Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System
Published: 2009-01-08T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The United States and other countries are in the midst of the worst financial crisis in more than 75 years. While much of the attention of policymakers understandably has been focused on taking short-term steps to address the immediate nature of the crisis, these events have served to strikingly demonstrate that the current U.S. financial regulatory system is in need of significant reform. To help policymakers better understand existing problems with the financial regulatory system and craft and evaluate reform proposals, this report (1) describes the origins of the current financial regulatory system, (2) describes various market developments and changes that have created challenges for the current system, and (3) presents an evaluation framework that can be used by Congress and others to shape potential regulatory reform efforts. To do this work, GAO synthesized existing GAO work and other studies and met with dozens of representatives of financial regulatory agencies, industry associations, consumer advocacy organizations, and others. Twenty-nine regulators, industry associations, and consumer groups also reviewed a draft of this report and provided valuable input that was incorporated as appropriate. In general, reviewers commented that the report represented an important and thorough review of the issues related to regulatory reform.
section_title: What GAO Found
paragraphs: The current U.S. financial regulatory system has relied on a fragmented and complex arrangement of federal and state regulators--put into place over the past 150 years--that has not kept pace with major developments in financial markets and products in recent decades. As the nation finds itself in the midst of one of the worst financial crises ever, the regulatory system increasingly appears to be ill-suited to meet the nation's needs in the 21st century. Today, responsibilities for overseeing the financial services industry are shared among almost a dozen federal banking, securities, futures, and other regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies. Much of this structure has developed as the result of statutory and regulatory 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 to financial 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. 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 the systemic risks posed by large and interconnected financial conglomerates and to ensure they adequately manage their risks. The portion of firms operating as conglomerates that cross financial sectors of banking, securities, and insurance increased significantly in recent years, but none of the regulators is tasked with assessing the risks posed across the entire financial system. 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 in today'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 retail mortgage and credit products. Regulators failed to adequately 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 in addressing challenges arising from the global convergence of accounting and auditing standards. ? Finally, despite the increasingly global aspects of financial markets, the current fragmented U.S. regulatory structure has complicated some efforts to coordinate internationally with other regulators.

section_title: Letter
paragraphs: The United States is in the midst of the worst financial crisis in more than  75 years. In recent months, federal officials 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, including the creation of a $700 billion  program that has been used so far to inject money into struggling  institutions in an attempt to stabilize markets. This current crisis largely  stems from defaults on U.S. subprime mortgage loans, many of which were  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. While  much of policymakers’ attention understandably has been focused on  taking short-term steps to address the immediate nature of the crisis, these  events have served to strikingly demonstrate that the current U.S. financial  regulatory system is in need of significant reform.
The current U.S. regulatory system has relied on a fragmented and  complex arrangement of federal and state regulators—put into place over  the past 150 years—that has not kept pace with the major developments  that have occurred in financial markets and products in recent decades. In  particular, the current system was not designed to adequately oversee  today’s large and interconnected financial institutions, whose activities  pose new risks to the institutions themselves as well as risk to the broader  financial system—called systemic risk, which is the risk that an event  could broadly effect the financial system rather than just one or a few  institutions. In addition, not all financial activities and institutions fall  under the direct purview of financial regulators, and market innovations  have led to the creation of new and sometimes very complex products that  were never envisioned as the current regulatory system developed. In light  of the recent turmoil in financial markets, the current financial regulatory  system increasingly appears to be ill-suited to meet the nation’s needs in  the 21st century.
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 the  likelihood that the U.S. will experience another financial crisis similar to  the current one. As a result, considerable debate is under way over  whether and how the current regulatory system should be changed,  including calls for consolidating regulatory agencies, broadening certain  regulators’ authorities, or subjecting certain products or entities to more  regulation. For example, in March 2008, the Department of the Treasury  (Treasury) proposed significant financial regulatory reforms in its  “Blueprint for a Modernized Financial Regulatory Structure,” and other  federal regulatory officials and industry groups have also put forth reform  proposals. Under the Emergency Economic Stabilization Act, Treasury is  required to submit to Congress by April 30, 2009, a report with  recommendations on “the current state of the financial markets and the  regulatory system.” As these and other proposals are developed or  evaluated, it will be important to carefully consider their advantages and  disadvantages and long-term implications.
To help policymakers weigh the various proposals and consider ways in  which the current regulatory system could be made more effective and  efficient, we prepared this report under the authority of the Comptroller  General.  Specifically, our report (1) describes the origins of the current  financial regulatory system, (2) describes various market developments  and changes that have raised challenges for the current system, and (3)  presents an evaluation framework that can be used by Congress and  others to craft or evaluate potential regulatory reform efforts going  forward. This report’s primary focus is on discussing how various market  developments have revealed gaps and limitations in the existing regulatory  system. Although drawing on examples of events from the current crisis,  we do not attempt to identify all of the potential weaknesses in the actions  of regulators that had authority over the institutions and products  involved.
To address these objectives, we synthesized existing GAO work on  challenges to the U.S. financial regulatory structure and on criteria for  developing and strengthening effective regulatory structures. We also  reviewed existing studies, government documents, and other research for  illustrations of how current and past financial market events have exposed  inadequacies in our existing financial regulatory system and for  suggestions for regulatory reform. In a series of forums, we discussed  these developments and the elements of a potential framework for an  effective regulatory system with groups of financial regulators of banking,  securities, futures, insurance, and housing markets; representatives of  financial services industry associations and individual financial  institutions; and with selected consumer advocacy organizations,  academics, and other experts in financial markets issues. 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 April 2008 and December  2008.  A more extensive discussion of our scope and methodology appears  in appendix I.
subsections: section_title: Background
paragraphs: While providing many benefits to our economy and citizens’ lives, financial  services activities can also cause harm if left unsupervised. As a result, the  United States and many other countries have found that regulating  financial markets, institutions, and products is more efficient and effective  than leaving the fairness and integrity of these activities to be ensured  solely by market participants themselves.
The federal laws related to financial regulation set forth specific  authorities and responsibilities for regulators, although these authorities  typically do not contain provisions explicitly linking such responsibilities  to overall goals of financial regulation. Nevertheless, financial regulation  generally has sought to achieve four broad goals:    Ensure adequate consumer protections. Because financial institutions’  incentives to maximize profits can in some cases lead to sales of  unsuitable or fraudulent financial products, or unfair or deceptive acts or  practices, U.S. regulators take steps to address informational  disadvantages that consumers and investors may face, ensure consumers  and investors have sufficient information to make appropriate decisions,  and oversee business conduct and sales practices to prevent fraud and  abuse.
Ensure the integrity and fairness of markets. Because some market  participants could seek to manipulate markets to obtain unfair gains in a  way that is not easily detectable by other participants, U.S. regulators set  rules for and monitor markets and their participants to prevent fraud and  manipulation, limit problems in asset pricing, and ensure efficient market  activity.
Monitor the safety and soundness of institutions. Because markets  sometimes lead financial institutions to take on excessive risks that can  have significant negative impacts on consumers, investors, and taxpayers,  regulators oversee risk-taking activities to promote the safety and  soundness of financial institutions.
Act to ensure the stability of the overall financial system. Because  shocks to the system or the actions of financial institutions can lead to  instability in the broader financial system, regulators act to reduce  systemic risk in various ways, such as by providing emergency funding to  troubled financial institutions.
Although these goals have traditionally been their primary focus, financial  regulators are also often tasked with achieving other goals as they carry  out their activities. These can include promoting economic growth, capital  formation, and competition in our financial markets. Regulators have also  taken actions with an eye toward ensuring the competitiveness of  regulated U.S. financial institutions with those in other sectors or with  others around the world. In other cases, financial institutions may be  required by law or regulation to foster social policy objectives such as fair  access to credit and increased home ownership.
In general, these goals are reflected in statutes, regulations, and  administrative actions, such as rulemakings or guidance, by financial  institution supervisors. Laws and regulatory agency policies can set a  greater priority on some roles and missions than others. Regulators are  usually responsible for multiple regulatory goals and often prioritize them  differently. For example, state and federal bank regulators generally focus  on the safety and soundness of depository institutions; federal securities  and futures regulators focus on the integrity of markets, and the adequacy  of information provided to investors; and state securities regulators  primarily address consumer protection. State insurance regulators focus  on the ability of insurance firms to meet their commitments to the insured.
The degrees to which regulators oversee institutions, markets, or products  also vary depending upon, among other things, the regulatory approach  Congress has fashioned for different sectors of the financial industry. For  example, some institutions, such as banks, are subject to comprehensive  regulation to ensure their safety and soundness. Among other things, they  are subject to examinations and limitations on the types of activities they  may conduct. Other institutions conducting financial activities are less  regulated, such as by only having to register with regulators or by having  less extensive disclosure requirements. Moreover, some markets, such as  those for many over-the-counter derivatives markets, as well as activities  within those markets, are not subject to oversight regulation at all.
section_title: Today’s Financial Regulatory System Was Built over More Than a Century, Largely in Response to Crises or Market Developments
paragraphs: As a result of 150 years of changes in financial regulation in the United  States, the regulatory system has become complex and fragmented. (See  fig. 1.) Our regulatory system has multiple financial regulatory bodies,  including five federal and multiple state agencies that oversee depository  institutions. Securities activities are overseen by federal and state  government entities, as well as by private sector organizations performing  self-regulatory functions. Futures trading is overseen by a federal regulator  and also by industry self-regulatory organizations. Insurance activities are  primarily regulated at the state level with little federal involvement.
Overall, responsibilities for overseeing the financial services industry are  shared among almost a dozen federal banking, securities, futures, and  other regulatory agencies, numerous self-regulatory organizations (SRO),  and hundreds of state financial regulatory agencies. The following sections  describe how regulation evolved in various sectors, including banking,  securities, thrifts, credit unions, futures, insurance, secondary mortgage  markets, and other financial institutions. The accounting and auditing  environment for financial institutions, and the role of the Gramm-Leach- Bliley Act in financial regulation, are also discussed.
subsections: section_title: Banking
paragraphs: Since the early days of our nation, banks have allowed citizens to store  their savings and used these funds to make loans to spur business  development. Until the middle of the 1800s, banks were chartered by  states and state regulators supervised their activities, which primarily  consisted of taking deposits and issuing currency. However, the existence  of multiple currencies issued by different banks, some of which were more  highly valued than others, created difficulties for the smooth functioning  of economic activity. In an effort to finance the nation’s Civil War debt and  reduce financial uncertainty, Congress passed the National Bank Act of  1863, which provided for issuance of a single national currency. This act  also created the Office of the Comptroller of the Currency (OCC), which  was to oversee the national currency and improve banking system  efficiency by granting banks national charters to operate and conducting  oversight to ensure the sound operations of these banks. As of 2007, of the  more than 16,000 depository institutions subject to federal regulation in  the United States, OCC was responsible for chartering, regulating, and  supervising nearly 1,700 commercial banks with national charters.
In the years surrounding 1900, the United States experienced troubled  economic conditions and several financial panics, including various  instances of bank runs as depositors attempted to withdraw their funds  from banks whose financial conditions had deteriorated. To improve the  liquidity of the U.S. banking sector and reduce the potential for such  panics and runs, Congress passed the Federal Reserve Act of 1913. This  act created the Federal Reserve System, which consists of the Board of  Governors of the Federal Reserve System (Federal Reserve), and 12  Federal Reserve Banks, which are congressionally chartered semiprivate  entities that undertake a range of actions on behalf of the Federal Reserve,  including supervision of banks and bank holding companies, and lending  to troubled banks.  The Federal Reserve was given responsibility to act as  the federal supervisory agency for state-chartered banks—banks  authorized to do business under charters issued by states—that are  members of the Federal Reserve System. In addition to supervising and  regulating bank and financial holding companies and nearly 900 state- chartered banks, the Federal Reserve also develops and implements  national monetary policy, and provides financial services to depository  institutions, the U.S. government, and foreign official institutions,  including playing a major role in operating the nation’s payments system.
Several significant changes to the U.S. financial regulatory system again  were made as a result of the turbulent economic conditions in the late  1920s and 1930s. In response to numerous bank failures resulting in the  severe contraction of economic activity of the Great Depression, the  Banking Act of 1933 created the Federal Deposit Insurance Corporation  (FDIC), which administers a federal program to insure the deposits of  participating banks. Subsequently, FDIC’s deposit insurance authority  expanded to include thrifts. Additionally, FDIC provides primary federal  oversight of any insured state-chartered banks that are not members of the  Federal Reserve System, and it serves as the primary federal regulator for  over 5,200 state-chartered institutions. Finally, FDIC has backup  examination and enforcement authority over all of the institutions it  insures in order to mitigate losses to the deposit insurance funds.
section_title: Securities
paragraphs: Prior to the 1930s, securities markets were overseen by various state  securities regulatory bodies and the securities exchanges themselves. In  the aftermath of the stock market crash of 1929, the Securities Exchange  Act of 1934 created a new federal agency, the Securities and Exchange  Commission (SEC) and gave it authority to register and oversee securities  broker-dealers, as well as securities exchanges, to strengthen securities  oversight and address inconsistent state securities rules. In addition to  regulation by SEC and state agencies, securities markets and the broker- dealers that accept and execute customer orders in these markets  continue to be regulated by SROs, including those of the exchanges and  the Financial Industry Regulatory Authority, that are funded by the  participants in the industry. Among other things, these SROs establish  rules and conduct examinations related to market integrity and investor  protection. SEC also registers and oversees investment companies and  advisers, approves rules for the industry, and conducts examinations of  broker-dealers and mutual funds. State securities regulators—represented  by the North American Securities Administrators Association—are  generally responsible for registering certain securities products and, along  with SEC, investigating securities fraud. SEC is also responsible for  overseeing the financial reporting and disclosures that companies issuing  securities must make under U.S. securities laws. SEC was also authorized  to issue and oversee U.S. accounting standards for entities subject to its  jurisdiction, but has delegated the creation of accounting standards to a  private-sector organization, the Financial Accounting Standards Board,  which establishes generally accepted accounting principles.
section_title: Thrifts and Credit Unions
paragraphs: The economic turmoil of the 1930s also prompted the creation of federal  regulators for other types of depository institutions, including thrifts and  credit unions. These institutions previously had been subject to oversight  only by state authorities. However, the Home Owners’ Loan Act of 1933  empowered the newly created Federal Home Loan Bank Board to charter  and regulate federal thrifts, and the Federal Credit Union Act of 1934  created the Bureau of Federal Credit Unions to charter and supervise  credit unions. Congress amended the Federal Credit Union Act in 1970 to  establish the National Credit Union Administration (NCUA), which is  responsible for chartering and supervising over 5,000 federally chartered  credit unions, as well as insuring deposits in these and more than 3,000  state-chartered credit unions. Oversight of these state-chartered credit  unions is managed by 47 state regulatory agencies, represented by the  National Association of State Credit Union Supervisors.
From 1980 to 1990, over 1,000 thrifts failed at a cost of about $100 billion  to the federal deposit insurance funds. In response, the Financial  Institutions Reform, Recovery, and Enforcement Act of 1989 abolished the  Federal Home Loan Bank Board and, among other things, established the  Office of Thrift Supervision (OTS) to improve thrift oversight. OTS  charters about 750 federal thrifts and oversees these and about 70 state- chartered thrifts, as well as savings and loan holding companies.
section_title: Futures
paragraphs: Oversight of the trading of futures contracts, which allow their purchasers  to buy or sell a specific quantity of a commodity for delivery in the future,  has also changed over the years in response to changes in the  marketplace. Under the Grain Futures Act of 1922, the trading of futures  contracts was overseen by the Grain Futures Administration, an office  within the Department of Agriculture, reflecting the nature of the products  for which futures contracts were traded. However, futures contracts  were later created for nonagricultural commodities, such as energy  products like oil and natural gas, metals such as gold and silver, and  financial products such as Treasury bonds and foreign currencies. In 1974,  a new independent federal agency, the Commodity Futures Trading  Commission (CFTC), was created to oversee the trading of futures  contracts. Like SEC, CFTC relies on SROs, including the futures  exchanges and the National Futures Association, to establish and enforce  rules governing member behavior. In 2000, the Commodity Futures  Modernization Act of 2000 established a principles-based structure for the  regulation of futures exchanges and derivatives clearing organizations, and  clarified that some off-exchange derivatives trading—and in particular  trading on facilities only accessible to large, sophisticated traders—was  permitted and would be largely unregulated or exempt from regulation.
section_title: Insurance
paragraphs: Unlike most other financial services, insurance activities traditionally have  been regulated at the state level. In 1944, a U.S. Supreme Court decision  determined that the insurance industry was subject to interstate  commerce laws, which could then have allowed for federal regulation, but  Congress passed the McCarran-Ferguson Act in 1945 to explicitly return  insurance regulation to the states. As a result, as many as 55 state,  territorial, or other local jurisdiction authorities oversee insurance  activities in the United States, although state regulations and other  activities are often coordinated nationally by the National Association of  Insurance Commissioners (NAIC).
section_title: Secondary Mortgage Markets
paragraphs: The recent financial crisis in the credit and housing markets has prompted  the creation of a new, unified federal financial regulatory oversight  agency, the Federal Housing Finance Agency (FHFA), to oversee the  government-sponsored enterprises (GSE) Fannie Mae, Freddie Mac, and  the Federal Home Loan Banks. Fannie Mae and Freddie Mac are private,  federally chartered companies created by Congress to, among other  things, provide liquidity to home mortgage markets by purchasing  mortgage loans, thus enabling lenders to make additional loans. The  system of 12 Federal Home Loan Banks provides funding to support  housing finance and economic development. Until enactment of the  Housing and Economic Recovery Act of 2008, Fannie Mae and Freddie  Mac had been overseen since 1992 by the Office of Federal Housing  Enterprise Oversight (OFHEO), an agency within the Department of  Housing and Urban Development, and the Federal Home Loan Banks were  subject to supervision by the Federal Housing Finance Board (FHFB), an  independent regulatory agency. OFHEO regulated Fannie Mae and  Freddie Mac on matters of safety and soundness, while HUD regulated  their mission-related activities. FHFB served as the safety and soundness  and mission regulator of the Federal Home Loan Banks. In July 2008, the  Housing and Economic Recovery Act of 2008 created FHFA to establish  more effective and more consistent oversight of the three housing GSEs— Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. With respect  to Fannie Mae and Freddie Mac, the law gives FHFA such new regulatory  authorities as the power to regulate the retained mortgage portfolios, to  set more stringent capital standards, and to place a failing entity in  receivership. In addition, the law provides FHFA with funding outside the  annual appropriations process. The law also combined the regulatory  authorities for all the housing GSEs that were previously distributed  among OFHEO, FHFB, and the Department of Housing and Urban  Development. In September 2008, Fannie Mae and Freddie Mac were  placed in conservatorship, with FHFA serving as the conservator under  powers provided in the 2008 act. Treasury also created a backstop lending  facility for the Federal Home Loan Banks, should they decide to use it.  In  November 2008, the Federal Reserve announced plans to purchase  mortgage-backed securities guaranteed by Fannie Mae and Freddie Mac  on the open market.
section_title: Gramm-Leach-Bliley
paragraphs: Changes in the types of financial activities permitted for depository  institutions and their affiliates have also shaped the financial regulatory  system over time. Under the Glass-Steagall provisions of the Banking Act  of 1933, financial institutions were prohibited from simultaneously  offering commercial and investment banking services. However, in the  Gramm-Leach-Bliley Act of 1999 (GLBA), Congress permitted financial  institutions to fully engage in both types of activities and, in addition,  provided a regulatory process allowing for the approval of new types of  financial activity. Under GLBA, qualifying financial institutions are  permitted to engage in banking, securities, insurance, and other financial  activities. When these activities are conducted within the same bank  holding company structure, they remain subject to regulation by  “functional regulators,” which are the federal authorities having  jurisdiction over specific financial products or services, such as SEC or  CFTC. As a result, multiple regulators now oversee different business lines  within a single institution. For example, broker-dealer activities are  generally regulated by SEC even if they are conducted within a large  financial conglomerate that is subject to the Bank Holding Company Act,  which is administered by the Federal Reserve. The functional regulator  approach was intended to provide consistency in regulation, focus  regulatory restrictions on the relevant functional area, and avoid the  potential need for regulatory agencies to develop expertise in all aspects  of financial regulation.
section_title: Accounting and Auditing
paragraphs: In addition to the creation of various regulators over time, the accounting  and auditing environment for financial institutions and market  participants—a key component of financial oversight—has also seen  substantial change. In the early 2000s, various companies with publicly  traded securities were found to have issued materially misleading financial  statements. These companies included Enron and WorldCom, both of  which filed for bankruptcy. When the actual financial conditions of these  companies became known, their auditors were called into question, and  one of the largest, Arthur Andersen, was dissolved after the Department of  Justice filed criminal charges related to its audits of Enron. As a result of  these and other corporate financial reporting and auditing scandals, the  Sarbanes-Oxley Act of 2002 was enacted. Among other things, Sarbanes- Oxley expanded public company reporting and disclosure requirements  and established new ethical and corporate responsibility requirements for  public company executives, boards of directors, and independent auditors.  The act also created a new independent public company audit regulator,  the Public Company Accounting Oversight Board, to oversee the activities  of public accounting firms. The activities of this board are, in turn,  overseen by SEC.
section_title: Other Financial Institutions
paragraphs: Some entities that provide financial services are not regulated by any of  the existing federal financial regulatory bodies. For example, entities such  as mortgage brokers, automobile finance companies, and payday lenders  that are not bank subsidiaries or affiliates primarily are subject to state  oversight, with the Federal Trade Commission acting as the primary  federal agency responsible for enforcing their compliance with federal  consumer protection laws.
section_title: Changes in Financial Institutions and Their Products Have Significantly Challenged the U.S. Financial Regulatory System
paragraphs: Several key developments in financial markets and products in the past  few decades have significantly challenged the existing financial regulatory  structure. (See fig. 2.) First, the last 30 years have seen waves of mergers  among financial institutions within and across sectors, such that the  United States, while still having large numbers of financial institutions,  also has several very large globally active financial conglomerates that  engage in a wide range of activities that have become increasingly  interconnected. Regulating these large conglomerates has proven  challenging, particularly in overseeing their risk management activities on  a consolidated basis and in identifying and mitigating the systemic risks  they pose. A second development has been the emergence of large and  sometimes less-regulated market participants, such as hedge funds and  credit rating agencies, which now play key roles in our financial markets.  Third, the development of new and complex products and services has  challenged regulators’ abilities to ensure that institutions are adequately  identifying and acting to mitigate risks arising from these new activities  and that investors and consumers are adequately informed of the risks. In  light of these developments, ensuring that U.S. accounting standards have  kept pace has also proved difficult, and the impending transition to  conform to international accounting standards is likely to create additional  challenges. Finally, despite the increasingly global aspects of financial  markets, the current fragmented U.S. regulatory structure has complicated  some efforts to coordinate internationally with other regulators.
subsections: section_title: Conglomeration and Increased Interconnectedness in Financial Markets Have Created Difficulties for a Regulatory System That Lacks a Systemwide Focus
paragraphs: Overseeing large financial conglomerates that have emerged in recent  decades has proven challenging, particularly in regulating their  consolidated risk management practices and in identifying and mitigating  the systemic risks they pose. These systemically important institutions in  many cases have tens of thousands or more customers and extensive  financial linkages with each other through loans, derivatives contracts, or  trading positions with other financial institutions or businesses. The  activities of these large financial institutions, as we have seen by recent  events, can pose significant systemic risks to other market participants  and the economy as a whole, but the regulatory system was not prepared  to adequately anticipate and prevent such risks.
Largely as the result of waves of mergers and consolidations, the number  of financial institutions today has declined. However, the remaining  institutions are generally larger and more complex, provide more and  varied services, offer similar products, and operate in increasingly global  markets. Among the most significant of these changes has been the  emergence and growth of large financial conglomerates or universal banks  that offer a wide range of products that cut across the traditional financial  sectors of banking, securities, and insurance. A 2003 IMF study highlighted  this emerging trend. Based on a worldwide sample of the top 500 financial  services firms in assets, the study found that the percentage of the largest  financial institutions in the United States that are conglomerates— financial institutions having substantial operations in more than one of the  sectors (banking, securities, and insurance)—increased from 42 percent of  the U.S. financial institutions in the sample in 1995 to 62 percent in 2000.  This new environment contrasts with that of the past in which banks  primarily conducted traditional banking activities such as deposit taking  and lending; securities broker-dealers were largely focused on brokerage  and underwriting activities; and insurance firms offered a more limited set  of insurance products. In a report that analyzed the regulatory structures  of various countries, The Group of Thirty noted that the last 25 years have  been a period of enormous transformation in the financial services sector,  with a marked shift from firms engaging in distinct banking, securities, and  insurance businesses to one in which more integrated financial services  conglomerates offer a broad range of financial products across the globe.  These fundamental changes in the nature of the financial service markets  around the world have exposed the shortcomings of financial regulatory  models, some of which have not been adapted to the changes in business  structures.
While posing challenges to regulators, these changes have resulted in  some benefits in the United States financial services industry. For  example, the ability of financial institutions to offer products of varying  types increased the options available to consumers for investing their  savings and preparing for their retirement. Conglomeration has also made  it more convenient for consumers to conduct their financial activities by  providing opportunities for one-stop shopping for most or all of their  needs, and by promoting the cross-selling of new innovative products of  which consumers may otherwise not have been aware.
However, the rise of large financial conglomerates has also posed risks  that our current financial regulatory system does not directly address.  First, although the activities of these large interconnected financial  institutions often cross traditional sector boundaries, financial regulators  under the current U.S. regulatory system did not always have full authority  or sufficient tools and capabilities to adequately oversee the risks that  these financial institutions posed to themselves and other institutions. As  we noted in a 2007 report, the activities of the Federal Reserve, SEC, and  OTS to conduct consolidated supervision of many of the largest U.S.  financial institutions were not as efficient and effective as needed because  these agencies were not collaborating more systematically. In addition,  the recent market crisis has revealed significant problems with certain  aspects of these regulators’ oversight of financial conglomerates. For  example, some of the top investment banks were subject to voluntary and  limited oversight at the holding-company level—the level of the institution  that generally managed its overall risks—as part of SEC’s Consolidated  Supervised Entity (CSE) Program. SEC’s program was created in 2004 as a  way for global investment bank conglomerates that lack a supervisor  under law to voluntarily submit to regulation. This supervision, which  could include SEC examinations of the parent companies’ and affiliates’  operations and monitoring of their capital levels, enabled the CSEs to  qualify for alternative capital rules in exchange for consenting to  supervision at the holding company level. Being subject to consolidated  supervision was perceived as necessary for these financial institutions to  continue operating in Europe under changes implemented by the  European Union in 2005.
However, according to a September 2008 report by SEC’s Inspector  General, this supervisory 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. In  comparison to commercial bank conglomerates, these investment banks  were holding much less capital in relation to the activities exposing them  to financial risk. For example, at the end of 2007, the five largest  investment banks had assets to equity capital leverage ratios of between  26 and 34 to 1—meaning that for every dollar of capital capable of  absorbing losses, these institutions held between $26 and $34 of assets  subject to loss. In contrast, the largest commercial bank conglomerates,  which were subject to different regulatory capital requirements, tended to  be significantly less leveraged, with the average leverage ratio of the top  five largest U.S. bank conglomerates at the end of 2007 only about 13 to 1.  Moreover, because the program SEC used to oversee these investment  bank conglomerates was voluntary, it had no authority to compel these  institutions to address any problems that may have been identified.  Instead, SEC’s only means for coercing an institution to take corrective  actions was to disqualify an institution from CSE status. SEC also lacked  the ability to provide emergency funding for these investment bank  conglomerates in a similar way that the Federal Reserve could for  commercial banks. As a result, these CSE firms, whose activities resulted  in their being significant and systemically important participants with vast  interconnections with other financial institutions, were more vulnerable to  market disruptions that could create risks to the overall financial system,  but not all were subject to full and consistent oversight by a supervisor  with adequate authority and resources. For example, one of the ways that  the bankruptcy filing of Lehman Brothers affected other institutions was  that 25 money market fund advisers had to act to protect their investors  against losses arising from their investments in that company’s debt, with  at least one of these funds having to be liquidated and distributed to its  investors.
Following the sale of Bear Stearns to JPMorgan Chase, the Lehman  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 suspended its CSE program and the  Chairman stated that “the last six months have made it abundantly clear  that voluntary regulation does not work.”
Recent events have also highlighted difficulties faced by the Federal  Reserve and OTS in their roles in overseeing risk management at large  financial and thrift holding companies, respectively. In June 2008  testimony, a Federal Reserve official acknowledged such supervisory  lessons, noting that under the current U.S. regulatory structure consisting  of multiple supervisory agencies, challenges can arise in assessing risk  profiles of large, complex financial institutions operating across financial  sectors, particularly given the growth in the use of sophisticated financial  products that can generate risks across various legal entities. He also  noted that recent events have highlighted the importance of  enterprisewide risk management, noting that supervisors need to  understand risks across a consolidated entity and assess the risk  management tools being applied across the financial institution. Our own  work had raised concerns over the adequacy of supervision of these large  financial conglomerates. For example, one of the large entities that OTS  oversaw was the insurance conglomerate AIG, which was subject to a  government takeover necessitated by financial difficulties the firm  experienced as the result of OTC derivatives activities related to  mortgages.  In a 2007 report, we expressed concerns over the  appropriateness of having OTS oversee diverse global financial institutions  given the size of the agency relative to the institutions for which it was  responsible. We had also noted that although OTS oversaw a number of  holding companies that are primarily in the insurance business, including  AIG, it had only one specialist in this area as of March 2007. An OTS  official noted, however, that functional regulation established by Gramm- Leach-Bliley avoided the need for regulatory agencies to develop expertise  in all aspects of financial regulation.
Second, the emergence of these large institutions with financial  obligations with thousands of other entities has revealed that the existing  U.S. regulatory system is not well-equipped for identifying and addressing  risks across the financial system as a whole. In the current environment,  with multiple regulators primarily responsible for just individual  institutions or markets, no one regulator is tasked with assessing the risks  posed across the entire financial system by a few institutions or by the  collective activities of the industry. For example, multiple factors  contributed to the subprime mortgage crisis, and many market  participants played a role in these events, including mortgage brokers, real  estate professionals, lenders, borrowers, securities underwriters,  investors, rating agencies and others. The collective activities of these  entities, rather than one particular institution, likely all contributed to the  overall market collapse. In particular, the securitization process created  incentives throughout the chain of participants to emphasize loan volume  over loan quality, which likely contributed to the problem as lenders sold  loans on the secondary market, passing risks on to investors. Similarly,  once financial institutions began to fail and the full extent of the financial  crisis began to become clear, no formal mechanism existed to monitor  market trends and potentially stop or help mitigate the fallout from these  events. Ad hoc actions by the Department of the Treasury, the Federal  Reserve, other members of the President’s Working Group on Financial  Markets, and FDIC were aimed at helping to mitigate the fallout once  events began to unfold. However, even given this ad hoc coordination,  our past work has repeatedly identified limitations of the current U.S.  federal regulatory structure to adequately coordinate and share  information to monitor risks across markets or “functional” areas to  identify potential systemic crises. Whether a greater focus on systemwide  risks would have fully prevented the recent financial crises is unclear, but  it is reasonable to conclude that such a mechanism would have had better  prospects of identifying the breadth of the problem earlier and been better  positioned to stem or soften the extent of the market fallout.
section_title: Existing Regulatory System Failed to Adequately Address Problems Associated with Less-Regulated Entities That Played Significant Roles in the U.S. Financial System
paragraphs: 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 with  entities such as banks, broker-dealers, and insurance companies that were  regulated 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 to  full regulation by such authorities have become important participants in  our financial services markets. These unregulated or less-regulated entities  can 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.
subsections: section_title: Activities of Nonbank Mortgage Lenders Played a Significant Role in Mortgage Crisis but Were Not Adequately Addressed by Existing Regulatory System
paragraphs: The role of nonbank mortgage lenders in the recent financial collapse  provides an example of a gap in our financial regulatory system resulting  from activities of institutions that were generally subject to little or no  direct oversight by federal regulators. The significant participation by  these nonbank lenders in the subprime mortgage market—which targeted  products with riskier features to borrowers with limited or poor credit  history—contributed to a dramatic loosening in underwriting standards  leading up to the crisis. In recent years, nonbank lenders came to  represent a large share of the consumer lending market, including for  subprime mortgages. Specifically, as shown in figure 3, of the top 25  originators of subprime and other nonprime loans in 2006 (which  accounted for more than 90 percent of the dollar volume of all such  originations), all but 4 were nonbank lenders, accounting for 81 percent of  origination by dollar volume.
Although these lenders were subject to certain federal consumer  protection and fair lending laws, they were generally not subject to the  same routine monitoring and oversight by federal agencies that their bank  counterparts were. From 2003 to 2006, subprime lending grew from about  9 percent to 24 percent of mortgage originations (excluding home equity  loans), and Alt-A lending (nonprime loans considered less risky than  subprime) grew from about 2 percent to almost 16 percent, according to  data from the trade publication Inside Mortgage Finance. The resulting  sharp rise in defaults and foreclosures that occurred as subprime and  other homeowners were unable to make mortgage payments led to the  collapse of the subprime mortgage market and set off a series of events  that led to today’s financial turmoil.
In previous reports, we noted concerns that existed about some of these  less-regulated nonbank lenders and recommended that federal regulators  actively monitor their activities. For example, in a 2004 report, we  reported that some of these nonbank lenders had been the targets of  notable federal and state enforcement actions involving abusive lending.  As a result, we recommended to Congress that the Federal Reserve should  be given a greater role in monitoring the activities of some nonbank  mortgage lenders that are subsidiaries of bank holding companies that the  Federal Reserve regulates. Only recently, in the wake of the subprime  mortgage crisis, the Federal Reserve began a pilot program in conjunction  with OTS and the Conference of State Bank Supervisors to monitor the  activities of nonbank subsidiaries of holding companies, with the states  conducting examinations of independent state-licensed lenders.  Nevertheless, other nonbank lenders continue to operate under less  rigorous federal oversight and remain an example of the risks posed by  less-regulated institutions in our financial regulatory system.
The increased role in recent years of investment banks securitizing and  selling mortgage loans to investors further illustrates gaps in the  regulatory system resulting from less-regulated institutions. Until recently,  GSEs Fannie Mae and Freddie Mac were responsible for the vast majority  of mortgage loan securitization. The securitization of loans that did not  meet the GSEs’ congressionally imposed loan limits or regulator-approved  quality standards—such as jumbo loans that exceeded maximum loan  limits and subprime loans—was undertaken by investment firms that were  subject to little or no standards to ensure safe and sound practices in  connection with the purchase or securitization of loans. As the volume of  subprime lending grew dramatically from around 2003 through 2006,  investment firms took over the substantial share of the mortgage  securitization market. As shown in figure 4, this channel of mortgage  funding—known as the private label mortgage-backed securities market— grew rapidly and in 2005 surpassed the combined market share of the  GSEs and Ginnie Mae—a government corporation that guarantees  mortgage-backed securities. As the volume of subprime loans increased, a  rapidly growing share was packaged into private label securities, reaching  75 percent in 2006, according to the Federal Reserve Bank of San  Francisco.
As shown in figure 4, this growth allowed private label securities to  become approximately 55 percent of all mortgage-backed security  issuance by 2005. This development serves as yet another example of how  a less-regulated part of the market, private label securitization, played a  significant role in fostering risky subprime mortgage lending, exposing a  gap in the financial regulatory structure.
The role of mortgage brokers in the sale of mortgage products in recent  years has also been a key focus of attention of policymakers. In past work,  we noted that the role of mortgage brokers grew in the years leading up to  the current crisis. By one estimate, the number of brokerages rose from  about 30,000 firms in 2000 to 53,000 firms in 2004. In 2005, brokers  accounted for about 60 percent of originations in the subprime market  (compared with about 25 percent in the prime market). In 2008, in the  wake of the subprime mortgage crisis, Congress enacted the Secure and  Fair Enforcement for Mortgage Licensing Act, as part of the Housing and  Economic Recovery Act, to require enhanced licensing and registration of  mortgage brokers.
section_title: Activities of Hedge Funds Can Pose Systemic Risks Not Recognized by Regulatory System
paragraphs: Hedge funds, which are professionally managed investment funds for  institutional and wealthy investors, have become significant participants in  many important financial markets. For example, hedge funds often assume  risks that other more regulated institutions are unwilling or unable to  assume, and therefore generally are recognized as benefiting markets by  enhancing liquidity, promoting market efficiency, spurring financial  innovation, and helping to reallocate financial risk. But hedge funds  receive less-direct oversight than other major market participants such as  mutual funds, another type of investment fund that manages pools of  assets on behalf of investors. Hedge funds generally are structured and  operated in a manner that enables them to qualify for exemptions from  certain federal securities laws and regulations. Because their participants  are presumed to be sophisticated and therefore not require the full  protection offered by the securities laws, hedge funds have not generally  been subject to direct regulation. Therefore, hedge funds are not subject to  regulatory capital requirements, are not restricted by regulation in their  choice of investment strategies, and are not limited by regulation in their  use of leverage. By soliciting participation in their funds from only certain  large institutions and wealthy individuals and refraining from advertising  to the general public, hedge funds are not required to meet the registration  and disclosure requirements of the Securities Act of 1933 or the Securities  Exchange Act of 1934, such as providing their investors with detailed  prospectuses on the activities that their fund will undertake using  investors’ proceeds. Hedge fund managers that trade on futures  exchanges and that have U.S. investors are required to register with CFTC  and are subject to periodic reporting, recordkeeping, and disclosure  requirements of their futures activities, unless they notify the Commission  that they qualify for an exemption from registration.
The activities of many, but not all, hedge funds have recently become  subject to greater oversight from SEC, although the rule requiring certain  hedge fund advisers to register as investment advisers was recently  vacated by a federal appeals court. In December 2004, SEC amended its  rules to require certain hedge fund advisers that had been exempt from  registering with SEC as investment advisers under its “private adviser”  exemption to register as investment advisers. In August 2006, SEC  estimated that over 2,500 hedge fund advisers were registered with the  agency, although what percentage of all hedge fund advisers active in the  United States that this represents is not known. Registered hedge fund  advisers are subject to the same requirements as all other registered  investment advisers, including providing current information to both SEC  and investors about their business practices and disciplinary history,  maintaining required books and records, and being subject to periodic  SEC examinations. Some questions exist over the extent of SEC’s  authority over these funds. In June 2006, the U.S. Court of Appeals for the  District of Columbia overturned SEC’s amended rule, concluding that the  rule was arbitrary because it departed, without reasonable justification,  from SEC’s long-standing interpretation of the term “client” in the private  adviser exemption as referring to the hedge fund itself, and not to the  individual investors in the fund. However, according to SEC, most hedge  fund advisers that previously registered have chosen to retain their  registered status as of April 2007.
Although many hedge fund advisers 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.  Hedge funds have important connections to the financial markets,  including significant business relationships with the largest regulated  commercial banks and broker-dealers. They act as trading counterparties  with many of these institutions and constitute in many markets a  significant portion of trading activity, from stocks to distressed debt and  credit derivatives.
The far-reaching consequences of potential hedge fund failures first  became apparent in 1998. The hedge fund Long Term Capital Management  (LTCM) experienced large losses related to the considerable positions— estimated to be as large as $100 billion—it had taken in various sovereign  debt and other markets, and regulators coordinated with market  participants to prevent a disorderly collapse that could have led to  financial problems among LTCM’s lenders and counterparties and  potentially to the rest of the financial system. No taxpayer funds were  used as part of this effort; instead, the various large financial institutions  with large exposures to this hedge fund agreed to provide additional  funding of $3.6 billion until the fund could be dissolved in an orderly way.  Since LTCM, other hedge funds have experienced near collapses or  failures, including two funds owned by Bear Stearns, but these events have  not had as significant impact on the broader financial markets as LTCM.
Also, since LTCM’s near collapse, investors, creditors, and counterparties  have increased their efforts to impose market discipline on hedge funds.  According to regulators and market participants, creditors and  counterparties have been conducting more extensive due diligence and  monitoring risk exposures to their hedge fund clients. In addition, hedge  fund advisers have improved disclosure and become more transparent  about their operations, including their risk-management practices.  However, we reported in 2008 that some regulators continue to be  concerned that the counterparty credit risk created when regulated  financial institutions transact with hedge funds can be a primary channel  for potentially creating systemic risk.
section_title: Credit Rating Agency Activities Also Illustrate the Failure of the Regulatory System to Address Risks Posed by Less-Regulated Entities
paragraphs: Similar to hedge funds, credit rating agencies have come to play a critical  role in financial markets, but until recently they received little regulatory  oversight. While not acting as direct participants in financial markets,  credit ratings are widely used by investors for distinguishing the  creditworthiness of bonds and other securities. Additionally, credit ratings  are used in local, federal, and international laws and regulations as a  benchmark for permissible investments by banks, pension funds, and  other institutional investors. Leading up to the recent crisis, some  investors had come to rely heavily on ratings in lieu of conducting  independent assessments on the quality of assets. This overreliance on  credit ratings of subprime mortgage-backed securities and other  structured credit products contributed to the recent turmoil in financial  markets. As these securities started to incur losses, it became clear that  their ratings did not adequately reflect the risk that these products  ultimately posed. According to the trade publication Inside B&C Lending,  the three major credit rating agencies have each downgraded more than  half of the subprime mortgage-backed securities they originally rated  between 2005 and 2007.
However, despite the critical nature of these rating agencies in our  financial system, the existing regulatory system failed to adequately  foresee and manage their role in recent events. Until recently, credit rating  agencies received little direct oversight and thus faced no explicit  requirements to provide information to investors about how to understand  and appropriately use ratings, or to provide data on the accuracy of their  ratings over time that would allow investors to assess their quality. In  addition, concerns have been raised over whether the way in which credit  rating agencies are compensated by the issuers of the securities that they  rate affects the quality of the ratings awarded. In a July 2008 report, SEC  noted multiple weaknesses in the management of these conflicts of  interest, including instances where analysts expressed concerns over fees  and other business interests when issuing ratings and reviewing ratings  criteria. However, until 2006, no legislation had established statutory  regulatory authority or disclosure requirements over credit rating  agencies. Then, to improve the quality of ratings in response to events  such as the failures of Enron and Worldcom—which highlighted the  limitations of credit ratings in identifying companies’ financial strength— Congress passed the Credit Rating Agency Reform Act of 2006, which  established limited SEC oversight, requiring their registration and certain  recordkeeping and reporting requirements.
Since the financial crisis began, regulators have taken steps to address the  important role of rating agencies in the financial system. In December  2008, in response to the subprime mortgage crisis and resulting credit  market strains, SEC adopted final rule amendments and proposed new  rule amendments that would impose additional requirements on nationally  recognized statistical rating organizations in order to address concerns  raised about the policies and procedures for, transparency of, and  potential conflicts of interest relating to ratings. Determining the most  appropriate government role in overseeing credit rating activities is  difficult. For example, SEC has expressed concerns that too much  government intervention—such as regulatory requirements of credit  ratings for certain investments or examining the underlying methodology  of ratings—would unintentionally provide an unofficial “seal of approval”  on the ratings and therefore be counterproductive to reducing  overreliance on ratings. Whatever the solution, it is clear that the current  regulatory system did not properly recognize and address the risks  associated with the important role these entities played.
section_title: Regulatory System Failed to Identify Risks Associated with Special-Purpose Entities
paragraphs: The use by financial institutions of special-purpose entities provides  another example of how less-regulated aspects of financial markets came  to play increasingly important roles in recent years, creating challenges for  regulators in overseeing risks at their regulated institutions. Many financial  institutions created and transferred assets to these entities as part of  securitizations for mortgages or to hold other assets and produce fee  income for the institution that created it—known as the sponsor. For  example, after new capital requirements were adopted in the late 1980s,  some large banks began creating these entities to hold assets for which  they would have been required to hold more capital against if the assets  were held within their institutions. As a result, these entities are also  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  sponsoring financial institution that created them. The amount of assets  accumulated in these entities resulted in them becoming significant  market participants in the last few years. For example, one large  commercial bank reported that its off-balance sheet entities totaled more  than $1 trillion in assets at the end of 2007.
Trditionlly, prodct receiving the highet  credit rting, such as AAA, were  ll et  of corporte nd overeign ond tht were  deemed to e the safend moable det  invetment. However, credit rting gencie  assigned imilrly high credit rting to mny  of the newer mortgge-relted prodct even  thogh thee prodct did not hve the same  chcteritic as previously highly rted  ecritie. A  result of thee rting,  intittion were able to successlly mrket  ny of thee prodct, inclding to other  finncil firm nd intittionl invetor in the  United Ste nd rond the world. Rting  were een to provide  common measure of  credit ricross ll det prodct, llowing  trctred credit prodct tht lcked ctive econdry mrket to e ved inimilrly rted prodct with ilable price.  Srting in mid-2007, increasing default on  reidentil mortgge, prticrly thoe for  subprime orrower, led to  widepred,  rpid, nd evere erie of downgrde y  rting gencie on subprime-relted  trctred credit prodct. Thee downgrde  ndermined confidence in the quality of  rting on thend relted prodct. Along  with increasing default, the ncertinty over  credit rting led to  rp repricing of  asset cross the finncitem nd  contributed to lrge writedown in the mrket  ve of asset bank nd other finncil  intittion. Thi contributed to the nwilling- ness of mny mrket prticipnt to trsact  with ech other de to concern over the  ctual ve of asset nd the finncil  condition of other finncil intittion. businesses. To obtain the funds to purchase these assets, these special- purpose vehicles often borrowed using shorter-term instruments, such as  commercial paper and medium-term notes. The difference between the  interest paid to the commercial paper or note holders and the income  earned on the entity’s assets produced fee and other income for the  sponsoring institution. However, these structures carried the risk that the  entity would find it difficult or costly to renew its debt financing under  less-favorable market conditions.
Although structured as off-balance sheet entities, when the turmoil in the  markets began in 2007, many financial institutions that had created these  entities had to take back the loans and securities in certain types of these  off-balance sheet entities. (See fig. 5.)
In general, banks stepped in to finance the assets held by these entities  when they were unable to refinance their expiring debt due to market  concerns over the quality of the assets. In some cases, off-balance sheet  entities relied on emergency financing commitments that many sponsoring  banks had extended to these entities. In other cases, financial institutions  supported troubled off-balance sheet entities to protect their reputations  with clients even when no explicit requirement to do so existed. This, in  turn, contributed to the reluctance of banks to lend as they had to fund  additional troubled assets on their balance sheets. Thus, although the use  of these entities seemingly had removed the risk of these assets from these  institutions, their inability to obtain financing resulted in the ownership,  risks, and losses of these entities’ assets coming back into many of the  sponsoring financial institutions.
According to a 2008 IMF study, financial institutions’ use of off-balance  sheet entities made it difficult for regulators, as well as investors, to fully  understand the associated risks of such activities. In response to these  developments, regulators and others have begun to reassess the  appropriateness of the regulatory and accounting treatment for these  entities. In January 2008, SEC asked the Financial Accounting Standards  Board (FASB), which establishes U.S. financial accounting and reporting  standards, to consider further improvements to the accounting and  disclosure for off-balance sheet transactions involving securitization.  FASB and the International Accounting Standards Board both have  initiated projects to improve the criteria for determining when financial  assets and related liabilities that institutions transfer to special-purpose  entities should be included on the institutions’ own balance sheets— known as consolidation—and to enhance related disclosures. As part of  this effort, FASB issued proposed standards that would eliminate a widely  used accounting exception for off-balance sheet entities, introduce a new  accounting model for determining whether special-purpose entities should  be consolidated that is less reliant on mathematical calculations and more  closely aligned with international standards, and require additional  disclosures about institutions’ involvement with certain special-purpose  entities. On December 18, 2008, the International Accounting Standards  Board also issued a proposed standard on consolidation of special- purpose entities and related risk disclosures. In addition, in April 2008, the  Basel Committee on Banking Supervision announced new measures to  capture off-balance sheet exposures more effectively.
Nevertheless, this serves as another example of the failure of the existing  regulatory system to recognize the problems with less-regulated entities  and take steps to address them before they escalate. Existing accounting  and disclosure standards had not required banks to extensively disclose  their holdings in off-balance sheet entities and allowed for very low capital  requirements. As a March 2008 study by the President’s Working Group on  Financial Markets noted, before the recent market turmoil, supervisory  authorities did not insist on appropriate disclosures of firms’ potential  exposure to off-balance sheet entities.
section_title: New and Complex Financial Products and Services Also Revealed Limitations in the Regulatory Structure
paragraphs: Another development that has revealed limitations in the current  regulatory structure has been the proliferation of more complex financial  products. Although posing challenges, these new products also have  provided certain benefits to financial markets and consumers. For  example, the creation of securitized products such as mortgage-backed  securities increased the liquidity of credit markets by providing additional  funds to lenders and a wider range of investment returns to investors with  excess funds. Other useful product innovations included OTC derivatives,  such as currency options, which provide a purchaser the right to buy a  specified quantity of a currency at some future date, and interest rate  swaps, which allow one party to exchange a stream of fixed interest rate  payments for a stream of variable interest rate payments. These products  help market participants hedge their risks or stabilize their cash flows.  Alternative mortgage products, such as interest-only loans, originally were  used by a limited subset of the population, mainly wealthy borrowers, to  obtain more convenient financing for home purchases. Despite these  advantages, the complexity and expanded use of new products has made it  difficult for the current regulatory system to oversee risk management at  institutions and adequately protect individual consumers and investors.
subsections: section_title: New Complex Securitized Products Have Created Difficulties for Institutions and Regulators in Valuing and Assessing Their Risks
paragraphs: Collateralized debt obligations (CDO) are one of the new products that  proliferated and created challenges for financial institutions and  regulators. In a basic CDO, a group of loans or debt securities are pooled  and securities are then issued in different tranches that vary in risk and  return depending on how the underlying cash flows produced by the  pooled assets are allocated. If some of the underlying assets defaulted, the  more junior tranches—and thus riskier ones—would absorb these losses  first before the more senior, less-risky tranches. Purchasers of these CDO  securities included insurance companies, mutual funds, commercial and  investment banks, and pension funds. Many CDOs in recent years largely  consisted of mortgage-backed securities, including subprime mortgage- backed securities.
Although CDOs have existed since the 1980s, recent changes in the  underlying asset mix of these products led to increased risk that was  poorly understood by the financial institutions involved in these  investments. CDOs had consisted of simple securities like corporate bonds  or loans, but more recently have included subprime mortgage-backed  securities, and in some cases even lower-rated classes of other equally  complex CDOs. Some of these CDOs included investments in 100 or more  asset-backed securities, each of which had its own large pool of loans and  specific payment structures. A large share of the total value of the  securities issued were rated AA or AAA—designating them as very safe  investments and unlikely to default—by the credit rating agencies. In part  because of their seemingly high returns in light of their rated risk, demand  for these new CDOs grew rapidly and on a large scale. Between 2004 and  2007, nearly all adjustable-rate subprime mortgages were packaged into  mortgage-backed securities, a large portion of which were structured into  CDOs.
As housing prices in the United States softened in the last 2 years, default  and foreclosure rates on the mortgages underlying many CDOs rose and  the credit rating agencies downgraded many CDO ratings, causing  investors to become unwilling to purchase these products in the same  quantities or at the prices previously paid. Many financial institutions,  including large commercial and investment banks, struggled to realize the  size of their exposure to subprime credit risk. Many of these institutions  appeared to have underestimated the amount of risk and potential losses  that they could face from creating and investing in these products.  Reductions in the value of subprime-backed CDOs have contributed to  reported losses by financial institutions totaling more than $750 billion  globally, as of September 2008, according to the International Monetary  Fund, which estimates that total losses on global holdings of U.S. loans  and securities could reach $1.4 trillion.
Several factors could explain why institutions—and regulators—did not  effectively monitor and limit the risk that CDOs represented. Products like  CDOs have risk characteristics that differ from traditional investments.  First, the variation and complexity of the CDO structures and the  underlying assets they contain often make estimating potential losses and  determining accurate values for these products more difficult than for  traditional securities. Second, although aggregating multiple assets into  these structures can diversify and thus reduce the overall risk of the  securities issued from them, their exposure to the overall housing market  downturn made investors reluctant to purchase even the safest tranches,  which produced large valuation losses for the holders of even the highest- rated CDO securities. Finally, Federal Reserve staff noted that an  additional reason these securities performed worse than expected was  that rating agencies and investors did not believe that housing prices could  have fallen as significantly as they have.
The lack of historical performance data for these new instruments also  presented challenges in estimating the potential value of these securities.  For example, 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. As a report by a group of senior  representatives of financial regulators and institutions has noted, the  absence of historical information on the performance of CDOs created  uncertainty around the standard risk-management tools used by financial  institutions. Further, structured products such as CDOs may lack an  active and liquid market, as in the recent period of market stress, 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.
section_title: Growth in OTC Derivatives Markets, Which Feature Complex Products That Are Not Regulated, Raised Regulator Concerns about Systemic Risk and Weak Market Infrastructure
paragraphs: The rapid growth in OTC derivatives—or derivatives contracts that are  traded outside of regulated exchanges—is another example of how the  emergence of large markets for increasingly complex products has  challenged our financial regulatory system. OTC derivatives, which began  trading in the 1980s, have developed into markets with an estimated  notional value—which is the amount underlying a financial derivatives  contract—of about $596 trillion, as of December 2007, according to the  Bank for International Settlements. OTC derivatives transactions are  generally not subject to regulation by SEC, CFTC, or any other U.S.  financial regulator and in particular are not subject to similar disclosure  and other requirements that are in place for most securities and exchange- traded futures products. Institutions that conduct derivatives transactions  may be subject to oversight of their lines of business by their regulators.  For example, commercial banks that deal in OTC derivatives are subject to  full examinations by their respective regulators. On the other hand,  investment banks generally conducted their OTC derivatives activities in  affiliates or subsidiaries that traditionally—since most OTC derivatives are  not securities—were not subject to direct oversight by SEC, although SEC  did review how the largest investment banks that were subject to its CSE  program were managing the risk of such activities.
Although OTC derivatives and their markets are not directly regulated, the  risk exposures that these products created among regulated financial  institutions can be sometimes large enough to raise systemic risk concerns  among regulators. For example, Bear Stearns, the investment bank that  experienced financial difficulties as the result of its mortgage-backed  securities activities, was also one of the largest OTC derivatives dealers.  According to regulators, one of the primary reasons the Federal Reserve,  which otherwise had no regulatory authority over this securities firm,  facilitated the sale of Bear Stearns rather than let it go bankrupt was to  avoid a potentially large systemic problem because of the firm’s large OTC  derivatives obligations. More than a decade ago, we reported that the large  financial interconnections between derivatives dealers posed risk to the  financial system and recommended that Congress and financial regulators  take action to ensure that the largest firms participating in the OTC  derivatives markets be subject to similar regulatory oversight and  requirements.
The market for one type of OTC derivative—credit default swaps—had  grown so large that regulators became concerned about its potential to  create systemic risks to regulated financial institutions. Credit default  swaps are contracts that act as a type of insurance, or a way to hedge  risks, against default or another type of credit event associated with a  security such as a corporate bond. One party in the contract—the seller of  protection—agrees, in return for a periodic fee, to compensate the other  party—the protection buyer—if the bond or other underlying entity  defaults or another specified credit event occurs. In recent years, the size  of the market for credit default swaps (in terms of the notional amount of  outstanding contracts) has increased almost tenfold from just over $6  trillion in 2004 to almost $58 trillion at the end of 2007, according to the  Bank for International Settlements.
As this market has grown, regulators increasingly have become concerned  about the adequacy of the infrastructure in place for clearing and settling  these contracts, especially the ability to quickly resolve contracts in the  event of a large market participant failure. For example, in September  2008, concerns over the effects that a potential bankruptcy of AIG—which  was a large seller of credit default swaps—would have on this firm’s swap  counterparties contributed to a decision by the Federal Reserve to lend  the firm up to $85 billion. The Federal Reserve expressed concern at the  time that a disorderly failure of AIG could add to already significant levels  of financial market fragility and lead to substantially higher borrowing  costs, reduced household wealth, and materially weaker economic  performance. As with other OTC derivatives, credit default swaps are not  regulated as products, but many of the large U.S. and internationally  regulated financial institutions act as dealers. Despite the credit default  market’s rapid growth, as recently as 2005 the processing of transactions  was still paper-based and decentralized. Regulators have put forth efforts  over the years to strengthen clearing and settlement mechanisms. For  example, in September 2005, the Federal Reserve Bank of New York began  working with dealers and market participants to strengthen arrangements  for clearing and settling these swap transactions. Regulators began  focusing on reducing a large backlog of unconfirmed trades, which can  inhibit market participants’ ability to manage their risks if errors are not  found quickly or if uncertainty exists about how other institutions would  be affected by the failure of a firm with which they hold credit default  swap contracts. Regulators continue to monitor dealers’ progress on these  efforts to reduce operational risk arising from these products, and recently  have begun holding discussions with the largest credit derivatives dealers  and other entities, including certain exchanges, regarding the need to  establish a centralized clearing facility, which could reduce the risk of any  one dealer’s failure to the overall system. In November 2008, the  President’s Working Group on Financial Markets announced policy  objectives to guide efforts to address challenges associated with OTC  derivatives, including recommendations to enhance the market  infrastructure for credit default swaps. However, as of December 2008, no  such entity had begun operations.
section_title: New Complex Products Have Also Created Challenges for Regulators in Ensuring Adequate Investor and Consumer Protection
paragraphs: The regulations requiring that investors receive adequate information  about the risks of financial assets being marketed to them are also being  challenged by the development of some of these new and complex  products. For some of the new products that have been created, market  participants sometimes had difficulty obtaining clear and accurate  information on the value of these assets, their risks, and other key  information. In some cases, investors did not perform needed due  diligence to fully understand the risks associated with their investment. In  other cases, investors have claimed they were misled by broker-dealers  about the advantages and disadvantages of products. For example,  investors for municipal governments in Australia have accused Lehman  Brothers of misleading them regarding the risks of CDOs. As another  example, the treasurer of Orange County who oversaw investments  leading to the county’s 1994 bankruptcy claimed to have relied on the  advice of a large securities firm for his decision to pursue leveraged  investments in complex structured products. Finally, a number of financial  institutions—including Bank of America, Wachovia, Merrill Lynch, and  UBS—have recently settled SEC allegations that these institutions misled  investors in selling auction-rate securities, which are bonds for which the  interest rates are regularly reset through auctions. In one case, Bank of  America, in October 2008, reached a settlement in principle in response to  SEC charges that it made misrepresentations to thousands of businesses,  charities, and institutional investors when it told them that the products  were safe and highly liquid cash and money market alternative  investments.
Similarly, the introduction and expansion of increasingly complicated  retail products to new and broader consumer populations has also raised  challenges for regulators in ensuring that consumers are adequately  protected. Consumers face growing difficulty in understanding the relative  advantages and disadvantages of products such as mortgages and credit  cards with new and increasingly complicated features, in part because of  limitations on the part of regulatory agencies to improve consumer  disclosures and financial literacy. For example, in the last few years many  borrowers likely did not understand the risks associated with taking out  their loans, especially in the event that housing prices would not continue  to increase at the rate at which they had been in recent years. In particular,  a significant majority of subprime borrowers from 2003 to 2006 took out  adjustable-rate mortgages whose interest rates were fixed for the first 2 or  3 years but then adjusted to often much higher interest rates and  correspondingly higher mortgage payments. In addition, many borrowers  took out loans with interest-only features that resulted in significant  increases in mortgage payments later in the loan. The combination of  reduced underwriting standards and a slowdown in house price  appreciation led many borrowers to default on their mortgages.
Alternative mortgage products such as interest-only or payment option  loans, which allow borrowers to defer repayment of principal and possibly  part of the interest for the first few years of the loan, grew in popularity  and expanded greatly in recent years. From 2003 through 2005,  originations of these types of mortgage products grew threefold, from less  than 10 percent of residential mortgage originations to about 30 percent.  For many years, lenders had primarily marketed these products to wealthy  and financially sophisticated borrowers as financial management tools.  However, lenders increasingly marketed alternative mortgage products as  affordability products that enabled a wider spectrum of borrowers to  purchase homes they might not have been able to afford using a  conventional fixed-rate mortgage. Lenders also increased the variety of  such products offered after interest rates rose and adjustable rate  mortgages became less attractive to borrowers.
In past work, we found that most of the disclosures for alternative  mortgage products that we reviewed did not always fully or effectively  explain the risks associated with these products and lacked information  on some important loan features. Some evidence suggests more generally  that existing mortgage disclosures were inadequate, a problem that is  likely to grow with the increased complexity of products. A 2007 Federal  Trade Commission report found that both prime and subprime borrowers  failed to understand key loan terms when viewing current disclosures. In  addition, some market observers have been critical of regulators’ oversight  of these products and whether products with such complex features were  appropriate for some of the borrowers to which they were marketed. For  example, some were critical of the Federal Reserve for not acting more  quickly to use its authority under the 1994 Home Ownership and Equity  Protection Act to prohibit unfair or deceptive acts or practices in the  mortgage market. Although the Federal Reserve took steps in 2001 to ban  some practices, such as engaging in a pattern or practice of refinancing  certain high-cost loans when it is not in the borrower’s interest, it did not  act again until 2008, when it banned additional products and practices,  such as certain loans with limited documentation. In a 2007 testimony, a  Federal Reserve official noted that writing such rules is difficult,  particularly since determinations of unfairness or deception depend  heavily on the facts of an individual case.
Efforts by regulators to respond to the increased risks associated with  new mortgage products also have sometimes been slowed in part because  of the need for five federal regulators to coordinate their response. In late  2005, regulators began crafting regulatory guidance to strengthen lending  practices and improve disclosures for loans that start with relatively low  payments but leave borrowers vulnerable to much higher ones later. The  regulators completed their first set of such standards in September 2006,  with respect to the disclosure of risks associated with nontraditional  mortgage products, and a second set, applicable to subprime mortgage  loans, in June 2007. Some industry observers and consumer advocacy  groups have criticized the length of time it took for regulators to issue  these changes, noting that the second set of guidance was released well  after many subprime lenders had already gone out of business.
As variations in the types of credit card products and terms have  proliferated, consumers also have faced difficulty understanding the rates  and terms of their credit card accounts. Credit card rate and fee  disclosures have not always been effective at clearly conveying associated  charges and fees, creating challenges to informed financial decision  making. Although credit card issuers are required to provide cardholders  with information aimed at facilitating informed use of credit, these  disclosures have serious weaknesses that likely reduce consumers’ ability  to understand the costs of using credit cards. Because the pricing of credit  cards is not generally subject to federal regulation, these disclosures are  the primary federal consumer protection mechanism against inaccurate  and unfair credit card practices. However, we reported in 2006 that the  disclosures in materials provided by four of the largest credit card issuers  were too complicated for many consumers to understand. Following our  report, Federal Reserve staff began using consumer testing to involve  them to a greater extent in the preparation of potentially new and revised  disclosures, and in May 2007, issued proposed changes to credit card  disclosure requirements. Nonetheless, the Federal Reserve recognizes the  challenge of presenting the information that consumers may need to  understand the costs of their cards in a clear way, given the increasingly  complicated terms of credit card products. In December 2008, the  Federal Reserve, OTS, and NCUA finalized rules to ban various unfair  credit card practices, such as allocating payments in a way that unfairly  maximizes interest charges.
The expansion of new and more complex products also raises challenges  for regulators in addressing financial literacy. We have also noted in past  work that even a relatively clear and transparent system of disclosures  may be of limited use to borrowers who lack sophistication about financial  matters. In response to increasing evidence that many Americans are  lacking in financial literacy, the federal government has taken steps to  expand financial education efforts. However, attempts by the Financial  Literacy and Education Commission to coordinate federal financial  literacy efforts have sometimes proven difficult due, in part, to the need to  reach consensus among its 20 participating federal agencies, which have  different missions and perspectives. Moreover, the commission’s staff and  funding resources are relatively small, and it has no legal authority to  require agencies to redirect their resources or take other actions.
section_title: Increased Complexity and Other Factors Have Challenged Accounting Standard Setters and Regulators
paragraphs: As new and increasingly complex financial products have become more  common, FASB and SEC have also faced challenges in trying to ensure  that accounting and financial reporting requirements appropriately meet  the needs of investors and other financial market participants. The  development and widespread use of increasingly complex financial  products has heightened the importance of having effective accounting  and financial reporting requirements that provide interested parties with  information that can help them identify and assess risk. As the pace of  financial innovation increased in the last 30 years, accounting and  financial reporting requirements have also had to keep pace, with 72  percent of the current 163 standards having been issued since 1980—some  of which were revisions and amendments to recently established  standards, which evidences the challenge of establishing accounting and  financial reporting requirements that respond to needs created by financial  innovation.
As a result of the growth in complex financial instruments and a desire to  improve the usefulness of financial information about them, U.S. standard  setters and regulators currently are dealing with accounting and auditing  challenges associated with recently developed standards related to valuing  financial instruments and special-purpose entities. Over the last year,  owners and issuers of financial instruments have expressed concerns  about implementing the new fair value accounting standard, which  requires that financial assets and liabilities be recorded at fair or market  value. SEC and FASB have recently issued clarifications of measuring fair  value when there is not an active market for the financial instrument. In  addition, market participants raised concerns about the availability of  useful accounting and financial reporting information to assess the risks  posed by special-purpose entities. Under current accounting rules,  publicly traded companies that create qualifying special-purpose entities  are allowed to move qualifying assets and liabilities associated with  certain complex financial instruments off the issuing company’s balance  sheets, which results in virtually no accounting and financial reporting  information being available about the entities’ activities. Due to the  accounting and financial reporting treatment for these special-purpose  entities, as the subprime crisis worsened, banks initially refused to  negotiate loans with homeowners because banks were concerned that the  accounting and financial reporting requirements would have the banks put  the assets and liabilities back onto their balance sheets. In response to  questions regarding modification of loans in special-purpose entities, the  SEC’s Chief Accountant issued a letter that concluded his office would not  object to loans being modified pursuant to specific screening criteria. In  response to these concerns, FASB expedited its standards-setting process  in order to reduce the amount of time before the issuance of a new  accounting standard that would effectively eliminate qualified special- purpose entities.
Standard setters and regulators also face new challenges in dealing with  global convergence of accounting and auditing standards. The rapid  integration of the world’s capital markets has made establishing a single  set of effective accounting and financial reporting standards increasingly  relevant. FASB and SEC have acknowledged the need to address the  convergence of U.S. and international accounting standards, and SEC has  proposed having U.S. public companies use International Financial  Reporting Standards by 2014. As the globalization of accounting standards  moves forward, U.S. standard setters and regulators need to anticipate and  manage the challenges posed by their development and implementation,  such as how to apply certain standards in unique legal and regulatory  environment frameworks in the United States as well as in certain unique  industry niches. Ensuring that auditing standards applicable to U.S. public  companies continue to provide the financial markets with the important  and independent assurances associated with existing U.S. auditing  standards will also prove challenging to the Public Company Accounting  Oversight Board.
section_title: Globalization Will Further Challenge the Existing U.S. Regulatory System
paragraphs: Just as global accounting and auditing standards are converging, financial  markets around the world are becoming increasingly interlinked and  global in nature, requiring U.S. regulators to work with each other and  other countries to effectively adapt. To effectively oversee large financial  services firms that have operations in many countries, regulators from  various countries must coordinate regulation and supervision of financial  services across national borders and must communicate regularly.  Although financial regulators have effectively coordinated in a number of  ways to accommodate some changes, the current fragmented regulatory  structure has complicated some of these efforts.
For example, the current U.S. regulatory system complicates the ability of  financial regulators to convey a single U.S. position in international  discussions, such as those related to the Basel Accords process for  developing international capital standards. Each federal regulator involved  in these efforts oversees a different set of institutions and represents an  important regulatory perspective, which has made reaching consensus on  some issues more difficult than others. Although U.S. regulators generally  agree on the broad underlying principles at the core of Basel II, including  increased risk sensitivity of capital requirements and capital neutrality, in  a 2004 report we noted that although regulators communicated and  coordinated, they sometimes had difficulty agreeing on certain aspects of  the process. As we reported, in November 2003, members of the House  Financial Services Committee warned in a letter to the bank regulatory  agencies that the discord surrounding Basel II had weakened the  negotiating position of the United States and resulted in an agreement that  was less than favorable to U.S. financial institutions. International  officials have also indicated that the lack of a single point of contact on,  for example, insurance issues has complicated regulatory decision  making. However, regulatory officials told us that the final outcome of the  Basel II negotiations was better than it would have been with a single U.S.  representative because of the agencies’ varying perspectives and  expertise. In particular, one regulator noted that, in light of the magnitude  of recent losses at banks and the failure of banks and rating agencies to  predict such losses, the additional safeguards built into how U.S.  regulators adopted Basel II are an example of how more than one  regulatory perspective can improve policymaking.
section_title: A Framework for Crafting and Assessing Alternatives for Reforming the U.S. Financial Regulatory System
paragraphs: The U.S. regulatory system is a fragmented and complex system of federal  and state regulators—put into place over the past 150 years—that has not  kept pace with the major developments that have occurred in financial  markets and products in recent decades. In 2008, the United States finds  itself in the midst of one of the worst financial crises ever, with instability  threatening global financial markets and the broader economy. While  much of the attention of policymakers understandably has been focused  on taking short-term steps to address the immediate nature of the crisis,  attention has also turned to the need to consider significant reforms to the  financial regulatory system to keep pace with existing and anticipated  challenges in financial regulation.
While the current U.S. system has many features that could be preserved,  the significant limitations of the system, if not addressed, will likely fail to  prevent future crises that could be as harmful as or worse than those that  have occurred in the past. Making changes that better position regulators  to oversee firms and products that pose risks to the financial system and  consumers and to adapt to new products and participants as these arise  would seem essential to ensuring that our financial services sector  continues to serve our nation’s needs as effectively as possible.
We have conducted extensive work in recent decades reviewing the  impacts of market developments and overseeing the effectiveness of  financial regulators’ activities. In particular, we have helped Congress  address financial crises dating back to the savings and loan and LTCM  crises, and more recently over the past few years have issued several  reports citing the need to modernize the U.S. financial regulatory  structure. In this report, consistent with our past work, we are not  proposing the form and structure of what a new financial regulatory  system should look like. Instead, we are providing a framework, consisting  of the following nine elements, that Congress and others can use to  evaluate or craft proposals for financial regulatory reform. By applying the  elements of this framework to proposals, the relative strengths and  weaknesses of each one should be better revealed. Similarly, the  framework we present could be used to craft a proposal or to identify  aspects to be added to existing proposals to make them more effective and  appropriate for addressing the limitations of the current system. The nine  elements could be addressed in a variety of ways, but each is critically  important in establishing the most effective and efficient financial  regulatory system possible.  1. Clearly defined regulatory goals. A regulatory system should  have 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 to  clearly define regulatory goals and objectives. In the background of this  report, we identify four broad goals of financial regulation that regulators  have generally sought to achieve. These include ensuring adequate  consumer protections, ensuring the integrity and fairness of markets,  monitoring the safety and soundness of institutions, and acting to ensure  the stability of the overall financial system. However, these goals are not  always explicitly set in the federal statutes and regulations that govern  these regulators. Having specific goals clearly articulated in legislation  could serve to better focus regulators on achieving their missions with  greater certainty and purpose, and provide continuity over time.
Given some of the key changes in financial markets discussed earlier in  this report—particularly the increased interconnectedness of institutions,  the increased complexity of products, and the increasingly global nature of  financial 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 of  financial regulation and the ad hoc approach through which the existing  goals have been established, as discussed earlier.
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 effectiveness  rather 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—are  able 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 that  cross 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  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 such  an approach would prevent institutions in a more rules-based system from  complying with the exact letter of the law while still engaging in unsound  or otherwise undesirable financial activities. However, such an approach  has potential limitations. Opponents note that regulators may face  challenges to implement such a subjective set of principles. A lack of clear  rules about activities could lead to litigation if financial institutions and  consumers 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 for  bright-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 technical  rules prohibiting specific activities that have been identified as  problematic.
Key issues to be addressed:    Clarify and update the goals of financial regulation and provide  sufficient information on how potentially conflicting goals might be  prioritized.
Determine the appropriate balance of broad principles and specific  rules 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 in a  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 same level 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 to  consider how to ensure that both the breadth and depth of regulation are  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 to  meet regulatory goals, and then make determinations about how extensive  such regulation should be. As we have noted, gaps in the current level of  federal oversight of mortgage lenders, credit rating agencies, and certain  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 that have  traditionally fallen within full federal oversight but for which existing  regulatory efforts, such as oversight related to risk management and  lending 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 in  place 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, for  determining 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 a  mechanism 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 just  institutions. As noted earlier, 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 the  industry. As we noted earlier in the report, 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 scope of oversight to identify the risks to the  broader financial system. Similarly, 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 and potentially 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 the  past. 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, and  globally. However, policymakers should consider that a potential  disadvantage of providing the agency with such broad responsibility for  overseeing nonbank entities could be that it may imply an 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.
Regardless of whether a new regulator is created, all regulators under a  new system should consider how their activities could better identify and  address systemic risks posed by their institutions. As the Federal Reserve  Chairman has noted, regulation and supervision of financial institutions is  a 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 the  business cycle, and what actions regulators can take to anticipate and  mitigate 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:  Identify approaches to broaden the focus of individual regulators  or establish new regulatory mechanisms for identifying and acting  on systemic risks.
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 a mechanism  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 and  services 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 particular  market segments—to determine the degree, if any, to which regulatory  intervention might be required. The rise of a very large market for credit  derivatives, while providing benefits to users, also created exposures that  warranted actions by regulators to rescue large individual participants in  this 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, as discussed above, would provide such a mechanism.  Designing a system to be flexible 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 new  financial products and services as they are developed to ensure the least  harm from inappropriate products. Some individuals commenting on this  framework, 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 and  therefore warrants intervention may be more appropriate. As with other  key policy questions, this may be answered with a combination of both  approaches, recognizing that a product approval approach may be  appropriate for some innovations with greater potential risk, while other  activities may warrant a more reactive approach.
Key issues to be addressed:    Determine 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 a  responsibility.
Consider how to strike the right balance between overseeing new  products as they come onto the market to take action as needed to  protect 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 oversight  of financial services. Accomplishing this in a regulatory system involves  many considerations. First, an efficient regulatory system is designed to  accomplish its regulatory goals using the least amount of public resources.  In this sense, policymakers must consider the number, organization, and  responsibilities of each agency, and eliminate undesirable overlap in  agency 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 their  business 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 these  agencies to potentially develop alternative or innovative approaches to  regulation separately, with the approach working best becoming known  over time. Such proven approaches can then be adopted by the other  agencies. On the other hand, this could lead to regulatory arbitrage, in  which institutions take advantage of variations in how agencies implement  regulatory responsibilities in order to be subject to less scrutiny. Both  situations 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 to  adequately protect consumers and ensure financial stability. As we noted  earlier, efforts by regulators to respond to the increased risks associated  with new mortgage products were sometimes slowed in part because of  the need for five federal regulators to coordinate their response. The  Chairman of the Federal Reserve has similarly noted that the different  regulatory and supervisory regimes for lending institutions and mortgage  brokers made monitoring such institutions difficult for both regulators and  investors. Similarly, we noted earlier in the report that the current  fragmented U.S. regulatory structure has complicated some efforts to  coordinate internationally with other regulators.
One first step to addressing such problems is to seriously consider the  need to consolidate depository institution oversight among fewer  agencies. Since 1996, we have been recommending that the number of  federal agencies with primary responsibilities for bank oversight be  reduced. Such a move would result in a system that was more efficient and  improve consistency in regulation, another important characteristic of an  effective regulatory system. In addition, Congress could consider the  advantages and disadvantages of providing a federal charter option for  insurance and creating a federal insurance regulatory entity. We have not  studied the issue of an optional federal charter for insurers, but have  through 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 have  unintended 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 will  need to consider how best to align agency responsibilities to better ensure  that consumers and investors are provided with clear, concise, and  effective 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 of  the 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 efficient  mechanisms to coordinate in cases where goals inevitably overlap. For  example, in some cases, the safety and soundness of an individual  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 to  effectiveness. For example, to the extent that policymakers see value in  the 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 to  the development of expertise among agency staff in particular areas of  financial 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, and  especially large institutions that offer services that cross sectors, are  subject 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 and  consumer protection, can run counter to other goals of a financial system  by stifling innovation and competitiveness. In addressing this concern, it is  also important to consider the potential benefits that might result in some  cases 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—can  provide 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  be less burdensome to institutions than others, such as ongoing  supervision 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 the  broader economy, and take steps to minimize such consequences.  6. Consistent consumer and investor protection. A regulatory  system should include consumer and investor protection as part of  the regulatory mission to ensure that market participants receive  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 the  situation. Different disclosures and regulatory protections may be  necessary for these different groups. Consumer protection should be  viewed from the perspective of the consumer rather than through the  various and sometimes divergent perspectives of the multitude of federal  regulators that currently have responsibilities in this area.
As discussed earlier, many consumers that received loans in the last few  years did not understand the risks associated with taking out their loans,  especially in the event that housing prices would not continue to increase  at the rate they had in recent years. In addition, increasing evidence exists  that many Americans are lacking in financial literacy, and the expansion of  new and more complex products will continue to create challenges in this  area. Furthermore, as noted above, regulators with existing authority to  better 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 to  improve upon the existing, largely fragmented, system of regulators that  must coordinate to act in these areas. As noted above, this should include  serious consideration of whether to consolidate regulatory responsibilities  to streamline 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 to extend suitability requirements—which require securities brokers  making recommendations to customers to have reasonable grounds for  believing that the recommendation is suitable for the customer—to  mortgage and other products.  Additional consideration could also be  given to determining whether certain products are simply too complex to  be well understood 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 the financial services industry.
Consider what distinctions are necessary between retail and  wholesale products, and how such distinctions should affect how  products are regulated.
Identify opportunities to protect and empower consumers through  improving 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 to carry out and enforce  statutory missions; and are clearly 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, especially  to 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 assessments  on the firms they supervise. Decision makers should consider whether  some of these various funding mechanisms are more likely to ensure that a  regulator 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 raise  safety and soundness or other concerns to Congress and the  administration in a timely manner. Mere knowledge of a deteriorating  situation would be insufficient if a regulator were unable to persuade  Congress and the administration to take timely corrective action. This  problem would be exacerbated if a regulated institution had more political  clout 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, as noted earlier, 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. It is important for a regulatory system to ensure that agencies  are provided with adequate resources and expertise to conduct 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 and  accountability.
Consider how to provide an appropriate level of authority to an  agency 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, and transparency,  which should help minimize negative competitive outcomes while  harmonizing oversight, both within the United States and  internationally.
A regulatory system should ensure that similar institutions, products, and  services 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 a number of important  considerations. Two institutions that look very similar may in fact pose very  different risks to the financial system, and therefore 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 from  increased globalization and potential harmonization in regulatory  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 and  financial holding companies, consolidated supervised entities, and other  holding 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. Recent events further  underscore the limitations brought about when there is a lack 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 similar  risks.
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 coordinated  internationally.  9. Minimal taxpayer exposure. A regulatory system should have  adequate safeguards that allow financial institution failures to  occur while limiting taxpayers’ exposure to financial risk.
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 and  assignment 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 and  regulators must consider the realities of today’s financial system. In some  cases, the immediate use of public funds to prevent the failure of a  critically important financial institution may be a worthwhile use of such  funds if it ultimately serves to prevent a systemic crisis that would result  in much greater use of public funds in the long run. However, an effective  regulatory system that incorporates the characteristics noted above,  especially by ensuring a systemwide focus, should be better equipped to  identify and mitigate problems before it become necessary to make  decisions 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 and  limitations in market infrastructures that prevent the orderly unwinding of  firms that fail. Another important consideration in minimizing taxpayer  exposure is to ensure that financial institutions provided with a  government guarantee that could result in taxpayer exposure are also  subject to an appropriate level of regulatory oversight to fulfill the  responsibilities discussed above.
Key issues to be addressed:  Identify safeguards that are most appropriate to prevent systemic  crises 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 the  U.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, and  consumers’ ability to access needed services. For example, if the changes  require regulators or institutions to make systems changes, file  registrations, or other activities that could require extensive time to  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. Although all of these factors are  likely important for a successful transformation for the financial  regulatory system, Congress and existing agencies should pay particular  attention to ensuring there are effective communication strategies so that  all affected parties, including investors and consumers, clearly understand  any changes being implemented. In addition, attention should be paid to  developing a sound human capital strategy to ensure that any new or  consolidated 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.
section_title: Comments from Agencies and Other Organizations, and Our Evaluation
paragraphs: We provided the opportunity to review and comment on a draft of this  report to representatives of 29 agencies and other organizations, including  federal and state financial regulatory agencies, consumer advocacy  groups, and financial service industry trade associations. A complete list of  organizations that reviewed the draft is included in appendix II. All  reviewers provided valuable input that was used in finalizing this report.   In general, reviewers commented that the report represented a high-quality  and thorough review of issues related to regulatory reform. We made  changes throughout the report to increase its precision and clarity and to  provide additional detail. For example, the Federal Reserve provided  comments indicating that our report should emphasize that the traditional  goals of regulation that we described in the background section are  incomplete unless their ultimate purpose is considered, which is to  promote the long-term growth, stability, and welfare of the United States.   As a result, we expanded the discussion of our framework element  concerning the need to have clearly defined regulatory goals to emphasize  that policymakers will need to ensure that such regulation is balanced  with other national goals, including facilitating capital raising and  fostering innovation.
In addition, we received formal written responses from the American  Bankers Association, the American Council of Life Insurers, the  Conference of State Bank Supervisors, Consumers Union, the Credit  Union National Association, the Federal Deposit Insurance Corporation,  the Mortgage Bankers Association, and the National Association of  Federal Credit Unions, and a joint letter from the Center for Responsible  Lending, the National Consumer Law Center, and U.S. PIRG; all formal  written responses are included as appendixes to this report.
Among the letters we received, various commenters raised additional  issues regarding consumer protection and risky products. For example, in  a joint letter, the Center for Responsible Lending, the National Consumer  Law Center, and the U.S. PIRG noted that the best way to avoid systemic  risk is to address problems that exist at the level of individual consumer  transactions, before they pose a threat to the system as a whole. They also  noted that although most of the subprime lending was done by nonbank  lenders, overly aggressive practices for other loan types and among other  lenders also contributed to the current crisis. In addition, they noted that  to effectively protect consumers, the regulatory system must prohibit  unsustainable lending and that disclosures and financial literacy are not  enough. The letter from FDIC agreed that effective reform of the U.S.  financial regulatory system would help avoid a recurrence of the economic  and financial problems we are now experiencing. It also noted that  irresponsible lending practices were not consistent with sound banking  practices. FDIC’s letter also notes that the regulatory structure collectively  permitted excessive levels of leverage in the nonbank financial system and  that statutory mandates that address consumer protection and aggressive  lending practices and leverage among firms would be equally important  for improving regulation as would changing regulatory structure. In a  letter from Consumers Union, that group urged that consumer protection  be given equal priority as safety and soundness and that regulators act  more promptly to address emerging risks rather than waiting until a  problem has become national in scope. The letter indicates that  Consumers Union supports an independent federal consumer protection  agency for financial services and the ability of states to also develop and  enforce consumer protections.  We made changes in response to many of  these comments.  For example, we enhanced our discussion of  weaknesses in regulators’ efforts to oversee the sale of mortgage products  that posed risks to consumers and the stability of the financial system, and  we made changes to the framework to emphasize the importance of  consumer protection.
Several of the letters addressed issues regarding potential consolidation of  regulatory agencies and the role of federal and state regulation. The letter  from the American Bankers Association said that the current system of  bank regulation and oversight has many advantages and that any reform  efforts should build on those advantages. The letter also noted that there  are benefits to having multiple federal regulators, as well as a dual banking  system. The letter from the Conference of State Bank Supervisors agreed  with our report that the U.S. regulatory system is complex and clearly has  gaps, but cautioned that consolidating regulation and making decisions  that could indirectly result in greater industry consolidation could  exacerbate problems. The letter also indicates concern that our report  does not fully acknowledge the importance of creating an environment  that promotes a diverse industry to serve the nation’s diverse communities  and prevents concentration of economic power in a handful of institutions.  Our report does discuss the benefits of state regulation of financial  institutions, but we did not address the various types of state institutions  because we focused mainly on the federal role over our markets.  In the  past, our work has acknowledged the dual banking system has benefits  and that concentration in markets can have disadvantages.  The  Conference of State Bank Supervisors letter also notes that state efforts to  respond to consumer abuses were stymied by federal pre-emption and that  a regulatory structure should preserve checks and balances, avoid  concentrations of power, and be more locally responsive. In response to  this letter, we also added information about the enactment of the Secure  and Fair Enforcement for Mortgage Licensing Act, as part of the Housing  and Economic Recovery Act, which requires enhanced licensing and  registration of mortgage brokers.
The letter from the National Association of Federal Credit Unions urged  that an independent regulator for credit unions be retained because of the  distinctive characteristics of federal credit unions. A letter from the Credit  Union National Association also strongly opposes combining the credit  union regulator or its insurance function with another agency.  The letter  from the Mortgage Bankers Association urges that a federal standard for  mortgage lending be developed to provide greater uniformity than the  currently diffuse set of state laws. They also supported consideration of  federal regulation of independent mortgage bankers and mortgage brokers  as a way of improving uniformity and effectiveness of the regulation of  these entities. A letter from the American Council of Life Insurers noted  that the lack of a federal insurance regulatory office provides for uneven  consumer protections and policy availability nationwide and hampers the  country’s ability to negotiate internationally on insurance industry issues,  and urged that we include a discussion of the need to consider a greater  federal role in the regulation of insurance. As a result, in the section where  we discuss the need for efficient and effective regulation we noted that  harmonizing insurance regulation across states has been difficult, and that  Congress could consider the advantages and disadvantages of providing a  federal charter option for insurance and creating a federal insurance  regulatory entity.
We are sending copies of this report to interested congressional  committees and members.  In addition, we are sending copies to the  federal financial regulatory agencies and associations representing state  financial regulators, financial industry participants, and consumers, as  well as to the President and Vice President, the President-Elect and Vice  President-Elect, and other interested parties. The report also is available at  no charge on GAO’s Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, 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.  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 XII.
section_title: Appendix I: Scope and Methodology
paragraphs: Our report objectives were to (1) describe the origins of the current  financial regulatory system, (2) describe various market developments and  changes that have raised challenges for the current system, and (3) present  an evaluation framework that can be used by Congress and others to craft  or evaluate potential regulatory reform efforts going forward.
To address all of these objectives, we synthesized existing GAO work on  challenges to the U.S. financial regulatory structure and on criteria for  developing and strengthening effective regulatory structures. These  reports are referenced in footnotes in this report and noted in the Related  GAO Products appendix. In particular, we relied extensively on our recent  body of work examining the financial regulatory structure, culminating in  reports issued in 2004 and 2007. We also reviewed existing studies,  government documents, and other research for illustrations of how  current and past financial market events have revealed limitations in our  existing regulatory system and suggestions for regulatory reform.
In addition, to gather input on challenges with the existing system and  important considerations in evaluating reforms, we interviewed several  key individuals with broad and substantial knowledge about the U.S.  financial regulatory system—including a former Chairman of the Board of  Governors of the Federal Reserve System (Federal Reserve), a former  high-level executive at a major investment bank that had also served in  various regulatory agencies, and an international financial organization  official that also served in various regulatory agencies. We selected these  individuals from a group of notable officials, academics, legal scholars,  and others we identified as part of this and other GAO work, including a  2007 expert panel on financial regulatory structure. We selected  individuals to interview in an effort to gather government, industry, and  academic perspectives, including on international issues. In some cases,  due largely to the market turmoil at the time of our study, we were unable  to or chose not to reach out to certain individuals, but took steps to ensure  that we selected other individuals that would meet our criteria.
To develop the evaluation framework, we also convened a series of three  forums in which we gathered comments on a preliminary draft of our  framework from a wide range of representatives of federal and state  financial regulatory agencies, financial industry associations and  institutions, and consumer advocacy organizations. In particular, at a  forum held on August 19, 2008, we gathered comments from  representatives of financial industry associations and institutions,  including the American Bankers Association, the American Council of Life  Insurers, The Clearing House, Columbia Bank, the Independent  Community Bankers of America, The Financial Services Roundtable,  Fulton Financial Corporation, the Futures Industry Association, the  Managed Funds Association, the Mortgage Bankers Association, the  National Association of Federal Credit Unions, the Securities Industry and  Financial Markets Association, and the U.S. Chamber of Commerce. We  worked closely with representatives at the American Bankers  Association—which hosted the forum at its Washington, D.C.,  headquarters—to identify a comprehensive and representative group of  industry associations and institutions.
At a forum held on August 27, 2008, we gathered comments from  representatives of consumer advocacy organizations, including the Center  for Responsible Lending, the Consumer Federation of America, the  Consumers Union, the National Consumer Law Center, and the U.S. PIRG.  We invited a comprehensive list of consumer advocacy organization  representatives—compiled based on extensive dealings with these groups  from current and past work—to participate in this forum and hosted it at  GAO headquarters in Washington, D.C.
At a forum held on August 28, 2008, we gathered comments from  representatives of federal and state banking, securities, futures, insurance  and housing regulatory oversight agencies, including the Commodity  Futures Trading Commission, the Conference of State Bank Supervisors,  the Department of the Treasury, the Federal Deposit Insurance  Corporation, the Federal Housing Finance Agency, the Federal Reserve,  the Financial Industry Regulatory Authority, the National Association of  Insurance Commissioners, the National Credit Union Administration, the  North American Securities Administrators Administration, the Office of  the Comptroller of the Currency, the Office of Thrift Supervision, the  Public Company Accounting Oversight Board, and the Securities and  Exchange Commission. We worked closely with officials at the Federal  Reserve—which hosted the forum at its Washington, D.C., headquarters— to identify a comprehensive and representative group of federal and state  financial regulatory agencies.
We conducted this work from April 2008 to December 2008 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.
section_title: Appendix II: Agencies and Other Organizations That Reviewed the Draft Report
section_title: Appendix III: Comments from the American Bankers Association
section_title: Appendix IV: Comments from the American Council of Life Insurers
section_title: Appendix V: Comments from the Conference of State Bank Supervisors
paragraphs: Appendix V: Comments from the Conference  of State Bank Supervisors  Orice M. Williams  Director  Financial Markets and Community Investment  U.S. Government Accountability Office  441 G Street, NW  Washington, DC  20548  Thank you for the opportunity to submit a second written comment in response to the  GAO’s upcoming report on the financial regulatory framework of the United States.
The Conference of State Bank Supervisors (CSBS) recognizes the current regulatory  structure at both the state and federal level is sometimes complex for the industry,  regulators, consumers, and policymakers to navigate.  As financial institutions and service  providers increase in size, complexity, and operations, our regulatory system must reflect  this evolution.  The current economic stresses have also shown that our financial  regulatory system must better address the interconnected risks of the capital markets and  our banking system.
CSBS is committed to working with the GAO, our federal counterparts, Congress, industry  associations, and consumer advocates to further the development of a fair and efficient  regulatory system that provides sufficient consumer protection and serves the interests of  financial institutions and financial service providers, while ultimately strengthening the  U.S. economy as a whole.
We believe that changes are needed in both regulation and the way our regulatory structure  functions to better respond to consumer needs and address systemic risks and market  integrity.  We are very concerned, however, that federal policy that addresses nationwide  and global regulatory business models continues to threaten—or perhaps eliminate—the  greatest strengths of our system.  Specifically, we see policies that promote the needs of  the very largest financial institutions at the expense of consumers, important federal checks  and balances and diversity of banking and other financial institutions that are critical to our  state economies.
The current financial regulatory structure allows for a diverse universe of financial  institutions of varying sizes.  While the financial industry continues to consolidate at a  rapid pace, there are still well over 8,000 financial institutions operating within the United  CONFERENCE OF STATE BANK SUPERVISORS  1155 Connecticut Ave., NW, 5th Floor
Washington DC 20036-4306 (202) 296-2840
Fax: (202) 296-1928  States, some of which are as small as $1 million in assets.  Obviously, our nation’s largest  money center banks play a critical role in the economy.  However, even the smallest bank  in the country is absolutely critical to the economic health of the community in which it  operates.
The complexity of the system is presented as a major source of the current financial crisis.   While there are clearly gaps in our regulatory system and the system is undeniably  complex, CSBS has observed that the greater failing of the system has been one of  insufficient political and regulatory will, primarily at the federal level.  We believe that  decisions to consolidate regulation do not fix, but rather exacerbate this problem.   Moreover, CSBS is deeply concerned that the GAO study does not fully appreciate the  importance of creating an environment that promotes a diverse industry which serves our  nation’s diverse communities and avoids a concentration of economic and political power  in a handful of institutions.
Specifically, we are offering the following comments to the elements of a successful  supervisory framework.
Clearly Defined Regulatory Goals Generally, we agree with the GAO’s goals of a regulatory system that ensures adequate  consumer protections, ensures the integrity and fairness of markets, monitors the safety  and soundness of institutions, and acts to ensure the stability of the overall financial  system.  We disagree, however, with the GAO’s claim that the safety and soundness goal  is necessarily in direct conflict with the goal of consumer protection.  It has been the  experience of state regulators that the very opposite can be true.  Indeed, consumer  protection should be recognized as integral to safety and soundness of financial institutions  and service providers.  The health of a financial institution ultimately is connected to the  health of its customers.  However, we have observed that federal regulators, without the  checks and balances of more locally responsive state regulators or state law enforcement  do not always give fair weight to consumer issues or have the perspective to understand  consumer issues.  We consider this a significant weakness of the current system.  Federal  preemption of state law and state law enforcement by the Office of the Comptroller of the  Currency and the Office of Thrift Supervision has resulted in less responsive consumer  protections and institutions that are much less responsive to needs of consumers in our  states.
Appropriately Comprehensive CSBS disagrees that federal regulators were unable to identify the risks to the financial  system because they did not have the necessary scope of oversight.  As previously noted,  we believe it was a failure of regulatory will and a philosophy of self-regulating markets  that allowed for risks to develop.  CSBS strongly believes a “comprehensive” system of  regulation should not be construed as a consolidated regime under one single regulator.   Instead, “comprehensive” should describe a regulatory system that is able to adequately  supervise a broad, diverse, and dynamic financial industry.  We believe that the checks and  balances of the dual system of federal and state supervision are more likely to result in  2 comprehensive and meaningful coverage of the industry.  From a safety and soundness  perspective and from a consumer protection standpoint, the public is better served by a  coordinated regulatory network that benefits from both the federal and state perspectives. We believe the Federal Financial Institutions Examination Council (FFIEC) could be much  better utilized to accomplish this approach.
Systemwide Focus The GAO report states “a regulatory system should include a mechanism for identifying,  monitoring, and managing risks to the financial system regardless of the source of the risk  or the institutions in which it was created.”  CSBS agrees with this assessment.  Our  current crisis has shown us that our regulatory structure was incapable of effectively  managing and regulating the nation’s largest institutions.  CSBS believes the solution,  however, is not to expand the federal government bureaucracy by creating a new super  regulator.  Instead, we should enhance coordination and cooperation among the federal  government and the states.  We believe regulators must pool resources and expertise to  better manage systemic risk.  The FFIEC provides a vehicle for working towards this goal  of seamless federal and state cooperative supervision.
In addition, CSBS provides significant coordination among the states as well as with  federal regulators.  This coordinating role reached new levels when Congress adopted the  Riegle-Neil Act to allow for interstate banking and branching.  The states, through CSBS,  quickly followed suit by developing the Nationwide Cooperative Agreement and the State- Federal Supervisory Agreement for the supervision of multi-state banks.  Most recently,  the states launched the Nationwide Mortgage Licensing System (NMLS) and a nationwide  protocol for mortgage supervision.  Further, the NMLS is the foundation for the recently  enacted Secure and Fair Enforcement for Mortgage Licensing Act of 2008, or the S.A.F.E.  Act.  The S.A.F.E. Act establishes minimum mortgage licensing standards and a  coordinated network of state and federal mortgage supervision.
Flexible and Adaptable CSBS agrees that a regulatory system should be adaptable and forward-looking so that  regulators can readily adapt to market innovations and chances to include a mechanism for  evaluating potential new risks to the system.  In fact, this is one of the greatest strengths of  the state system.  The traditional dynamic of the dual-banking system of regulation has  been that the states experiment with new products, services, and practices that, upon  successful implementation, Congress later enacts on a nationwide basis.  In addition, state  bank examiners are often the first to identify and address economic problems.  Often, states  are the first responders to almost any problem in the financial system.  The states can—and  do—respond to these problems much more quickly than the federal government as  evidenced by escalating state responses to the excesses and abuses of mortgage lending  over the past decade.  Unfortunately, the federal response was to thwart rather than  encourage these policy responses.  3 Efficient and Effective In the report, GAO asserts that a system should provide for efficient and effective  oversight by eliminating overlapping federal regulatory missions and minimizing  regulatory burden.  CSBS believes efficiency must not be achieved at the cost of protecting  consumers, providing for a competitive industry that serves all communities or maintaining  the safety and soundness of financial institutions.  We recognize that our regulatory  structure is complex and may not be as efficient as some in the industry would prefer.   There is undoubtedly a need for improved coordination and cooperation among functional  regulators.  However, this efficiency must not be met through the haphazard consolidation  or destruction of supervisory agencies and authorities.  CSBS strongly believes that it is  more important to preserve a regulatory framework with checks and balances among and  between regulators.  This overlap does not need to be a negative characteristic of our  system.  Instead, it has most often offered additional protection for our consumers and  institutions.  We believe that the weakening of these overlays in recent years weakened our  system and contributed to the current crisis.
In addition, we should consider how “efficient” is defined.  Efficient does not inherently  mean effective.  Our ideal regulatory structure should balance what is efficient for large  and small institutions as well as what is efficient for consumers and our economy.  While a  centralized and consolidated regulatory system may look efficient on paper or benefit our  largest institutions, the outcomes may be inflexible and be geared solely at the largest  banks at the expense of the small community institutions, the consumer or our diverse  economy.
Consistent Consumer and Investor Protection The states have long been regarded as leaders in the consumer protection arena.  This is an  area where the model of states acting as laboratories of innovation is clearly working. State authorities often discover troubling practices, trends, or warning signs before the  federal agencies can identify these emerging concerns.  State authorities and legislature  then are able to respond quickly to protect consumers.  Ultimately, Congress and federal  regulators can then rely on state experience to develop uniform and nationwide standards  or best practices.  Ultimately, we believe the federal government is simply not able to  respond quickly enough to emerging threats and consumer protection issues.  State  authorities have also been frustrated by federal preemption of state consumer protection  laws.  If Congress were to act to repeal or more clearly limit these preemptions, states  would be able to more effectively and consistently enforce consumer protection laws.
CSBS also agrees that there were significant loopholes and unequal regulation and  examination of the mortgage industry.  In fact, the states led the way to address these  regulatory gaps.  However, in describing where subprime lending occurred, we believe the  report should acknowledge the fact that subprime lending took place in nearly equal parts  between nonbank lenders and institutions subject to federal bank regulation.  Federal  regulation of operating subsidiaries has been inconsistent at best and nonexistent at worst. As acknowledged in the report, affiliate regulation for consumer compliance simply did  4 not exist at the federal level until a recent pilot project led by the Federal Reserve was  initiated.
The report also fails to acknowledge the very significant reforms of mortgage regulation  adopted by Congress under the S.A.F.E. Act or the major efforts the states have engaged in  to regulate the nonbank mortgage lenders and originators.
Regulators Provided with Independence, Prominence, Authority, and Accountability  The dual-banking system helps preserve both regulator independence and accountability.   The state system of chartering, with an independent primary federal regulator probably  serves as the best model for this goal.
Consistent Financial Oversight Consistency in regulation is important, but our financial system must also be flexible  enough to allow our diverse institutions all to flourish. The diversity of our nation’s  banking system has created the most dynamic and powerful economy in the world,  regardless of the current problems we are experiencing.  The strength at the core of our  banking system is that it is comprised of thousands of financial intuitions of vastly  different sizes.  Even as our largest banks are struggling to survive, the vast majority of  community banks remains strong and continues to provide financial services to their local  citizens.  It is vital that a one-size-fits-all regulatory system does not adversely affect the  industry by putting smaller banks at a competitive disadvantage with larger, more complex  institutions.
It is our belief that the report should acknowledge the role of federal preemption of state  consumer protections and the lack of responsiveness of federal law and regulation to  mortgage lending and consumer protection issues.  For example, the states began  responding in 1999 to circumventions of HOEPA and consumer abuses related to subprime  lending.  Nine years later and two years into a nationwide subprime crisis and Congress  has not yet been able to adopt a predatory lending law.  We believe that some industry  advocates have pushed for preemption to prevent the states from being able to develop  legislative and regulatory models for consumer protection and because they have been  successful in thwarting legislation and significant regulation at the federal level.
Minimal Taxpayer Exposure CSBS strongly agrees that a regulatory system should have adequate safeguards that allow  financial institution failures to occur while limiting taxpayers’ exposure to financial risk.   Part of this process must be to prevent institutions from becoming “too big to fail,” “too  systemic to fail,” or simply too big to regulate.   Specifically, the federal government must  have regulatory tools in place to manage the orderly failure of the largest institutions rather  than continuing to prop up failed systemic institutions.
CSBS Principles of Regulatory Reform While numerous proposals will be advanced to overhaul the financial regulatory system,  CSBS believes the structure of the regulatory system should:  5 1. Usher in a new era of cooperative federalism, recognizing the rights of states to  protect consumers and reaffirming the state role in chartering and supervising  financial institutions.  2. Foster supervision that is tailored to the size, scope, and complexity of the  institution and the risk they pose to the financial system.  3. Assure the promulgation and enforcement of consumer protection standards that  are applicable to both state and nationally chartered financial institutions and are  enforceable by locally-responsive state officials against all such institutions.  4. Encourage a diverse universe of financial institutions as a method of reducing risk  to the system, encouraging competition, furthering innovation, insuring access to  financial markets, and promoting efficient allocation of credit.  5. Support community and regional banks, which provide relationship lending and  fuel local economic development.  6. Require financial institutions that are recipients of governmental protection or pose  systemic risk to be subject to safety and soundness and consumer protection  oversight.
The states, through CSBS and the State Liaison Committee’s involvement on the FFIEC,  will be part of any solution to regulatory restructuring or our current economic condition.   We want to ensure consumers are protected, and preserve the viability of both the federal  and state charter to ensure the success of our dual-banking system and our economy as a  whole.
CSBS believes there is significant work to be done on this issue, and we commend the  GAO for undertaking this report.
section_title: Appendix VI: Comments from Consumers Union
section_title: Appendix VII: Comments from the Credit Union National Association
section_title: Appendix VIII: Comments from the Federal Deposit Insurance Corporation
section_title: Appendix IX: Comments from the Mortgage Bankers Association
paragraphs: Appendix IX: Comments from the Mortgage  Bankers Association  Ms. Orice M. Williams  Director, Financial Markets and Community Investment   U.S. Government Accountability Office  441 G Street, N.W.  Washington, D.C. 20548  The Mortgage Bankers Association greatly appreciates the opportunity to comment on the  forthcoming report of the United States Government Accountability Office entitled "Financial  Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S.  Regulatory System."  MBA strongly supports the improvement of the regulatory requirements  and the regulatory structure for mortgage lending and commends GAO’s efforts in this vital  area.
MBA’s main comments are that the report should recognize that: (1) responsibility for the  current financial crisis is diffuse; (2) solutions recommended for the lending sphere should  include consideration of a uniform mortgage lending standard that is preemptive of state lending  standards; and (3) federal regulation of at least independent mortgage bankers deserves  discussion.
In MBA’s view, the factors contributing to the current crisis are manifold.  They include, but are  not limited to, traditional factors such as unemployment and family difficulties, high real estate  prices and overbuilding, extraordinary appetites for returns, lowering of lending standards to  satisfy investor and borrower needs, the growth of unregulated and lightly regulated entities  and, to some degree, borrower misjudgment and even fraud.
In MBA’s view no single actor or actors can fairly be assigned sole or even predominant blame  for where we are today. On the other hand, MBA strongly believes that all of these factors  contributing to the crisis deserve review as we fashion regulatory solutions.  Specifically,  respecting mortgage lending, MBA believes that the crisis presents an unparalleled opportunity  to reevaluate the current regulatory requirements and structure for mortgage lending to protect  the nation going forward.
MBA has long supported establishment of a uniform national mortgage lending standard that  establishes strong federal protections, preempts the web of state laws and updates and  expands federal requirements.  Currently, lending is governed, and consumers are protected by,  a patchwork of more than 30 different state laws which are piled on top of federal requirements.  Some state laws are overly intrusive and some are weak. The federal requirements in some  cases are duplicative and in some areas are out-of-date.  In some states, there are no lending  laws and borrowers have little protection beyond federal requirements.
December 18, 2008  GAO Comment Letter   Page 2  MBA believes legislators should look at the most effective state and federal approaches and  work with stakeholders to fashion a new uniform standard which is appropriately up-to-date,  robust, applies to every lender, and protects every borrower.  It should be enacted by the  Congress and preempt state laws.  A uniform standard would help restore investor confidence  and be the most effective and least costly means of protecting consumers against lending  abuses nationwide.  Having one standard would avoid undue compliance costs, facilitate  competition and ultimately decrease consumer costs.
MBA recognizes that one of the key objections to a preemptive national standard is that it would  not be flexible and adaptable and preclude state responses to future abuse.  MBA believes this  problem is surmountable and could be resolved by injecting dynamism into the law.   One  approach would be to supplement the law as needed going forward with new prohibitions and  requirements formulated by federal and state officials in consultation.
Currently, some mortgage lenders are regulated as federal depository institutions, some as  state depositories and some as state-regulated non-depositories. MBA believes that along with  establishment of a uniform standard, a new federal regulator for independent mortgage bankers  and mortgage brokers should be considered and MBA is interested in exploring that possibility.
A new regulator should have sufficient authorities to assure prudent operations to address  financing needs of consumers. If such an approach is adopted, states also could maintain a  partnership with the federal regulator in examination, enforcement and licensing.  MBA believes  the combined efforts of state and federal officials in regulatory reviews and enforcement under a  uniform standard would greatly increase regulatory effectiveness and focus.
Notably, any new regulatory scheme should address the differing regulatory concerns presented  by mortgage bankers and by mortgage brokers, considering their differing functions and the  differing policy concerns which the respective industries present.  MBA has written extensively  on this subject and commends to GAO’s attention the attached report entitled Mortgage  Bankers and Mortgage Brokers: Distinct Businesses Warranting Distinct Regulation (2008).
Again, MBA strongly believes today’s financial difficulties present an unparalleled opportunity to  establish better regulation in the years to come.  Today’s financial crisis reminds us daily that  financial markets are national and international in scope.  As the crisis worsened, the world  looked to national and international governments for solutions.  MBA believes it would be  unwise not to use this moment to establish a national standard and cease dispersing regulatory  responsibility, to help prevent crises ahead.
Thank you again for the opportunity to comment.
section_title: Appendix X: Comments from the National Association of Federal Credit Unions
section_title: Appendix XI: Comments from the Center for Responsible Lending, the National Consumer Law Center, and the U.S. PIRG
paragraphs: Appendix XI: Comments from the Center for  Responsible Lending, the National Consumer  Law Center, and the U.S. PIRG  VIA EMAIL AND U.S. MAIL Ms. Orice M. Williams (williamso@gao.gov)  Director, Financial Markets and Community Investment  U.S. Government Accountability Office  441 G Street, N.W.  Washington, D.C. 20548  with copies via email to: Mr. Cody Goebel, Assistant Director (goebelc@gao.gov)  Mr. Randall Fasnacht (fasnachtr@gao.gov)
Re:  Comments on Draft Report, GAO-09-216 We appreciate the opportunity to review the draft report at your offices on December 4,  and to offer comments.  These are offered jointly by CRL, the National Consumer Law  Center and USPIRG.
The report is a thoughtful and thorough review of the structural issues regarding  regulatory reform.  We especially appreciate that your report notes the problem of charter  competition and the distorting impact of the funding structure for the banking regulators.
We would like to preface our comments by stating the obvious – that this review does not  occur in a vacuum, but rather in the context of a major crisis which exposed fundamental  weaknesses on many fronts.  The structural problems in the federal regulator system are  but one.  Some of these comments derive not from the specific content of the report, but  the messages conveyed by some of the references to other aspects of the crisis, such as  the nature of the market and consumer behavior.  Another especially important comment   derives as much from what is left unsaid.  Perhaps it seems as though it should go without  saying, but given much of the debate that this crisis has engendered, we fear that without  at least an acknowledgement of what is not addressed by your report, necessary  reminders of other integral parts of regulatory reform may be lost.
While the structure of regulation can create its own problems,  such as the potential for  charter competition and regulatory capture that you note, regulators also need tools (in  the form of laws to enforce, or directives to promulgate rules in furtherance of such  laws), adequate resources and, above all, the will to regulate.  No amount of structural  reform will succeed if regulators have no charge to fulfill in their job, nor the will to do  so.  We have had three decades of a deregulatory agenda, and without a change in that  overarching view, structural changes will be insufficient.  We recognize that the  prevailing philosophy of regulation was not the focus of this report.  However, we believe  that any discussion of regulatory structural reform must be accompanied by an explicit   caveat that it addresses only one aspect of the overall regulatory issues that contributed to  1 Appendix XI: Comments from the Center for  Responsible Lending, the National Consumer  Law Center, and the U.S. PIRG  this crisis, and that changing the structure, alone, will be insufficient if these other  necessary conditions for effective oversight are not reformed, as well.
Beyond that overarching context for regulatory reform, we offer the following comments.  1.  The best way to avoid systemic risk is to address problems that exist at the level  of individual consumer transactions, before they pose a threat to the system as a  whole.
The report appropriately addresses the need to effectively monitor and regulate problems  that threaten the financial system as a whole.  However, the most effective way to address  systemic risk is to identify market failures that threaten abuse of individual consumers,  and to address these failures before they threaten the system as a whole.  The crisis today  would not have reached its current state had problems been addressed and prevented  before they evolved into the foreclosure epidemic now underway.
The report correctly notes that most subprime lending was done by nonbank lenders who  were not subject to oversight by the federal banking agencies. However, the market  failures that contributed to the current crisis are not limited to the subprime market.  The  failure of the Alt-A market, including poorly underwritten non-traditional loans, are also  significant contributors, as is becoming increasingly apparent.  The failures of IndyMac  and Washington Mutual, among others, are largely the function of overly aggressive  lending of risky products that were unsuitable for far too many borrowers, and these did  occur under the watch of the federal banking agencies.  Though the federal banking  agencies issued some guidelines for nontraditional lending, it was too little and too late.   Further, to judge from the performance of the late vintages of these loans, even then, they  were insufficiently enforced.
But in any case, neither bank nor nonbank lenders were subject to adequate consumer  protection laws.  Both banks and non-bank lenders pressed legislators and regulators not  to enact such protections.  Furthermore, banks subject to federal regulation also  contributed to the problem by being part of the secondary market’s demand for the risky  products that permeated the subprime and Alt-A markets.  The report should make clear  that to adequately protect consumers, and avoid systemic risk in the future, whatever  regulatory structure emerges will need to be more robust and effective in protecting  consumers than the current system has been to date.
Appendix XI: Comments from the Center for  Responsible Lending, the National Consumer  Law Center, and the U.S. PIRG  2.  To effectively protect consumers the regulatory system must prohibit  unsustainable lending; disclosures and “financial literacy” are not enough.
The fundamental problem at the heart of today’s crisis is that loan originators pushed  borrowers into loan products that were inherently risky and unsustainable by design, and  they did so notwithstanding the availability of the more suitable and affordable loans for  which they qualified.  The most common product in the subprime market in recent years  was not merely an adjustable rate mortgage, but rather an adjustable rate mortgage with  built-in payment shock that lenders anticipated most borrowers could not afford, but that  they could avoid only by refinancing before the payment shock took effect, typically  paying typically 3% to 4% of the loan balance as a “prepayment penalty” in order to  refinance.
According to a Wall Street Journal study, 55% of the borrowers who received such loans  in 2005, and 60% of those who received them in 2006, had credit scores high enough to  have qualified for lower cost prime loans.  And even those borrowers who did not  qualify for prime could have had 30-year fixed rate loans for approximately 65 basis  points above the introductory rate on the loans they received.  The report suggests  incorrectly (pp. 43-44) that subprime loans “help borrowers afford houses” they could  not otherwise afford, when in fact, most subprime loans refinanced existing loans, rather  than purchased new homes.  But in either case, had borrowers been offered the more  suitable loans for which many qualified, many more borrowers could have sustained  homeownership.
The experience with the recent vintages of Alt-A loans are similarly instructive.  Chris  Ferrell, an economics editor with the NPR program Marketplace referred to the Payment  Option ARM product (many of which are Alt-A) as “the most complicated mortgage  product ever marketed to consumers.”  The greater the complexity, the less suitable that  disclosure is as a “market perfecting” tool.  Further, the huge jump in payment option  ARMS, (from $145 billion to $255 billion from 2004-2007), was primarily possible only  by the increasingly poor underwriting.  Countrywide, one of the major issuers of these  Appendix XI: Comments from the Center for  Responsible Lending, the National Consumer  Law Center, and the U.S. PIRG  loans (that issued them under both its national bank and federal thrift charters, as well as  some of its non-depository entities) admitted that an estimated 80% of its recent  POARMs would not meet the late 2006 federal guidelines.
The Federal Reserve has noted that, given the misaligned incentives of originators and  the complexity of products and loan features, even with increased information or  knowledge, borrowers could not have defended against poorly underwritten, risky  products and deceptive practices.   The main problem with these loans was not the  inadequacy of the disclosures or the financial literacy of the borrowers.  Rather, the  fundamental problem was that – as the federal banking regulators belatedly recognized  with respect to non-traditional loans in late 2006 and subprime lending in 2007 --  lenders  should not have made loans that they knew borrowers would be unable to sustain without  refinancing.  3. To effectively protect consumers, the regulatory system must monitor and  address market incentives that encourage loan originators to push risky or  unsuitable loan products.
The report correctly notes that market incentives encouraged loan originators to extend  excessive credit (p. 22).  It should also note that these same incentives encouraged them  to push riskier productions and features than the borrowers qualified for.  The report  should note the need for regulatory oversight of market failures that reward market  participants for irresponsible behavior.
We understand that philosophies of consumer protection and the adequacy of consumer  protection laws is not your intended focus.  However, there were occasional statements in  the report which, intended or not, seemed to convey a message that improved disclosure  or literacy would be adequate. Yet more people – including some of the regulators  themselves – are recognizing that in an era of highly complex products and unseen  perverse incentives, disclosure is an insufficient tool, and literacy is an elusive goal.
We would be happy to provide further information.
section_title: Appendix XII: GAO Contacts and Staff Acknowledgments
paragraphs: Orice M. Williams, (202) 512-8678 or williamso@gao.gov, or   Richard J. Hillman, (202) 512-8678 or hillmanr@gao.gov.
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the contacts named above, Cody Goebel (Assistant  Director), Kevin Averyt, Nancy Barry, Rudy Chatlos, Randy Fasnacht,  Jeanette Franzel, Thomas McCool, Jim McDermott, Kim McGatlin, Thomas  Melito, Marc Molino, Susan Offutt, Scott Purdy, John Reilly, Barbara  Roesmann, Paul Thompson, Winnie Tsen, Jim Vitarello, and Steve Westley  made key contributions to this report.
section_title: Related GAO Products
paragraphs: 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 to  Strengthen 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 the  Federal Regulatory Structure. GAO-08-32. Washington, D.C.: October 12,  2007.
Financial Market Regulation: Agencies Engaged in Consolidated  Supervision Can Strengthen Performance Measurement and  Collaboration. 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 Need  for 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.
Long-Term Capital Management: Regulators Need to Focus Greater  Attention on Systemic Risk. GAO/GGD-00-3. Washington, D.C.: October 29,  1999.
Financial Derivatives: Actions Needed to Protect the Financial System.  GAO/GGD-94-133. Washington, D.C.: May 18, 1994.