Financial Regulation: Recent Crisis Reaffirms the Need to Overhaul the U.S. Regulatory System
Published: 2009-09-29T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses issues relating to efforts to reform the regulatory structure of the financial system. In the midst of the worst economic crisis affecting financial markets globally in more than 75 years, federal officials have taken unprecedented steps to stem the unraveling of the financial services sector. While these actions aimed to provide relief in the short term, the severity of the crisis has shown clearly that in the long term, the current U.S. financial regulatory system was in need of significant reform. Our January 2009 report presented a framework for evaluating proposals to modernize the U.S. financial regulatory system, and work we have conducted since that report further underscores the urgent need for changes in the system. Given the importance of the U.S. financial sector to the domestic and international economies, in January 2009, we also added modernization of its outdated regulatory system as a new area to our list of high-risk areas of government operations because of the fragmented and outdated regulatory structure. We noted that modernizing the U.S. financial regulatory system will be a critical step to ensuring that the challenges of the 21st century can be met. This testimony discusses (1) how regulation has evolved and recent work that further illustrates the significant limitations and gaps in the existing regulatory system, (2) the experiences of countries with other types of varying regulatory structures during the financial crisis, and (3) how certain aspects of proposals would reform the U.S. regulatory system.
section_title: What GAO Found
paragraphs: The current U.S. financial regulatory system is fragmented due to complex arrangements of federal and state regulation put into place over the past 150 years. It has not kept pace with major developments in financial markets and products in recent decades. Today, almost a dozen federal regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies share responsibility for overseeing the financial services industry. Several key changes in financial markets and products in recent decades have highlighted significant limitations and gaps in the existing U.S. regulatory system. For example, regulators have struggled, and often failed, both to identify the systemic risks posed by large and interconnected financial conglomerates and to ensure these entities adequately manage their risks. In addition, regulators have had to address problems in financial markets resulting from the activities of sometimes less-regulated and large market participants--such as nonbank mortgage lenders, hedge funds, and credit rating agencies--some of which play significant roles in today's financial markets. Further, the increasing prevalence of new and more complex financial products has challenged regulators and investors, and consumers have faced difficulty understanding new and increasingly complex retail mortgage and credit products. Our recent work has also highlighted significant gaps in the regulatory system and the need for an entity responsible for identifying existing and emerging systemic risks. Various countries have implemented changes in their regulatory systems in recent years, but the current crisis affected most countries regardless of their structure. All of the countries we reviewed have more concentrated regulatory structures than that of the United States. Some countries, such as the United Kingdom, have chosen an integrated approach to regulation that unites safety and soundness and business conduct issues under a single regulator. Others, such as Australia, have chosen a "twin peaks" approach, in which separate agencies are responsible for safety and soundness and business conduct regulation. However, regardless of regulatory structure, each country we reviewed was affected to some extent by the recent financial crisis. One regulatory approach was not necessarily more effective than another in preventing or mitigating a financial crisis. However, regulators in some countries had already taken some actions that may have reduced the impact on their institutions. These and other countries also have taken or are currently contemplating additional changes to their regulatory systems to address weaknesses identified during this crisis. The Department of the Treasury's recent proposal to reform the U.S. financial regulatory system includes some elements that would likely improve oversight of the financial markets and make the financial system more sound, stable, and safer for consumers and investors. For example, under this proposal a new governmental body would have responsibility for assessing threats that could pose systemic risk. This proposal would also create an entity responsible for business conduct, that is, ensuring that consumers of financial services were adequately protected. However, our analysis indicated that additional opportunities exist beyond the Treasury's proposal for additional regulatory consolidation that could further decrease fragmentation in the regulatory system, reduce the potential for differing regulatory treatment, and improve regulatory independence.

section_title: Letter
paragraphs: I am pleased to be here today to discuss issues relating to efforts to reform  the regulatory structure of the financial system. In the midst of the worst  economic crisis affecting financial markets globally in more than 75 years,  federal officials have taken unprecedented steps to stem the unraveling of  the financial services sector. While these actions aimed to provide relief in  the short term, the severity of the crisis has shown clearly that in the long  term, the current U.S. financial regulatory system was in need of  significant reform. Our January 2009 report presented a framework for  evaluating proposals to modernize the U.S. financial regulatory system,  and work we have conducted since that report further underscores the  urgent need for changes in the system. Given the importance of the U.S.  financial sector to the domestic and international economies, in January  2009, we also added modernization of its outdated regulatory system as a  new area to our list of high-risk areas of government operations because  of the fragmented and outdated regulatory structure.  We noted that  modernizing the U.S. financial regulatory system will be a critical step to  ensuring that the challenges of the 21st century can be met. In my  statement today, which is based on our reports and additional work we  have completed, I will discuss (1) how regulation has evolved and recent  work that further illustrates the significant limitations and gaps in the  existing regulatory system, (2) the experiences of countries with other  types of varying regulatory structures during the financial crisis, and (3)  how certain aspects of proposals would reform the U.S. regulatory system.
To do this work, we synthesized existing GAO work and other studies on  the financial crisis, such as those from the Department of Treasury, Group  of Twenty (G20), Group of Thirty (G30), and the Committee on Capital  Markets Regulation, among others. We also selected a judgmental sample  of countries—Australia, Canada, The Netherlands, Sweden, and the United  Kingdom—because they each had advanced financial markets and were  illustrative of regulatory changes made internationally. We compiled  information from publicly available sources on the individual countries’  regulatory systems and the countries’ experiences during the crisis.  Finally, we used our framework of regulatory reform elements that was  developed for our January 2009 report to analyze the strengths and  weaknesses of legislative proposals on regulatory reform. Our work 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 August 2009 and September 2009.
subsections: section_title: U.S. Financial Regulatory System’s Failure to Keep Pace with Market Developments Underscores the Need for Reforms
paragraphs: As a result of 150 years of changes to financial regulation in the United  States, the regulatory system has become complex and fragmented. Today,  responsibilities for overseeing the financial services industry are shared  among almost a dozen federal banking, securities, futures, and other  regulatory agencies, numerous self-regulatory organizations, and hundreds  of state financial regulatory agencies. For example:  Insured depository institutions are overseen by five federal agencies—the  Federal Deposit Insurance Corporation (FDIC), the Board of Governors of  the Federal Reserve System (Federal Reserve), the Office of the  Comptroller of the Currency (OCC), the Office of Thrift Supervision  (OTS), and the National Credit Union Administration (NCUA)—and states  supervise state-chartered depository and certain other institutions.
Securities activities and markets are overseen by the Securities and  Exchange Commission (SEC) and state government entities, and private  sector organizations performing self-regulatory functions.
Commodity futures markets and activities are overseen by the Commodity  Futures Trading Commission (CFTC) and also by industry self-regulatory  organizations.
Insurance activities are primarily regulated at the state level with little  federal involvement.
Other federal regulators also play important roles in the financial  regulatory system, such as the Federal Trade Commission, which acts as  the primary federal agency responsible for enforcing compliance with  federal consumer protection laws for financial institutions such as finance  companies that are not overseen by another financial regulator.
Much of this structure has developed as the result of statutory and  regulatory measures taken in response to financial crises or significant  developments in the financial services sector. For example, the Federal  Reserve 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. Changes in the types of  financial activities permitted for financial institutions and their affiliates  have also shaped the financial regulatory system over time. For example,  under the Glass-Steagall provisions of the Banking Act of 1933, financial  institutions were prohibited from simultaneously offering commercial and  investment banking services, but with the passage of the Gramm-Leach- Bliley Act of 1999, Congress permitted financial institutions to fully engage  in both types of activities, under certain conditions.
subsections: section_title: Various Market Developments Have Revealed Limitations in the Existing Regulatory Structure
paragraphs: Several key developments in financial markets and products in the past  few decades have significantly challenged the existing financial regulatory  structure. (See fig. 1.)
Regulators have struggled, and often failed, to identify the systemic risks  posed by large and interconnected financial conglomerates, as well as new  and complex products, and to adequately manage these risks. These firms’  operations increasingly cross financial sectors, but no single regulator is  tasked with assessing the risks such an institution might pose across the  entire financial system. In addition, regulators have had to address  problems in financial markets resulting from the activities of sometimes  less-regulated and large market participants—such as nonbank mortgage  lenders, hedge funds, and credit rating agencies—some of which play  significant roles in today’s financial markets. Further, the increasing  prevalence of new and more complex financial products has challenged  regulators and investors, and consumers have faced difficulty  understanding new and increasingly complex retail mortgage and credit  products. Standard setters for accounting and financial regulators have  also faced growing challenges in ensuring that accounting and audit  standards appropriately respond to financial market developments. And  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.
Because of this hearing’s focus on prudential regulation of the banking  industry, I would like to reinforce that our prior work has repeatedly  identified limitations of the fragmented banking regulatory structure.  For  example:   In 1996, we reported that the division of responsibilities among the four  federal bank oversight agencies in the United States was not based on  specific areas of expertise, functions or activities, either of the regulator or  the banks for which they are responsible, but based on institution type and  whether the banks were members of the Federal Reserve System.  Despite  their efforts to coordinate, this multiplicity of regulators was cited as  resulting in inconsistent treatment of banking institutions in examinations,  enforcement actions, and regulatory decisions.
In a 2007 report we noted that having bank holding company affiliates  supervised by multiple banking regulators increased the potential for  conflicting information to be provided to the institution, such as when a  large, complex banking organization initially received conflicting  information from the Federal Reserve, its consolidated supervisor, and  OCC, its primary bank supervisor, about the firm’s business continuity  provisions.
In 2005, we reported that a difference in authority across the banking  regulators could lead to problems in oversight.  For example, FDIC’s  authority over the holding companies and affiliates of industrial loan  corporations was not as extensive as the authority that the other  supervisors have over the holding companies and affiliates of banks and  thrifts. For example, FDIC’s authority to examine an affiliate of an insured  depository institution exists only to disclose the relationship between the  depository institution and the affiliate and the effect of that relationship on  the depository institution. Therefore, any reputation or other risk from an  affiliate that has no relationship with the industrial loan corporation could  go undetected.
In a 2004 report, we noted cases in which interagency cooperation  between bank regulators has been hindered when two or more agencies  share responsibility for supervising a bank.  For example, in the failure of  Superior Bank of West Virginia problems between OTS, Superior’s primary  supervisor, and FDIC hindered a coordinated supervisory approach,  including OTS refusing to let FDIC participate in at least one examination.  Similarly, disagreements between OCC and FDIC contributed to the 1999  failure of Keystone Bank.
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.
Our recent work has further revealed limitations in the current regulatory  system, reinforcing the need for change and the need for an entity  responsible for identifying existing and emerging systemic risks. In  January 2009, we designated modernizing the outdated U.S. financial  regulatory system as a new high-risk area to bring focus to the need for a  broad-based systemwide transformation to address major economy,  efficiency, and effectiveness challenges. We have found that:    Having multiple regulators results in inconsistent oversight. Our February  2009 report on the Bank Secrecy Act found that multiple regulators are  examining for compliance with the same laws across industries and, for  some larger holding companies, within the same institution. However,  these regulators lack a mechanism for promoting greater consistency,  reducing unnecessary regulatory burden, and identifying concerns across  industries. In July 2009, we reported many violations by independent  mortgage lenders of the fair lending laws intended to prevent lending  discrimination could go undetected because of less comprehensive  oversight provided by various regulators.
Lack of oversight exists for derivatives products. In March 2009, we  reported that the lack of a regulator with authority over all participants in  the market for credit default swaps (CDS) has made it difficult to monitor  and manage the potential systemic risk that these products can create.
Gaps in the oversight of significant market participants. We reported in  May 2009 on the issues and concerns related to hedge funds, which have  grown into significant market participants with limited regulatory  oversight. For example, under the existing regulatory structure, SEC’s  ability to directly oversee hedge fund advisers is limited to those that are  required to register or voluntarily register with the SEC as an investment  advisor. Further, multiple regulators (SEC, CFTC, and federal banking  regulators) each oversee certain hedge fund-related activities and advisers.
We concluded that given the recent experience with the financial crisis,  regulators should have the information to monitor the activities of market  participants that play a prominent role in the financial system, such as  hedge funds, to protect investors and manage systemic risk.
Lack of appropriate resolution authorities for financial market institutions.
We recently reported that one of the reasons that federal authorities  provided financial assistance to at least one troubled institution—the  insurance conglomerate AIG—in the crisis stemmed from concerns that a  disorderly failure by this institution would have contributed to higher  borrowing costs and additional failures, further destabilizing fragile  financial markets. According to Federal Reserve officials, the lack of a  centralized and orderly resolution mechanism presented the Federal  Reserve and Treasury with few alternatives in this case. The lack of an  appropriate resolution mechanism for non-banking institutions has  resulted in the federal government providing assistance and having  significant ongoing exposure to AIG.
Lack of a focus on systemwide risk. In March 2009 we also reported on the  results of work we conducted at some large, complex financial institutions  that indicated that no existing U.S. financial regulator systematically looks  across institutions to identify factors that could affect the overall financial  system. While regulators periodically conducted horizontal examinations  on stress testing, credit risk practices, and risk management, they did not  consistently use the results to identify potential systemic risks and have  only a limited view of institutions’ risk management or their  responsibilities. Our July 2009 report on approaches regulators used to  restrict the use of financial leveraging—the use of debt or other products  to purchase assets or create other financial exposures—by financial  institutions also found that regulatory capital measures did not always  fully capture certain risks and that none of the multiple regulators  responsible for individual markets or institutions had clear responsibility  to assess the potential effects of the buildup of systemwide leverage.
Recognition of the need for regulatory reform extends beyond U.S.  borders. Various international organizations such as the G20, G30, Bank  for International Settlements, and Committee on Capital Markets  Regulation have all reported that weaknesses in regulation contributed to  the financial crisis. Specifically, among other things, these reports  pointed to the fragmented regulatory system, the lack of a systemwide  view of risks, and the lack of transparency or oversight of all market  participants as contributing to the crisis. Further, the reports noted that  sound regulation and a systemwide focus were needed to prevent  instability in the financial system, and that recent events have clearly  demonstrated that regulatory failures had contributed to the current crisis.
section_title: Other Countries Have Adopted Various Structures for Their Regulatory Systems, but the Recent Crisis Is Prompting Additional Changes
paragraphs: In response to consolidation in the financial services industry and past  financial crises, other countries have previously made changes to their  financial regulatory systems in the years before the most recent crisis. For  the purposes of our study, we selected five countries—Australia, Canada,  Sweden, the Netherlands, and the United Kingdom—that had  sophisticated financial systems and different regulatory structures. Each  of these countries restructured their regulatory systems within the last 20  years in response to market developments or financial crises (see table 1).
The countries we reviewed chose one of two models—with some  implementing an integrated approach, in which responsibilities for  overseeing safety and soundness issues and business conduct issues are  centralized and unified in usually a single regulator, and with others  implementing what is commonly referred to as a “twin peaks” model, in  which separate regulatory organizations are responsible for safety and  soundness and business conduct regulation. A single regulator is viewed  by some as advantageous because, with financial firms not being as  specialized as they used to be, a single regulator presents economies of  scale and efficiency advantages, can quickly resolve conflicts that arise  between regulatory objectives, and the regulatory model increases  accountability. For example, the United Kingdom moved to a more  integrated model of financial services regulation because it recognized  that major financial firms had developed into more integrated full services  businesses. As a result, this country created one agency (Financial  Services Authority) to deal with banking, insurance, asset management  and market supervision and regulation. Similarly, Canada and Sweden  integrated their regulatory systems prior to the current global financial  crisis.
In contrast, other countries chose to follow a twin peaks model. The twin  peaks model is viewed by some as advantageous because they view the  two principal objectives of financial regulation—systemic protection and  consumer protection—as being in conflict. Putting these objectives in  different agencies institutionalizes the distinction and ensures that each  agency focuses on one objective. For example, in order to better regulate  financial conglomerates and minimize regulatory arbitrage, Australia  created one agency responsible for prudential soundness of all deposit  taking, general and life insurance, and retirement pension funds  (Australian Prudential Regulatory Authority) and another for business  conduct regulation across the financial system including all financial  institutions, markets, and market participants (Australian Securities and  Investment Commission). In the Netherlands, regulators were divided  along the lines of banking, insurance, and securities until the twin peaks  approach was adopted. Under the revised structure, the prudential and  systemic risk supervisor of all financial services including banking,  insurance, pension funds, and securities is the central bank (DNB).  Another agency (Netherlands Authority for Financial Markets) is  responsible for conduct of business supervision and promoting  transparent markets and processes to protect consumers.
However, regardless of the regulatory system structure, these and many  other countries were affected to some extent by the recent financial crisis.  For example, the United Kingdom experienced bank failures, and the  government provided financial support to financial institutions. Further, in  the Netherlands, where the twin peaks approach is used, the government  took over the operations of one bank, provided assistance to financial  institutions to reinforce their solvency positions, and took on the risk of a  high-risk mortgage portfolio held by another bank, among other actions.
However, regulators or financial institutions in some of these countries  took steps that may have reduced the impact of the crisis on their  institutions. For example, according to a testimony that we reviewed, the  impact on Australian institutions was mitigated by the country’s relatively  stricter prudential standards compared to other countries. The Australian  prudential regulator had also conducted a series of stress tests on its five  largest banks that assessed the potential impact of asset price changes on  institutions. According to Canadian authorities, the positive performance  of Canadian banks relative to banks in other countries in the recent crisis  was the result of a more conservative risk appetite that limited their  activities in subprime mortgages, and exotic financial instruments.  However, both countries still experienced some turbulence, requiring  among other actions, some government purchases of mortgage-backed  securities by the Australian government and some Canadian banks taking  advantage of liquidity facilities provided by the Bank of Canada.
Authorities in these five countries have taken actions or are contemplating  additional changes to their financial regulatory systems based on  weaknesses identified during the current financial crisis. These changes  included strengthening bank capitalization requirements, enhancing  corporate governance standards, and providing better mechanisms for  resolving failed financial institutions. For example, in the United Kingdom,  in response to its experience dealing with one large bank failure (Northern  Rock) the government has called for strengthening the role of the central  bank. The Banking Act of 2009 formalized a leading role for the Bank of  England in resolving financial institution and provided it statutory  authority in the oversight of systemically important payment and  settlement systems.
section_title: Reform Proposals Would Enhance U.S. Regulatory System, but Additional Opportunities to Improve System Appear to Exist
paragraphs: With a clear need to improve regulatory oversight, our January 2009 report  offered a framework for crafting and evaluating regulatory reform  proposals. This framework includes nine characteristics that should be  reflected in any new regulatory system, including:    goals that are clearly articulated and relevant, so that regulators can  effectively conduct activities to implement their missions.    appropriately comprehensive coverage to ensure that financial institutions  and activities are regulated in a way that ensures regulatory goals are fully  met;    a mechanism for identifying, monitoring, and managing risks on a  systemwide basis, regardless of the source of the risk or the institution in  which it is created;    an adaptable and forward-looking approach allows regulators to readily  adapt to market innovations and changes and evaluate potential new risks;    efficient oversight of financial services by, for example, eliminating  overlapping federal regulatory missions, while effectively achieving the  goals of regulation;    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 practices standards, and suitability  requirements;    assurance that regulators have independence from inappropriate  influence; have sufficient resources and authority, and are clearly  accountable for meeting regulatory goals;    assurance that similar institutions, products, risks, and services are  subject to consistent regulation, oversight, and transparency; and    adequate safeguards that allow financial institution failures to occur while  limiting taxpayers’ exposure to financial risk.
Various organizations have made proposals to reform the U.S. regulatory  system, and several proposals have been introduced to the Congress.  Among these proposals are the administration’s proposal, which is  specified in its white paper and draft legislation, and another proposal that  has been introduced as legislation in the House of Representatives (H.R.  3310).
The administration’s proposal includes various elements that could  potentially improve federal oversight of the financial markets and better  protect consumers and investors. For example, it establishes a council  consisting of federal financial regulators that would, among other things,  advise Congress on financial regulation and monitor the financial services  market to identify the potential risks systemwide. Under H.R. 3310, a  board consisting of federal financial regulators and private members,  would also monitor the financial system for exposure to systemic risk and  advise Congress. The creation of such a body under either proposal would  fill an important need in the current U.S. regulatory system by establishing  an entity responsible for helping Congress and regulators identify potential  systemic problems and making recommendations in response to existing  and emerging risks. However, such an entity would also need adequate  authority to ensure that actions were taken in response to its  recommendations. As discussed, the inability of regulators to take  appropriate action to mitigate problems that posed systemic risk  contributed to the current crisis.
The administration’s proposal also contains measures to improve the  consistency of consumer and investor protection. First, the administration  proposes to create a new agency, the Consumer Financial Protection  Agency (CFPA). Among other things, this agency would assume the  consumer protection authorities of the current banking regulators and  would have broad jurisdiction and responsibility for protecting consumers  of credit, savings, payment and other consumer financial products and  services. Its supervisory and enforcement authority generally would cover  all persons subject to the financial consumer protection statutes it would  be charged with administering. However, the SEC and CFTC would retain  their consumer protection role in securities and derivatives markets. As  our January report described, consumers have struggled with  understanding complex products and the multiple regulators responsible  for overseeing such issues have not always performed effectively. We  urged that a new regulatory system be designed to provide high-quality,  effective, and consistent protection for consumers and investors in similar  situations. The administration’s proposal addresses this need by charging a  single financial regulatory agency with broad consumer protection  responsibilities. This approach could improve the oversight of this  important issue and better protect U.S. consumers. However, separating  the conduct of consumer protection and prudential regulation can also  create challenges. Therefore, having clear requirements to coordinate  efforts across regulators responsible for these different missions would be  needed.
Although the Administration’s proposal would make various  improvements in the U.S. regulatory system, our analysis indicated that  additional opportunities exist to further improve the system exist. Unlike  H.R. 3310, which would combine all five federal depository institution  regulators, the Administration’s proposal would only combine the current  regulators for national banks and thrifts into one agency, leaving the three  other depository institution regulators—the Federal Reserve, the FDIC,  and NCUA—to remain separate. As we reported in our January 2009  report, having multiple regulators performing similar functions presents  challenges. For example, we found that some regulators lacked sufficient  resources and expertise, that the need to coordinate among multiple  regulators slowed responses to market events, and that institutions could  take advantage of regulatory arbitrage by seeking regulation from an  agency more likely to offer less scrutiny. Regulators that are funded by  assessments on their regulated entities can also become overly dependent  on individual institutions for funding, which could potentially compromise  their independence because such firms have the ability to choose to be  overseen by another regulator.
Finally, regardless of any regulatory reforms that are adopted, we urge  Congress to continue to actively monitor the progress of such  implementation and to be prepared to make legislative adjustments to  ensure that any changes to the U.S. financial regulatory system are as  effective as possible. In addition, we believe that it is important that  Congress provides for appropriate GAO oversight of any regulatory  reforms to ensure accountability and transparency in any new regulatory  system. GAO stands ready to assist the Congress in its oversight capacity  and evaluate the progress agencies are making in implementing any  changes.
Mr. Chairman and Members of the Committee, I appreciate the  opportunity to discuss these critically important issues and would be  happy to answer any questions that you may have. Thank you.
section_title: Staff Contributions and Acknowledgments
paragraphs: For further information on this testimony, please contact Orice Williams  Brown 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 statement. Individuals making key contributions to this testimony  include Cody J. Goebel, Assistant Director; Sonja J. Bensen; Emily R.  Chalmers, Patrick S. Dynes; Marc W. Molino; Jill M. Naamane; and Paul  Thompson.
section_title: Appendix I: Framework for Crafting and Evaluating Regulatory Reform
paragraphs: As a result of significant market developments in recent decades that have  outpaced a fragmented and outdated regulatory structure, significant  reforms to the U.S. regulatory system are critically and urgently needed.  The following framework consists of nine elements that should be  reflected in any new regulatory system. This framework could be used to  craft proposals, or to identify aspects to be added to existing proposals to  make them more effective and appropriate for addressing the limitations  of the current system.
Goals should be clearly articulated and relevant, so that regulators can effectively carry out  their missions and be held accountable. Key issues include considering the benefits of re- examining the goals of financial regulation to gain needed consensus and making explicit a  set of updated comprehensive and cohesive goals that reflect today’s environment.
Financial regulations should cover all activities that pose risks or are otherwise important  to meeting regulatory goals and should ensure that appropriate determinations are made  about how extensive such regulations should be, considering that some activities may  require less regulation than others. Key issues include identifying risk-based criteria, such  as a product’s or institution’s potential to create systemic problems, for determining the  appropriate level of oversight for financial activities and institutions, including closing gaps  that contributed to the current crisis.
Mechanisms should be included for identifying, monitoring, and managing risks to the  financial system regardless of the source of the risk. Given that no regulator is currently  tasked with this, key issues include determining how to effectively monitor market  developments to identify potential risks; the degree, if any, to which regulatory intervention  might be required; and who should hold such responsibilities.
A regulatory system that is flexible and forward looking allows regulators to readily adapt  to market innovations and changes. Key issues include identifying and acting on emerging  risks in a timely way without hindering innovation.
Effective and efficient oversight should be developed, including eliminating overlapping  federal regulatory missions where appropriate, and minimizing regulatory burden without  sacrificing effective oversight. Any changes to the system should be continually focused on  improving the effectiveness of the financial regulatory system. Key issues include  determining opportunities for consolidation given the large number of overlapping  participants now, identifying the appropriate role of states and self-regulation, and ensuring  a smooth transition to any new system.
Consumer and investor protection should be included 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. Key issues include determining what amount, if  any, of consolidation of responsibility may be necessary to streamline consumer protection  activities across the financial services industry.
Regulators should have independence from inappropriate influence, as well as prominence  and authority to carry out and enforce statutory missions, and be clearly accountable for  meeting regulatory goals. With regulators with varying levels of prominence and funding  schemes now, key issues include how to appropriately structure and fund agencies to  ensure that each one’s structure sufficiently achieves these characteristics.
Similar institutions, products, risks, and services should be subject to consistent regulation,  oversight, and transparency, which should help minimize negative competitive outcomes  while harmonizing oversight, both within the United States and internationally. Key issues  include identifying activities that pose similar risks, and streamlining regulatory activities  to achieve consistency.
A regulatory system should foster financial markets that are resilient enough to absorb  failures and thereby limit the need for federal intervention and limit taxpayers’ exposure to  financial risk. Key issues include identifying safeguards to prevent systemic crises and  minimizing moral hazard.
section_title: Related GAO Products
paragraphs: Financial Markets Regulation: Financial Crisis Highlights Need to  Improve Oversight of Leverage at Financial Institutions and across  System. GAO-09-739. Washington, D.C.: Jul. 22, 2009.
Fair Lending: Data Limitations and the Fragmented U.S. Financial  Regulatory Structure Challenge Federal Oversight and Enforcement  Efforts. GAO-09-704. Washington, D.C.: Jul. 15, 2009.
Hedge Funds: Overview of Regulatory Oversight, Counterparty Risks,  and Investment Challenges. GAO-09-677T. Washington, D.C.: May 7, 2009.
Financial Regulation: Review of Regulators’ Oversight of Risk  Management Systems at a Limited Number of Large, Complex Financial  Institutions. GAO-09-499T. Washington, D.C.: Mar. 18, 2009.
Federal Financial Assistance: Preliminary Observations on Assistance  Provided to AIG. GAO-09-490T. Washington, D.C.: Mar. 18, 2009.
Systemic Risk: Regulatory Oversight and Recent Initiatives to Address  Risk Posed by Credit Default Swaps. GAO-09-397T. Washington, D.C.:  Mar. 5, 2009.
Bank Secrecy Act: Federal Agencies Should Take Action to Further  Improve Coordination and Information-Sharing Efforts. GAO-09-227.  Washington, D.C.: Feb. 12, 2009.
Financial Regulation: A Framework for Crafting and Assessing  Proposals to Modernize the Outdated U.S. Financial Regulatory System.  GAO-09-216. Washington, D.C.: Jan. 8, 2009.
Troubled Asset Relief Program: Additional Actions Needed to Better  Ensure Integrity, Accountability, and Transparency. GAO-09-161.  Washington, D.C.: December 2, 2008.
Hedge Funds: Regulators and Market Participants Are Taking Steps 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.
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