off-site discussions throughout the month. SEC did
not rate risk-management systems or use a detailed risk assessment
processes to determine areas of highest risk. During the CSE program,
SEC staff concentrated their efforts on market, credit, and liquidity
risks, because the alternative net capital rule focused on these risks,
and on operational risk because of the need to protect investors.
Because only five broker-dealer holding companies were subject to SEC's
consolidated supervision, SEC staff tailored certain reporting
requirements and reviews to focus on activities that posed material
risks for that firm. According to SEC staff, the CSE program allowed
SEC to conduct reviews across the five firms to gain insights into
business areas that were material by risk or balance sheet measures,
rapidly growing, posed particular challenges in implementing the Basel
regulatory risk-based capital regime, or had some combination of these
characteristics. Such reviews resulted in four firms modifying their
capital computations.
In September 2008, the former SEC Chairman announced that the agency
ended the CSE program. According to the SEC Chairman, the three
investments banks formerly designated as CSEs are now part of a bank
holding company structure and subject to supervision by the Federal
Reserve. The chairman noted that SEC will continue to work closely with
the Federal Reserve under a memorandum of understanding between the two
agencies but will focus on its statutory obligation to regulate the
broker-dealer subsidiaries of the bank holding companies, including the
implementation of the alternative net capital computation by certain
broker-dealers. While no institutions are subject to SEC oversight at
the consolidated level under the CSE program, several broker-dealers
within bank holding companies are still subject to the alternative net
capital rule on a voluntary basis.[Footnote 69]
Hedge Funds Generally Are Not Subject to Direct Regulations That
Restrict Their Use of Leverage but Face Limitations through Market
Discipline:
Hedge funds have become important participants in the financial markets
and many use leverage, such as borrowed funds and derivatives, in their
trading strategies. They generally are structured and operated in a
manner that enables them to qualify for exemptions from certain federal
securities laws and regulations.[Footnote 70] Because their investors
are presumed to be sophisticated and therefore not require the full
protection offered by the securities laws, hedge funds generally have
not been subject to direct regulation. As a result, hedge funds
typically are not subject to regulatory capital requirements or limited
by regulation in their use of leverage. Instead, market discipline has
the primary role, supplemented by indirect regulatory oversight of
commercial banks and securities and futures firms, in constraining risk
taking and leveraging by hedge fund managers (advisers).
Market participants (for example, investors, creditors, and
counterparties) can impose market discipline by rewarding well-managed
hedge funds and reducing their exposure to risky, poorly managed hedge
funds. Hedge fund advisers use leverage, in addition to money invested
into the fund by investors, to employ sophisticated investment
strategies and techniques to generate returns. A number of large
commercial banks and prime brokers bear and manage the credit and
counterparty risks that hedge fund leverage creates. Typically, hedge
funds seeking direct leverage can obtain funding either through margin
financing from a prime broker or through the repurchase agreement
markets. Exercising counterparty risk-management is the primary
mechanism by which these types of financial institutions impose market
discipline on hedge funds' use of leverage. The credit risk exposures
between hedge funds and their creditors and counterparties arise
primarily from trading and lending relationships, including various
types of derivatives and securities transactions. Creditors and
counterparties of large hedge funds use their own internal rating and
credit or counterparty risk management processes and may require
additional collateral from hedge funds as a buffer against increased
risk exposure. As part of their due diligence, they typically request
from hedge funds information such as capital and risk measures;
periodic net asset valuation calculations; fees and redemption policy;
and annual audited statements along with hedge fund managers'
background and track record. Creditors and counterparties can establish
credit terms partly based on the scope and depth of information that
hedge funds are willing to provide, the willingness of the fund
managers to answer questions during on-site visits, and the assessment
of the hedge fund's risk exposure and capacity to manage risk. If
approved, the hedge fund receives a credit rating and a line of credit.
Some creditors and counterparties also can measure counterparty credit
exposure on an ongoing basis through a credit system that is updated
each day to determine current and potential exposures. As we reported
in our earlier work, for market discipline to be effective, (1)
investors, creditors, and counterparties must have access to, and act
upon, sufficient and timely information to assess a fund's risk
profile; (2) investors, creditors, and counterparties must have sound
risk-management policies, procedures, and systems to evaluate and limit
their credit risk exposures to hedge funds; and (3) creditors and
counterparties must increase the costs or decrease the availability of
credit to their hedge fund clients as the creditworthiness of the
latter deteriorates.[Footnote 71] Similar to other financial
institutions, hedge funds also have had to deleverage. According to the
2008 Global Financial Stability Report by the International Monetary
Fund, due to the current financial crisis, margin financing from prime
brokers has been cut, and haircuts and fees on repurchase agreements
have increased. The combination of these factors has caused average
hedge fund leverage to fall to 1.4 times capital (from 1.7 times last
year) according to market estimates.
Although hedge funds generally are not directly regulated, many
advisers to hedge funds are subject to federal oversight. Under the
existing regulatory structure, SEC and CFTC regulate those hedge fund
advisers that are registered with them, and SEC, CFTC, as well as the
federal bank regulators monitor hedge fund-related activities of other
regulated entities, such as broker-dealers and commercial banks. As
registered investment advisers, hedge fund advisers are subject to SEC
examinations and reporting, record keeping, and disclosure
requirements. Similarly, CFTC regulates those hedge fund advisers
registered as commodity pool operators or commodity trading
advisors.[Footnote 72] CFTC has authorized the National Futures
Association, an SRO, to conduct day-to-day monitoring of such
registered entities. In addition, SEC, CFTC, and bank regulators use
their existing authorities--to establish capital standards and
reporting requirements, conduct risk-based examinations, and take
enforcement actions--to oversee activities, including those involving
hedge funds, of broker-dealers, futures commission merchants, and
banks, respectively. As we recently reported, although none of the
regulators we interviewed specifically monitored hedge fund activities
on an ongoing basis, regulators generally have increased reviews--by
such means as targeted examinations--of systems and policies to
mitigate counterparty credit risk at the large regulated entities.
[Footnote 73]
Federal banking and securities regulators have established regulatory
and supervisory structures to limit and oversee the use of leverage by
financial institutions. However, as the financial crisis has unfolded
and the regulatory oversight of troubled institutions has been
scrutinized, concerns have been raised about the adequacy of such
oversight in some areas. For example, in its material loss review on
IndyMac Bank, the Treasury Inspector General (IG) found that OTS failed
to take PCA action in a timely manner when IndyMac's capital adequacy
classification first appeared to haven fallen below minimum
standards.[Footnote 74] In addition, the Treasury IG noted that OTS had
given IndyMac satisfactory CAMELS ratings despite a number of concerns
about IndyMac's capital levels, asset quality, management and liquidity
during 2001 through 2007. Separately, a Federal Reserve official
testified in March 2009 that the Federal Reserve has recognized that it
needs to improve its communication of supervisory and regulatory
policies, guidance, and expectations to those banks it regulates by
frequently updating their rules and regulations and more quickly
issuing guidance as new risks and concerns are identified.[Footnote 75]
As another example, in its audit of SEC's oversight of CSEs, the SEC IG
found that the CSE program failed to effectively oversee these
institutions for several reasons, including the lack of an effective
mechanism for ensuring that these entities maintained sufficient
capital.[Footnote 76] The SEC IG made a number of recommendations to
improve the CSE program. In commenting on the SEC IG report, management
of SEC's Division of Trading and Markets stated that the report is
fundamentally flawed in its processes, premises, analysis, and key
findings and reaches inaccurate, unrealistic, and impracticable
conclusions. Although the CSE program has ended, the former SEC
Chairman stated in response to the IG report that the agency will look
closely at the applicability of the recommendations to other areas of
SEC's work.
The Federal Reserve Regulates the Use of Credit to Purchase Securities
under Regulation T and U, but Regulators Said That Such Credit Did Not
Play a Significant Role in the Buildup of Leverage:
To increase their leverage, investors can post securities as collateral
with broker-dealers, banks, and other lenders to obtain loans to
finance security purchases. Historically, such lending has raised
concerns that it diverted credit away from productive uses to
speculation in the stock market and caused excessive fluctuations in
stock prices. But the preponderance of academic evidence is that margin
lending does not divert credit from productive uses and its regulation
is not an effective tool for preventing stock market volatility. To
prevent the excessive use of credit to purchase or trade securities,
Section 7 of the Securities and Exchange Act of 1934 authorized the
Federal Reserve System to regulate such loans.[Footnote 77] Pursuant to
that authority, the Federal Reserve has promulgated Regulations T, U,
and X, which set the minimum amount of margin that customers must
initially post when engaging in securities transactions on credit.
[Footnote 78] Regulation T applies to margin loans made by broker-
dealers, Regulation U applies to margin loans made by banks and other
lenders, and Regulation X applies to margin loans obtained by U.S.
persons and certain related persons who obtain securities credit
outside the United States to purchase U.S. securities, whose
transactions are not explicitly covered by the other two regulations.
[Footnote 79] In effect, these regulations limit the extent to which
customers can increase their leverage by using debt to finance their
securities positions.
The Federal Reserve has raised and lowered the initial margin
requirements for equity securities many times since enactment of the
Securities Exchange Act of 1934. The highest margin requirement was 100
percent, adopted for about a year after the end of World War II. The
lowest margin requirement was 40 percent and was in effect during the
late 1930s and early 1940s. Otherwise, the initial margin requirement
for equity securities has varied between 50 and 75 percent. The Federal
Reserve has left the initial margin requirement at 50 percent since
1974.[Footnote 80]
Federal Reserve, OCC, and SEC staff told us that credit extended under
Regulation T and U generally did not play a significant role in the
buildup of leverage before the current crisis. According to Federal
Reserve staff, Regulation T and U cover only one of many sources of
credit and market participants have many ways to obtain leverage not
covered by the regulations. For example, the credit markets are
international, and market participants can obtain credit overseas where
Regulation T and U do not apply. Similarly, OCC staff said that the
margin regulations largely have been made obsolete by market
developments. Under Regulation T and U, margins are set at 50 percent
for the initial purchase of equities, but large investors can obtain
greater leverage using non-equity securities (such as government
securities) as collateral and various types of derivatives.[Footnote
81] Finally, SEC staff told us that hedge funds and other investors do
not widely use equities for margin and, in turn, leverage purposes
because of Regulation T's restrictions. The staff said that hedge funds
and other market participants can use other financial instruments to
increase their leverage, such as exchange-traded futures contracts. As
shown in figure 7, the total margin debt (dollar value of securities
purchased on margin) consistently increased from year-end 2002 to year-
end 2007, but the amount of margin debt as a percentage of the total
capitalization of NYSE and NASDAQ stock markets was less than 2
percent.[Footnote 82]
Figure 7: Margin Debt and Margin Debt as a Percentage of the Total
Capitalization of the NYSE and NASDAQ Stock Markets, 2000 through 2008:
[Refer to PDF for image: multiple line graph]
Year: 2000;
Percentage of market capitalization: 1.3%;
Dollars in billions: $198,790.
Year: 2001;
Percentage of market capitalization: 1.1%;
Dollars in billions: $150,450.
Year: 2002;
Percentage of market capitalization: 1.2%;
Dollars in billions: $134,380.
Year: 2003;
Percentage of market capitalization: 1.2%;
Dollars in billions: $173,220.
Year: 2004;
Percentage of market capitalization: 1.3%;
Dollars in billions: $203,790.
Year: 2005;
Percentage of market capitalization: 1.3%;
Dollars in billions: $221,660.
Year: 2006;
Percentage of market capitalization: 1.4%;
Dollars in billions: $275,380.
Year: 2007;
Percentage of market capitalization: 1.6%;
Dollars in billions: $322,780.
Year: 2008;
Percentage of market capitalization: 1.6%;
Dollars in billions: $186,710.
Source: GAO analysis of NYSE’s margin debt data and the World
Federation of Exchanges’ market capitalization data.
Note: Margin debt as a percentage of the total stock market
capitalization is overstated in the figure because the margin debt data
include equity and non-equity securities but the market capitalization
data include only equity securities.
[End of figure]
Regulators Are Considering Reforms to Address Limitations the Crisis
Revealed in Regulatory Framework for Restricting Leverage, but Have Not
Reevaluated Basel II Implementation:
The financial crisis has revealed limitations in existing regulatory
approaches that restrict leverage, and 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 formally reevaluated U.S. Basel II
implementation in considering needed reforms. 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 crisis. Federal financial
regulators 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 crisis illustrated how
the existing regulatory framework might have contributed to cyclical
leverage trends that potentially exacerbated the current 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. 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.
Regulatory Capital Measures Did Not Fully Capture Certain Risks:
While a key goal of the regulatory capital framework is to align
capital requirements with risks, the financial crisis revealed that a
number of large financial institutions did not hold capital
commensurate with the full range of risks they faced. U.S. federal
financial regulators and market observers have noted that the accuracy
of risk-based regulatory capital measures depends on proper evaluation
of firms' on and off-balance sheet risk exposures. However, according
to regulators, before the crisis many large financial institutions and
their regulators underestimated the actual and contingent risks
associated with certain risk exposures. As a result, capital
regulations permitted institutions to hold insufficient capital against
those exposures, some of which became sources of large losses or
liquidity pressures as market conditions deteriorated in 2007 and 2008.
When severe stresses appeared, many large banks did not have sufficient
capital to absorb losses and faced pressures to deleverage suddenly and
in ways that collectively may have exacerbated market stresses.
Credit Risks:
The limited risk-sensitivity of the Basel I framework allowed U.S.
banks to increase certain credit risk exposures without making
commensurate increases in their capital requirements.[Footnote 83]
Under the Basel I framework, banks apply one of five risk-weightings in
calculating their risk-based capital requirements for loans,
securities, certain off-balance sheet exposures, and other assets held
in their banking books.[Footnote 84] Because Basel I does not recognize
differences in credit quality among assets in the same risk-weighted
category, some banks may have faced incentives to take on high-risk,
low-quality assets within each broad risk category.
U.S. regulators have noted that the risks associated with a variety of
loan types increased in the years before the crisis due to a number of
factors, including declining underwriting standards and weakening
market discipline. For example, subprime and Alt-A mortgages originated
in recent years have exhibited progressively higher rates of
delinquency (see figure 8). However, as the risks of these loans
increased, capital requirements did not increase accordingly. For
example, under Basel I risk-weighting, a riskier loan reflecting
declining underwriting standards could have received the same 50
percent risk-weighting as a higher quality mortgage loan. In
particular, before the crisis, alternative mortgage products, such as
interest-only and payment-option adjustable-rate mortgages, represented
a growing share of mortgage originations as home prices increased
nationally between 2003 and 2005.[Footnote 85] Although mortgage
statistics for these products reflected declining underwriting
standards, Basel I rules did not require banks to hold additional
capital for these loans relative to lower-risk, traditional mortgage
loans in the same risk-weighting category. Larger-than-expected losses
on loan portfolios depleted the regulatory capital of some large
financial institutions, including two large thrift holding companies
that ultimately failed. Through efforts to move certain large banks to
the Basel II framework, U.S. federal financial regulators have sought
to improve the risk-sensitivity of the risk-based capital
framework.[Footnote 86] However, FDIC officials told us that they are
concerned that the advanced approaches of Basel II could require
substantially less capital than Basel I. (For more detailed information
about the Basel II framework, see appendix IV.)
Figure 8: Foreclosures by Year of Origination--Alt-A and Subprime Loans
for the Period 2000 to 2007:
[Refer to PDF for image: vertical bar graph]
Year: 2000;
Active Alt-A loans: 4%;
Active subprime loans: 8%.
Year: 2001;
Active Alt-A loans: 3%;
Active subprime loans: 6%.
Year: 2002;
Active Alt-A loans: 2%;
Active subprime loans: 6%.
Year: 2003;
Active Alt-A loans: 1%;
Active subprime loans: 5%.
Year: 2004;
Active Alt-A loans: 4%;
Active subprime loans: 7%.
Year: 2005;
Active Alt-A loans: 7%;
Active subprime loans: 13%.
Year: 2006;
Active Alt-A loans: 11%;
Active subprime loans: 16%.
Year: 2007;
Active Alt-A loans: 8%;
Active subprime loans: 12%.
Source: GAO analysis of Loan Performance data.
Note: Analysis excludes investor loans.
[End of figure]
Trading Book Risks:
The financial crisis has highlighted limitations associated with the
use of internal models by financial institutions to calculate capital
requirements for their trading book assets.[Footnote 87] Under the
Market Risk Amendment adopted in 1996, banks with significant trading
assets used internal risk models to determine how much capital to hold
against the market risk of their trading book assets. Banks widely use
Value-at-Risk (VaR) models to help measure their market risk.[Footnote
88] The capital rules require the use of VaR models as well as an
additional capital requirement for specific risk. According to a report
published by the Financial Services Authority, banks generally
attributed low risk to their trading book positions based on the use of
their models before the crisis and, thus, were subjected to relatively
low regulatory capital charges for their trading positions.[Footnote
89] However, since the onset of the crisis, several large banks have
suffered, among other losses on trading book assets, billions of
dollars in writedowns on "super senior," or highly rated CDOs.
According to some regulators, losses on these financial instruments
have been significantly higher than minimum capital charges implied by
the institutions' internal risk models. That is, the risk models
underestimated the institutions' risk exposures to CDOs. For some
leveraged institutions, the size of these CDO positions were small
relative to total assets, but the writedowns constituted a significant
portion of total capital and led to a significant erosion of the
institutions' regulatory capital. As discussed earlier, all else equal,
a small decline in assets will result in a larger percentage decrease
in capital for a leveraged institution.
U.S. and international regulators have identified problems in the way
that some financial institutions applied internal risk models to
determine capital requirements and noted that the crisis has raised
fundamental questions about the inherent limitations of such models and
the assumptions and inputs employed by some users. For example, banks'
VaR models often relied on recent historical observation periods,
rather than observations during periods of financial stress. An
institution's reliance on short-term data from a period of high
liquidity and low market volatility generally would have suggested that
certain trading book assets carried low risks and required little
capital. According to one international regulator, in the years leading
up to the crisis, VaR measures may have suggested declining risk when,
in fact, risks associated with certain mortgage-related securities and
other trading book positions--and capital needs--were growing. However,
even if longer time periods had been used, VaR models may not have
identified the scale of risks associated with certain exposures because
VaR measures do not fully capture risks associated with low-
probability, high-stress events. Moreover, as the crisis illustrated,
VaR primarily measures the price volatility of assets but does not
capture other risks associated with certain trading assets, including
default risk. Although the Basel market risk framework directed
institutions to hold capital against specific risks such as default
risk, according to regulatory officials we spoke with, capital charges
for specific risk did not adequately capture the default risk
associated with certain exposures. Because of the inherent limitations
of VaR models, financial institutions also are required to use stress
tests to determine how much capital and liquidity might be needed to
absorb losses in the event of a large shock to the system or a
significant underestimation of the probability of large losses.
According to the Basel Committee on Banking Supervision, institutions
should test not only for events that could lower their profitability
but also for rare but extreme scenarios that could threaten their
solvency. However, according to regulatory officials, many firms did
not test for sufficiently extreme scenarios, including scenarios that
would render them insolvent.
The crisis also revealed challenges with modeling the risks associated
with relatively recent financial innovations. According to regulators,
many market participants entered into new product lines without having
sufficient data to properly measure the associated risks for
determining capital needs. For example, the lack of historical
performance data for CDOs presented challenges in estimating the
potential value of these securities. In a March 2008 report, the Senior
Supervisors Group--a body comprising senior financial supervisors from
France, Germany, Switzerland, the United Kingdom, and the United
States--reported that some financial institutions substituted price and
other data associated with traditional corporate debt in their loss
estimation models for similarly rated CDO debt, which did not have
sufficient historical data.[Footnote 90] Furthermore, CDOs may lack an
active and liquid market, as in the recent market turmoil, forcing
participants to look for other sources of valuation information when
market prices are not readily available. For instance, market
participants often turned to internal models and other methods to value
these products, which raised concerns about the consistency and
accuracy of the resulting valuation information.
Liquidity risks:
In addition to capital required for credit and market risks, regulators
direct financial institutions to consider whether additional capital
should be held against risks that are not explicitly covered by minimum
regulatory capital requirements.[Footnote 91] Liquidity risk--the risk
that a bank will be unable to meet its obligations when they come due,
because of an inability to liquidate assets or obtain adequate funding-
-is one such risk. Prior to the crisis, most large financial
institutions qualified as "well-capitalized," holding capital levels
considered by regulators to exceed minimum requirements and provide
some protection against risks such as liquidity risk. Regulators have
noted that although strong capital positions can reduce the likelihood
of liquidity pressures, capital alone is not a solution to inadequate
liquidity. Many such "well-capitalized" institutions faced severe
liquidity problems, underscoring the importance of liquidity risk
management.
In particular, Bear Stearns, formerly a CSE, reported that it was in
compliance with applicable rules with respect to capital and liquidity
pools shortly before its failure, but SEC and Bear Stearns did not
anticipate that certain sources of liquidity could rapidly disappear.
According to SEC officials, Bear Stearns' failure was due to a run on
liquidity, not capital. Shortly after Bear Stearns' failure, the then
SEC Chairman noted that Bear Stearns failed in part when many lenders,
concerned that the firm would suffer greater losses in the future,
stopped providing funding to the firm, even on a fully-secured basis
with high quality assets provided as collateral. SEC officials told us
that neither they nor the broader regulatory community anticipated this
development and that SEC had not directed CSEs to plan for the
unavailability of secured funding in their contingent funding plans.
SEC officials stated that no financial institution could survive
without secured funding. Rumors about clients moving cash and security
balances elsewhere and, more importantly, counterparties not
transacting with Bear Stearns also placed strains on the firm's ability
to obtain secured financing. Prior to these liquidity pressures, Bear
Stearns reported that it held a pool of liquid assets well in excess of
the SEC's required liquidity buffer, but this buffer quickly eroded as
a growing number of lenders refused to rollover short-term funding.
Bear Stearns faced the prospect of bankruptcy as it could not continue
to meet its funding obligations. Although SEC officials have attributed
Bear Stearns' failure to a liquidity crisis rather than capital
inadequacy, these officials and market observers also stated that
concerns about the strength of Bear Stearns' capital position--
particularly given uncertainty about the potential for additional
losses on its mortgage-backed securities--may have contributed to a
crisis of confidence among its lenders, counterparties, and customers.
Before Bear Stearns' collapse in March 2008, the Senior Supervisors
Group noted that many financial institutions underestimated their
vulnerability to the prolonged disruption in market liquidity that
began in the summer of 2007. In a March 2008 report, the group noted
that many firms were forced to fund exposures that had not been
anticipated in their contingency funding plans. Notably, the sudden
sharp drop-off in demand for securitizations forced some firms to
retain loans that they had "warehoused" to package as securitized
products, intending to transfer their credit risk to another entity. As
a result, many banks retained credit exposure to certain assets over a
far longer time horizon than expected, increasing the risk that they
would suffer losses on these assets. In a strained funding environment,
many banks also had to provide larger amounts of funding than expected
against certain unfunded lending commitments made prior to the crisis.
Off-Balance Sheet Risks:
The financial crisis also has raised concerns about the management of
and capital treatment for risks associated with certain off-balance
sheet assets, including contingent liquidity and reputation risks. Many
large financial institutions created SPEs to buy and hold mortgage-
related securities and other assets that were previously on their
balance sheets. For example, after new capital requirements were
adopted in the late 1980s, some large banks began creating SPEs to hold
assets against which they would have been required to hold more capital
if the assets had been held in their institutions. SPEs also are known
as off-balance sheet entities, because they generally are structured in
such a way that their assets and liabilities are not required to be
consolidated and reported as part of the overall balance sheet of the
financial institution that created them. According to federal banking
regulators, when a bank committed to provide contingent funding support
to an SPE, it generally would have been required to hold a small amount
of capital against such a commitment.[Footnote 92] For some types of
SPEs, such as structured investment vehicles, banks provided no such
contingent commitments and were subject to no capital charge.
Nevertheless, some institutions retained significant reputation risk
associated with their structured investment vehicles, even if they were
under no legal obligation to provide financial support.[Footnote 93]
The market turmoil in 2007 revealed that many institutions and
regulators underestimated the contingent liquidity risks and reputation
risks associated with their SPEs.[Footnote 94] In a 2008 report, the
Senior Supervisors Group noted that some firms failed to price properly
the risk that exposures to certain off-balance sheet vehicles might
need to be funded on the balance sheet precisely when it became
difficult or expensive to raise such funds externally. Some off-balance
sheet entities were structured in a way that left them vulnerable to
market disruptions. For example, some SPEs held long-term assets (for
example, financial institution debt and CDOs) financed with short-term
liabilities (such as commercial paper), exposing them to the risk that
they would find it difficult or costly to renew their debt financing
under less-favorable market conditions.
When the turmoil in the markets began in 2007, some banks had to
finance the assets held by their SPEs when those SPEs were unable to
refinance their expiring debt due to market concerns over the quality
of the assets. In some cases, SPEs relied on financing commitments that
banks had extended to them. In other cases, financial institutions
supported troubled SPEs to protect their reputations with clients even
when no legal requirement to do so existed. Some large banks brought
SPE assets onto their balance sheets where they became subject to
capital requirements (see figure 9). According to an official at the
Federal Reserve, one large institution's decision to bring its
structured investment vehicle assets onto the balance sheet did not
have a significant, immediate impact on its capital ratio.
Nevertheless, taking SPE assets onto their balance sheets required
banks to hold capital against risk exposures that they previously had
sought to transfer outside their institutions.
Figure 9: Example of an Off-Balance Sheet Entity:
[Refer to PDF for image: illustration]
Bank:
Before financial turmoil:
Bank balance sheet:
* Assets A;
* Assets B (no longer reflected after (1), below).
Assets B:
(1) Bank arranged for assets to be held in a Special Purpose Entity
(SPE). In doing so, the assets were no longer reflected on the bank’s
balance sheet and the bank could hold less capital.
Special Purpose Entity (SPE):
(2) The SPE issued debt to investors.
Assets B:
(3) The assumption that the assets posed no harm to the bank and did
not need to be reflected on the bank’s balance sheet proved untrue.
Some banks had entered emergency financing commitments that were
instituted when the financial turmoil began, forcing them to fund the
SPE and reflect its assets back on the bank balance sheet. In other
cases, sponsors of different SPEs financed them directly to protect
their reputations with clients.
After financial turmoil:
Bank balance sheet:
* Assets A;
* Assets B (fully reflected).
Source: GAO.
[End of figure]
Market Developments Have Challenged the Regulatory System's Ability to
Oversee the Capital Adequacy of Financial Institutions:
While regulators have the authority to require banks to hold capital in
excess of minimum capital requirements, the crisis highlighted
challenges they face in identifying and responding to capital adequacy
problems before market stresses appear.[Footnote 95] In prior work on
the financial regulatory structure, we have noted that the current U.S.
financial regulatory system has relied on a fragmented and complex
arrangement of federal and state regulators that has not kept pace with
the major developments that have occurred in financial markets and
products in recent decades (see figure 10).[Footnote 96] The current
system was not designed to adequately oversee today's large and
interconnected financial institutions, the activities of which pose new
risks to the institutions themselves as well as the risk that an event
could affect the broader financial system (systemic risk). In addition,
the increasingly critical role played by less-regulated entities, such
as hedge funds, has further hindered the effectiveness of the financial
regulatory system. Although many hedge fund advisors are now subject to
some SEC oversight, some financial regulators and market participants
remain concerned that hedge funds' activities can create systemic risk
by threatening the soundness of other regulated entities and asset
markets.
Figure 10: 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: Financial market size,
complexity, interactions: 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 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]
In prior work on regulatory oversight of risk management at selected
large institutions, we found that oversight of institutions' risk-
management systems before the crisis illustrated some limitations of
the current regulatory system.[Footnote 97] For example, regulators
were not looking across groups of institutions to effectively identify
risks to overall financial stability. In addition, primary, functional,
and holding company regulators faced challenges aggregating certain
risk exposures within large, complex financial institutions. According
to one regulatory official, regulators faced difficulties understanding
one large banks' subprime-related exposures, in part because these
exposures were held in both the national bank and broker-dealer
subsidiaries, each of which was overseen by a different primary or
functional regulator. We found that regulators identified weaknesses in
risk-management systems at the selected large, complex institutions
before the crisis, but did not fully recognize the threats they posed
and did not take forceful actions to address them until the crisis
began.
Regulators Have Proposed Revisions to the Regulatory Capital Framework,
but Have Not Yet Reevaluated Basel II Implementation in Light of Risk-
Evaluation Concerns:
Since the crisis began, U.S. federal financial regulators have worked
together and with international regulators, such as through the Group
of Twenty and the Basel Committee on Banking Supervision, in
considering reforms that could increase the risk coverage of the
regulatory capital framework.[Footnote 98] U.S. and international
regulators have proposed revisions to the Basel market risk framework
to better ensure that institutions hold adequate levels of capital
against trading book exposures.[Footnote 99] Proposed revisions include
applying higher capital requirements to resecuritizations such as CDOs
and applying the same capital treatment to these securitizations
whether on the bank's trading or banking book.[Footnote 100] Regulators
also have suggested raising the capital requirements that apply to
certain off-balance sheet commitments. In June 2009, the Financial
Accounting Standards Board published new accounting standards related
to off-balance sheet entities, including a new rule that will require
financial institutions to consolidate assets from certain SPEs.
[Footnote 101] In addition, regulators have issued recommendations
related to improving risk management at institutions, including
strengthening supervision of their VaR models and stress testing. As
many institutions failed to anticipate the impact that liquidity
pressures could have on their regulatory capital, regulators also have
recommended ways to improve coordination of capital and liquidity
planning. The current crisis demonstrated that risks such as liquidity
and asset quality risks were increasing at institutions long before
firms experienced losses that eroded capital. However, because capital
can be a lagging indicator of problems that may threaten a firm's
solvency, regulators have recommended that they and other market
participants assess a broader range of risk indicators when assessing
capital adequacy.
Although federal financial regulators have taken a number of steps to
strengthen supervision of capital adequacy since the crisis began, they
have not yet implemented proposals to increase the risk coverage of
regulatory capital requirements. Among other actions, SEC staff are
reviewing the liquidity of assets held by broker-dealers and
considering whether capital charges for less liquid positions are
appropriate, and the Federal Reserve has conducted stress tests to
assess the capital adequacy of 19 banks under the Supervisory Capital
Assessment Program and required 10 of the banks to raise capital to be
better prepared to withstand a more adverse economic scenario. Federal
financial regulators are continuing to work with international
regulators in forums such as the Basel Committee on Banking
Supervision, but have not formally revised capital requirements to
address limitations revealed by the crisis or fully evaluated how some
proposals would be implemented. For example, U.S. and international
regulators have acknowledged the need to provide greater weight in
determining capital adequacy to low-probability, high-loss events and
are continuing to develop reforms to accomplish this goal. In its
financial regulatory reform proposal released in June 2009, Treasury
announced its intention to lead a working group of regulators and
outside experts in conducting a reassessment of the existing regulatory
capital framework for banks and bank holding companies and expressed
support for the Basel Committee's ongoing efforts to reform the Basel
II framework.[Footnote 102]
In addition, the crisis highlighted some important concerns raised
about the Basel II framework prior to the crisis, but federal financial
regulators have not taken steps to formally reevaluate current U.S.
plans to transition certain large financial institutions to Basel II.
In our prior work on the U.S. Basel II transition, we noted that some
regulators and market observers expressed concern about the ability of
banks' models to adequately measure risks for regulatory capital
purposes and the regulators' ability to oversee them. Although most
U.S. banks have not yet implemented advanced risk-based approaches for
credit risk, internal risk models applied by many U.S. firms before the
crisis significantly underestimated risks and capital needs for trading
book assets. Moreover, FDIC officials have indicated that capital
requirements for most forms of credit risk under Basel II's advanced
approaches will be substantially less than the Basel I requirements.
Regulators already face resource constraints in hiring and retaining
talent that are more binding than the resource constraints faced by the
banks they regulate and this issue is likely to become more significant
under Basel II. These resource constraints are a critical point because
under Basel II regulators' judgment will likely play an increasingly
important role in determining capital adequacy. In 2007, we recommended
that regulators, at the end of the last transition period, reevaluate
whether the advanced approaches of Basel II can and should be relied on
to set appropriate capital requirements for the long term.[Footnote
103] Federal financial regulators have proposed a study of banks'
implementation of the advanced approaches after the second transitional
year, but as a result of delays attributable in part to the financial
crisis, it is unclear when this study will be completed. In 2008, we
further recommended that regulators take steps jointly to plan for a
study to determine if major changes need to be made to the advanced
approaches or whether banks will be able to fully implement the current
rule. We recommended that in their planning they consider, among other
issues, the timing needs for the future evaluation of Basel II. Given
the challenges regulators faced overseeing capital adequacy under Basel
I, if regulators move forward with full implementation of Basel II
before conducting such a reevaluation, changes to the regulatory
capital framework may not address, and in some cases, possibly
exacerbate limitations the crisis revealed in the regulatory framework.
Federal Reserve officials with whom we spoke said that federal
financial regulators are continuing to participate in international
efforts to reevaluate the Basel II framework and expect the outcome of
this work to influence U.S. Basel II implementation.
Sidebar: Nonrisk-based Capital Requirements:
In light of the risk-evaluation challenges revealed by the crisis, U.S.
and international financial regulators and market observers have
commented on the potential benefits of supplementing risk-based capital
measures with a nonrisk-based capital requirement. While U.S. banks and
bank holding companies were and continue to be subject to a minimum
leverage ratio (Tier 1 Capital/Total Assets) and risk-based capital
requirements, international banks based in industrialized countries
generally were not subject to a minimum leverage requirement before and
during the crisis. U.S. and international regulators have noted that
the minimum leverage requirement can serve as an important backstop in
the event that financial institutions quantify risks incorrectly, as
many appear to have done in the years prior to the crisis. Moreover,
the leverage ratio is easy to calculate and can be considered to cover
areas that risk-based requirements do not currently address, such as
interest rate risk and concentration risk. By limiting the total size
of a firm’s assets regardless of their associated risks, a minimum
leverage requirement may serve to restrict the aggregate size of
positions that might need to be simultaneously unwound during a crisis,
thereby limiting the build-up of systemic risk. According to one
regulatory official, subjecting institutions to both risk-based and
minimum leverage requirements may reduce opportunities for regulatory
arbitrage. However, the current crisis also illustrated limitations of
the leverage ratio. For example, the U.S. leverage ratio requirement,
as currently formulated, does not capture off-balance sheet exposures
and, as a result, did not capture increasing risks associated with
certain off-balance sheet vehicles. Furthermore, having a minimum
leverage ratio in place did not safeguard against the failures and near-
failures of some large financial institutions. Officials at some banks
we spoke with noted that imposing a leverage ratio requirement
conflicts with the purpose of moving to a conceptually more risk-
sensitive capital allocation framework. Some bank officials expressed
concern that the leverage ratio may, in some cases, provide
disincentives for banks to hold low-risk assets on the balance sheet.
However, according to the Federal Reserve, this disincentive does not
present a regulatory capital problem from a prudential perspective so
long as appropriate risk-based capital charges are levied against all
assets and risk exposures that are retained by a bank. In a March 12,
2009, press release, the Basel Committee announced, among other things,
its plan to improve the risk coverage of the capital framework and
introduce a non-risk based supplementary measure.
[End of sidebar]
Regulatory Capital Framework May Not Have Provided Adequate Incentives
to Counteract Cyclical Leverage Trends and Regulators Are Considering
Reforms to Limit Procyclicality:
According to U.S. and international financial regulators, the tendency
for leverage to move procyclically--increasing in strong markets and
decreasing when market conditions deteriorate--can amplify business
cycle fluctuations and exacerbate financial instability. As discussed
earlier in this report, heightened systemwide leverage can increase the
vulnerability of the financial system to a crisis, and when stresses
appear, simultaneous efforts by institutions to deleverage may have
adverse impacts on the markets and real economy. U.S. and international
regulators, through forums such as the Financial Stability Forum and
the Basel Committee on Banking Supervision, have expressed concern that
the financial regulatory framework did not provide adequate incentives
for firms to mitigate their procyclical use of leverage. For example,
according to regulators, many financial institutions did not increase
regulatory capital and other loss-absorbing buffers during the market
upswing, when it would have been easier and less costly to do so.
[Footnote 104] Moreover, when the crisis began, rather than drawing
down capital buffers in a controlled manner, these institutions faced
regulatory requirements and market pressures to increase them. Although
procyclicality may be inherent in banking to some extent, regulators
have noted that elements of the regulatory framework may act as
contributing factors.
Several interacting factors, including risk-measurement limitations,
accounting rules, and market discipline can cause capital buffers to
fall during a market expansion and rise during a contraction. With
respect to risk-measurement limitations, the more procyclical the
measurements of risk used to calculate regulatory capital requirements
are, the more likely that these requirements will contribute to
procyclical leverage trends. For example, U.S. and international
regulators have noted that VaR measures of market risk tended to move
procyclically before and during the crisis, particularly to the extent
that banks relied on near-horizon estimates of quantitative inputs such
as short-term volatility. In the years preceding the crisis, the
internal risk models relying on such near-horizon estimates generally
indicated that market risks were low, allowing banks to hold relatively
small amounts of capital against trading book assets. Conversely, when
measured risk spiked during the crisis, firms' models directed them to
increase capital, when it was significantly more costly and difficult
to do so. To the extent that risk measures are procyclical, the use of
fair value accounting, which requires banks to periodically revalue
trading book positions, also may contribute to procyclical leverage
trends.[Footnote 105] For example, when the fair value of super senior
CDOs decreased suddenly, the associated writedowns taken in accordance
with fair value accounting resulted in significant deductions to
regulatory capital at some firms. Conversely, FDIC officials told us
that attention should be given to whether regulatory rules motivated
financial institutions to overvalue these illiquid instruments during
the years leading up to the crisis. Finally, independent of regulatory
requirements, market forces can influence the size of regulatory
capital buffers through the market cycle. For example, banks consider
the expectations of counterparties and credit rating agencies when
deciding how much capital to hold.
U.S. and international financial regulators have acknowledged that
limiting procyclical leverage trends is critical to improving the
systemwide focus of the regulatory framework and have taken steps to
assess possible reforms.[Footnote 106] In addition to changes proposed
to expand coverage of trading book risks, U.S. and international
regulators have suggested revising the Basel market risk framework to
reduce reliance on cyclical VaR-based capital estimates. For example,
the Basel Committee has proposed requiring banks to calculate a
stressed VaR (in addition to the existing VaR requirement) based on
historical data from a period of financial distress relevant to the
firm's portfolio. While most U.S. banks have not fully implemented
Basel II approaches for modeling capital needs for credit risks, U.S.
financial regulators noted before the crisis that elements of the U.S.
implementation of Basel II, including use of through-the-cycle measures
of risk and stress testing practices, would help to moderate the
cyclicality of capital requirements.[Footnote 107] However, federal
financial regulators identified weaknesses with the stress testing
practices of some large banks. In prior work, we recommended that
federal financial regulators clarify the criteria that would be used
for determining an appropriate average level of required capital and
appropriate cyclical variation in minimum capital.[Footnote 108]
Although U.S. and international regulators have made progress in
developing proposals to limit procyclical leverage trends, federal
financial regulators have not formally incorporated such criteria into
the regulatory framework.
Beyond limiting procyclicality arising from risk-measurement practices,
U.S. and international regulators have acknowledged that additional
measures may be needed to ensure that firms build adequate buffers
during strong economic conditions and that they can draw down these
buffers during periods of stress. Regulators have proposed implementing
countercyclical buffers, such as through explicit adjustments to
increase minimum capital requirements during a market expansion and
reduce them in a contraction, but have acknowledged some challenges in
designing and implementing such measures. For example, regulators would
need to assess the appropriate balance of discretionary and non-
discretionary measures in achieving adjustment of capital requirements
throughout the cycle. One regulatory official told us that regulators
face challenges identifying market troughs and, as a result, may find
it difficult to adjust minimum capital requirements appropriately
throughout the cycle. For example, uncertainty about the timing of an
economic recovery may make it difficult in practice to reduce minimum
capital requirements in a downturn. Furthermore, even if minimum
regulatory capital requirements adjust appropriately, some
procyclicality in buffers may be unavoidable as institutions respond to
market expectations. As an example, an institution might face pressures
from credit rating agencies and other market participants to reduce
leverage as market strains appear, despite facing a lower minimum
regulatory capital requirement. Finally, any such changes will need to
incorporate ways to promote greater international consistency while
reflecting differences in national economic cycles.
Financial Regulatory System Does Not Provide Sufficient Attention to
Systemic Risk:
In our prior work, we have noted that a regulatory system should focus
on risk to the financial system, not just institutions.[Footnote 109]
The financial crisis has highlighted the potential for financial market
disruptions, not just firm failures, to be a source of systemic risk.
Ensuring the solvency of individual institutions may not be sufficient
to protect the stability of the financial system, in part because
deleveraging by institutions could have negative spillover effects.
During economic weakness or market stress, an individual institution's
efforts to protect its own safety and soundness (by reducing lending,
selling assets, or raising collateral requirements) can cause stress
for other market participants and contribute to a financial crisis.
With multiple regulators primarily responsible for individual markets
or institutions, none of the financial regulators is tasked with
assessing the risks posed by the systemwide buildup of leverage and
sudden deleveraging that may result from the collective activities of
many institutions. Without a single entity responsible for assessing
threats to the overall financial system, regulators may be limited in
their ability to prevent or mitigate future crises.
U.S. regulators have recognized that regulators often focus on the
financial condition of individual institutions and not on the financial
stability of the financial system. In an August 2008 speech, the
Federal Reserve Chairman stated that U.S. regulation and supervision
focuses, at least informally, on some systemwide elements but outlined
some more ambitious approaches to systemwide regulation.[Footnote 110]
Examples included (1) developing a more fully integrated overview of
the entire financial system, partly because the system has become less-
bank centered; and (2) conducting stress tests for a range of firms and
markets, in part to provide insight into how a sharp change in asset
prices might affect not only a particular institution but also impair
liquidity in key markets. Regulators also have recommended that
financial regulators monitor systemwide measures of leverage and
measures of liquidity to enhance supervision of risks through the
cycle. However, as the Federal Reserve Chairman has noted, the more
comprehensive the regulatory approach, the more technically demanding
and costly it would be for regulators and affected institutions.
Finally, creating a new body or designating one or more existing
regulators with the responsibility to oversee systemic risk could serve
to address a significant gap in the current U.S. regulatory system.
Various groups, such as the Department of the Treasury, the Group of
Thirty, and the Congressional Oversight Panel have put forth proposals
for addressing systemic risk. Our analysis of these proposals found
that each generally addresses systemic risk issues similarly by calling
for a specific organization to be tasked with the responsibility of
overseeing systemic risk in the financial system, but not all provided
detail on which entity should perform this role or how it would
interact with other existing regulators (see table 1).
Table 1: Comparison of Various Regulatory Reform Proposals to Address
Systemic Risk:
Proposal: Treasury Financial Regulatory Reform Proposal (2009);
How proposal addresses systemic risk:
* Calls for creation of a Financial Services Oversight Council (FSOC)
to oversee systemic risk across institutions, products, and markets.
FSOC would have eight members, including the Treasury Secretary and the
Chairmen of the Federal Reserve, CFTC, FDIC, and SEC. FSOC would
replace the President's Working Group on Financial Markets and have a
permanent, full-time staff;
* Calls for stricter and more conservative regulatory capital,
liquidity, and risk management requirements for all financial firms
that are found to pose a threat to the U.S. economy's financial
stability based on their size, leverage, and interconnectedness;
* FSOC would identify such financial firms as Tier 1 Financial Holding
Companies and these firms all would be subject to consolidated
supervision by the Federal Reserve.
Proposal: FDIC Chairman;
How proposal addresses systemic risk:
* Suggests creation of a systemic risk council (SRC) to oversee
systemic risk across institutions, products, and markets. Treasury,
FDIC, and the Federal Reserve, among others, would hold positions on
SRC;
* SRC would be responsible for setting capital and other standards
designed to provide incentives to reduce or eliminate potential
systemic risks;
* SRC could have authority to overrule or force actions on behalf of
other regulatory entities and would have authority to demand better
information from systemically important entities.
Proposal: Federal Reserve Chairman;
How proposal addresses systemic risk:
* Calls for designation of an organization to oversee systemic risk
across institutions, products, and markets;
* Calls for strengthening regulatory standards for governance, risk
management, capital, and liquidity;
* Authority would look broadly at systemic risks, beyond the
institution level to connections between institutions and other gaps in
the current system.
Proposal: SEC Chairman;
How proposal addresses systemic risk:
* Calls for maintaining an independent capital markets regulator that
focuses on investor protection and complements the role of any systemic
risk regulator, in order to provide a more effective financial
oversight regime;
* Favors concept of a new "systemic risk council" comprised of the
Treasury Department, Federal Reserve, FDIC, and SEC to monitor large
institutions against financial threats and ensure sufficient capital
levels and risk management;
* Calls for bringing all OTC derivatives and hedge funds within a
regulatory framework.
Proposal: Group of Thirty;
How proposal addresses systemic risk:
* Advocates consolidated supervision of all systemically important
financial institutions;
* Strengthens regulatory standards for risk management, capital, and
liquidity;
* Increases regulation and transparency of OTC derivatives markets.
Proposal: Congressional Oversight Panel;
How proposal addresses systemic risk:
* Calls for designation of an organization to oversee systemic risk
across institutions, products, and markets;
* Acknowledges the need for regulatory improvements regarding financial
institution capital and liquidity;
* Increases regulation and transparency of OTC derivatives markets.
Proposal: Treasury Blueprint (2008);
How proposal addresses systemic risk:
* Designates an organization--the Federal Reserve--to have broad
authority to oversee systemic risk across institutions, products, and
markets;
* Regulator would collect, analyze, and disclose information on
systemically important issues and could examine institutions and
generally take corrective actions to address problems;
* Regulator could provide liquidity in systemic situations.
Source: GAO analysis of regulatory reform proposals.
[End of table]
For such an entity to be effective, it would likely need to have the
independent ability to collect information, conduct examinations, and
compel corrective actions across all institutions, products, and
markets that could be a source of systemic risk. Such a regulator could
assess the systemic risks that arise within and across financial
institutions, within specific financial markets, across the nation, and
globally. However, policymakers should consider that a potential
disadvantage of providing an agency or agencies with such broad
responsibility for overseeing financial entities could be that it may
imply new or increased official government support or endorsement, such
as a government guarantee, of such activities, and thus encourage
greater risk taking by these financial institutions and investors. To
address such concerns, some have proposed that entities designated as
systemically important could correspondingly have increased
requirements for capital adequacy or leverage limitations to offset the
advantages that they may gain from implied government support. For
example, in its recent proposal for financial regulatory reform,
Treasury called for higher regulatory capital and other requirements
for all financial firms found to pose a threat to financial stability
based on their size, leverage, and interconnectedness to the financial
system.
Conclusions:
The causes of the current 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 current
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.
The federal regulatory capital framework can serve an important role in
restricting the buildup of leverage at individual institutions and
across the financial system and thereby reduce the potential for a
disorderly deleveraging process. However, the crisis has revealed
limitations in the framework's ability to restrict leverage and to
mitigate crises. Federal financial regulators have proposed a number of
changes to improve the risk coverage of the regulatory capital
framework, but they continue to face challenges in identifying and
responding to capital adequacy problems before unexpected losses are
incurred. These challenges will take on greater significance as
regulators consider changes under Basel II that would increase reliance
on complex risk models for determining capital needs, placing even
greater demands on regulators' judgment in assessing capital adequacy.
Although advanced modeling approaches offer the potential to align
capital requirements more closely with risks, the crisis has
underscored the potential for uncritical application of these models to
miss or understate significant risks, especially when underlying data
are limited. Indeed, concerns that advanced approaches could result in
unsafe reductions in risk-based capital requirements influenced
decisions by U.S. regulators to retain the leverage ratio requirement
and to slowly phase in Basel II over several years. In prior work on
the U.S. transition to Basel II for certain large financial
institutions, we recommended that regulators, at the end of the last
transition period, reevaluate whether the advanced approaches of Basel
II can and should be relied on to set appropriate regulatory capital
requirements in the long term. U.S. regulators plan to conduct an
evaluation of the advanced approaches at the end of the second
transitional year, but the timing of the completion of this study is
uncertain. Without a timely reevaluation, regulators may not have the
information needed to ensure that reforms to the regulatory capital
framework adequately address the lessons learned from the crisis.
A principal lesson of the crisis is that an approach to supervision
that focuses narrowly on individual institutions can miss broader
problems that are accumulating in the financial system. In that regard,
regulators need to focus on systemwide risks to and weaknesses in the
financial system--not just on individual institutions. Although federal
regulators have taken steps to focus on systemwide issues, no regulator
has clear responsibility for monitoring and assessing the potential
effects of a buildup in leverage in the financial system or a sudden
deleveraging when financial market conditions deteriorate. However,
leverage has been a source of problems in past financial market crises,
such as the 1998 market disruptions involving Long-Term Capital
Management. After that crisis, regulators recognized not only the need
for better measures of leverage but also the difficulties in measuring
leverage. Given the potential role leverage played in the current
crisis, regulators clearly need to identify ways in which to measure
and monitor systemwide leverage to determine whether their existing
framework is adequately limiting the use of leverage and resulting in
unacceptably high levels of systemic risk. In addition, research and
experience have helped to provide insights on market, regulatory, and
other factors that can reinforce the tendency for leverage to move
procyclically and amplify business cycle fluctuations and exacerbate
financial instability. Although regulators are taking action to address
elements of the regulatory framework that may act as contributing
factors, each regulator's authority to address the issue is limited to
the institutions it supervises. To that end, without a systemwide
focus, regulators may be limited in their ability to prevent or
mitigate future crises.
Matter for Congressional Consideration:
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:
* identifying ways to measure and monitor systemwide leverage and:
* evaluating options to limit procyclical leverage trends.
Recommendation for Executive Action:
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, we recommend that the heads of the Federal Reserve,
FDIC, OCC, and OTS 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 Comments and Our Evaluation:
We provided the heads of the Federal Reserve, FDIC, OCC, OTS, SEC, and
Treasury with a draft of this report for their review and comment. We
received written comments from the Federal Reserve, FDIC, OCC, and SEC.
These comments are summarized below and reprinted in appendixes V
through VIII. We did not receive written comments from OTS and
Treasury. Except for Treasury, the agencies also provided technical
comments that we incorporated in the report where appropriate.
The Federal Reserve commented that high levels of leverage throughout
the global financial system contributed significantly to the current
financial crisis. It agreed that the recent crisis has uncovered
opportunities to improve the risk sensitivity of the Basel I-and Basel
II-based risk-based capital standards and noted that its staff is
involved in current international efforts to strengthen minimum capital
requirements. The Federal Reserve concurred with our recommendation for
a more fundamental review of the Basel II capital framework, including
risk evaluation and regulatory oversight concerns associated with the
advanced approaches.
FDIC commented that the excessive use of leverage during the buildup to
the crisis made individual firms and the financial system more
vulnerable to shocks and reduced the regulators' ability to intervene
before problems cascaded. FDIC also agreed with our recommendation and
noted that it, along with other U.S. banking agencies, is working with
the Basel Committee to develop proposals to address regulatory concerns
discussed in our report. To the extent such proposals do not address
the concerns, FDIC noted that it will consider the matter as part of
the interagency review of Basel II that the agencies committed by
regulation to undertake and will propose suitable remedies, if needed.
OCC agreed that recent events have highlighted certain weaknesses in
its regulatory capital framework (both Basel I-based and Basel II) and
noted that it is in the process of making modifications to address such
weaknesses. It commented that Basel II lays a strong foundation for
addressing supervisory challenges and remains committed to scrutinizing
and improving the framework. With respect to our recommendation, OCC
reiterated that it, along with the other banking agencies, will develop
more formal plans to study the implementation of Basel II after a
firmer picture of banks' implementation progress develops.
Finally, SEC staff commented that our recommendation is a valuable
contribution and will take it into consideration in its recommendations
to the SEC Commission. The staff also commented that SEC rules,
including the broker-dealer net capital rule, largely conform to our
conclusion that regulators need to identify ways in which to monitor
and measure systemwide leverage to determine whether their existing
framework is adequately limiting the use of leverage. Finally, the
staff noted that SEC, along with other financial regulators, should
build on and strengthen approaches that have worked, while taking
lessons from what has not worked in order to be better prepared for
future crises.
We are sending copies of this report to the Congressional Oversight
Panel and interested congressional parties, the Chairman of the Board
of Governors of the Federal Reserve System, the Chairman of FDIC, the
Comptroller of the Currency, the Director of OTS, the Chairman of SEC,
and the Secretary of the Treasury. In addition, the report will be
available at no charge on GAO's Web site at [hyperlink,
http://www.gao.gov].
If you or your staff have any questions regarding this report, please
contact me at (202) 512-5837 or williamso@gao.gov. Contact points for
our Offices of Congressional Relations and Public Affairs may be found
on the last page of this report. GAO staff who made major contributions
to this report are listed in appendix X.
Signed by:
Orice Williams Brown:
Director, Financial Markets and Community Investment:
List of Congressional Committees:
The Honorable Christopher J. Dodd:
Chairman:
The Honorable Richard C. Shelby:
Ranking Member:
Committee on Banking, Housing, and Urban Affairs:
United States Senate:
The Honorable Barney Frank:
Chairman:
The Honorable Spencer Bachus:
Ranking Member:
Committee on Financial Services:
House of Representatives:
[End of section]
Appendix I: Scope and Methodology:
To assess the way in which the leveraging and deleveraging by financial
institutions has contributed to the current financial crisis, we
reviewed and summarized academic and other studies that included
analysis of deleveraging as a potential mechanism for propagating a
market disruption. Based on our searches of research databases
(EconLit, Google Scholar, and the Social Science Research Network), we
identified 15 studies, which included published and working papers that
were released between 2008 and 2009. (See the bibliography for the
studies included in our literature review.) Given our mandate, our
literature search and review focused narrowly on deleveraging by
financial institutions, although other economic mechanisms might have
played a role in propagating the disruptions in the subprime mortgage
markets to other financial markets. Based on our selection criteria, we
determined that the 15 studies were sufficient for our purposes.
Nonetheless, these studies 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
reviewed. To obtain information on the ways that financial institutions
increased their leverage before the crisis and deleveraged during the
crisis and effects such activities had, we interviewed officials from
two securities firms that used to participate in SEC's now defunct
Consolidated Supervised Entity Program (CSE), a large bank, and a
credit rating agency. We also interviewed staff from the Board of
Governors of the Federal Reserve System (Federal Reserve), Federal
Reserve Bank of New York, Federal Deposit Insurance Corporation (FDIC),
Office of the Comptroller of the Currency (OCC), Office of Thrift
Supervision (OTC), and Securities and Exchange Commission (SEC) for the
same purposes.
To describe regulations that federal financial regulators have adopted
to try to limit the use of leverage by financial institutions and
federal oversight of the institutions' compliance with the regulations,
we reviewed and analyzed relevant laws and regulations, and other
regulatory guidance and materials, related to the federal oversight of
the use of leverage by financial institutions. For example, we reviewed
examination manuals and capital adequacy guidelines for banks and bank
holding companies used by their respective federal bank regulators. In
addition, we reviewed SEC's net capital guidelines for broker-dealers.
We also reviewed the extensive body of work that GAO has completed on
the regulation of banks, securities firms, hedge funds, and other
financial institutions. In addition, we interviewed staff from the
Federal Reserve, FDIC, OCC, OTS, and SEC about the primary regulations
their agencies have adopted to limit the use of leverage by their
regulated financial institutions and their regulatory framework for
overseeing the capital adequacy of their institutions. To obtain more
detailed information, we interviewed Federal Reserve Bank of New York
and OCC examiners responsible for supervising a bank holding company
and two national banks, respectively. We also interviewed officials
from two securities firms and one bank to obtain information on the
effect federal regulations had on their use of leverage. Finally, to
gain insights on the extent to which federal financial regulators used
their regulatory tools to limit the use of leverage, we also reviewed
testimonies provided by officials of federal financial regulatory
agencies as well as reports by the offices of inspector general at the
Department of the Treasury and SEC.
To identify and analyze limitations in the regulatory framework used to
restrict leverage and changes that regulators and others have proposed
to address such limitations, we reviewed and analyzed relevant reports,
studies, and public statements issued by U.S. and international
financial regulators. Specifically, to identify potential limitations
in the regulatory capital framework, we reviewed analyses and
recommendations published by regulators through working groups such as
the President's Working Group on Financial Markets,[Footnote 111] the
Basel Committee on Banking Supervision,[Footnote 112] the Financial
Stability Forum,[Footnote 113] and the Senior Supervisors' Group.
[Footnote 114] To obtain perspectives on limitations revealed by the
crisis and regulatory efforts to address these limitations, we also
spoke with officials from the federal financial regulators and market
participants (two securities firms, a large bank, and a credit rating
agency) discussed above. Finally, we reviewed prior GAO work on the
need to modernize the financial regulatory system and the U.S.
transition to Basel II for certain large financial institutions.
For our three objectives, we collected and analyzed data for
descriptive purposes. For example, to identify leverage trends, we
collected and analyzed publicly available financial data on selected
financial institutions, including large broker-dealer and bank holding
companies, and industrywide data, including the Federal Reserve's Flow
of Funds data and Bureau of Economic Analysis's gross domestic product
data. To illustrate trends in margin debt, we used margin debt data
from the New York Stock Exchange and market capitalization data from
the World Federation of Exchanges. To describe foreclosure trends, we
collected and analyzed LoanPerformance's foreclosure data on certain
types of mortgages. We assessed the reliability of the data and found
they were sufficiently reliable for our purposes.
We conducted this performance audit from February 2009 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.
[End of section]
Appendix II: Briefing to Congressional Staff:
Draft: Briefing to Staff of the Senate Committee on Banking, Housing
and Urban Affairs:
Mandated Report on Leveraging and Deleveraging by Financial
Institutions and the Current Financial Crisis Preliminary Findings:
May 27, 2009:
Draft: Briefing to Staff of the House Committee on Financial Services:
Mandated Report on Leveraging and Deleveraging by Financial
Institutions and the Current Financial Crisis Preliminary Findings:
May 27, 2009:
Draft: Briefing to Staff of the Congressional Oversight Panel:
Mandated Report on Leveraging and Deleveraging by Financial
Institutions and the Current Financial Crisis Preliminary Findings:
May 27, 2009:
Briefing Outline:
* Objectives;
* Scope and Methodology;
* Background:
* Summary:
* Leverage Increased before the Crisis, and Research Suggests That
Subsequent Deleveraging Could Have Contributed to the Crisis:
* Financial Regulators Seek to Limit Financial Institutions’ Use of
Leverage Primarily through Varied Regulatory Capital Requirements:
* Crisis Revealed Limitations in Regulatory Framework for Restricting
Leverage, and Regulators Are Considering Reforms to Improve Rules and
Oversight:
Objectives:
How have the leveraging and deleveraging by financial institutions
contributed to the current financial crisis, according to primarily
academic and other studies?
What regulations have federal financial regulators adopted to try to
limit the use of leverage by financial institutions, and how do the
regulators oversee the institutions’ compliance with the regulations?
What, if any, limitations has the current financial crisis revealed
about the regulatory framework used to restrict leverage, and what
changes have regulators and others proposed to address these
limitations?
Scope and Methodology:
To accomplish our objectives, we:
* reviewed and analyzed academic and other studies assessing the
economic mechanisms that possibly helped the mortgage-related losses
spread to other markets and expand into the current financial crisis;
* analyzed publicly available financial data for selected financial
institutions and industrywide data, including the Board of Governors of
the Federal Reserve System’s (Federal Reserve) Flow of Funds data, to
identify leverage trends;
* reviewed and analyzed relevant laws and regulations, and other
regulatory guidance and materials, related to the federal oversight of
the use of leverage by financial institutions;
* interviewed federal financial regulators and market participants,
including officials from a bank, two securities firms, and a credit
rating agency;
* reviewed and analyzed studies identifying challenges associated with
the regulation and oversight of the use leverage by financial
institutions and proposals to address such challenges; and;
* reviewed prior GAO work on the financial regulatory system.
Background:
The financial services industry comprises a broad range of financial
institutions.
In the United States, large parts of the financial services industry
are regulated under a complex system of multiple federal and state
regulators and self-regulatory organizations that operate largely along
functional lines.
* Bank supervisors include the Federal Reserve, Federal Deposit
Insurance Corporation (FDIC), Office of the Comptroller of the Currency
(OCC), and Office of Thrift Supervision (OTS).
* Other functional supervisors include the Securities and Exchange
Commission (SEC), self-regulatory organizations, and state insurance
regulators.
* Consolidated supervisors are the Federal Reserve and OTS.
Leverage can be defined and measured in numerous ways.
* One broad definition is the ratio between some measure of risk and
capital.
* A simple measure of balance sheet leverage is the ratio of total
assets to equity, but this measure treats all assets as equally risky.
* A risk-based leverage measure, as used by regulators, is the ratio of
capital to risk-weighted assets.
Many financial institutions use leverage to expand their ability to
invest or trade in financial assets and to increase their return on
equity.
Financial institutions can increase their leverage, or their risk
exposure relative to capital, in a number of ways. For example, they
can use borrowed funds, rather than capital, to finance an asset or
enter into derivatives contracts.
Figures 1 and 2 show the changes in balance sheet leverage in aggregate
for five large broker-dealer and bank holding companies, respectively,
from 2002 to 2007.
Figure 1: Assets-to-Equity Ratio for Five Large U.S. Broker-Dealer
Holding Companies, 2002 to 2007 (dollars in billions):
[Refer to PDF for image: combination line and multiple vertical bar
graph]
Year: 2002;
Total assets: $1,778;
Total equity: $79;
Leverage ratio: 22.5 to 1.
Year: 2003;
Total assets: $2,027;
Total equity: $96;
Leverage ratio: 21.1 to 1.
Year: 2004;
Total assets: $2,604;
Total equity: $109;
Leverage ratio: 24 to 1.
Year: 2005;
Total assets: $2,984;
Total equity: $120;
Leverage 24.8 to 1.
Year: 2006;
Total assets: $3,654;
Total equity: $142;
Leverage 25.8 to 1.
Year: 2007;
Total assets: $4,272;
Total equity: $140;
Leverage 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]
Figure 2: Assets-to-Equity Ratio for Five Large U.S. Bank Holding
Companies, 2002 to 2007 (dollars in billions):
[Refer to PDF for image: combination line and multiple vertical bar
graph]
Year: 2002;
Total assets: $3,208;
Total equity: $242;
Assets-to-equity ratio: 13.3 to 1.
Year: 2003;
Total assets: $3,560;
Total equity: $259;
Assets-to-equity ratio: 13.71 to 1.
Year: 2004;
Total assets: $4,675;
Total equity: $400;
Assets-to-equity ratio: 11.7 to 1.
Year: 2005;
Total assets: $4,990;
Total equity: $410;
Assets-to-equity ratio: 12.2 to 1.
Year: 2006;
Total assets: $5,889;
Total equity: $486;
Assets-to-equity ratio: 12.1 to 1.
Year: 2007;
Total assets: $6,829;
Total equity: $508;
Assets-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]
Summary:
Studies we reviewed suggested that leverage increased before the
current crisis and deleveraging by financial institutions could have
contributed to the current crisis in two ways. Specifically,
deleveraging through (1) sales of financial assets during times of
market stress could lead to downward price spirals for such assets and
(2) the restriction of new lending could slow economic growth. However,
these studies do not provide definitive findings.
For financial institutions subject to regulation, federal financial
regulators primarily limit the use of leverage by such institutions
through varied regulatory capital requirements. In addition, regulators
can oversee the capital adequacy of their regulated institutions
through ongoing monitoring, which includes on-site examinations and off-
site tools. However, other entities such as hedge funds generally are
not subject to regulation that directly restricts their leverage;
instead, market discipline plays the primary role in constraining risk
taking and leveraging by hedge funds.
The financial crisis has revealed limitations in existing regulatory
approaches used to restrict leverage. According to regulators, the
regulatory capital framework did not ensure that institutions held
capital commensurate with their risks and did not provide adequate
incentives for institutions to build prudential buffers during the
market upswing. When the crisis began, many institutions lacked the
capital needed to absorb losses and faced pressure to deleverage.
Regulators have called for reforms to improve the risk coverage of the
regulatory capital framework and the systemwide focus of the financial
regulatory system.
Leveraging and Deleveraging Could Have Contributed to the Crisis:
Leverage within the financial sector increased before the financial
crisis began around mid-2007, and financial institutions have attempted
to deleverage since the crisis began.
* Since no single measure of leverage exists, the studies we reviewed
generally identified sources that aided in the build up of leverage
before the crisis. These sources included the use of repurchase
agreements, special purpose entities, and over-the-counter derivatives,
such as credit default swaps.
* Studies we reviewed found that banks have tended to manage their
leverage in a procyclical manner—increasing their leverage when prices
rise and decreasing their leverage when prices fall.
* Despite generally reducing their exposure to subprime mortgages
through securitization, some banks ended up with large exposures to
such mortgages relative to their capital. For example, some banks held
mortgage-related securities for trading or investment purpose; some
were holding mortgages or mortgage-related securities that they planned
to securitize but could not do so after the crisis began, and some
brought onto their balance sheets mortgage-related securities held by
structured investment vehicles.
* Following the onset of the financial crisis, banks and financial
institutions have attempted to deleverage in a number of ways,
including raising equity and selling assets.
Some studies suggested that deleveraging through asset sales could lead
to downward spirals in asset prices under certain circumstances and
contribute to a crisis.
* In theory, a sharp decline in an asset’s price can become self-
sustaining and lead to a financial market crisis, because financial
intermediation has moved into markets and away from institutions. But
not all academics subscribe to this theory.
* Studies we reviewed suggested that deleveraging through asset sales
can lead to a downward asset spiral during times of market stress when
market liquidity is low.
* Studies we reviewed also suggested that deleveraging through asset
sales could lead to a downward asset spiral when funding liquidity, or
the ease with which firms can obtain funding, is low.
Alternative theories also may help to explain the recent decline in
asset prices.
Studies suggested that deleveraging by restricting new lending could
have a negative effect on economic growth.
* The concern is that banks will need to cut back their lending to
restore their balance sheets, leading to a decline in consumption and
investment spending, which reduces business and household incomes and
negatively affects the real economy.
* A former Federal Reserve official noted that banks are important
providers of credit, but a key factor in the current crisis is the
sharp decline in securities issuance, which has to be an important part
of why the current financial market turmoil is affecting economic
activity. The official said that the mortgage credit losses are a
problem because they are hitting bank balance sheets at the same time
that the securitization market is experiencing difficulties.
Regulators and market participants that we interviewed had mixed views
about the effects of deleveraging in the current crisis.
* Some regulators and market participants said that asset sales
generally have not led to downward price spirals, but others said that
asset sales of a broad range of debt instruments have led to such
spirals.
* Regulators and market participants told us that some banks have
tightened their lending standards for some types of loans, such as ones
that have less favorable risk-adjusted returns or have been performing
poorly. Federal bank examiners told us that the tightening of lending
standards corresponded with a decline in loan demand.
* Federal bank examiners told us that large banks rely on their ability
to securitize loans to facilitate their ability to make such loans and,
thus the inability to securitize loans has impaired their ability to
make loans.
* Since the crisis began, federal regulators and other authorities have
facilitated financial intermediation by banks and the securities
markets.
Federal Financial Regulatory Oversight of Use of Leverage by Financial
Institutions:
Federal banking and thrift regulators (Federal Reserve, FDIC, OCC and
OTS) try to restrict the use of leverage by their regulated financial
institutions primarily through minimum risk-based capital and leverage
requirements.
* Banks and thrifts are required to meet two minimum risk-based capital
ratios. However, regulators told us that they can require an
institution to meet more than the minimum requirements if, for example,
the institution has concentrated positions or a high risk profile.
* Regulators impose minimum leverage ratios on banks and thrifts to
provide a cushion against risks not explicitly covered in the risk-
based capital requirements (such as for operational weaknesses in
internal policies, systems, and controls).
* Regulators are required to classify institutions based on their level
of capital and take increasingly severe actions, known as prompt
corrective action, as an institution’s capital deteriorates.
Federal bank and thrift regulators oversee the capital adequacy of
their regulated institutions through ongoing monitoring, which includes
on-site examinations and off-site tools.
* Examiners evaluate the institution’s overall risk exposure with
particular emphasis on what is known as CAMELS—the adequacy of its
capital, and asset quality, the quality of its management and internal
control procedures, the strength of its earnings, the adequacy of its
liquidity, and its sensitivity to market risk.
* Regulators can also use off-site tools to monitor the capital
adequacy of institutions such as by remotely assessing the financial
condition of their regulated institutions and plan the scope of on-site
examinations.
* Regulators also can conduct targeted reviews, such as those related
to capital adequacy of their regulated entities.
Although bank holding companies are subject to similar capital and
leverage ratio requirements as banks, thrift holding companies are not
subject to such requirements.
* Bank holding companies are subject to risk-based capital and leverage
ratio requirements, which are similar to those applied to banks.
* In contrast, OTS requires that thrift holding companies hold a
“prudential” level of capital on a consolidated basis to support the
risk profile of the company.
* To supervise the capital adequacy of bank and thrift holding
companies, the Federal Reserve and OTS, respectively, focus on those
business activities posing the greatest risk to holding companies and
managements’ processes for identifying, measuring, monitoring, and
controlling those risks.
* The Federal Reserve and OTS have a range of formal and informal
actions they can take to enforce their regulations for holding
companies and they also monitor the capital adequacy of their
respective regulated holding companies by obtaining uniform information
from their holding companies and conducting peer analysis.
SEC regulated the use of leverage by broker-dealers participating in
SEC’s Consolidated Supervised Entity (CSE) program under an alternative
net capital rule from 2005 to 2008.
* Under the alternative net capital rule, CSE broker-dealers were
required to hold minimum levels of net capital (i.e., net liquid
assets) but permitted to use their own internal models to calculate
their haircuts for the credit and market risk associated with their
trading and investment positions. SEC required as a safeguard that they
maintain at least $500 million in net capital and at least $1 billion
in tentative net capital (equity before haircut deductions). SEC staff
said that CSE broker-dealers, in effect, had to maintain a minimum of
$5 billion in tentative net capital or face remedial action.
* The CSE holding companies calculated their risk-based capital ratio
consistent with the method banks used, were expected to maintain a risk-
based capital ratio of no less than 10 percent, and had to notify SEC
if they breached or were likely to breach this ratio.
* SEC also expected each CSE holding company to maintain a liquid
portfolio of cash and highly liquid and highly rated debt instruments
in an amount based on its liquidity risk management analysis.
* SEC’s Division of Trading and Markets had responsibility for
administering the CSE program, and SEC’s continuous supervision of CSEs
usually was conducted off site.
Other entities, such as hedge funds, have become important financial
market participants, and many use leverage. However, they generally are
not subject to regulation that directly restricts their use of leverage
but may face limitations through market discipline.
* Although hedge funds generally are not subject to regulatory capital
requirements, SEC and the Commodity Futures Trading Commission (CFTC)
regulate some hedge fund advisers and subject them to disclosure
requirements.
* Large banks and prime brokers bear the credit and counterparty risks
that hedge fund leverage creates. They may seek to impose market
discipline on hedge funds primarily by exercising counterparty risk
management through due diligence, monitoring, and requiring additional
collateral to secure existing exposures and provide a buffer against
future exposures.
* SEC, CFTC, and bank regulators also use their authority to establish
capital standards and reporting requirements, conduct risk-based
examinations, and take enforcement actions to oversee activities of
their regulated institutions acting as creditors and counterparties to
hedge funds.
The Federal Reserve limits investors’ use of credit to purchase
securities under Regulation T and U, but regulators told us such credit
did not play a significant role in the buildup of leverage because
market participants can obtain credit elsewhere where these regulations
do not apply.
Crisis Revealed Limitations in Regulatory Framework for Restricting
Leverage:
The existing regulatory capital framework did not fully capture certain
risks.
A key goal of the regulatory capital framework is to align capital
requirements with risks.
However, according to regulators, many large financial institutions and
their regulators underestimated capital needs for certain risk
exposures.
* Credit risks: The limited risk-sensitivity of the Basel I framework
allowed banks to increase certain credit risk exposures without making
commensurate increases in their capital requirements.
* Trading book risks: Internal risk models, as applied by some large
banks, underestimated the market risk and capital needs for certain
trading assets.
* Liquidity risks: Many institutions underestimated their vulnerability
to a prolonged disruption in market liquidity.
* Off-balance sheet exposures: Some large banks held no capital against
the risk that certain special purpose entity (SPE) assets could have to
be brought back on the bank’s balance sheet if these entities
experienced difficulties.
The crisis illustrated challenges with increasing reliance on internal
risk models for calculating capital requirements.
Through forums such as the President’s Working Group on Financial
Markets and the Financial Stability Forum, U.S. and foreign regulators
have called for changes to better align capital requirements with
risks.
The regulatory framework may contribute to procyclical leverage trends.
* According to regulators, the tendency for leverage to move
procyclically—increasing in strong markets and decreasing when market
conditions deteriorate—can amplify business cycle fluctuations and
exacerbate financial instability.
* U.S. regulators have expressed concern that capital requirements did
not provide adequate incentives to increase loss-absorbing capital
buffers during the market upswing, when it would have been less costly
to do so.
* According to regulators, several interacting factors can cause
capital buffers to fall during a market expansion and rise during a
contraction. These factors include:
- limitations in risk measurement,
- accounting rules, and,
- market discipline.
The current regulatory framework does not adequately address systemic
risk.
* The regulatory system focuses on the solvency of individual
institutions, but more attention to other sources of systemic risk is
needed.
* For example, during a period of market stress, an individual
institution’s efforts to protect its safety and soundness can cause
stress for other market participants and heighten systemic risk.
* Regulatory officials have acknowledged the need to improve the
systemwide focus of the financial regulatory system and suggested
changes include:
- taking steps to limit the contribution of the regulatory framework to
procyclicality;
- use of sector-level leverage ratios and systemwide stress tests; and;
- creation of a systemic regulator.
[End of section]
Appendix III: Transition to Basel II Has Been Driven by Limitations of
Basel I and Advances in Risk Management at Large:
(Information in this appendix is based solely on a GAO report issued in
early 2007.[Footnote 115] Thus, the information does not capture any of
the events that have transpired since the current financial crisis
began.)
When established internationally in 1988, Basel I represented a major
step forward in linking capital to risks taken by banking
organizations, strengthening banks' capital positions, and reducing
competitive inequality among international banks. Regulatory officials
have noted that Basel I continues to be an adequate capital framework
for most banks, but its limitations make it increasingly inadequate for
the largest and most internationally active banks. As implemented in
the United States, Basel I consists of five broad credit risk
categories, or risk weights (table 2).[Footnote 116] Banks must hold
total capital equal to at least 8 percent of the total value of their
risk-weighted assets and tier 1 capital of at least 4 percent. All
assets are assigned a risk weight according to the credit risk of the
obligor and the nature of any qualifying collateral or guarantee, where
relevant. Off-balance sheet items, such as credit derivatives and loan
commitments, are converted into credit equivalent amounts and also
assigned risk weights. The risk categories are broadly intended to
assign higher risk weights to--and require banks to hold more capital
for--higher risk assets.
Table 2: U.S. Basel I Credit risk Categories:
Major assets: Cash: claims on or guaranteed by central banks of
Organization for Economic Cooperation and Development countries; claims
on or guaranteed by Organization for Economic Cooperation and
Development central governments and U.S. government agencies. The zero
weight reflects the lack of credit risk associated with such positions;
Risk weight: 0%.
Major assets: Claims on banks in Organization for Economic Cooperation
and Development countries, obligations of government-sponsored
enterprises, or cash items in the process of collection;
Risk weight: 20%.
Major assets: Most one-to-four family residential mortgages; certain
privately issued mortgage-backed securities and municipal revenue
bonds;
Risk weight: 50%.
Major assets: Represents the presumed bulk of the assets of commercial
banks. It includes commercial loans, claims on non-Organization for
Economic Cooperation and Development central governments, real assets,
certain one-to-four family residential mortgages not meeting prudent
underwriting standards, and some multifamily residential mortgages;
Risk weight: 100%.
Major assets: Asset-backed and mortgage-backed securities and other on-
balance sheet positions in asset securitizations that are rated one
category below investment grade;
Risk weight: 200%.
Source: GAO analysis of federal regulations. See, e.g., 12 C.F.R. Part
3, appendix A (OCC).
[End of table]
However, Basel I's risk-weighting approach does not measure an asset's
level of risk with a high degree of accuracy, and the few broad
categories available do not adequately distinguish among assets within
a category that have varying levels of risk. For example, although
commercial loans can vary widely in their levels of credit risk, Basel
I assigns the same 100 percent risk weight to all these loans. Such
limitations create incentives for banks to engage in regulatory capital
arbitrage--behavior in which banks structure their activities to take
advantage of limitations in the regulatory capital framework. By doing
so, banks may be able to increase their risk exposure without making a
commensurate increase in their capital requirements.
In addition, Basel I recognizes the important role of credit risk
mitigation activities only to a limited extent. By reducing the credit
risk of banks' exposures, techniques such as the use of collateral,
guarantees, and credit derivatives play a significant role in sound
risk management. However, many of these techniques are not recognized
for regulatory capital purposes. For example, the U.S. Basel I
framework recognizes collateral and guarantees in only a limited range
of cases.[Footnote 117] It does not recognize many other forms of
collateral and guarantees, such as investment grade corporate debt
securities as collateral or guarantees by externally rated corporate
entities. As a result, regulators have indicated that Basel II should
provide for a better recognition of credit risk mitigation techniques
than Basel I.
Furthermore, Basel I does not address all major risks faced by banking
organizations, resulting in required capital that may not fully address
the entirety of banks' risk profiles. Basel I originally focused on
credit risk, a major source of risk for most banks, and was amended in
1996 to include market risk from trading activity. However, banks face
many other significant risks--including interest rate, operational,
liquidity, reputational, and strategic risks--which could cause
unexpected losses for which banks should hold capital. For example,
many banks have assumed increased operational risk profiles in recent
years, and at some banks operational risk is the dominant risk.
[Footnote 118] Because minimum required capital under Basel I does not
depend directly on these other types of risks, U.S. regulators use the
supervisory review process to ensure that each bank holds capital above
these minimums, at a level that is commensurate with its entire risk
profile. In recognition of Basel I's limited risk focus, Basel II aims
for a more comprehensive approach by adding an explicit capital charge
for operational risk and by using supervisory review (already a part of
U.S. regulators' practices) to address all other risks.
Banks are developing new types of financial transactions that do not
fit well into the risk weights and credit conversion factors in the
current standards. For example, there has been significant growth in
securitization activity, which banks engaged in partly as regulatory
arbitrage opportunities.[Footnote 119] To respond to emerging risks
associated with the growth in derivatives, securitization, and other
off-balance sheet transactions, federal regulators have amended the
risk-based capital framework numerous times since implementing Basel I
in 1992. Some of these revisions have been international efforts, while
others are specific to the United States. For example, in 1996, the
United States and other Basel Committee members adopted the Market Risk
Amendment, which requires capital for market risk exposures arising
from banks' trading activities.[Footnote 120] By contrast, federal
regulators amended the U.S. framework in 2001 to better address risk
for asset securitizations. These changes, while consistent with early
proposals of Basel II, were not adopted by other countries at the time.
The finalized international Basel II accord, which other countries are
now adopting, incorporates many of these changes.
Despite these amendments to the current framework, the simple risk-
weighting approach of Basel I has not kept pace with more advanced risk
measurement approaches at large banking organizations. By the late
1990s, some large banking organizations had begun developing economic
capital models, which use quantitative methods to estimate the amount
of capital required to support various elements of an organization's
risks. Banks use economic capital models as tools to inform their
management activities, including measuring risk-adjusted performance,
setting pricing and limits on loans and other products, and allocating
capital among various business lines and risks. Economic capital models
measure risks by estimating the probability of potential losses over a
specified period and up to a defined confidence level using historical
loss data. This method has the potential for more meaningful risk
measurement than the current regulatory framework, which differentiates
risk only to a limited extent, mostly based on asset type rather than
on an asset's underlying risk characteristics. Recognizing the
potential of such advanced risk measurement techniques to inform the
regulatory capital framework, Basel II introduces "advanced approaches"
that share a conceptual framework that is similar to banks' economic
capital models. With these advanced approaches, regulators aim not only
to increase the risk sensitivity of regulatory measures of risk but
also to encourage the advancement of banks' internal risk management
practices.
Although the advanced approaches of Basel II aim to more closely align
regulatory and economic capital, the two differ in significant ways,
including in their fundamental purpose, scope, and consideration of
certain assumptions. Given these differences, regulatory and economic
capital are not intended to be equivalent. Instead, some regulators
expect that the systems and processes that a bank uses for regulatory
capital purposes should be consistent with those used for internal risk
management purposes. Regulatory and economic capital approaches both
share a similar objective: to relate potential losses to a bank's
capital in order to ensure it can continue to operate. However,
economic capital is defined by bank management for internal business
purposes, without regard for the external risks the bank's performance
poses on the banking system or broader economy. By contrast, regulatory
capital requirements must set standards for solvency that support the
safety and soundness of the overall banking system. In addition, while
the precise definition and measurement of economic capital can differ
across banks, regulatory capital is designed to apply consistent
standards and definitions to all banks. Economic capital also typically
includes a benefit from portfolio diversification, while the
calculation of credit risk in Basel II fails to reflect differences in
diversification benefits across banks and over time. Also, certain key
assumptions may differ, such as the time horizon, confidence level or
solvency standard, and data definitions. For example, the probability
of default can be measured at a point in time (for economic capital) or
as a long-run average measured through the economic cycle (for Basel
II). Moreover, economic capital models may explicitly measure a broader
range of risks, while regulatory capital as proposed in Basel II will
explicitly measure only credit, operational, and where relevant, market
risks.
[End of section]
Appendix IV: Three Pillars of Basel II:
Basel II aims for a more comprehensive approach to addressing risks,
based on three pillars: (1) minimum capital requirements, (2)
supervisory review, and (3) market discipline in the form of increased
public disclosure.
Pillar 1: Minimum Capital Requirements:
Pillar 1 of the advanced approaches rule features explicit minimum
capital requirements, designed to ensure bank solvency by providing a
prudent level of capital against unexpected losses for credit,
operational, and market risk. The advanced approaches, which are the
only measurement approaches available to and required for core banks in
the United States, will make capital requirements depend in part on a
bank's own assessment, based on historical data, of the risks to which
it is exposed.
Credit Risk:
Under the advanced internal ratings-based approach, banks must
establish risk rating and segmentation systems to distinguish risk
levels of their wholesale (most exposures to companies and governments)
and retail (most exposures to individuals and small businesses)
exposures, respectively. Banks use the results of these rating systems
to estimate several risk parameters that are inputs to supervisory
formulas. Figure 11 illustrates how credit risk will be calculated
under the Basel II advanced internal ratings-based approach. Banks must
first classify their assets into exposure categories and subcategories
defined by regulators: for wholesale exposures those subcategories are
high-volatility commercial real estate and other wholesale; for retail
exposures those subcategories are residential mortgages, qualifying
revolving exposures (e.g., credit cards), and other retail. Banks then
estimate the following risk parameters, or inputs: the probability a
credit exposure will default (probability of default or PD), the
expected size of the exposure at the time of default (exposure at
default or EAD), economic losses in the event of default (loss given
default or LGD) in "downturn" (recession) conditions, and, for
wholesale exposures, the maturity of the exposure (M). In order to
estimate these inputs, banks must have systems for classifying and
rating their exposures as well as a data management and maintenance
system. The conceptual foundation of this process is that a statistical
approach, based on historical data, will provide a more appropriate
measure of risk and capital than a simple categorization of asset
types, which does not differentiate precisely between risks. Regulators
provide a formula for each exposure category that determines the
required capital on the basis of these inputs. If all the assumptions
in the supervisory formula were correct, the resulting capital
requirement would exceed a bank's credit losses in a given year with
99.9 percent probability. That is, credit losses at the bank would
exceed the capital requirement with a 1 in 1,000 chance in a given
year, which could result in insolvency if the bank only held capital
equal to the minimum requirement.
Figure 11: Computation of Wholesale and Retail Capital Requirements
under the Advanced Internal Ratings-based Approach for Credit Risk:
[Refer to PDF for image: illustration]
This illustration depicts the calculation of credit risk under the
Basel II advanced internal ratings-based approach.
Noted in the illustration are the following:
Wholesale exposures:
High volatility commercial real estate;
Other wholesale.
Retail exposures:
Residential mortgage;
Qualifying revolving (e.g., credit card);
Other retail.
Risk inputs:
PD = Probability of default (estimated by banks);
LGD = Loss given default (estimated by banks);
EAD = Exposure at default (estimated by banks);
M = Maturity of exposure (estimated by banks);
R = Correlation factor (defined by regulators).
The computation is represented as:
Wholesale capital formula;
plus:
Retail capital formula;
times:
1.06 scaling factor;
equals:
Wholesale and retail capital requirements.
Source: GAO analysis of information from the advanced approaches rule.
Notes: This figure focuses on wholesale and retail nondefaulted
exposures, an important component of the total credit risk calculation.
The total credit risk capital requirement also covers defaulted
wholesale and retail exposures, as well as risk from securitizations
and equity exposures. A bank's qualifying capital is also adjusted,
depending on whether its eligible credit reserves exceed or fall below
its expected credit losses.
[End of figure]
Banks may incorporate some credit risk mitigation, including
guarantees, collateral, or derivatives, into their estimates of PD or
LGD to reflect their efforts to hedge against unexpected losses.
Operational Risk:
To determine minimum required capital for operational risk, banks will
use their own quantitative models of operational risk that incorporate
elements required in the advanced approaches rule. To qualify to use
the advanced measurement approaches for operational risk, a bank must
have operational risk management processes, data and assessment
systems, and quantification systems. The elements that banks must
incorporate into their operational risk data and assessment system are
internal operational loss event data, external operational loss event
data, results of scenario analysis, and assessments of the bank's
business environment and internal controls. Banks meeting the advanced
measurement approaches' qualifying criteria would use their internal
operational risk quantification system to calculate the risk-based
capital requirement for operational risk, subject to a solvency
standard specified by regulators, to produce a capital buffer for
operational risk designed to be exceeded only once in a thousand years.
Market Risk:
Regulators have allowed certain banks to use their internal models to
determine required capital for market risk since 1996 (known as the
market risk amendment or MRA). Under the MRA, a bank's internal models
are used to estimate the 99th percentile of the bank's market risk loss
distribution over a 10-business-day horizon, in other words a solvency
standard designed to exceed trading losses for 99 out of 100 10-
business-day intervals. The bank's market risk capital requirement is
based on this estimate, generally multiplied by a factor of three. The
agencies implemented this multiplication factor to provide a prudential
buffer for market volatility and modeling error. The OCC, Federal
Reserve, and FDIC are proposing modifications to the market risk rules,
to include modifications to the MRA developed by the Basel Committee,
in a separate notice of proposed rulemaking issued concurrently with
the proposal for credit and operational risk. OTS is proposing its own
market risk rule, including the proposed modifications, as a part of
that separate notice of proposed rulemaking.
In previous work, regulatory officials generally said that changes to
the rules for determining capital adequacy for market risk were
relatively modest and not a significant overhaul. The regulators have
described the objectives of the new market risk rule as including
enhancing the sensitivity of required capital to risks not adequately
captured in the current methodologies of the rule and enhancing the
modeling requirements consistent with advances in risk management since
the implementation of the MRA. In particular, the rule contains an
incremental default risk capital requirement to reflect the growth in
traded credit products, such as credit default swaps, that carry some
default risk as well as market risk. The Basel Committee currently is
in the process of finalizing more far-reaching modifications to the MRA
to address issues highlighted by the financial crisis.
Pillar 2: Supervisory Review:
The Pillar 2 framework for supervisory review is intended to ensure
that banks have adequate capital to support all risks, including those
not addressed in Pillar 1, and to encourage banks to develop and use
better risk management practices. Banks adopting Basel II must have a
rigorous process of assessing capital adequacy that includes strong
board and senior management oversight, comprehensive assessment of
risks, rigorous stress testing and validation programs, and independent
review and oversight. In addition, Pillar 2 requires supervisors to
review and evaluate banks' internal capital adequacy assessments and
monitor compliance with regulatory capital requirements. Under Pillar
2, supervisors must conduct initial and ongoing qualification of banks
for compliance with minimum capital calculations and disclosure
requirements. Regulators must evaluate banks against established
criteria for their (1) risk rating and segmentation system, (2)
quantification process, (3) ongoing validation, (4) data management and
maintenance, and (5) oversight and control mechanisms. Regulators are
to assess a bank's implementation plan, planning and governance
process, and parallel run, and ongoing performance. Under Pillar 2,
regulators should also assess and address risks not captured by Pillar
1 such as credit concentration risk, interest rate risk, and liquidity
risk.
Pillar 3: Market Discipline in the Form of Increased Disclosure:
Pillar 3 is designed to encourage market discipline by requiring banks
to disclose additional information and allowing market participants to
more fully evaluate the institutions' risk profiles and capital
adequacy. Such disclosure is particularly appropriate given that Pillar
I allows banks more discretion in determining capital requirements
through greater reliance on internal methodologies. Banks would be
required to publicly disclose both quantitative and qualitative
information on a quarterly and annual basis, respectively. For example,
such information would include a bank's risk-based capital ratios and
their capital components, aggregated information underlying the
calculation of their risk-weighted assets, and the bank's risk
assessment processes. In addition, federal regulators will collect, on
a confidential basis, more detailed data supporting the capital
calculations. Federal regulators would use this additional data, among
other purposes, to assess the reasonableness and accuracy of a bank's
minimum capital requirements and to understand the causes behind
changes in a bank's risk-based capital requirements. Federal regulators
have developed detailed reporting schedules to collect both public and
confidential disclosure information.
[End of section]
Appendix V: Comments from the Board of Governors of the Federal Reserve
System:
Board Of Governors Of The Federal Reserve System:
Daniel K. Tarullo:
Member of the Board:
Washington, D.C. 20551:
E-mail: DanielTarullo@frb.gov:
Telephone: (202) 452-3735:
Facsimile: (202) 736-1960:
July 13, 2009:
Ms. Orice Williams:
Director, Financial Markets and Community Investment:
U.S. General Accountability Office:
Washington, DC 20548:
Dear Ms. Williams,
The Federal Reserve appreciates the opportunity to review and comment
on the GAO's report entitled "Financial Crisis Highlights Need to
Improve Oversight of Leverage at Financial Institutions and Across the
System" (GAO-09-739) (Report). High levels of leverage throughout the
global financial system ranging from consumer and homeowner
indebtedness, to the leverage embedded in various types of financial
products, to the capital structures of many financial institutions,
along with a number of other factors, contributed significantly to the
current financial crisis. The Report provides a thorough review of the
academic literature and other studies in its endeavor to isolate the
role of leverage and de-leveraging in the crisis. It also provides an
important view into the various regulatory capital regimes underlying
the trends in leverage at both commercial and investment banking
organizations and an assessment of those regimes moving forward.
The Federal Reserve supports the Report's analysis of the limits of the
Basel I-based risk-based capital standards to appropriately measure and
allocate capital against the risks undertaken by banking organizations.
The Federal Reserve also agrees that the recent crisis has revealed
problems in both the U.S. Basel I- and Basel II-based risk-based
capital standards. Federal Reserve staff is significantly involved in
current international efforts to strengthen minimum capital
requirements in areas where many banks have experienced losses
including those related to securitizations, counterparty credit risk
exposures, and trading book exposures. Changes to the trading book
framework include proposals to better capture the credit risk of
trading activities and incorporate a new stressed value-at-risk (VaR)
requirement that is expected to help dampen the cyclicality of risk-
based capital requirements. The Federal Reserve concurs with the
Report's recommendation for a more fundamental review of the Basel II
capital framework.
The Federal Reserve supports the Report's observation that the current
regulatory capital framework may not have provided adequate incentives
to counteract cyclical leverage trends. As the Report notes,
international and U.S. supervisors have efforts currently underway to
explore countercyclical capital buffers, strengthen loan loss
provisioning practices, and undertake concrete steps to dampen
excessive capital volatility over the cycle. The Federal Reserve
believes the financial system would benefit from a more explicitly
macroprudential approach to financial regulation in addition to the
current microprudential approach. Such an approach should include
monitoring of system-wide leverage and identifying options to limit
procyclical leverage trends.
The Federal Reserve believes that, as part of a broad agenda to address
systemic risks, Congress should consider establishing a robust
framework for consolidated supervision of all systemically important
financial firms. Firms whose failure would pose a systemic risk must be
subject to especially close supervisory oversight of risk-taking, risk
management, and financial condition, and be held to high capital and
liquidity standards.
Federal Reserve staff has separately provided GAO staff with technical
and correcting comments on the draft report. We hope these comments
were helpful.
Thank you for your efforts on this important matter. The Federal
Reserve appreciates the professionalism of, and the careful analysis
performed by, the GAO review team.
Sincerely,
Signed by:
Daniel K. Tarullo:
[End of section]
Appendix VI: Comments from the Federal Deposit Insurance Corporation:
FDIC:
Federal Deposit Insurance Corporation:
Office of the Chairman:
550 17th Street NW:
Washington, D.C. 20429-9990:
July 9, 2009:
Ms. Orice M. Williams:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
441 G Street, NW:
Washington, D.C. 20548:
Dear Ms. Williams:
The Federal Deposit Insurance Corporation (FDIC) appreciates the
opportunity to comment on the draft report Financial Markets
Regulation: Financial Crisis Highlights Need to Improve Oversight of
Leverage at Financial Institutions and Across System (GAO-09-739)
(Report) that the Government Accountability Office (GAO) submitted to
the FDIC on June 22, 2009. The Report addresses how leverage and de-
leveraging may have contributed to the financial crisis, existing
regulations and supervisory approaches to limit leverage, and
limitations the crisis has revealed in these regulatory approaches.
This letter represents our overall reaction to the Report, additional
technical comments have been provided by our staff.
Excessive use of leverage during the buildup to the crisis made
individual firms and our financial system more vulnerable to shocks,
and reduced the regulators' ability to intervene before problems
cascaded. The Report's emphasis on the importance of regulatory
mechanisms to constrain leverage in the financial system is entirely
appropriate.
We strongly endorse the Report's recommendation that the regulators
undertake a fundamental review of Basel II to assess whether that new
framework would adequately address concerns about the use of banks'
internal models for determining regulatory capital requirements. In
addition to requiring insufficient capital as revealed by the crisis,
the advanced approaches of Basel II embody a degree of regulatory
deference to banks that is concerning. Accordingly, while the Report
cites the locus of regulatory capital authority over systemically
important financial firms as a matter for Congressional consideration,
attention also needs to be given to ensuring that regulatory
authorities are used strongly and as intended.
The FDIC and the other U.S. banking agencies are working with the Basel
Committee to develop proposals to increase the level and quality of
capital in the banking system, reduce the procyclicality of capital
regulation, improve the risk-capture of the Basel framework, and
introduce a non-risk based (leverage) capital ratio internationally to
supplement the risk-based capital requirements. It is anticipated these
proposals would be developed by the end of this year for subsequent
comment and implementation. Whether these Basel Committee proposals and
their ultimate form of implementation will address the fundamental
concerns about Basel II raised in the Report remains to be seen. The
FDIC will consider this matter as part of the interagency review of
Basel II that the agencies committed by regulation to undertake, and
will propose suitable remedies if needed.
In conclusion, we would like to commend the GAO's review team for
producing a thoughtful and comprehensive report.
Sincerely,
Signed by:
Sheila C. Bair:
Chairman:
[End of section]
Appendix VII: Comments from the Office of the Comptroller of the
Currency:
Comptroller of the Currency:
Administrator of National Banks
Washington, DC 20219:
July 10, 2009:
Ms. Orice M. Williams Brown:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548
Dear Ms. Brown:
We have received and reviewed your draft report titled "Financial
Markets Regulation: Financial Crisis Highlights Need to Improve
Oversight of Leverage at Financial Institutions and Across System."
Your report responds to a Congressional mandate to study the role of
leverage in the current financial crisis and federal oversight of
leverage. The report examines the extent to which leverage and the
sudden deleveraging of financial institutions was a factor driving the
current financial crisis.
The study considers the effectiveness of the regulatory capital
framework during the crisis and finds:
The financial crisis has revealed limitations in existing regulatory
approaches that serve to restrict leverage.... Furthermore, the crisis
highlighted past concerns about the approach to be taken under Basel
II, a new risk-based capital framework based on an international
accord, such as the ability of banks' models to adequately measure
risks for regulatory capital purposes and the regulators' ability to
oversee them.[Footnote 1]
To address this issue, the study recommends that "regulators should
assess the extent to which Basel II reforms may address risk evaluation
and regulatory oversight concerns associated with advanced modeling
approaches used for capital adequacy purposes."[Footnote 2]
The OCC agrees that recent events have highlighted certain weaknesses
in our regulatory capital framework - both Basel I-based and Basel II -
and we are in the process of making modifications to address them.
During the course of the development of the Basel II framework, and
consistent with the evolution of our current Basel I-based regulatory
capital regime, we have consistently maintained that the Basel II
framework will need refinement and adjustment over time. To this end,
in January 2009, the Basel Committee on Banking Supervision (BCBS)
proposed amendments to strengthen the Basel II framework.[Footnote 3]
The proposals primarily target the framework's ability to measure and
assess appropriate capital for the risks in banks' trading books and
complex securitization exposures. To prevent a recurrence of the
dramatic increase in leverage that contributed to the recent losses
from trading activities, the proposals include an incremental capital
charge to augment the existing Value at Risk (VaR) capital charge.
Supervisory enhancements to the securitization framework include
additional guidance for complex derivative structures known as
ReRemics. This guidance will facilitate the continuance of healthy
secondary market activity, while dampening the growth in more risky
segments. Prior to finalizing these revisions and enhancements, the
Basel Committee expects to undertake a detailed impact analysis to
ensure a better understanding of the level of minimum required capital
generated by the Basel II framework.
We continue to believe that Basel II lays a strong foundation for
addressing the supervisory challenges posed by an increasingly complex,
sophisticated, and global financial environment. However, we remain
committed to scrutinizing and improving the framework. As stated in our
previous response to the GAO's study[Footnote 4] on Basel II
implementation:
To ensure the effectiveness of Basel II in meeting supervisory needs,
the banking agencies are committed to conducting a study of the
advanced approaches implementation to determine if there are any
material deficiencies in the framework. The banking agencies will
develop more formal plans for the interagency study after a firmer
picture of banks' implementation progress develops.Footnote 5]
We appreciate the opportunity to comment on the draft report.
Sincerely,
Signed by:
John C. Dugan
Comptroller of Currency
Footnotes for Appendix VII:
[1] GAO Report to Congressional Committees Financial Crisis Highlights
Need to Improve Oversight of Leverage at Financial Institutions and
Across System (GAO-09-739), July 2009, Pages 6-7.
[2] GAO Report, Page 8.
[3] The Basel Committee on Banking Supervision Consultative Document
Proposed enhancements to the Basel II framework (January 2009), The
Basel Committee on Banking Supervision Consultative Document Guidelines
for computing capital for incremental risk in the trading book (January
2009), and The Basel Committee on Banking Supervision Consultative
Document Revisions to the Basel II market risk framework (January
2009)."
[4] Risk-Based Capital: New Basel II Rules Reduced Certain Competitive
Concerns, but Bank Regulators Should Address Remaining Uncertainties
(GAO-08-953, September 2008).
[5] Interagency response to GAO-08-953, December 2008.
[End of section]
Appendix VIII: Comments from the Securities and Exchange Commission:
United States Securities And Exchange Commission:
Division Of Trading And Markets:
Washington, D.C. 20549:
July 17, 2009:
Ms. Orice M. Williams Brown:
Director, Financial Markets and Community Investment:
United States Government Accountability Office:
Washington, DC 20548
Dear Ms. Williams Brown:
We have received and reviewed the draft GAO report "Financial Markets
Regulation: Financial Crisis Highlights Need to Improve Oversight of
Leverage at Financial Institutions and Across System" (GAO-09-739) (the
"GAO Report"). We are pleased to have this opportunity to comment on
the report as well as the issue of leverage in financial institutions.
The GAO Report has recommended that federal financial regulators need
to assess the extent to which Basel II's 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 GAO Report states that regulators should
determine whether consideration of more fundamental changes under a new
Basel regime is warranted. We believe these are valuable contributions
to the regulatory framework and will take them into consideration in
our recommendations to the Commission. The GAO Report also states that
regulators "clearly need to identify ways in which to measure and
monitor systemwide leverage to determine whether their existing
framework is adequately limiting the use of leverage and resulting in
unacceptably high levels of systemic risk." We believe our rules, which
are described in more detail below, conform in large measure to your
suggestions.
Broker-dealer Net Capital Rule:
The importance of maintaining high levels of liquidity has been the
underlying premise of the Commission's net capital rule since it was
adopted in 1975, and the Commission continued to emphasize liquidity
when creating the Consolidated Supervised Entity or "CSE" program.
Whereas commercial banks may use insured deposits to fund their
businesses and have access to the Federal Reserve as a backstop
liquidity provider, the CSE broker-dealers were prohibited under
Commission rules from financing their investment bank activities with
customer funds or securities held in a broker-dealer. The Commission
was not authorized to provide a liquidity backstop to CSE broker-
dealers or CSE holding companies.
The Commission action in 2004 to adopt rules establishing the CSE
Program that permitted a broker-dealer to use an alternate method to
compute net capital has been mischaracterized by some commenters as
being a major contributor to the current crisis, or alternately, as
having allowed broker-dealers to increase their leverage. Since August
2008, these commenters have suggested that the 2004 amendments removed
a "l2-to-l" leverage restriction that had prevented broker-dealers from
taking on debt that exceeded more than twelve times their capital and,
as a consequence, the Commission allowed these firms to increase their
debt-to-capital ratios. These commenters point to the 2004 amendments
as a significant factor leading to the demise of Bear Steams. However,
in fact, the 2004 amendments did not alter the leverage limits in the
broker-dealer net capital rule.
The net capital rule requires a broker-dealer to undertake two
calculations: (1) a computation of the minimum amount of net capital
the broker-dealer must maintain; and (2) a computation of the actual
amount of net capital held by the broker-dealer. The "12-to-1"
restriction is part of the first computation, and it was not changed by
the 2004 amendments. The greatest changes effected by the 2004
amendments were to the second computation of actual net capital.
Under the net capital rule, a broker-dealer calculates its actual net
capital amount by starting with net worth computed according to
generally accepted accounting principles and then adding to that amount
qualifying subordinated loans. Next, the broker-dealer deducts from
that amount illiquid assets such as fixed assets, goodwill, real
estate, most unsecured receivables, and certain other assets. This
leaves the broker-dealer with what is known as "tentative net capital,"
which generally consists of liquid securities positions and cash. A
broker-dealer's tentative net capital represents the amount of liquid
assets that exceed all liabilities of the broker-dealer. The final step
in calculating net capital is to take percentage deductions (haircuts)
from the securities positions. The percentage deductions are prescribed
in the rule and are based on, among other things, the type of security,
e.g., debt or equity, the type of issuer, e.g., US government or public
company, the availability of a ready market to trade the security, and,
if a debt security, the time to maturity and credit rating. The amount
left after deducting the haircuts from the securities positions is the
broker-dealer's net capital. This actual amount of net capital needs to
be equal to or greater than the required minimum.
The 2004 amendments permitted the CSE broker-dealers to reduce the
value of the securities positions (the last step in computing actual
net capital) using statistical value-at-risk (VaR) models rather than
the prescribed percentage deductions in the net capital rule. This is
how commercial banks under the Basel Accord had been computing market
risk charges for trading positions since 1997.
Because the CSE broker-dealers were permitted to use modeling
techniques to compute market and credit risk deductions, the Commission
imposed a requirement that they file an early warning notice if their
tentative net capital fell below $5 billion. This became their
effective minimum tentative net capital requirement. The $5 billion
minimum amount was comparable to the amount of tentative net capital
the broker dealers maintained prior to the 2004 amendments. The early
warning requirement was designed to ensure that the use of models to
compute haircuts would not substantially change the amount of tentative
net capital actually maintained by the broker-dealers. The levels of
tentative net capital in the broker-dealer subsidiaries remained
relatively stable after they began operating under the 2004 amendments,
and, in some cases, increased significantly.
CSE Program:
In 2004, the Commission adopted two regimes to fill a statutory gap -
there is no provision in the law that requires investment bank holding
companies to be supervised on a consolidated basis at the holding
company level. One regime, the Supervised Investment Bank Holding
Company ("SIBHC") program, provided group-wide supervision of holding
companies that include broker-dealers based on the specific statutory
authority in the Gramm-Leach-Bliley Act concerning voluntary
consolidated supervision of investment bank holding companies. However,
the Commission's authority under the SIBHC program is severely limited
because holding companies that owned a subsidiary that was an insured
depository institution were ineligible under the statute for this
program. The other regime, the CSE program, provided for voluntary
consolidated supervision based on the Commission's authority over the
regulated broker-dealer. The CSE program permitted certain broker-
dealers to utilize an alternate net capital computation provided the
broker-dealer's holding company submitted to consolidated oversight.
Each CSE holding company was required, among other things, to compute
on a monthly basis its group-wide capital in accordance with the Basel
standards, and was expected to maintain an overall Basel capital ratio
at the consolidated level of not less than the Federal Reserve Bank's
10% "well-capitalized" standard for bank holding companies. CSEs were
also required to file an "early warning" notice with the Commission in
the event that certain minimum thresholds, including the 10% capital
ratio, were breached or were likely to be breached.
Each CSE holding company was required to provide the Commission, on a
periodic basis, with extensive information regarding its capital and
risk exposures, including market risk, credit risk, and liquidity risk.
For the first time, the Commission had the ability to examine the
activities of a CSE holding company that took place outside the U.S.
registered broker-dealer subsidiary. This allowed Commission staff to
get a direct view of the risk taking (and corresponding risk management
controls) of the entire enterprise.
Thus, the Commission did not eliminate or relax any requirements at the
holding company level because previously there had been no
requirements. In fact, through the creation and implementation of the
CSE program, the Commission increased regulatory standards applicable
to the CSE holding companies.
Importance of Liquidity Risk:
CSE holding companies relied on the ongoing secured and unsecured
credit markets for funding, rather than broker-dealer customer
deposits; therefore liquidity and liquidity risk management were of
critical importance. In particular, the Commission's rules required CSE
holding companies to maintain funding procedures designed to ensure
that the holding company had sufficient stand-alone liquidity to
withstand the complete loss of all short term sources of unsecured
funding for at least one year. In addition, with respect to secured
funding, these procedures incorporated a stress test that estimated
what a prudent lender would lend on an asset under stressed market
conditions, e.g., a haircut. Another premise of this liquidity risk
management planning was that assets held in a regulated entity could
not be used to resolve financial weaknesses elsewhere in the holding
company structure. The assumption was that during a stress event,
including a tightening of market liquidity, regulators in the U.S. and
relevant foreign jurisdictions would not permit a withdrawal of capital
from regulated entities. Therefore, each CSE holding company was
required to maintain a substantial "liquidity pool" comprised of
unencumbered highly liquid assets, such as U.S. Treasuries, that could
be moved to any subsidiary experiencing financial stress.
The CSE program required stress testing and substantial liquidity pools
at the holding company to allow firms to continue to operate normally
in stressed market environments. But what neither the CSE regulatory
approach nor most existing regulatory models had taken into account was
the possibility that secured funding could become unavailable, even for
high-quality collateral such as U.S. Treasury and agency securities.
The existing models for both commercial and investment banks are
premised on the expectation that secured funding would be available in
any market environment, albeit perhaps on less favorable terms than
normal. Thus, one lesson from the Commission's oversight of CSEs - Bear
Steams in particular - is that no parent company liquidity pool can
withstand a "run on the bank." Supervisors simply did not anticipate
that a run-on-the-bank was indeed a real possibility for a well-
capitalized securities firm with high quality assets to fund.
Recent events in the capital markets and the broader economy have
presented significant challenges that are rightly the subject of
review, notwithstanding the financial regulatory system's long record
of accomplishment. The Commission, along with other financial
regulators, should build on and strengthen approaches that have worked,
while taking lessons from what has not worked in order to be better
prepared for future crises.
Thank you again for the opportunity to provide comments to the GAO as
it prepares its final draft of the report.
Sincerely,
Signed by:
Michael A. Macchiaroli:
Associate Director:
Division of Trading and Markets:
[End of section]
Appendix IX: Letter from the Federal Reserve regarding Its Authority to
Regulate Leverage and Set Margin Requirements:
Board Of Governors Of The Federal Reserve System:
Scott G. Alvarez, General Counsel:
Washington, D.C. 20551:
May 26, 2009:
Susan D. Sawtelle, Esq.
Managing Associate General Counsel:
United States Government Accountability Office:
441 G Street, NW:
Washington, DC 20548:
Dear. Ms. Sawtelle:
This is in response to your letter dated April 2, 2009, requesting
information about the Board's authority to monitor and regulate
leverage among financial institutions and to set margin requirements.
Limiting leverage of financial institutions supervised by the Board:
The Board has general statutory authority to limit leverage among
institutions that it supervises, including state member banks and bank
holding companies, under the Federal Reserve Act, the Federal Deposit
Insurance Act, the Bank Holding Company Act, and the International
Lending Standards Act.[Footnote 1] The Board also has specific
statutory authority to evaluate and regulate the capital adequacy of
supervised institutions.[Footnote 2]
Through its capital adequacy guidelines, the Board has limited the
leverage of state member banks and bank holding companies by requiring
them to meet a minimum "leverage ratio" and two minimum risk-based
capital ratios, the "tier 1 risk-based capital ratio" and the "total
risk-based capital ratio."[Footnote 3]
Leverage ratio. The leverage ratio is a ratio of an institution's core
capital ("tier 1 capital")[Footnote 4] to average total consolidated
assets.[Footnote 5] The purpose of the leverage ratio is to provide a
simple measure of an institution's tangible capital to assets. State
member banks generally must meet a minimum leverage ratio of 4 percent
[Footnote 6] Bank holding companies with consolidated assets of $500
million or more generally also must meet a minimum leverage ratio of 4
percent. [Footnote 7]
Risk-based capital ratios. The tier 1 risk-based capital ratio is a
ratio of an institution's tier 1 capital to its risk-weighted assets
[Footnote 8] (including certain off balance sheet exposures). The total
risk-based capital ratio is a ratio of total capital (tier 1 capital
plus tier 2 capital)[Footnote 9] to risk-weighted assets.[Footnote 10]
The purpose of the risk-based capital ratios is to provide risk-
sensitive measures of state member banks and bank holding companies'
capital adequacy. All state member banks and bank holding companies
with consolidated assets of $500 million or more generally must meet a
minimum tier 1 risk-based capital ratio of 4 percent and a minimum
total risk-based capital ratio of 8 percent.[Footnote 11]
While the leverage and risk-based ratios establish minimum capital
requirements for state member banks and bank holding companies, the
Board generally expects such institutions to operate well above these
minimum ratios and in all cases, hold capital commensurate with the
level and nature of the risks to which they are exposed.[Footnote 12]
Where an institution's capital is deemed inadequate in light of its
risk profile, the Board has the authority to issue a capital directive
against it to require it to improve its capital position.[Footnote 13]
Through these requirements and its authority over capital levels of
supervised institutions, the Board is able to monitor and limit the
leverage of state member banks and bank holding companies.
Limiting leverage through securities margin authority:
The Board also has authority to establish some limits on the leverage
of market participants where the credit is used for the purpose of
purchasing securities. The Board's securities margin authority is found
in section 7 of the Securities Exchange Act of 1934 ("SEA").[Footnote
14] Section 7(a) authorizes the Board to limit the amount of credit
that may be extended and maintained on securities (other than exempted
securities and security futures products). It also contains a statutory
initial margin requirement. Section 7(b) authorizes the Board to raise
or lower the margin requirements contained in section 7(a). The Board
has adopted three margin regulations pursuant to section 7 of the SEA,
each described below. These regulations apply to specific types of
credits and specific types of transactions.
Regulation T, "Credit by Brokers and Dealers," regulates extensions of
credit by brokers and dealers for the purpose of purchasing securities.
[Footnote 15] In addition to establishing initial margin requirements
for purchases and short sales of securities, it establishes payment
periods for margin and cash transactions. It also contains exceptions
for credit to certain broker-dealers, arbitrage transactions and loans
to employee stock option plans. Specific authority for Regulation T is
found in section 7(c) of the SEA.
Regulation U, "Credit by Banks or Persons Other Than Brokers or Dealers
for the Purpose of Purchasing or Carrying Margin Stock," applies the
Board's margin requirements to United States lenders other than those
covered by Regulation T.[Footnote 16] Nonbank lenders who extend
securities credit above certain dollar thresholds must register with
the Federal Reserve and file annual reports on this activity. Bank and
nonbank lenders are generally subject to the same requirements.
Specific authority for this regulation is found in section 7(d) of the
SEA. Regulation U covers equity securities only, as section 7(d)
exempts loans by a bank on a security other than an equity security.
Regulation X, "Borrowers of Securities Credit," applies margin
requirements to United States persons and certain related persons who
obtain securities credit outside the United States to purchase United
States securities.[Footnote 17] It also imposes liability on borrowers
who obtain credit within the United States by willfully causing a
violation of Regulation T or Regulation U. Regulation X implements
section 7(f) of the SEA.
The Board has raised and lowered the initial margin requirements many
times since enactment of the SEA. The highest margin requirement was
100 percent, adopted for about a year after the end of World War II.
The lowest margin requirement was 40 percent and was in effect during
the late 1930s and early 1940s. Otherwise, the initial margin
requirement has varied between 50 and 75 percent. The Board has left
the initial margin requirement at 50 percent since 1974.
Although section 7 of the SEA gives the Board the authority to adopt
initial and maintenance margins, the Board has chosen to adopt only
initial margin requirements. Broker-dealers, however, are required to
join the Financial Industry Regulatory Authority and are therefore
subject to its maintenance margin requirements.[Footnote 18]
Limiting leverage through monetary policy:
The Federal Reserve, acting through the Federal Open Market Committee,
also can use monetary policy to affect indirectly the amount of
leverage in the financial system.[Footnote 19] By raising interest
rates, the Federal Reserve reduces the money supply and raises the cost
of credit, thereby reducing the amount of leverage available in the
U.S. financial system. Similarly, by lowering interest rates, the
Federal Reserve increases the money supply and reduces the cost of
credit, thereby allowing the amount of leverage available in the U.S.
financial system to increase.
We hope this information is helpful. If you have additional questions
regarding the Board's authority to establish capital requirements,
please contact April C. Snyder, Counsel, at (202) 452-3099, and
Benjamin W. McDonough, Senior Attorney, at (202) 452-2036. If you have
any questions regarding the Board's margin rules (Regulations T, U, and
X), please contact Scott Holz, Senior Counsel, at (202) 452-2966.
Sincerely,
Signed by:
Scott G. Alverez:
Footnotes for Appendix IX:
[1] See 12 U.S.C. 329; 12 U.S.C. 1831o; 12 U.S.C. 1844(b); 12 U.S.C.
3907, 3909.
[2] 12 U.S.C. 1844(b); 12 U.S.C. 3907, 3909.
[3] See 12 CFR part 208, subpart D and Appendices A and B; 12 CFR part
225, Appendices A and D.
[4] Tier 1 capital is defined in the Board's capital adequacy
guidelines. Generally, it consists of voting common stock, certain
types of preferred stock, limited amounts of trust preferred
securities, and certain minority interests. 12 CFR parts 208 and 225,
Appendix A, section II.A.1.
[5] See 12 CFR part 208, Appendix B; 12 CFR part 225, Appendix D.
[6] 12 CFR 208.43; 12 CFR part 208, Appendix B, section II.a. The Board
has established a minimum leverage ratio of 3 percent for state member
banks with a composite rating of "l."
[7] 12 CFR part 225, Appendix D, section II.a. The Board has
established a minimum leverage ratio of 3 percent for bank holding
companies with a composite rating of "1," and for bank holding
companies that have implemented the Board's market risk rule. See
infra, n.8. In addition, bank holding companies with consolidated
assets of less than $500 million are subject to similar restrictions on
leverage under the Board's Small Bank Holding Company Policy Statement.
See 12 CFR part 225, Appendix C.
[8] Risk-weighted assets are calculated under the Board's capital
adequacy guidelines. See 12 CFR part 208, Appendices A and F (state
member banks); 12 CFR part 225, Appendices A and G (bank holding
companies). State member banks and bank holding companies whose trading
activity equals or exceeds 10 percent or more of total assets or $1
billion also must calculate their exposure to market risk under the
Board's market risk rule. See 12 CFR parts 208 and 225, Appendix E.
[9] Tier 2 capital is defined in the Board's capital adequacy
guidelines and generally consists of allowances for loan and leases
losses, subordinated debt, perpetual preferred stock and trust
preferred securities that cannot be included in tier 1 capital. 12 CFR
parts 208 and 225, Appendix A, section II.A.2.
[10] See 12 CFR part 208, Appendices, A, E, and F; 12 CFR part 225,
Appendices A, E, and G.
[11] 12 CFR parts 208 and 225, Appendix A, section IV.A. See supra,
n.7.
[12] 12 CFR parts 208 and 225, Appendix A, section I.
[13] 12 U.S.C. 1818(i); 12 U.S.C. 1831o; 12 U.S.C. 1844(b); 12 U.S.C.
3907(b)(2); 12 CFR part 263, subpart E.
[14] 15 U.S.C. 78g. Section 7 of the SEA only covers financial products
that are "securities" under the SEA. Other financial products and
derivatives are not within the Board's SEA authority.
[15] 12 CFR part 220.
[16] 12 CFR part 221.
[17] 12 CFR part 224.
[18] See New York Stock Exchange Rule 431 and National Association of
Securities Dealers Rule 2520.
[19] 12 U.S.C. 263.
[End of section]
Appendix X: GAO Contact and Staff Acknowledgments:
GAO Contact:
Orice Williams Brown (202) 512-8678 or williamso@gao.gov:
Staff Acknowledgments:
In addition to the contacts named above, Karen Tremba (Assistant
Director); Lawrence Evans, Jr.; John Fisher; Marc Molino; Timothy
Mooney; Akiko Ohnuma; Linda Rego; Barbara Roesmann; John Treanor; and
Richard Tsuhara made significant contributions to this report.
[End of section]
Bibliography:
Acharya, V. and P. Schnabl. How Banks Played the Leverage "Game"?" in
Acharya, V. and Richardson, M. (Eds.) Restoring Financial Stability:
How to Repair a Failed System. John Wiley and Sons. Chapter 2. 2009.
Adrian, Tobias, and Hyun Song Shin. "Liquidity, Financial Cycles and
Monetary Policy." Current Issues in Economics and Finance. Federal
Reserve Bank of New York. Vol. 14, No. 1, January/February 2008.
Tobias Adrian and Hyun Song Shin. "Liquidity and Financial Contagion."
Banque de France. Financial Stability Review. Special issue on
liquidity. No. 11. February 2008.
Baily, Martin N., 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.
Blundell-Wignall. "The Subprime Crisis: Size, Deleveraging and Some
Policy Options." Financial Market Trends. Organization for Economic
Cooperation and Development. 2008.
Brunnermeier, Markus K. "Deciphering the 2007-08 Liquidity and Credit
Crunch." Journal of Economic Perspectives 23, No. 1. 2009. 77-100.
Buiter, Willem H. "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).
Cohen, Ben, and Eli Remolona. "The Unfolding Turmoil of 2007-2008:
Lessons and Responses." Proceedings of a Conference, Sydney, Australia,
Reserve Bank of Australia, Sydney.
Devlin, Will, and Huw McKay. "The Macroeconomic Implications of
Financial 'Deleveraging'." Economic Roundup. Issue 4. 2008.
Frank, Nathaniel, Brenda Gonzalez-Hermosillo, and Heiko Hesse.
"Transmission of Liquidity Shocks: Evidence from the 2007 Subprime
Crisis." International Monetary Fund Working Paper WP/08/200. August
2008.
Gorton, Gary B. "The Panic of 2007." Paper prepared for Federal Reserve
Bank of Kansas City, Jackson Hole Conference, August 2008. October 4,
2008.
Greenlaw, David, Jan Hatzius, Anil K. Kashyap, and Hyun Song Shin.
"Leveraged Losses: Lessons from the Mortgage Meltdown." U.S. Monetary
Policy Forum Report No. 2. Rosenberg Institute, Brandeis International
Business School and Initiative on Global Markets, University of Chicago
Graduate School of Business. 2008.
International Monetary Fund. "Financial Stress and Deleveraging:
Macrofinancial Implications and Policy." Global Financial Stability
Report. Washington, D.C.: October 2008.
Kashyap, Anil K., 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.
Khandani, Amir E., and Andrew W. Lo. "What Happened to the Quants in
August 2007?: Evidence from Factors and Transactions Data. Working
paper. October 23, 2008.
[End of section]
Related GAO Products:
Troubled Asset Relief Program: March 2009 Status of Efforts to Address
Transparency and Accountability Issues. [hyperlink,
http://www.gao.gov/products/GAO-09-504]. Washington, D.C.: March 31,
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, DC.: March 18, 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.: January 8,
2009.
Risk-Based Capital: New Basel II Rules Reduce Certain Competitive
Concerns, but Bank Regulators Should Address Remaining Uncertainties.
[hyperlink, http://www.gao.gov/products/GAO-08-953]. Washington, D.C.:
September 12, 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.
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.
Deposit Insurance: Assessment of Regulators' Use of Prompt Corrective
Action Provisions and FDIC's New Deposit Insurance Program. [hyperlink,
http://www.gao.gov/products/GAO-07-242]. Washington, D.C.: February 15,
2007.
Risk-Based Capital: Bank Regulators Need to Improve Transparency and
Overcome Impediments to Finalizing the Proposed Basel II Framework.
[hyperlink, http://www.gao.gov/products/GAO-07-253]. Washington, D.C.:
February 15, 2007.
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.
[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] Pub. L. No. 110-343, div. A, 122 Stat. 3765 (2008), codified at 12
U.S.C. §§ 5201 et seq.
[4] Section 102 of the act, 12 U.S.C. § 5212, authorizes Treasury to
guarantee troubled assets originated or issued prior to March 14, 2008,
including mortgage-backed securities.
[5] Section 117 of the act, 12 U.S.C. § 5227.
[6] In a May 26, 2009, letter, the Federal Reserve outlined its
authority to monitor and regulate leverage and to set margin
requirements (see appendix IX).
[7] For example, see, GAO, Troubled Asset Relief Program: March 2009
Status of Efforts to Address Transparency and Accountability Issues,
[hyperlink, http://www.gao.gov/products/GAO-09-504] (Washington, D.C.:
Mar. 31, 2009).
[8] Under its CSE program, SEC supervised five 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.
[9] See 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).
[10] For more detailed information about bank and financial holding
companies, see 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).
[11] For a more detailed discussion of the regulatory structure, see
[hyperlink, http://www.gao.gov/products/GAO-07-154] and [hyperlink,
http://www.gao.gov/products/GAO-09-216].
[12] As discussed below, SEC used to oversee certain broker-dealer
holding companies on a consolidated basis.
[13] 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.
[14] According to OTS staff, OTS did not adopt the capital requirements
for trading book market risk.
[15] 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).
[16] See, for example, Mark Jickling, Causes of the Financial Crisis,
Congressional Research Service, R40173 (Washington, D.C.: Jan. 29,
2009).
[17] Our review of the literature included primarily academic studies
analyzing the events surrounding the current financial crisis. Because
the crisis began around mid-2007, we limited the scope of our
literature search to studies issued after June 2007. These studies
include published papers and working papers.
[18] 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.
[19] Under a repurchase agreement, a borrower generally acquires funds
by selling securities to a lender and agreeing to repurchase the
securities after a specified time at a given price. Such a transaction
is called a repurchase agreement when viewed from the perspective of
the borrower, and a reverse repurchase agreement from the point of view
of the lender.
[20] For example, a market observer commented that Lehman Brothers'
failure stemmed partly from the firm's high level of leverage and use
of short-term debt. According to the market observer, Lehman Brothers
used short-term debt to finance more than 50 percent of its assets at
the beginning of the crisis, which is a profitable strategy in a low
interest rate environment but increases the risk of "runs" similar to
the ones a bank faces when it is rumored to be insolvent. Any doubt
about the solvency of the borrower makes short-term lenders reluctant
about renewing their lending.
[21] See, for example, Acharya, V. and P. Schnabl, How Banks Played the
Leverage "Game"? in Acharya, V., Richardson, M. (Eds.) Restoring
Financial Stability: How to Repair a Failed System, John Wiley and Sons
(chap. 2) (2009).
[22] For a discussion of embedded leverage in CDOs, see The Joint
Forum, Credit Risk Transfer, Basel Committee on Banking Supervision
(Basel, Switzerland: October 2004).
[23] We use the term "securities firms" generally to refer to the
holding companies of broker-dealers.
[24] See, for example, Adrian, Tobias, and Hyun Song Shin, "Liquidity,
Financial Cycles and Monetary Policy," Current Issues in Economics and
Finance, Federal Reserve Bank of New York, vol. 14, no. 1, January/
February 2008.
[25] Fair value accounting, also called "mark-to-market," is a way to
measure assets and liabilities that appear on a company's balance sheet
and income statement. Measuring companies' assets and liabilities at
fair value may affect their income statement. For more detailed
information, see SEC's Office of Chief Accountant and Division of
Corporate Finance, "Report and Recommendations Pursuant to Section 133
of the Emergency Economic Stabilization Act of 2008: Study on Mark-To-
Market Accounting" (Washington, D.C.: Dec. 30, 2008).
[26] The 30-to-1 ratio of assets to equity is not unprecedented. In
1998, four of the five broker-dealer holding companies had assets-to-
equity ratio equal to or greater than 30 to 1.
[27] See, for example, David Greenlaw, Jan Hatzius, Anil K. Kashyap,
and Hyun Song Shin, "Leveraged Losses: Lessons from the Mortgage
Meltdown," paper for the U.S. Monetary Policy Forum (2008).
[28] Meredith Whitney, Kaimon Chung, and Joseph Mack, "No Bad Bank
Please," Oppenheimer Equity Research Industry Update, Financial
Institutions (New York: Jan. 29, 2009).
[29] Sovereign wealth funds generally are pools of government funds
invested in assets in other countries.
[30] 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).
[31] Darryll Hendricks, John Kambhu, and Patricia Mosser, "Systemic
Risk and the Financial System, Appendix B: Background Paper," Federal
Reserve Bank of New York Economic Policy Review (November 2007).
[32] A full analysis of the role played by banks in financial
intermediation would need to consider the share of credit intermediated
or securitized by affiliates, subsidiaries, and sponsored investment
vehicles of bank holding companies and financial holding companies.
[33] In addition to increases in haircuts, other factors can cause
liquidity stress. For example, financial institutions negotiate margins
on OTC derivatives to protect themselves from the risk of counterparty
default. Changes in the value of OTC derivatives can result in margin
calls and result in liquidity stress.
[34] 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.
[35] See, for example, Devlin, Will, and Huw McKay, The Macroeconomic
Implications of Financial "Deleveraging," Economic Roundup, Issue 4,
2008; Greenlaw et al. (2008); and Kashyup et al. (2008). Devlin and Hew
(2008) note that there is a large and growing body of empirical
evidence to suggest that shocks to a bank capital-to-asset ratios that
lead to a contraction in the availability of credit within an economy
can have large and long-lasting economic effects.
[36] Greenlaw et al. (2008).
[37] On the other hand, any decline in lending may be partially offset
by the Troubled Asset Relief Program, the Term Asset-Backed Securities
Loan Facility, or other monetary and fiscal policies designed to
mitigate the effects of the financial crisis.
[38] Frederic S. Mishkin, Governor of the Board of the Federal Reserve
System, Speech on "Leveraged Losses: Lessons from the Mortgage
Meltdown," at the U.S. Monetary Policy Forum (New York, N.Y.: Feb. 29,
2008).
[39] Timothy F. Geithner, "Actions by the New York Fed in Response to
Liquidity Pressures in Financial Markets," Testimony before the U.S.
Senate Committee on Banking, Housing and Urban Affairs (Washington,
D.C.: Apr. 3, 2008).
[40] Treasury, Public-Private Investment Program, $500 Billion to $1
Trillion Plan to Purchase Legacy Assets, White Paper.
[41] See, for example, [hyperlink,
http://www.gao.gov/products/GAO-09-504].
[42] 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.
[43] Under its CSE program, 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.
[44] The Prompt Corrective Action regulations and the key regulatory
capital requirements for banks and thrifts are outlined in 12 C.F.R.
pts. 3, 6 (OCC); 208 (FRB); 325 (FDIC) and 565, 567 (OTS).
[45] Regulations limit what may be included in Tier 1 and Tier 2
capital. Tier 1 capital can include common stockholders' equity,
noncumulative perpetual preferred stock, and minority equity
investments in consolidated subsidiaries. For example, see 12 C.F.R.
pt. 325, appendix A (I)(A)(1). The remainder of a bank's total capital
also can consist of tier 2 capital which can include items such as
general loan and lease loss allowances (up to a maximum of 1.25 percent
of risk-weighted assets), cumulative preferred stock, certain hybrid
(debt/equity) instruments, and subordinated debt with a maturity of 5
years or more. For example, see 12 C.F.R. pt. 325, appendix A(I)(A)(2).
[46] Banks holding the highest supervisory rating have a minimum
leverage ratio of 3 percent; all other banks must meet a leverage ratio
of at least 4 percent. Bank holding companies that have adopted the
Market Risk Amendment or hold the highest supervisory rating are
subject to a 3 percent minimum leverage ratio; all other bank holding
companies must meet a 4 percent minimum leverage ratio. According to
FDIC officials, in practice, a bank with a 3 to 4 percent leverage
ratio would be less than well capitalized for Prompt Corrective Action
purposes (discussed below) and would be highly unlikely to be assigned
the highest supervisory rating.
[47] 12 U.S.C. § 1831o. The Federal Deposit Insurance Act, as amended
by the Federal Deposit Insurance Corporation Improvement Act of 1991,
requires federal regulators to take specific action against banks and
thrifts that have capital levels below minimum standards.
[48] Regulators use three different capital measures to determine an
institution's capital category: (1) a total risk-based capital measure,
(2) a Tier 1 risk-based capital measure, and (3) a leverage (or non-
risk-based) capital measure. For additional information, see GAO,
Deposit Insurance: Assessment of Regulators' Use of Prompt Corrective
Action Provisions and FDIC's New Deposit Insurance Program, [hyperlink,
http://www.gao.gov/products/GAO-07-242] (Washington, D.C.: Feb. 15,
2007).
[49] Any determination to take other action in lieu of receivership or
conservatorship for a critically undercapitalized institution is
effective for no more than 90 days. After the 90-day period, the
regulator must place the institution in receivership or conservatorship
or make a new determination to take other action. Each new
determination is subject to the same 90-day restriction. If the
institution is critically undercapitalized, on average, during the
calendar quarter beginning 270 days after the date on which the
institution first became critically undercapitalized, the regulator is
required to appoint a receiver for the institution. Section 38 contains
an exception to this requirement, if, among other things, the regulator
and chair of the FDIC Board of Directors both certify that the
institution is viable and not expected to fail.
[50] Banks usually are examined at least once during each 12-month
period and more frequently if they have serious problems. In addition,
well-capitalized banks with total assets of less than $250 million can
be examined on an 18-month cycle.
[51] At each examination, examiners assign a supervisory CAMELS rating,
which assesses six components of an institution's financial health:
capital, asset quality, management, earnings, liquidity, and
sensitivity to market risk. An institution's CAMELS rating is known
directly only by the institution's senior management and appropriate
regulatory staff. Regulators never publicly release CAMELS ratings,
even on a lagged basis.
[52] All FDIC-insured banks and savings institutions that are
supervised by FDIC, OCC, or the Federal Reserve must submit quarterly
Consolidated Reports on Condition and Income (Call Reports), which
contain a variety of financial information, including capital amounts.
FDIC-insured thrifts supervised by OTS must file similar reports,
called Thrift Financial Reports.
[53] On December 7, 2007, the banking regulatory agencies issued a
final rule entitled "Risk-Based Capital Standards: Advanced Capital
Adequacy Framework - Basel II." 72 Fed. Reg. 69288 (Dec. 7, 2007). In
addition to this final rule, the agencies issued a proposed revision to
the market risk capital rule. 71 Fed. Reg. 55958 (Sept. 25, 2006).
[54] Well-capitalized for bank holding companies does not have the same
meaning as in a PCA context; it is used in the application process.
[55] Under the Homeowners' Loan Act of 1933, as amended, companies that
own or control a savings association are subject to supervision by OTS.
12 U.S.C. § 1467a.
[56] Each bank holding company is assigned a composite rating (C) based
on an evaluation and rating of its managerial and financial condition
and an assessment of future potential risk to its subsidiary depository
institution(s). The main components of the rating system represent:
Risk Management (R); Financial Condition (F); and potential Impact (I)
of the parent company and nondepository subsidiaries on the subsidiary
depository institution(s). The Impact rating focuses on downside risk-
-that is, on the likelihood of significant negative impact on the
subsidiary depository institutions. A fourth component rating,
Depository Institution (D), will generally mirror the primary
regulator's assessment of the subsidiary depository institution(s).
[57] The Federal Reserve's formal enforcement powers for bank holding
companies and their nonbank subsidiaries are set forth at 12 U.S.C. §
1818(b)(3).
[58] See 12 U.S.C. § 1467a(g), (i) and 12 U.S.C. § 1818(b)(9).
[59] Senior Deputy Director and Chief Operating Officer, Scott M.
Polakoff, before the Subcommittee on Securities, Insurance, and
Investment, Committee on Banking, Housing, and Urban Affairs, U.S.
Senate (Washington, D.C.: June 19, 2008).
[60] SEC has broad authority to adopt rules and regulations regarding
the financial responsibility of broker-dealers that it finds are
necessary or appropriate in the public interest or for the protection
of investors and, pursuant to that authority, adopted the net capital
rule (17 C.F.R. § 240.15c3-1) and related rules. 40 Fed. Reg. 29795,
29799 (July 16, 1975). Specifically, the SEC determined that the net
capital rule was necessary and appropriate to provide safeguards with
respect to the financial responsibility and related practices of
brokers or dealers; to eliminate illiquid and impermanent capital; and
to assure investors that their funds and securities are protected
against financial instability and operational weaknesses of brokers or
dealers. Id. See also 17 C.F.R. 240.15c3-3.
[61] 15 U.S.C. § 78o(c)(3).
[62] CFTC imposes capital requirements on futures commission merchants,
which are similar to broker-dealers but act as intermediaries in
commodity futures transactions. Some firms are registered as both a
broker-dealer and futures commission merchant and must comply with both
SEC's and CFTC's regulations.
[63] In comparison, under the basic method, broker-dealers must have
net capital equal to at least 6 2/3 percent of their aggregate
indebtedness. The 6-2/3 percent requirement implies that broker-dealers
must have at least $1 of net capital for every $15 of its indebtedness
(that is, a leverage constraint). Most small broker-dealers typically
use the basic method because of the nature of their business.
[64] See 17 C.F.R. § 240.15c3-3.
[65] Pub. L. No. 91-598, 84 Stat. 1636, codified at 15 U.S.C. §§ 78aaa-
78lll.
[66] As part of its oversight, SEC also evaluates the quality of FINRA
oversight in enforcing its members' compliance through oversight
inspections of FINRA and inspections of broker-dealers. SEC also
directly assesses broker-dealer compliance with federal securities laws
through special and cause examinations.
[67] To assess the adequacy of both capital and liquid assets, SEC
staff takes a scenario-based approach. A key premise of the scenario
analysis is that during a liquidity stress event, the holding company
would not receive additional unsecured funding.
[68] GAO, 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.: Oct. 29,
1999). The report did not present the assets-to-equity ratio for Bear
Stearns, but its ratio also was above 28 to 1 in 1998.
[69] Bear Stearns was acquired by JPMorgan Chase, Lehman Brothers
failed, Merrill Lynch was acquired by Bank of America, and Goldman
Sachs and Morgan Stanley have become bank holding companies.
[70] Although there is no statutory definition of "hedge fund," the
term commonly is used to describe pooled investment vehicles directed
by professional managers that often engage in active trading of various
types of assets, such as securities and derivatives and are structured
and operated in a manner that enables the fund and its advisers to
qualify for exemptions from certain federal securities laws and
regulations that apply to other investment pools, such as mutual funds.
[71] See GAO, 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.: Jan. 24, 2008).
[72] Except as may otherwise be provided by law, a commodity pool
operator (CPO) is an individual or organization that operates an
enterprise, and, in connection therewith, solicits or receives funds,
securities or property from third parties, for the purpose of trading
in any commodity for future delivery on a contract market or
derivatives execution facility. 7 U.S.C. § 1a(5). A commodity trading
advisor (CTA) is, except as otherwise provided by law, any person who,
for compensation or profit, (1) directly or indirectly advises others
on the advisability of buying or selling any contract of sale of a
commodity for future delivery, commodity options or certain leverage
transactions contracts, or (2) as part of a regular business, issues
analyses or reports concerning the activities in clause (1). 7 U.S.C. §
1a(6). In addition to statutory exclusions to the definition of CPO and
CTA, CFTC has promulgated regulations setting forth additional criteria
under which a person may be excluded from the definition of CPO or CTA.
See 17 C.F.R. §§ 4.5 and 4.6 (2007).
[73] See [hyperlink, http://www.gao.gov/products/GAO-08-200].
[74] Office of Inspector General, Department of the Treasury, Safety
and Soundness: Material Loss Review of IndyMac Bank, FSB, OIG-09-032
(Washington, D.C.: Feb. 26, 2009).
[75] Roger T. Cole, Director, Division of Banking Supervision and
Regulation, before the Subcommittee on Securities, Insurance, and
Investment, Committee on Banking, Housing, and Urban Affairs, U.S.
Senate (Washington, D.C.: Mar. 18, 2009).
[76] Office of Inspector General, U.S. Securities and Exchange
Commission, SEC's Oversight of Bear Stearns and Related Entities: The
Consolidated Supervised Entity Program, 446-A (Washington, D.C.: Sept.
25, 2008).
[77] Ch. 404, § 7, 48 Stat. 881 (June 6, 1934) codified at 15 U.S.C. §
78g.
[78] Margin rules also have been established by U.S. securities self-
regulatory organizations, such as NYSE Rule 431 and NASD Rule 2520,
which limit the extension of credit by member broker-dealers. While
FINRA is establishing new FINRA rules, the old rules continue to be
effective until replaced by an applicable new FINRA rule.
[79] Regulation X, 12 C.F.R pt. 224, generally applies to U.S. citizens
borrowing from non-U.S. lenders. Regulation X extends to borrowers the
provisions of Regulations T and U for the purpose of purchasing or
carrying securities. In that regard, our discussion focuses on
Regulations T and U, 12 C.F.R. pts. 220 and 221.
[80] Although section 7 of the Securities Exchange Act gives the
Federal Reserve the authority to adopt initial and maintenance margins,
the Federal Reserve has chosen to adopt only initial margin
requirements. Broker-dealers, however, are required to join the
Financial Industry Regulatory Authority and are therefore subject to
its maintenance margin requirements. See New York Stock Exchange Rule
431 and National Association of Securities Dealers Rule 2520.
[81] Under regulation T, broker-dealers may accept exempted and margin
securities as collateral for loans used to purchase securities.
Exempted securities include government and municipal securities. Margin
securities comprise a broad range of equity and non-equity, or debt,
securities. The Federal Reserve has set the initial margin requirement
for equity securities at 50 percent of their market value. In contrast,
non-equity securities (e.g., corporate bonds, mortgage-related
securities, and repurchase agreements on non-equity securities) and
exempt securities are subject to a "good faith" margin requirement.
Good faith margin means that a broker-dealer may extend credit on a
particular security in any amount consistent with sound credit
judgment.
[82] Even though the total amount of margin debt decreased
significantly from December 2007 to December 2008, the total margin
debt as a percentage of total market capitalization did not decline,
because the total market capitalization also declined significantly
during this period.
[83] With the exception of broker-dealer holding companies
participating in the SEC's CSE program, U.S. banks operated under the
Basel I regulatory capital framework prior to the crisis.
[84] Assets held in the banking book generally include assets that are
not actively traded and intended to be held for longer periods than
trading portfolio assets. See appendix III for information about how
assets are assigned to risk-weighting categories under Basel I.
[85] Before the crisis, to purchase homes borrowers might not be able
to afford with a conventional fixed-rate mortgage, an increasing number
of borrowers turned to alternative mortgage products, which offer
comparatively lower and more flexible monthly mortgage payments for an
initial period. Interest-only and payment option adjustable rate
mortgages allow borrowers to defer repayment of principal and possibly
part of the interest for the first few years of the mortgage. For more
about the risks associated with alternative mortgage products, see GAO,
Alternative Mortgage Products: Impact on Defaults Remains Unclear, but
Disclosure of Risks to Borrowers Could Be Improved, GAO-06-1021
(Washington, D.C.: Sept. 19, 2006).
[86] For more about the U.S. efforts to transition large banks to the
Basel II framework, see GAO, Risk-Based Capital: Bank Regulators Need
to Improve Transparency and Overcome Impediments to Finalizing the
Proposed Basel II Framework, [hyperlink,
http://www.gao.gov/products/GAO-07-253] (Washington, D.C.: Feb. 15,
2007).
[87] Trading book assets generally include securities that the bank
holds in its trading portfolio and trades frequently. Trading book
assets also can include securities that institutions intend to hold
until maturity. For example, a security may be booked in the trading
book because the derivative position used to hedge its return is in the
trading book.
[88] VaR is a statistical measure of the potential loss in the fair
value of a portfolio due to adverse movements in underlying risk
factors. The measure is an estimate of the expected loss that an
institution is unlikely to exceed in a given period with a particular
degree of confidence. Specific risk means changes in the market value
of specific positions due to factors other than broad market movements
and includes such risks as the credit risk of an instrument's issuer.
[89] See the Financial Services Authority, The Turner Review: A
Regulatory Response to the Global Banking Crisis (London: March 2009).
The Financial Services Authority is the United Kingdom's financial
regulator.
[90] See Senior Supervisors Group, Observations on Risk Management
Practices during the Recent Market Turbulence (New York: Mar. 6, 2008).
[91] Risk-based regulatory capital ratios measure credit risk, market
risk, and (under Basel II) operational risk. Risks not measured under
pillar I include liquidity risk, concentration risk, reputational risk,
and strategic risk.
[92] Contingent funding support includes liquidity facilities and
credit enhancements. Liquidity facilities are the assurance of a loan
or guarantee of financial support to back up an off-balance sheet
entity. Credit enhancements are defined as a contractual arrangement in
which a bank retains or assumes a securitization exposure and, in
substance, provides some degree of added protection to the parties to
the transaction.
[93] Reputation risk is the potential for financial loss associated
with negative publicity regarding an institution's business practices
and subsequent decline in customers, costly litigation, or revenue
reductions.
[94] Contingent liquidity risk refers to the risk that a bank would
have to satisfy contractual or non-contractual obligations contingent
upon certain events taking place.
[95] 12 U.S.C. §1831o(c)(1)(B)(i).
[96] See [hyperlink, http://www.gao.gov/products/GAO-09-216].
[97] 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).
[98] In April 2009, the Group of Twenty, which represents the world's
leading and largest emerging economies, met in London to discuss the
international response to the global financial crisis.
[99] In January 2009, the Basel Committee on Banking Supervision
proposed revisions to the Basel II market risk framework.
[100] The Basel Committee on Banking Supervision has defined a
resecuritization exposure as a securitization exposure where one or
more of the underlying exposures is a securitization exposure.
[101] Statement 166 eliminates the exemption from consolidation for
certain SPEs. A second new standard, Statement 167, requires ongoing
reassessments of whether consolidation is appropriate for assets held
by certain off-balance sheet entities. These new standards will impact
financial institution balance sheets beginning in 2010.
[102] Department of the Treasury, Financial Regulatory Reform: A New
Foundation (Washington, D.C.: June 2009).
[103] [hyperlink, http://www.gao.gov/products/GAO-07-253].
[104] Other regulatory loss-absorbing buffers include loan loss
provisions and margin and collateral requirements. Provisions for loan
losses allow banks to recognize income statement losses for expected
loan portfolio losses before they occur. Current accounting rules
require recognition of a loan loss provision only when a loan
impairment event takes place or events occur that are likely to result
in future non-payment of a loan. Some observers have commented that
earlier provisioning for loan losses may help to reduce the magnitude
of financial losses that hit the income statement and deplete
regulatory capital when market conditions deteriorate. To address the
potential contribution of these other buffers to procyclicality,
domestic and international regulators have proposed changes in a
Financial Stability Forum report: Report of the Financial Stability
Forum on Addressing Procyclicality in the Financial System (Basel,
Switzerland: April 2009).
[105] The financial crisis has highlighted challenges associated with
balancing the goals of providing sufficient financial disclosures for
investors and maintaining financial stability. The Financial Accounting
Standards Board recently revised fair value accounting rules to allow
firms to distinguish between losses arising from the underlying
creditworthiness of assets and losses arising from market conditions.
[106] See [hyperlink, http://www.gao.gov/products/GAO-09-216]. GAO
included systemwide focus as one of nine elements in a proposed
framework for evaluating financial regulatory reforms. Systemwide focus
refers to having mechanisms to identify, monitor, and manage risks to
the financial system regardless of the source of the risk or the
institutions in which it is created.
[107] 72 Fed. Reg. 69288, 69393 (Dec. 7, 2007).
[108] [hyperlink, http://www.gao.gov/products/GAO-07-253].
[109] [hyperlink, http://www.gao.gov/products/GAO-09-216].
[110] Federal Reserve Chairman Ben S. Bernanke, Opening Remarks at
Kansas City Federal Reserve's Bank 2008 Symposium on Maintaining
Stability in a Changing Financial System (August 2008).
[111] The President's Working Group on Financial Markets was
established by Executive Order No. 12631, 53 Fed. Reg. 9421 (Mar. 18,
1988). The Secretary of the Treasury chairs the group, the other
members of which are the chairpersons of the Federal Reserve, SEC, and
Commodity Futures Trading Commission. The group was formed to enhance
the integrity, efficiency, orderliness, and competitiveness of the U.S.
financial markets and maintain investor confidence in those markets.
[112] 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.
[113] The Financial Stability Forum comprises national financial
authorities (central banks, supervisory authorities, and finance
ministries) from the G7 countries, Australia, Hong Kong, Netherlands,
Singapore, and Switzerland, as well as international financial
institutions, international regulatory and supervisory groupings,
committees of central bank experts and the European Central Bank. In
April 2009, the Financial Stability Forum was re-established as the
Financial Stability Board, with a broadened mandate to promote
financial stability.
[114] The Senior Supervisors Group is composed of eight supervisory
agencies: France's Banking Commission, Germany's Federal Financial
Supervisory Authority, the Swiss Federal Banking Commission, the
Financial Services Authority, the Federal Reserve, the Federal Reserve
Bank of New York, OCC, and SEC.
[115] See GAO, Risk Based Capital: Bank Regulators Need to Improve
Transparency and Overcome Impediments to Finalizing Basel II Framework,
[hyperlink, http://www.gao.gov/products/GAO-07-253] (Washington, D.C.:
Feb. 15, 2007).
[116] In addition to the risk weights in table 2, a dollar-for-dollar
capital charge applies for certain recourse obligations. See 66 Fed.
Reg. 59614, 59620 (Nov. 29, 2001).
[117] As implemented in the United States, Basel I assigns reduced risk
weights to exposures collateralized by cash on deposit; securities
issued or guaranteed by central governments of Organization for
Economic Cooperation and Development countries, U.S. government
agencies, and U.S. government-sponsored enterprises; and securities
issued by multilateral lending institutions. Basel I also has limited
recognition of guarantees, such as those made by Organization for
Economic Cooperation and Development countries, central governments,
and certain other entities. See 12 C.F.R. Part 3 (OCC); 12 C.F.R. Parts
208 and 225 (Federal Reserve); 12 C.F.R. Part 325 (FDIC); and 12 C.F.R.
Part 567 (OTS).
[118] The Basel Committee defines operational risk as the risk of loss
resulting from inadequate or failed internal processes, people, and
systems or from external events, including legal risks, but excluding
strategic and reputational risk. Examples of operational risks include
fraud, legal settlements, systems failures, and business disruptions.
[119] Securitization is the process of pooling debt obligations and
dividing that pool into portions (called tranches) that can be sold as
securities in the secondary market. Banks can use securitization for
regulatory arbitrage purposes by, for example, selling high-quality
tranches of pooled credit exposures to third-party investors, while
retaining a disproportionate amount of the lower-quality tranches and
therefore, the underlying credit risk.
[120] 61 Fed. Reg. 47358 (Sept. 6, 1996).
[121] 66 Fed. Reg. 59614 (Nov. 29, 2001).
[End of section]
GAO's Mission:
The Government Accountability Office, the audit, evaluation and
investigative arm of Congress, exists to support Congress in meeting
its constitutional responsibilities and to help improve the performance
and accountability of the federal government for the American people.
GAO examines the use of public funds; evaluates federal programs and
policies; and provides analyses, recommendations, and other assistance
to help Congress make informed oversight, policy, and funding
decisions. GAO's commitment to good government is reflected in its core
values of accountability, integrity, and reliability.
Obtaining Copies of GAO Reports and Testimony:
The fastest and easiest way to obtain copies of GAO documents at no
cost is through GAO's Web site [hyperlink, http://www.gao.gov]. Each
weekday, GAO posts newly released reports, testimony, and
correspondence on its Web site. To have GAO e-mail you a list of newly
posted products every afternoon, go to [hyperlink, http://www.gao.gov]
and select "E-mail Updates."
Order by Phone:
The price of each GAO publication reflects GAO’s actual cost of
production and distribution and depends on the number of pages in the
publication and whether the publication is printed in color or black and
white. Pricing and ordering information is posted on GAO’s Web site,
[hyperlink, http://www.gao.gov/ordering.htm].
Place orders by calling (202) 512-6000, toll free (866) 801-7077, or
TDD (202) 512-2537.
Orders may be paid for using American Express, Discover Card,
MasterCard, Visa, check, or money order. Call for additional
information.
To Report Fraud, Waste, and Abuse in Federal Programs:
Contact:
Web site: [hyperlink, http://www.gao.gov/fraudnet/fraudnet.htm]:
E-mail: fraudnet@gao.gov:
Automated answering system: (800) 424-5454 or (202) 512-7470:
Congressional Relations:
Ralph Dawn, Managing Director, dawnr@gao.gov:
(202) 512-4400:
U.S. Government Accountability Office:
441 G Street NW, Room 7125:
Washington, D.C. 20548:
Public Affairs:
Chuck Young, Managing Director, youngc1@gao.gov:
(202) 512-4800:
U.S. Government Accountability Office:
441 G Street NW, Room 7149:
Washington, D.C. 20548: