United States Government Accountability Office

GAO

Testimony
Before the Committee on Banking,Housing, and Urban Affairs, U.S. Senate

For Release on Delivery
Expected at 3:00 p.m. EST
Wednesday, February 4, 2009

FINANCIAL REGULATION
A Framework for Crafting
and Assessing Proposals toModernize the Outdated
U.S. Financial Regulatory
SystemStatement of Gene L. Dodaro
Acting Comptroller General of the United States

GAO-09-349T

Mr. Chairman and Members of the Committee:
I am pleased to be here today to discuss our January 8, 2009, report thatprovides a framework for modernizing the outdated U.S. financial
regulatory system.1 We prepared this work under the authority of theComptroller General to help policymakers weigh various regulatory
reform proposals and consider ways in which the current regulatory
system could be made more effective and efficient. My statement today isbased on our report, which (1) describes how regulation has evolved inbanking, securities, thrifts, credit unions, futures, insurance, secondary
mortgage markets and other important areas; (2) describes several key
changes in financial markets and products in recent decades that havehighlighted significant limitations and gaps in the existing regulatory
system; and (3) presents an evaluation framework that can be used by
Congress and others to shape potential regulatory reform efforts. On
January 22, we released an update to our biennial High-Risk Series, which
described high-risk areas in federal programs, including focusing on theneed for broad-based transformations to address major economy,
efficiency, or effectiveness challenges. Based on recent economic eventsand our past work on financial regulatory reform, we added the need tomodernize the outdated U.S. financial regulatory system as a new high-riskarea this year.2
To do this work, we synthesized existing GAO work and other studies andmet with representatives of financial regulatory agencies, industry
associations, consumer advocacy organizations, and others. The work
upon which the report is based was conducted in accordance withgenerally 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 April 2008 andDecember 2008.

1

GAO, Financial Regulation: A Framework for Crafting and Assessing Proposals toModernize the Outdated U.S. Financial Regulatory System, GAO-09-216 (Washington,
D.C.: Jan. 8, 2009).
2

GAO, High Risk Series: An Update, GAO-09-271 (Washington, D.C.: Jan. 22, 2009).

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The report was enhanced by input from representatives of 29 agencies andother organizations, including federal and state financial regulatory
agencies, consumer advocacy groups, and financial service industry tradeassociations, who reviewed and commented on a draft of the report prior
to its release. A list of organizations that reviewed the draft report isincluded at the end of my statement. In general, reviewers commented thatthe report represented an important and thorough review of the issues
related to regulatory reform.

Summary

The current U.S. financial regulatory system has relied on a fragmented
and complex arrangement of federal and state regulators—put into placeover the past 150 years—that has not kept pace with major developments
in financial markets and products in recent decades. Today, almost adozen federal regulatory agencies, numerous self-regulatory organizations,and hundreds of state financial regulatory agencies share responsibility foroverseeing the financial services industry. As the nation finds itself in the
midst of one of the worst financial crises ever, it has become apparent thatthe regulatory system is ill-suited to meet the nation’s needs in the 21st
century.
Several key changes in financial markets and products in recent decades
have highlighted significant limitations and gaps in the existing regulatory
system.
•First, regulators have struggled, and often failed, to mitigate thesystemic risks posed by large and interconnected financial
conglomerates and to ensure they adequately manage their risks.

•

Second, regulators have had to address problems in financial markets
resulting from the activities of large and sometimes less-regulated
market participants—such as nonbank mortgage lenders, hedge funds,
and credit rating agencies—some of which play significant roles intoday’s financial markets.

•

Third, the increasing prevalence of new and more complex investment
products has challenged regulators and investors, and consumers have
faced difficulty understanding new and increasingly complex retailmortgage and credit products.

•

Fourth, standard setters for accounting and financial regulators have
faced growing challenges in ensuring that accounting and audit

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standards appropriately respond to financial market developments, andin addressing challenges arising from the global convergence ofaccounting and auditing standards.
•

Finally, as financial markets have become increasingly global, thecurrent fragmented U.S. regulatory structure has complicated someefforts to coordinate internationally with other regulators.

These significant developments have outpaced a fragmented and outdated
regulatory structure, and, as a result, significant reforms to the U.S.
regulatory system are critically and urgently needed. The current system
has significant weaknesses that, if not addressed, will continue to expose
the nation’s financial system to serious risks. Our report offers aframework for crafting and evaluating regulatory reform proposals
consisting of nine characteristics that should be reflected in any new
regulatory system. By applying the elements of the framework, the relative
strengths and weaknesses of any reform proposal should be better
revealed, and policymakers should be able to focus on identifying tradeoffs and balancing competing goals. Similarly, the framework could be
used to craft proposals, or to identify aspects to be added to existing
proposals to make them more effective and appropriate for addressing thelimitations of the current system.

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Table 1: Framework for Crafting and Evaluating Regulatory Reform Proposals
Characteristic

Description

9

Clearly defined
regulatory goals

Goals should be clearly articulated and relevant, so that regulators can effectively carry out their missions
and be held accountable. Key issues include considering the benefits of re-examining the goals offinancial regulation to gain needed consensus and making explicit a set of updated comprehensive andcohesive goals that reflect today’s environment.

9

Appropriately
comprehensive

Financial regulations should cover all activities that pose risks or are otherwise important to meeting
regulatory goals and should ensure that appropriate determinations are made about how extensive such
regulations should be, considering that some activities may require less regulation than others. Key
issues include identifying risk-based criteria, such as a product’s or institution’s potential to create
systemic problems, for determining the appropriate level of oversight for financial activities andinstitutions, including closing gaps that contributed to the current crisis.

9

Systemwide
focus

Mechanisms should be included for identifying, monitoring, and managing risks to the financial system
regardless of the source of the risk. Given that no regulator is currently tasked with this, key issues
include determining how to effectively monitor market developments to identify potential risks; the degree,
if any, to which regulatory intervention might be required; and who should hold such responsibilities.

9

Flexible andadaptable

A regulatory system that is flexible and forward looking allows regulators to readily adapt to market
innovations and changes. Key issues include identifying and acting on emerging risks in a timely way
without hindering innovation.

9

Efficient andeffective

Effective and efficient oversight should be developed, including eliminating overlapping federal regulatory
missions where appropriate, and minimizing regulatory burden without sacrificing effective oversight. Anychanges to the system should be continually focused on improving the effectiveness of the financial
regulatory system. Key issues include determining opportunities for consolidation given the large numberof overlapping participants now, identifying the appropriate role of states and self-regulation, and ensuring
a smooth transition to any new system.

9

Consistentconsumer andinvestorprotection

Consumer and investor protection should be included as part of the regulatory mission to ensure thatmarket participants receive consistent, useful information, as well as legal protections for similar financial
products and services, including disclosures, sales practice standards, and suitability requirements. Key
issues include determining what amount, if any, of consolidation of responsibility may be necessary to
streamline consumer protection activities across the financial services industry.

9

Regulators
provided withindependence,prominence,authority, andaccountability

Regulators should have independence from inappropriate influence, as well as prominence and authority
to carry out and enforce statutory missions, and be clearly accountable for meeting regulatory goals. With
regulators with varying levels of prominence and funding schemes now, key issues include how toappropriately structure and fund agencies to ensure that each one’s structure sufficiently achieves thesecharacteristics.

9

Consistentfinancialoversight

Similar institutions, products, risks, and services should be subject to consistent regulation, oversight, andtransparency, which should help minimize negative competitive outcomes while harmonizing oversight,
both within the United States and internationally. Key issues include identifying activities that pose similarrisks, and streamlining regulatory activities to achieve consistency.

9

Minimal taxpayer A regulatory system should foster financial markets that are resilient enough to absorb failures andexposure
thereby limit the need for federal intervention and limit taxpayers’ exposure to financial risk. Key issues
include identifying safeguards to prevent systemic crises and minimizing moral hazard.
Source: GAO.

As the administration and Congress continue to take actions to address
the immediate financial crisis, determining how to create a regulatory
system that reflects new market realities is a key step to reducing thePage 4

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likelihood that the United States will experience another financial crisis
similar to the current one.

Today’s Financial
Regulatory System
Was Built over the
Course of More Thana Century, Largely in
Response to Crises orMarket Developments

As a result of 150 years of changes in financial regulation in the UnitedStates, the regulatory system has become complex and fragmented. Today,
responsibilities for overseeing the financial services industry are shared
among almost a dozen federal banking, securities, futures, and otherregulatory agencies, numerous self-regulatory organizations, and hundredsof state financial regulatory agencies. In particular, five federal agencies—
including the Federal Deposit Insurance Corporation, the Federal Reserve,
the Office of the Comptroller of the Currency, the Office of Thrift
Supervision, and the National Credit Union Administration—and multiple
state agencies oversee depository institutions. Securities activities areoverseen by the Securities and Exchange Commission and state
government entities, as well as by private sector organizations performing
self-regulatory functions. Futures trading is overseen by the Commodity
Futures Trading Commission and also by industry self-regulatoryorganizations. Insurance activities are primarily regulated at the state levelwith little federal involvement. Other federal regulators also play
important roles in the financial regulatory system, such as the PublicCompany Accounting Oversight Board, which oversees the activities ofpublic accounting firms, and the Federal Trade Commission, which acts as
the primary federal agency responsible for enforcing compliance withfederal consumer protection laws for financial institutions, such as financecompanies, which are not overseen by another financial regulator.
Much of this structure has developed as the result of statutory andregulatory changes that were often implemented in response to financial
crises or significant developments in the financial services sector. For
example, the Federal Reserve System was created in 1913 in response tofinancial panics and instability around the turn of the century, and much of
the remaining structure for bank and securities regulation was created as
the result of the Great Depression turmoil of the 1920s and 1930s. Changes
in the types of financial activities permitted for depository institutions andtheir affiliates have also shaped the financial regulatory system over time.
For example, under the Glass-Steagall provisions of the Banking Act of
1933, financial institutions were prohibited from simultaneously offeringcommercial and investment banking services, but with the passage of theGramm-Leach-Bliley Act of 1999 (GLBA), Congress permitted financial
institutions to fully engage in both types of activities.

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Changes in Financial
Institutions and Their
Products Have
Significantly
Challenged the U.S.
Financial Regulatory
SystemSeveral key developments in financial markets and products in the pastfew decades have significantly challenged the existing financial regulatory
structure. (See fig. 1.) First, the last 30 years have seen waves of mergers
among financial institutions within and across sectors, such that theUnited States, while still having large numbers of financial institutions,also has several very large globally active financial conglomerates thatengage in a wide range of activities that have become increasinglyinterconnected. Regulators have struggled, and often failed, to mitigate thesystemic risks posed by these conglomerates, and to ensure theyadequately manage their risks. The portion of firms that conduct activities
across the financial sectors of banking, securities, and insurance increased
significantly in recent years, but none of the regulators is tasked withassessing the risks posed across the entire financial system.
A second dramatic development in U.S. financial markets in recent
decades has been the increasingly critical roles played by less-regulated
entities. In the past, consumers of financial products generally dealt withentities such as banks, broker-dealers, and insurance companies that wereregulated by a federal or state regulator. However, in the last few decades,
various entities—nonbank lenders, hedge funds, credit rating agencies,
and special-purpose investment entities—that are not always subject tofull regulation by such authorities have become important participants in
our financial services markets. These unregulated or less regulated entities
can sometimes provide substantial benefits by supplying information or
allowing financial institutions to better meet demands of consumers,
investors or shareholders, but pose challenges to regulators that do not
fully or cannot oversee their activities. For example, significant
participation in the subprime mortgage market by generally less-regulated
nonbank lenders contributed to a dramatic loosening in underwriting
standards leading up to the current financial crisis.
A third development that has revealed limitations in the current regulatory
structure has been the proliferation of more complex financial products.
In particular, the increasing prevalence of new and more complex
investment products has challenged regulators and investors, andconsumers have faced difficulty understanding new and increasingly
complex retail mortgage and credit products. Regulators failed toadequately oversee the sale of mortgage products that posed risks to
consumers and the stability of the financial system.
Fourth, standard setters for accounting and financial regulators have faced
growing challenges in ensuring that accounting and audit standards
appropriately respond to financial market developments, and inPage 6

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addressing challenges arising from the global convergence of accounting
and auditing standards.
Finally, with the increasingly global aspects of financial markets, thecurrent fragmented U.S. regulatory structure has complicated some efforts
to coordinate internationally with other regulators. For example, thecurrent system has complicated the ability of financial regulators toconvey a single U.S. position in international discussions, such the Basel
Accords process for developing international capital standards, andinternational officials have also indicated that the lack of a single point ofcontact on, for example, insurance issues has complicated regulatory
decision making.

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Figure 1: Key Developments and Resulting Challenges That Have Hindered the Effectiveness of the Financial Regulatory
SystemDevelopments in financial markets and productsFi
ma nanciar
com ket siz linte plexi e,
rac ty,tionsEmergence 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 andmitigate risks.
Identifying, preventing, mitigating, and resolving systemic crises has become moredifficult.

Less-regulated entities havecome to play increasingly
critical roles in financial
systemNonbank 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 disclosureand exacerbated recent market instability.

New and complex productsthat pose challenges tofinancial stability andinvestor and consumer
understanding of risks.

Complex structured finance products have made it difficult for institutions and theirregulators to manage associated risks.
Growth in complex and less-regulated over-the-counter derivatives markets havecreated 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 ofinvestors and other financial market participants.

Financial markets havebecome increasingly global
in nature, and regulators
have had to coordinate
their efforts internationally.

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).

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A Framework for
Crafting andAssessing Alternatives
for Reforming the U.S.
Financial Regulatory
SystemAs a result of significant market developments in recent decades that haveoutpaced a fragmented and outdated regulatory structure, significant
reforms to the U.S. regulatory system are critically and urgently needed.
The current system has important weaknesses that, if not addressed, willcontinue to expose the nation’s financial system to serious risks. As early
as 1994, we identified the need to examine the federal financial regulatory
structure, including the need to address the risks from new unregulated
products.3 Since then, we have described various options for Congress toconsider, each of which provides potential improvements, as well as somerisks and potential costs.4 Our report offers a framework for crafting andevaluating regulatory reform proposals; it consists of the following ninecharacteristics that should be reflected in any new regulatory system. By
applying the elements of this framework, the relative strengths andweaknesses of any reform proposal should be better revealed, andpolicymakers should be able to focus on identifying trade-offs andbalancing competing goals. Similarly, the framework could be used tocraft proposals, or to identify aspects to be added to existing proposals to
make them more effective and appropriate for addressing the limitationsof the current system.
1. Clearly defined regulatory goals. A regulatory system shouldhave goals that are clearly articulated and relevant, so that
regulators can effectively conduct activities to implement their
missions.
A critical first step to modernizing the regulatory system and enhancing its
ability to meet the challenges of a dynamic financial services industry is toclearly define regulatory goals and objectives. In the background of ourreport, we identified four broad goals of financial regulation that
regulators have generally sought to achieve. These include ensuring
adequate consumer protections, ensuring the integrity and fairness ofmarkets, monitoring the safety and soundness of institutions, and acting toensure the stability of the overall financial system. However, these goals
are not always explicitly set in the federal statutes and regulations thatgovern these regulators. Having specific goals clearly articulated in

3

GAO, Financial Derivatives: Actions Needed to Protect the Financial System,
GAO/GGD-94-133 (Washington, D.C.: May 18, 1994).
4

GAO, Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure, GAO-05-61 (Washington, D.C.: Oct. 6, 2004); and Financial
Regulation: Industry Trends Continue to Challenge the Federal Regulatory Structure,
GAO-08-32 (Washington, D.C.: Oct. 12, 2007).

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legislation could serve to better focus regulators on achieving their
missions with greater certainty and purpose, and provide continuity overtime.
Given some of the key changes in financial markets discussed in ourreport—particularly the increased interconnectedness of institutions, theincreased complexity of products, and the increasingly global nature offinancial markets—Congress should consider the benefits that may result
from re-examining the goals of financial regulation and making explicit a
set of comprehensive and cohesive goals that reflect today’s environment.
For example, it may be beneficial to have a clearer focus on ensuring that
products are not sold with unsuitable, unfair, deceptive, or abusive
features; that systemic risks and the stability of the overall financial
system are specifically addressed; or that U.S. firms are competitive in a
global environment. This may be especially important given the history offinancial regulation and the ad hoc approach through which the existing
goals have been established.
We found varying views about the goals of regulation and how they should
be prioritized. For example, representatives of some regulatory agencies
and industry groups emphasized the importance of creating a competitive
financial system, whereas members of one consumer advocacy group
noted that reforms should focus on improving regulatory effectivenessrather than addressing concerns about market competitiveness. In
addition, as the Federal Reserve notes, financial regulatory goals often will
prove interdependent and at other times may conflict.
Revisiting the goals of financial regulation would also help ensure that all
involved entities—legislators, regulators, institutions, and consumers—areable to work jointly to meet the intended goals of financial regulation.
Such goals and objectives could help establish agency priorities and define
responsibility and accountability for identifying risks, including those thatcross markets and industries. Policymakers should also carefully define
jurisdictional lines and weigh the advantages and disadvantages of having
overlapping authorities. While ensuring that the primary goals of financial
regulation—including system soundness, market integrity, and consumer
protection—are better articulated for regulators, policymakers will also
have to ensure that regulation is balanced with other national goals,
including facilitating capital raising, innovation, and other benefits that
foster long-term growth, stability, and welfare of the United States.
Once these goals are agreed upon, policymakers will need to determine
the extent to which goals need to be clarified and specified through rules

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and requirements, or whether to avoid such specificity and provide
regulators with greater flexibility in interpreting such goals. Some reform
proposals suggest “principles-based regulation” in which regulators apply
broad-based regulatory principles on a case-by-case basis. Such an
approach offers the potential advantage of allowing regulators to better
adapt to changing market developments. Proponents also note that suchan approach would prevent institutions in a more rules-based system fromcomplying with the exact letter of the law while still engaging in unsoundor otherwise undesirable financial activities. However, such an approachhas potential limitations. Opponents note that regulators may facechallenges to implement such a subjective set of principles. A lack of clear
rules about activities could lead to litigation if financial institutions andconsumers alike disagree with how regulators interpreted goals.
Opponents of principles-based regulation note that industry participants
who support such an approach have also in many cases advocated forbright-line standards and increased clarity in regulation, which may be
counter to a principles-based system. The most effective approach may
involve both a set of broad underlying principles and some clear technicalrules prohibiting specific activities that have been identified asproblematic.
Key issues to be addressed:•

Clarify and update the goals of financial regulation and provide
sufficient information on how potentially conflicting goals might beprioritized.

•

Determine the appropriate balance of broad principles and specificrules that will result in the most effective and flexible
implementation of regulatory goals.

2. Appropriately comprehensive. A regulatory system should
ensure that financial institutions and activities are regulated ina way that ensures regulatory goals are fully met. As such,activities that pose risks to consumer protection, financial
stability, or other goals should be comprehensively regulated,while recognizing that not all activities will require the samelevel of regulation.
A financial regulatory system should effectively meet the goals of financial
regulation, as articulated as part of this process, in a way that is
appropriately comprehensive. In doing so, policymakers may want toconsider how to ensure that both the breadth and depth of regulation are

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appropriate and adequate. That is, policymakers and regulators should
consider how to make determinations about which activities and products,
both new and existing, require some aspect of regulatory involvement tomeet regulatory goals, and then make determinations about how extensive
such regulation should be. As we noted in our report, gaps in the current
level of federal oversight of mortgage lenders, credit rating agencies, andcertain complex financial products such as CDOs and credit default swaps
likely have contributed to the current crisis. Congress and regulators may
also want to revisit the extent of regulation for entities such as banks thathave traditionally fallen within full federal oversight but for which existing
regulatory efforts, such as oversight related to risk management andlending standards, have been proven in some cases inadequate by recent
events. However, overly restrictive regulation can stifle the financial
sectors’ ability to innovate and stimulate capital formation and economic
growth. Regulators have struggled to balance these competing objectives,
and the current crisis appears to reveal that the proper balance was not inplace in the regulatory system to date.
Key issues to be addressed:•

Identify risk-based criteria, such as a product’s or institution’s
potential to harm consumers or create systemic problems, fordetermining the appropriate level of oversight for financial activities
and institutions.

•

Identify ways that regulation can provide protection but avoid
hampering innovation, capital formation, and economic growth.

3. Systemwide focus. A regulatory system should include amechanism for identifying, monitoring, and managing risks to
the financial system regardless of the source of the risk or the
institutions in which it is created.
A regulatory system should focus on risks to the financial system, not justinstitutions. As noted in our report, with multiple regulators primarily
responsible for individual institutions or markets, none of the financial
regulators is tasked with assessing the risks posed across the entire
financial system by a few institutions or by the collective activities of theindustry. The collective activities of a number of entities—including
mortgage brokers, real estate professionals, lenders, borrowers, securities
underwriters, investors, rating agencies and others—likely all contributed
to the recent market crisis, but no one regulator had the necessary scopeof oversight to identify the risks to the broader financial system. Similarly,

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once firms began to fail and the full extent of the financial crisis began to
become clear, no formal mechanism existed to monitor market trends andpotentially stop or help mitigate the fallout from these events.
Having a single entity responsible for assessing threats to the overall
financial system could prevent some of the crises that we have seen in thepast. For example, in its Blueprint for a Modernized Financial
Regulatory Structure, Treasury proposed expanding the responsibilities of
the Federal Reserve to create a “market stability regulator” that would
have broad authority to gather and disclose appropriate information,
collaborate with other regulators on rulemaking, and take corrective
action as necessary in the interest of overall financial market stability.
Such a regulator could assess the systemic risks that arise at financial
institutions, within specific financial sectors, across the nation, andglobally. However, policymakers should consider that a potential
disadvantage of providing the agency with such broad responsibility foroverseeing nonbank entities could be that it may imply an official
government support or endorsement, such as a government guarantee, ofsuch activities, and thus encourage greater risk taking by these financial
institutions and investors.
Regardless of whether a new regulator is created, all regulators under a
new system should consider how their activities could better identify andaddress systemic risks posed by their institutions. As the Federal Reserve
Chairman has noted, regulation and supervision of financial institutions isa critical tool for limiting systemic risk. This will require broadening the
focus from individual safety and soundness of institutions to a systemwide
oversight approach that includes potential systemic risks and weaknesses.
A systemwide focus should also increase attention on how the incentives
and constraints created by regulations affects risk taking throughout thebusiness cycle, and what actions regulators can take to anticipate andmitigate such risks. However, as the Federal Reserve Chairman has noted,
the more comprehensive the approach, the more technically demanding
and costly it would be for regulators and affected institutions.
Key issues to be addressed:•

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Identify approaches to broaden the focus of individual regulators or
establish new regulatory mechanisms for identifying and acting on
systemic risks.

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•

Determine what additional authorities a regulator or regulators
should have to monitor and act to reduce systemic risks.

4. Flexible and adaptable. A regulatory system should be
adaptable and forward-looking such that regulators can readily
adapt to market innovations and changes and include amechanism for evaluating potential new risks to the system.
A regulatory system should be designed such that regulators can readily
adapt to market innovations and changes and include a formal mechanism
for evaluating the full potential range of risks of new products andservices to the system, market participants, and customers. An effective
system could include a mechanism for monitoring market developments—
such as broad market changes that introduce systemic risk, or new
products and services that may pose more confined risks to particularmarket segments—to determine the degree, if any, to which regulatoryintervention might be required. The rise of a very large market for credit
derivatives, while providing benefits to users, also created exposures thatwarranted actions by regulators to rescue large individual participants inthis market. While efforts are under way to create risk-reducing clearing
mechanisms for this market, a more adaptable and responsive regulatory
system might have recognized this need earlier and addressed it sooner.
Some industry representatives have suggested that principles-based
regulation would provide such a mechanism. Designing a system to beflexible and proactive also involves determining whether Congress,
regulators, or both should make such determinations, and how such an
approach should be clarified in laws or regulations.
Important questions also exist about the extent to which financial
regulators should actively monitor and, where necessary, approve newfinancial products and services as they are developed to ensure the least
harm from inappropriate products. Some individuals commenting on thisframework, including industry representatives, noted that limiting
government intervention in new financial activities until it has become
clear that a particular activity or market poses a significant risk andtherefore warrants intervention may be more appropriate. As with otherkey policy questions, this may be answered with a combination of both
approaches, recognizing that a product approval approach may beappropriate for some innovations with greater potential risk, while otheractivities may warrant a more reactive approach.

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Key issues to be addressed:•

Determine how to effectively monitor market developments to
identify potential risks; the degree, if any, to which regulatoryintervention might be required; and who should hold such a
responsibility.

•

Consider how to strike the right balance between overseeing new
products as they come onto the market to take action as needed toprotect consumers and investors, without unnecessarily hindering
innovation.

5. Efficient and effective. A regulatory system should provide
efficient oversight of financial services by eliminating
overlapping federal regulatory missions, where appropriate,
and minimizing regulatory burden while effectively achieving
the goals of regulation.
A regulatory system should provide for the efficient and effective oversightof financial services. Accomplishing this in a regulatory system involves
many considerations. First, an efficient regulatory system is designed toaccomplish its regulatory goals using the least amount of public resources.
In this sense, policymakers must consider the number, organization, andresponsibilities of each agency, and eliminate undesirable overlap inagency activities and responsibilities. Determining what is undesirable
overlap is a difficult decision in itself. Under the current U.S. system,
financial institutions often have several options for how to operate theirbusiness and who will be their regulator. For example, a new or existing
depository institution can choose among several charter options. Having
multiple regulators performing similar functions does allow for theseagencies to potentially develop alternative or innovative approaches toregulation separately, with the approach working best becoming known
over time. Such proven approaches can then be adopted by the otheragencies. On the other hand, this could lead to regulatory arbitrage, inwhich institutions take advantage of variations in how agencies implement
regulatory responsibilities in order to be subject to less scrutiny. Bothsituations have occurred under our current structure.
With that said, recent events clearly have shown that the fragmented U.S.
regulatory structure contributed to failures by the existing regulators toadequately protect consumers and ensure financial stability. As we note inour report, efforts by regulators to respond to the increased risks
associated with new mortgage products were sometimes slowed in part

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because of the need for five federal regulators to coordinate their
response. The Chairman of the Federal Reserve has similarly noted thatthe different regulatory and supervisory regimes for lending institutions
and mortgage brokers made monitoring such institutions difficult for both
regulators and investors. Similarly, we noted in our report that the current
fragmented U.S. regulatory structure has complicated some efforts tocoordinate internationally with other regulators.
One first step to addressing such problems is to seriously consider theneed to consolidate depository institution oversight among fewer
agencies. Since 1996, we have been recommending that the number offederal agencies with primary responsibilities for bank oversight be
reduced.5 Such a move would result in a system that was more efficientand improve consistency in regulation, another important characteristic ofan effective regulatory system. In addition, Congress could consider theadvantages and disadvantages of providing a federal charter option for
insurance and creating a federal insurance regulatory entity. We have notstudied the issue of an optional federal charter for insurers, but havethrough the years noted difficulties with efforts to harmonize insurance
regulation across states through the NAIC-based structure. The
establishment of a federal insurance charter and regulator could help
alleviate some of these challenges, but such an approach could also haveunintended consequences for state regulatory bodies and for insurance
firms as well.
Also, given the challenges associated with increasingly complex
investment and retail products as discussed earlier, policymakers willneed to consider how best to align agency responsibilities to better ensurethat consumers and investors are provided with clear, concise, andeffective disclosures for all products.
Organizing agencies around regulatory goals as opposed to the existing
sector-based regulation may be one way to improve the effectiveness ofthe system, especially given some of the market developments discussed
earlier. Whatever the approach, policymakers should seek to minimize
conflict in regulatory goals across regulators, or provide for efficientmechanisms to coordinate in cases where goals inevitably overlap. For
example, in some cases, the safety and soundness of an individual5

See GAO, Bank Oversight: Fundamental Principles for Modernizing the U.S. Structure,
GAO/T-GGD-96-117 (Washington, D.C.: May 2, 1996).

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institution may have implications for systemic risk, or addressing an unfair
or deceptive act or practice at a financial institution may have implications
on the institution’s safety and soundness by increasing reputational risk. If
a regulatory system assigns these goals to different regulators, it will be
important to establish mechanisms for them to coordinate.
Proposals to consolidate regulatory agencies for the purpose of promoting
efficiency should also take into account any potential trade-offs related toeffectiveness. For example, to the extent that policymakers see value inthe ability of financial institutions to choose their regulator, consolidating
certain agencies may reduce such benefits. Similarly, some individuals
have commented that the current system of multiple regulators has led tothe development of expertise among agency staff in particular areas offinancial market activities that might be threatened if the system were to
be consolidated. Finally, policymakers may want to ensure that any
transition from the current financial system to a new structure should
minimize as best as possible any disruption to the operation of financial
markets or risks to the government, especially given the current
challenges faced in today’s markets and broader economy.
A financial system should also be efficient by minimizing the burden on
regulated entities to the extent possible while still achieving regulatory
goals. Under our current system, many financial institutions, andespecially large institutions that offer services that cross sectors, aresubject to supervision by multiple regulators. While steps toward
consolidated supervision and designating primary supervisors have helped
alleviate some of the burden, industry representatives note that many
institutions face significant costs as a result of the existing financial
regulatory system that could be lessened. Such costs, imposed in an effort
to meet certain regulatory goals such as safety and soundness andconsumer protection, can run counter to other goals of a financial system
by stifling innovation and competitiveness. In addressing this concern, it isalso important to consider the potential benefits that might result in somecases from having multiple regulators overseeing an institution. For
example, representatives of state banking and other institution regulators,
and consumer advocacy organizations, note that concurrent jurisdiction—
between two federal regulators or a federal and state regulator—canprovide needed checks and balances against individual financial regulators
who have not always reacted appropriately and in a timely way to address
problems at institutions. They also note that states may move more quickly
and more flexibly to respond to activities causing harm to consumers.
Some types of concurrent jurisdiction, such as enforcement authority, may

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be less burdensome to institutions than others, such as ongoingsupervision and examination.
Key issues to be addressed:•

Consider the appropriate role of the states in a financial regulatory
system and how federal and state roles can be better harmonized.

•

Determine and evaluate the advantages and disadvantages of having
multiple regulators, including nongovernmental entities such as
SROs, share responsibilities for regulatory oversight.

•

Identify ways that the U.S. regulatory system can be made more
efficient, either through consolidating agencies with similar roles or
through minimizing unnecessary regulatory burden.

•

Consider carefully how any changes to the financial regulatory
system may negatively impact financial market operations and thebroader economy, and take steps to minimize such consequences.

6. Consistent consumer and investor protection. A regulatory
system should include consumer and investor protection as partof the regulatory mission to ensure that market participantsreceive consistent, useful information, as well as legal
protections for similar financial products and services,
including disclosures, sales practice standards, and suitability
requirements.
A regulatory system should be designed to provide high-quality, effective,
and consistent protection for consumers and investors in similar
situations. In doing so, it is important to recognize important distinctions
between retail consumers and more sophisticated consumers such as
institutional investors, where appropriate considering the context of thesituation. Different disclosures and regulatory protections may benecessary for these different groups. Consumer protection should beviewed from the perspective of the consumer rather than through thevarious and sometimes divergent perspectives of the multitude of federal
regulators that currently have responsibilities in this area.
As discussed in our report, many consumers that received loans in the last
few years did not understand the risks associated with taking out theirloans, especially in the event that housing prices would not continue toincrease at the rate they had in recent years. In addition, increasing

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evidence exists that many Americans are lacking in financial literacy, andthe expansion of new and more complex products will continue to create
challenges in this area. Furthermore, regulators with existing authority tobetter protect consumers did not always exercise that authority
effectively. In considering a new regulatory system, policymakers should
consider the significant lapses in our regulatory system’s focus on
consumer protection and ensure that such a focus is prioritized in any
reform efforts. For example, policymakers should identify ways toimprove upon the existing, largely fragmented, system of regulators thatmust coordinate to act in these areas. This should include serious
consideration of whether to consolidate regulatory responsibilities tostreamline and improve the effectiveness of consumer protection efforts.
Another way that some market observers have argued that consumer
protections could be enhanced and harmonized across products is toextend suitability requirements—which require securities brokers making
recommendations to customers to have reasonable grounds for believingthat the recommendation is suitable for the customer—to mortgage andother products. Additional consideration could also be given to
determining whether certain products are simply too complex to be wellunderstood and make judgments about limiting or curtailing their use.
Key issues to be addressed:•

Consider how prominent the regulatory goal of consumer
protection should be in the U.S. financial regulatory system.

•

Determine what amount, if any, of consolidation of responsibility
may be necessary to enhance and harmonize consumer protections,
including suitability requirements and disclosures across thefinancial services industry.

•

Consider what distinctions are necessary between retail andwholesale products, and how such distinctions should affect how
they are regulated.

•

Identify opportunities to protect and empower consumers throughimproving their financial literacy.

7. Regulators provided with independence, prominence,authority, and accountability. A regulatory system should
ensure that regulators have independence from inappropriate
influence; have sufficient resources, clout, and authority tocarry out and enforce statutory missions; and are clearly

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accountable for meeting regulatory goals.
A regulatory system should ensure that any entity responsible for financial
regulation is independent from inappropriate influence; has adequate
prominence, authority, and resources to carry out and enforce its statutory
mission; and is clearly accountable for meeting regulatory goals. With
respect to independence, policymakers may want to consider advantages
and disadvantages of different approaches to funding agencies, especiallyto the extent that agencies might face difficulty remaining independent if
they are funded by the institutions they regulate. Under the current
structure, for example, the Federal Reserve primarily is funded by income
earned from U.S. government securities that it has acquired through open
market operations and does not assess charges to the institutions it
oversees. In contrast, OCC and OTS are funded primarily by assessmentson the firms they supervise. Decision makers should consider whether
some of these various funding mechanisms are more likely to ensure that aregulator will take action against its regulated institutions without regard
to the potential impact on its own funding.
With respect to prominence, each regulator must receive appropriate
attention and support from top government officials. Inadequate
prominence in government may make it difficult for a regulator to raisesafety and soundness or other concerns to Congress and theadministration in a timely manner. Mere knowledge of a deteriorating
situation would be insufficient if a regulator were unable to persuadeCongress and the administration to take timely corrective action. This
problem would be exacerbated if a regulated institution had more politicalclout and prominence than its regulator because the institution could
potentially block action from being taken.
In considering authority, agencies must have the necessary enforcement
and other tools to effectively implement their missions to achieve
regulatory goals. For example, in a 2007 report we expressed concerns
over the appropriateness of having OTS oversee diverse global financial
firms given the size of the agency relative to the institutions for which it
was responsible.6 It is important for a regulatory system to ensure thatagencies are provided with adequate resources and expertise to conduct

6
GAO, Financial Market Regulation: Agencies Engaged in Consolidated Supervision Can
Strengthen Performance Measurement and Collaboration, GAO-07-154 (Washington, D.C.:
Mar. 15, 2007).

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their work effectively. A regulatory system should also include adequate
checks and balances to ensure the appropriate use of agency authorities.
With respect to accountability, policymakers may also want to consider
different governance structures at agencies—the current system includes a
combination of agency heads and independent boards or commissions—and how to ensure that agencies are recognized for successes and held
accountable for failures to act in accordance with regulatory goals.
Key issues to be addressed:•

Determine how to structure and fund agencies to ensure each has
adequate independence, prominence, tools, authority andaccountability.

•

Consider how to provide an appropriate level of authority to anagency while ensuring that it appropriately implements its mission
without abusing its authority.

•

Ensure that the regulatory system includes effective mechanisms
for holding regulators accountable.

8. Consistent financial oversight. A regulatory system should
ensure that similar institutions, products, risks, and services
are subject to consistent regulation, oversight, andtransparency, which should help minimize negative competitive
outcomes while harmonizing oversight, both within the UnitedStates and internationally.
A regulatory system should ensure that similar institutions, products, andservices posing similar risks are subject to consistent regulation,
oversight, and transparency. Identifying which institutions and which of
their products and services pose similar risks is not easy and involves anumber of important considerations. Two institutions that look very
similar may in fact pose very different risks to the financial system, andtherefore may call for significantly different regulatory treatment.
However, activities that are done by different types of financial institutions
that pose similar risks to their institutions or the financial system should
be regulated similarly to prevent competitive disadvantages between
institutions.
Streamlining the regulation of similar products across sectors could also
help prepare the United States for challenges that may result fromincreased globalization and potential harmonization in regulatory

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standards. Such efforts are under way in other jurisdictions. For example,
at a November 2008 summit in the United States, the Group of 20 countries
pledged to strengthen their regulatory regimes and ensure that all financial
markets, products, and participants are consistently regulated or subject
to oversight, as appropriate to their circumstances. Similarly, a working
group in the European Union is slated by the spring of 2009 to propose
ways to strengthen European supervisory arrangements, including
addressing how their supervisors should cooperate with other major
jurisdictions to help safeguard financial stability globally. Promoting
consistency in regulation of similar products should be done in a way that
does not sacrifice the quality of regulatory oversight.
As we noted in a 2004 report, different regulatory treatment of bank andfinancial holding companies, consolidated supervised entities, and otherholding companies may not provide a basis for consistent oversight of
their consolidated risk management strategies, guarantee competitive
neutrality, or contribute to better oversight of systemic risk.7 Recent
events further underscore the limitations brought about when there is alack of consistency in oversight of large financial institutions. As such,
Congress and regulators will need to seriously consider how best to
consolidate responsibilities for oversight of large financial conglomerates
as part of any reform effort.
Key issues to be addressed:•

Identify institutions and products and services that pose similarrisks.

•

Determine the level of consolidation necessary to streamline
financial regulation activities across the financial services industry.

•

Consider the extent to which activities need to be coordinatedinternationally.

9. Minimal taxpayer exposure. A regulatory system should haveadequate safeguards that allow financial institution failures tooccur while limiting taxpayers’ exposure to financial risk.

7

GAO-05-61.

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A regulatory system should have adequate safeguards that allow financial
institution failures to occur while limiting taxpayers’ exposure to financial
risk. Policymakers should consider identifying the best safeguards andassignment of responsibilities for responding to situations where
taxpayers face significant exposures, and should consider providing clear
guidelines when regulatory intervention is appropriate. While an ideal
system would allow firms to fail without negatively affecting other firms—
and therefore avoid any moral hazard that may result—policymakers andregulators must consider the realities of today’s financial system. In somecases, the immediate use of public funds to prevent the failure of a
critically important financial institution may be a worthwhile use of suchfunds if it ultimately serves to prevent a systemic crisis that would resultin much greater use of public funds in the long run. However, an effective
regulatory system that incorporates the characteristics noted previously,
especially by ensuring a systemwide focus, should be better equipped to
identify and mitigate problems before it become necessary to makedecisions about whether to let a financial institution fail.
An effective financial regulatory system should also strive to minimize
systemic risks resulting from interrelationships between firms andlimitations in market infrastructures that prevent the orderly unwinding offirms that fail. Another important consideration in minimizing taxpayer
exposure is to ensure that financial institutions provided with agovernment guarantee that could result in taxpayer exposure are also
subject to an appropriate level of regulatory oversight to fulfill their
responsibilities.
Key issues to be addressed:•

Identify safeguards that are most appropriate to prevent systemiccrises while minimizing moral hazard.

•

Consider how a financial system can most effectively minimize
taxpayer exposure to losses related to financial instability.

Finally, although significant changes may be required to modernize theU.S. financial regulatory system, policymakers should consider carefully
how best to implement the changes in such a way that the transition to a
new structure does not hamper the functioning of the financial markets,
individual financial institutions’ ability to conduct their activities, andconsumers’ ability to access needed services. For example, if the changes
require regulators or institutions to make systems changes, fileregistrations, or other activities that could require extensive time to

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complete, the changes could be implemented in phases with specific target
dates around which the affected entities could formulate plans. In
addition, our past work has identified certain critical factors that should
be addressed to ensure that any large-scale transitions among government
agencies are implemented successfully.8 Although all of these factors arelikely important for a successful transformation for the financial
regulatory system, Congress and existing agencies should pay particularattention to ensuring there are effective communication strategies so that
all affected parties, including investors and consumers, clearly understandany changes being implemented. In addition, attention should be paid todeveloping a sound human capital strategy to ensure that any new orconsolidated agencies are able to retain and attract additional quality staff
during the transition period. Finally, policymakers should consider how
best to retain and utilize the existing skills and knowledge base within
agencies subject to changes as part of a transition.

Mr. Chairman and Members of the Committee, I appreciate theopportunity to discuss these critically important issues and would be
happy to answer any questions that you may have. Thank you.

Contacts

For further information on this testimony, please contact Orice M.
Williams at (202) 512-8678 or williamso@gao.gov, or Richard J. Hillman at(202) 512-8678 or hillmanr@gao.gov.

8

See GAO, Homeland Security: Critical Design and Implementation Issues, GAO-02-957T(Washington, D.C.: July 17, 2002).

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Appendix I: Agencies and Other
Organizations That Reviewed the Draft
ReportAmerican Bankers Association
American Council of Life Insurers
Center for Responsible Lending
Commodity Futures Trading Commission
Conference of State Bank Supervisors
Consumer Federation of America
Consumers Union
Credit Union National Association
Department of the Treasury
Federal Deposit Insurance Corporation
Federal Housing Finance Agency
Federal Reserve
Financial Industry Regulatory Authority
Financial Services Roundtable
Futures Industry Association
Independent Community Bankers of America
International Swaps and Derivates Association
Mortgage Bankers Association
National Association of Federal Credit Unions
National Association of Insurance Commissioners
National Consumer Law Center
National Credit Union Administration
National Futures Association
Office of the Comptroller of the Currency
Office of Thrift Supervision
Public Company Accounting Oversight Board
Securities and Exchange Commission
Securities Industry and Financial Markets Association
U.S. PIRG

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Related GAO Products

High-Risk Series: An Update. GAO-09-271. Washington, D.C.: January 22,
2009.
Financial Regulation: A Framework for Crafting and Assessing
Proposals to Modernize the Outdated U.S. Financial Regulatory System.
GAO-09-216. Washington, D.C.: January 8, 2009.
Troubled Asset Relief Program: Additional Actions Needed to Better
Ensure Integrity, Accountability, and Transparency. GAO-09-161.
Washington, D.C.: December 2, 2008.
Hedge Funds: Regulators and Market Participants Are Taking Steps toStrengthen Market Discipline, but Continued Attention Is Needed.
GAO-08-200. Washington, D.C.: January 24, 2008.
Information on Recent Default and Foreclosure Trends for Home
Mortgages and Associated Economic and Market Developments.
GAO-08-78R. Washington, D.C.: October 16, 2007.
Financial Regulation: Industry Trends Continue to Challenge theFederal Regulatory Structure. GAO-08-32. Washington, D.C.: October 12,
2007.
Financial Market Regulation: Agencies Engaged in Consolidated
Supervision Can Strengthen Performance Measurement andCollaboration. GAO-07-154. Washington, D.C.: March 15, 2007.
Alternative Mortgage Products: Impact on Defaults Remains Unclear,but Disclosure of Risks to Borrowers Could Be Improved. GAO-06-1021.
Washington, D.C.: September 19, 2006.
Credit Cards: Increased Complexity in Rates and Fees Heightens Needfor More Effective Disclosures to Consumers. GAO-06-929. Washington,
D.C.: September 12, 2006.
Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.
Regulatory Structure. GAO-05-61. Washington, D.C.: October 6, 2004.
Consumer Protection: Federal and State Agencies Face Challenges in
Combating Predatory Lending. GAO-04-280. Washington, D.C.: January
30, 2004.

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Long-Term Capital Management: Regulators Need to Focus Greater
Attention on Systemic Risk. GAO/GGD-00-3. Washington, D.C.: October
29, 1999.
Bank Oversight: Fundamental Principles for Modernizing the U.S.
Structure. GAO/T-GGD-96-117. Washington, D.C.: May 2, 1996.
Financial Derivatives: Actions Needed to Protect the Financial System.
GAO/GGD-94-133. Washington, D.C.: May 18, 1994.

(250443)

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