Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System
GAO-09-739
Published: Jul 22, 2009. Publicly Released: Jul 22, 2009.
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Highlights
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.
Recommendations
Matter for Congressional Consideration
| Matter | Status | Comments |
|---|---|---|
| As Congress considers assigning a single regulator, a group of regulators, or a newly created entity with responsibility for overseeing systemically important firms, products, or activities to enhance the systemwide focus of the financial regulatory system, Congress may wish to consider the merits of tasking this systemic regulator with: (1) identifying ways to measure and monitor systemwide leverage and (2) evaluating options to limit procyclical leverage trends. | Congress passed the Dodd-Frank Act in 2010, which created the (1) Financial Stability Oversight Council (FSOC) and (2) Office of Financial Research (OFR). FSOC is charged with identifying risks to the financial stability of the United States; promoting market discipline; and responding to emerging risks to the stability of the U.S. financial system. On behalf of FSOC, OFR is responsible for, among other things, developing and maintaining metrics and reporting systems for risks to U.S. financial stability and monitoring and reporting changes in systemwide risk levels and patterns to FSOC. |
Recommendations for Executive Action
| Agency Affected | Recommendation | Status |
|---|---|---|
| Office of the Comptroller of the Currency | The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted. |
OCC, FDIC and the Federal Reserve approved a final rule on July 9, 2013 that offers fundamental changes to the current Basel regime. The new rule sets a new common equity tier 1 requirement and higher minimum tier 1 requirements for all banking organizations. It also places limits on capital distributions and certain discretionary bonus payments if a banking organization does not maintain a buffer of common equity tier 1 capital above minimum capital requirements. The rule revises the prompt corrective action framework to incorporate the new regulatory capital minimums. It also enhances risk sensitivity and addresses weaknesses identified over recent years with the measure of risk-weighted assets, including through new measures of creditworthiness to replace references to credit ratings, consistent with section 939A of the Dodd-Frank Act. Under the new capital rule, banking organizations with more than $50 billion in assets have enhanced disclosure requirements related to regulatory capital adequacy and risk management. Banking organizations subject to the advanced approaches capital rules also must meet a supplementary leverage ratio requirement that incorporates a broader set of exposures, a countercyclical capital buffer, and additional capital charges and standards for derivatives exposures.
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| Federal Reserve System | The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted. |
In a comment letter to the report, the Federal Reserve agreed that the financial crisis has revealed weaknesses in both the Basel-I and Basel-II based risk-based capital standards and concurred with the recommendation for a more fundamental review of the Basel II capital framework to assess whether this new framework would address concerns about the use of using banks' internal models to determine capital requirements. In 2010 the bank regulators jointly proposed revisions to the Basel II Market Risk Framework. The revisions placed additional prudential requirements on banks' internal models for measuring market risk and required enhanced qualitative and quantitative disclosures, particularly with respect to banks' securitization activities. To help prevent a recurrence of the dramatic increase in leverage that contributed to the losses from trading activities during the recent crisis, the proposals include an incremental capital charge to augment the existing Value at Risk capital charge.
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| Office of Thrift Supervision | The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted. |
OTS has been terminated. Thrifts that were supervised by OTS are now under the supervision of OCC. OCC has implemented this recommendation.
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| Federal Deposit Insurance Corporation | The current financial crisis has shown that risk models, as applied by many financial institutions and overseen by their regulators, could significantly underestimate the capital needed to absorb potential losses. Given that the Basel II approach would increase reliance on complex risk models for determining a financial institution's capital needs and place greater demands on regulators' judgment in assessing capital adequacy, the heads of the Federal Reserve, Federal Deposit Insurance Corporation (FDIC), Office of the Comptroller of the Currency (OCC), and Office of Thrift Supervision (OTS) should apply lessons learned from the current crisis and assess the extent to which Basel II reforms proposed by U.S. and international regulators may address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches. As part of this assessment, the regulators should determine whether consideration of more fundamental changes under a new Basel regime is warranted. |
In a comment letter to the report, FDIC said that the agency strongly endorses the report's recommendation that regulators undertake a fundamental review of Basel II to assess whether the framework would adequately address concerns about the use of banks' internal models to determine capital requirements. It further noted that it would consider this matter as part of the interagency review of Basel II that the agencies committed by regulation to undertake, and would propose suitable remedies as needed. In 2010, the regulators proposed revisions to the Market Risk Capital Framework. These revisions placed additional prudential requirements on the use of banks' internal models for measuring market risk and require enhanced qualitative and quantitative disclosures, particularly with respect to banks' securitization activities. To help prevent a recurrence of the dramatic increase in losses from trading activities during the recent crisis, the proposals include an incremental capital charge to augment the existing Value at Risk (VAR) capital charge.
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