Financial Regulatory Reform: Financial Crisis Losses and Potential Impacts of the Dodd-Frank Act
Published: 2013-01-16T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: The 2007-2009 financial crisis threatened the stability of the U.S. financial system and the health of the U.S. economy. To address regulatory gaps and other problems revealed by the crisis, Congress enacted the Dodd- Frank Act. Federal regulators will need to issue hundreds of rules to implement the act. Industry representatives, academics, and others generally have supported the act's goal of enhancing U.S. financial stability, but implementation of certain of the act's provisions has led to much debate. These experts have expressed a wide range of views on the potential positive and negative effects that the act could have on the U.S. financial system and broader economy.
GAO was asked to examine the (1) losses associated with the recent financial crisis; (2) benefits of the act for the U.S. financial system and the broader economy; and (3) costs of the act's reforms. GAO reviewed empirical and other studies on the impacts of financial crises and the Dodd-Frank reforms, as well as congressional testimonies, comment letters, and other public statements by federal regulators, industry representatives, and others. GAO obtained and analyzed data on agency resources devoted to the act's implementation. GAO also obtained perspectives from regulators, academics, and representatives of industry and public interest groups through interviews and an expert roundtable held with the assistance of the National Academy of Sciences. GAO provided a draft of this report to the financial regulators for review and comment and received technical comments, which were incorporated as appropriate.
section_title: What GAO Found
paragraphs: The 2007-2009 financial crisis has been associated with large economic losses and increased fiscal challenges. Studies estimating the losses of financial crises based on lost output (value of goods and services not produced) suggest losses associated with the recent crisis could range from a few trillion dollars to over $10 trillion. Also associated with the crisis were large declines in employment, household wealth, and other economic indicators. Some studies suggest the crisis could have long-lasting effects: for example, high unemployment, if persistent, could lead to skill erosion and lower future earnings for those affected. Finally, since the crisis began, federal, state, and local governments have faced greater fiscal challenges, in part because of reduced tax revenues from lower economic activity and increased spending to mitigate the impact of the recession.
While the Dodd-Frank Wall Street Reform and Consumer Protection Act's (Dodd- Frank Act) reforms could enhance the stability of the U.S. financial system and provide other benefits, the extent to which such benefits materialize will depend on many factors whose effects are difficult to predict. According to some academics, industry representatives, and others, a number of the act's provisions could help reduce the probability or severity of a future crisis and thereby avoid or reduce the associated losses. These include subjecting large, complex financial institutions to enhanced prudential supervision, authorizing regulators to liquidate a financial firm whose failure could pose systemic risk, and regulating certain complex financial instruments. In contrast, some experts maintain these measures will not help reduce the probability or severity of a future crisis, while others note that their effectiveness will depend on how they are implemented by regulators, including through their rulemakings, and other factors, such as how financial firms respond to the new requirements. Quantifying the act's potential benefits is difficult, but several studies have framed potential benefits of certain reforms by estimating output losses that could be avoided if the reforms lowered the probability of a future crisis.
Federal agencies and the financial industry are expending resources to implement and comply with the Dodd-Frank Act. First, federal agencies are devoting resources to fulfill rulemaking and other new regulatory responsibilities created by the act. Many of these agencies do not receive any congressional appropriations, limiting federal budget impacts. Second, the act imposes compliance and other costs on financial institutions and restricts their business activities in ways that may affect the provision of financial products and services. While regulators and others have collected some data on these costs, no comprehensive data exist. Some experts stated that many of the act's reforms serve to impose costs on financial firms to reduce the risks they pose to the financial system. Third, in response to reforms, financial institutions may pass increased costs on to their customers. For example, banks could charge more for their loans or other services, which could reduce economic growth. Although certain costs, such as paperwork costs, can be quantified, other costs, such as the act's impact on the economy, cannot be easily quantified. Studies have estimated the economic impact of certain of the act's reforms, but their results vary widely and depend on key assumptions. Finally, some experts expressed concern about the act's potential unintended consequences and their related costs, adding to the challenges of assessing the benefits and costs of the act.

section_title: Letter
paragraphs: The 2007-2009 financial crisis threatened the stability of the U.S. financial  system—composed of financial institutions, markets, and infrastructure— and the health of the U.S. economy. At the peak of the crisis, the federal  government introduced unprecedented support for financial markets,  providing hundreds of billions of dollars of capital and over a trillion dollars  of emergency loans to financial institutions. Many households suffered as  a result of falling asset prices, tightening credit, and increasing  unemployment. While many factors likely contributed to the crisis and the  relative role of these factors is subject to debate, gaps and weaknesses in  the supervision and regulation of the U.S. financial system generally  played an important role. To address such shortcomings, Congress  enacted the Dodd-Frank Wall Street Reform and Consumer Protection  Act (the Dodd-Frank Act). As summarized on the Senate Banking  Committee’s website, the act seeks to (1) address risks to the stability of  the U.S. financial system, in part through the creation of the Financial  Stability Oversight Council (FSOC), (2) end too-big-to-fail bailouts of  large, complex financial institutions, (3) increase transparency and  regulation for certain complex financial instruments, and (4) strengthen  protections for consumers and investors.
Federal financial regulators and other agencies are continuing to make  progress in implementing the Dodd-Frank Act’s numerous provisions,  which may require hundreds of rulemakings. While the financial services  industry, academics, and others generally have supported the Dodd- Frank Act’s goal of enhancing the stability of the U.S. financial system,  the act’s implementation has not been free of controversy or debate. For  example, a consensus exists neither on the extent to which the act will  help to reduce the likelihood and severity of future financial crises nor on  the magnitude of the costs that the act, generally, and its regulations,  specifically, will impose on U.S. financial institutions and the U.S.  economy. The Dodd-Frank Act has not yet been fully implemented; thus,  its impacts have not fully materialized. Nonetheless, analyses of the  potential and actual impacts can help inform policymakers about the  ongoing implementation of the act’s reforms.
As requested, the objectives of this report are to describe what is known  about  the losses and related economic impacts associated with the 2007- 2009 financial crisis;  the benefits of the Dodd-Frank Act, particularly its key financial  stability provisions, for the U.S. financial system and broader  economy; and  the costs associated with the act, particularly its key financial stability  provisions.
To address our objectives, we reviewed and analyzed academic and  other studies that assess the economic impacts of financial crises or  financial regulatory reforms, including the Dodd-Frank Act. We reviewed  the methodological approaches of selected studies and determined that  they were sufficient for our purposes. However, the results should not  necessarily be considered as definitive, given the methodological or data  limitations contained in the studies individually and collectively. To show  changes in economic indicators following the start of the financial crisis,  we obtained and analyzed data from the Bureau of Economic Analysis,  Bureau of Labor Statistics, National Bureau of Economic Research, and  other sources. We obtained and summarized data on the incremental  budgetary costs associated with the act’s implementation for 10 federal  entities: the Board of Governors of the Federal Reserve System (Federal  Reserve); Commodity Futures Trading Commission (CFTC); Federal  Deposit Insurance Corporation (FDIC); Federal Housing Finance Agency  (FHFA); Office of the Comptroller of the Currency (OCC); Securities and  Exchange Commission (SEC); Department of the Treasury (Treasury);  Bureau of Consumer Financial Protection, commonly known as the  Consumer Financial Protection Bureau (CFPB); FSOC; and the Office of  Financial Research (OFR). For parts of our methodology that involved the  analysis of computer-processed data, we assessed the reliability of these  data and determined that they were sufficiently reliable for our purposes.  Through interviews and an expert roundtable we held with the assistance  of the National Academy of Sciences, we obtained perspectives from  academics; current and former federal financial regulators;  representatives of industry, public interest, and investor groups; and other  experts on the potential benefits and costs of the act’s reforms. In  addition, we reviewed relevant reports and public statements by these  groups as well as Dodd-Frank Act rules and comment letters. Finally, we  reviewed prior GAO work on the fiscal outlook for federal, state, and local  governments and on financial regulatory reform. Appendix I contains  additional information on our scope and methodology.
We conducted this performance audit from November 2011 to January  2013 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.
subsections: section_title: Background
subsections: section_title: U.S. Financial Regulatory Framework
paragraphs: The financial regulatory framework in the United States was built over  more than a century, largely in response to crises and significant market  developments. As a result, the regulatory system is complex and  fragmented. While the Dodd-Frank Act has brought additional changes,  including the creation of new regulatory entities and the consolidation of  some regulatory responsibilities that had been shared by multiple  agencies, the U.S. financial regulatory structure largely remains the  same. It is a complex system of multiple federal and state regulators, as  well as self-regulatory organizations, that operates largely along  functional lines. The U.S. regulatory system is described as “functional” in  that financial products or activities are generally regulated according to  their function, no matter who offers the product or participates in the  activity.
In the banking industry, the specific regulatory configuration depends on  the type of charter the banking institution chooses. Depository institution  charter types include  commercial banks, which originally focused on the banking needs of  businesses but over time have broadened their services;  thrifts, which include savings banks, savings associations, and  savings and loans and were originally created to serve the needs— particularly the mortgage needs—of those not served by commercial  banks; and  credit unions, which are member-owned cooperatives run by member- elected boards with an historical emphasis on serving people of  modest means.
These charters may be obtained at the state or federal level. State  regulators charter institutions and participate in their oversight, but all  institutions that have federal deposit insurance have a federal prudential  regulator. The federal prudential regulators—which generally may issue  regulations and take enforcement actions against industry participants  within their jurisdiction—are identified in table 1. The act eliminated the  Office of Thrift Supervision (OTS) and transferred its regulatory  responsibilities to OCC, the Federal Reserve, and FDIC. To achieve their  safety and soundness goals, bank regulators establish capital  requirements, conduct onsite examinations and off-site monitoring to  assess a bank’s financial condition, and monitor compliance with banking  laws. Regulators also issue regulations, take enforcement actions, and  close banks they determine to be insolvent.
Holding companies that own or control a bank or thrift are subject to  supervision by the Federal Reserve. The Bank Holding Company Act of  1956 and the Home Owners’ Loan Act set forth the regulatory frameworks  for bank holding companies and savings and loan (S&L) holding  companies, respectively. Before the Dodd-Frank Act, S&L holding  companies had been subject to supervision by OTS and a different set of  regulatory requirements from those of bank holding companies. The  Dodd-Frank Act made the Federal Reserve the regulator of S&L holding  companies and amended the Home Owners’ Loan Act and the Bank  Holding Company Act to create certain similar requirements for both bank  holding companies and S&L holding companies. The Dodd-Frank Act  also grants new authorities to FSOC to designate nonbank financial  companies for supervision by the Federal Reserve.
The securities and futures markets are regulated under a combination of  self-regulation (subject to oversight by the appropriate federal regulator)  and direct oversight by SEC and CFTC, respectively. SEC regulates the  securities markets, including participants such as securities exchanges,  broker-dealers, investment companies, and investment advisers. SEC’s  mission is to protect investors; maintain fair, orderly, and efficient  markets; and facilitate capital formation. In the securities industry, certain  self-regulatory organizations—including the securities exchanges and the  Financial Industry Regulatory Authority—have responsibility for  overseeing the securities markets and their members; establishing the  standards under which their members conduct business; monitoring  business conduct; and bringing disciplinary actions against members for  violating applicable federal statutes, SEC’s rules, and their own rules.
CFTC is the primary regulator of futures markets, including futures  exchanges and intermediaries, such as futures commission merchants.  CFTC’s mission is to protect market users and the public from fraud,  manipulation, abusive practices, and systemic risk related to derivatives  that are subject to the Commodity Exchange Act, and to foster open,  competitive, and financially sound futures markets. Like SEC, CFTC  oversees the registration of intermediaries and relies on self-regulatory  organizations, including the futures exchanges and the National Futures  Association, to establish and enforce rules governing member behavior.  In addition, Title VII of the Dodd-Frank Act expands regulatory  responsibilities for CFTC and SEC by establishing a new regulatory  framework for swaps. The act authorizes CFTC to regulate “swaps” and  SEC to regulate “security-based swaps” with the goals of reducing risk,  increasing transparency, and promoting market integrity in the financial  system.
The Dodd-Frank Act established CFPB as an independent bureau within  the Federal Reserve System and provided it with rule-making,  enforcement, supervisory, and other powers over many consumer  financial products and services and many of the entities that sell them.  Certain consumer financial protection functions from seven existing  federal agencies were transferred to CFPB. Consumer financial  products and services over which CFPB has primary authority include  deposit taking, mortgages, credit cards and other extensions of credit,  loan servicing, debt collection, and others. CFPB is authorized to  supervise certain nonbank financial companies and large banks and  credit unions with over $10 billion in assets and their affiliates for  consumer protection purposes. CFPB does not have authority over most  insurance activities or most activities conducted by firms regulated by  SEC or CFTC.
The Housing and Economic Recovery Act of 2008 (HERA) created FHFA  to oversee the government-sponsored enterprises (GSE): Fannie Mae,  Freddie Mac, and the Federal Home Loan Banks. Fannie Mae and  Freddie Mac were created by Congress as private, federally chartered  companies to provide, among other things, 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 HERA, 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 (HUD), and the Federal Home Loan Banks were subject to  supervision by the Federal Housing Finance Board (FHFB), an  independent regulatory agency. In July 2008, HERA created FHFA to  establish more effective and more consistent oversight of the three  housing GSEs. Given their precarious financial condition, Fannie Mae  and Freddie Mac were placed in conservatorship in September 2008, with  FHFA serving as the conservator under powers provided in HERA.
While insurance activities are primarily regulated at the state level, the  Dodd-Frank Act created the Federal Insurance Office within Treasury to  monitor issues related to regulation of the insurance industry. The  Federal Insurance Office is not a regulator or supervisor, and its  responsibilities include identifying issues or gaps in the regulation of  insurers that could contribute to a systemic crisis in the insurance industry  or the U.S. financial system.
The Dodd-Frank Act established FSOC to identify risks to the financial  stability of the United States, promote market discipline, and respond to  emerging threats to the stability of the U.S. financial system. The Dodd- Frank Act also established OFR within Treasury to serve FSOC and its  member agencies by improving the quality, transparency, and  accessibility of financial data and information; conducting and sponsoring  research related to financial stability; and promoting best practices in risk  management.
FSOC’s membership consists of the Secretary of the Treasury, who  chairs the council, and the heads of CFPB, CFTC, FDIC, the Federal  Reserve, FHFA, the National Credit Union Administration, OCC, SEC, the  directors of OFR and the Federal Insurance Office, representatives from  state-level financial regulators, and an independent member with  insurance experience.
section_title: Financial Crises
paragraphs: There is no universally accepted definition of a financial crisis. Some  academic studies identify three major types of financial crises: banking  crises, public debt crises, and currency crises. The most recent financial  crisis in the United States is widely considered to have been a banking  crisis. While researchers have defined banking crises in different ways,  their definitions generally focus on indicators of severe stress on the  financial system, such as runs on financial institutions or large-scale  government assistance to the financial sector. The large increases in  public debt that tend to follow the onset of a banking crisis can make a  country more susceptible to a public debt crisis.
Studies reviewing historical banking crises in the United States and other  countries found that such crises were associated with large losses in  output (the value of goods and services produced in the economy) and  employment that can persist for years. A disruption to the financial system  can have a ripple effect through the economy, harming the broader  economy through several channels. For example, some studies identify  ways that strains in the financial system can negatively impact the cost  and availability of credit and, in turn, reduce total output. During the  recent crisis, certain securitization markets collapsed and households and  businesses faced tightened credit conditions. Higher funding costs for  firms in the form of higher interest rates and lower equity prices can  contribute to declines in investment. Furthermore, as asset prices fall,  declines in the wealth and confidence of consumers, businesses, and  investors also can contribute to output declines. Historically, governments  have provided substantial assistance to financial institutions during  banking crises to avert more severe disruptions to the key functions  performed by the financial system.
The causes of the 2007-2009 crisis are complex and remain subject to  debate and ongoing research. According to many researchers, around  mid-2007, losses in the mortgage market triggered a reassessment of  financial risk in other debt instruments and sparked the financial crisis.  Uncertainty about the financial condition and solvency of financial entities  resulted in a liquidity and credit crunch that made the financing on which  many businesses and individuals depend increasingly difficult to obtain.  By late summer of 2008, the ramifications of the financial crisis ranged  from the failure of financial institutions to increased losses of individual  savings and corporate investments.
Academics and others have identified a number of factors that may have  helped set the stage for problems in the mortgage market and the  broader financial system. These factors, in no particular order, include  financial innovation in the form of asset securitization, which reduced  mortgage originators’ incentives to be prudent in underwriting loans  and made it difficult to understand the size and distribution of loss  exposures throughout the system;  imprudent business and risk management decisions based on the  expectation of continued housing price appreciation;  faulty assumptions in the models used by credit rating agencies to  rate mortgage-related securities; gaps and weaknesses in regulatory oversight, which allowed financial  institutions to take excessive risks by exploiting loopholes in capital  rules and funding themselves increasingly with short-term liabilities; government policies to increase homeownership, including the role of  Fannie Mae and Freddie Mac in supporting lending to higher-risk  borrowers; and economic conditions, characterized by accommodative monetary  policies, ample liquidity and availability of credit, and low interest rates  that spurred housing investment.
The United States periodically has experienced banking crises of varying  severity. The financial crisis that began in 2007 was the most severe  banking crisis experienced by the United States since the 1930s. While  this most recent financial crisis may have had some new elements—such  as the role of asset securitization in spreading risks across the financial  system—studies have found that it followed patterns common to past  crises in the United States and other countries. For example, experts  have noted that the recent crisis, like many past crises, was preceded by  an asset price boom that was accompanied by an excessive buildup in  leverage. Another common pattern between the recent and past crises  has been the buildup of risks and leverage in unregulated or less  regulated financial institutions. While academic studies have used  different criteria to identify and date banking crises, studies we reviewed  identify the following episodes as U.S. banking crises since the Civil War:  the banking panics of 1873, 1893, 1907, and the 1930s; the Savings and  Loan Crisis that began in the1980s; and the 2007-2009 crisis. The studies  do not consider the stock market crash of 1987 or the bursting of the  technology bubble during 2000-2001 to be banking crises, because  neither placed severe strains on the financial system that threatened the  economy.
section_title: 2007-2009 Financial Crisis Was Associated with Large Economic Losses and Increases in Government Debt
paragraphs: Several studies measure the overall economic costs associated with past  financial crises based on the decline in economic output (the value of  goods and services produced in the economy) relative to some  benchmark, such as the long-term trend in output. While using a variety of  methods to quantify these output losses, the studies generally have found  the losses from past financial crises to be very large. Some of these  studies also analyze changes in unemployment, household wealth, and  other economic indicators to show the effects of the crises at a more  granular level. In addition, some studies use measures of fiscal costs— such as increases in government debt—to analyze the losses associated  with financial crises. In the following section, we review what is known  about the losses associated with the recent financial crisis based on  these measures.
subsections: section_title: Studies Generally Find That the Recent Crisis Was Associated with Large Losses in Economic Output, but Estimates of Such Losses Vary and Depend on Several Assumptions
paragraphs: The 2007-2009 financial crisis, like past financial crises, was associated  with not only a steep decline in output but also the most severe economic  downturn since the Great Depression of the 1930s (see fig. 1). According  to a study, in the aftermath of past U.S. and foreign financial crises,  output falls (from peak to trough) an average of over 9 percent and the  associated recession lasts about 2 years on average. The length and  severity of this economic downturn was roughly consistent with the  experience of past financial crises. The U.S. economy entered a  recession in December 2007, a few months after the start of the financial  crisis. Between December 2007 and the end of the recession in June  2009, U.S. real gross domestic product (GDP) fell from $13.3 trillion to  $12.7 trillion (in 2005 dollars), or by nearly 5 percent. As shown in figure  1, real GDP did not regain its pre-recession level until the third quarter of  2011.
Although the decline in the U.S. economy’s real GDP during the  recession may reflect some of the losses associated with the 2007-2009  financial crisis, the decline does not capture the cumulative losses from  the crisis. To quantify the overall losses associated with past financial  crises, researchers have estimated output losses as the cumulative  shortfall between actual GDP and estimates of what GDP would have  been if the crisis had not occurred. Measuring the shortfall in GDP in the  aftermath of a crisis requires making a number of assumptions, and the  measurement will vary depending on what assumptions are used. Figure  2 provides two examples to show how estimates of output losses vary  depending on the assumptions used. The output shortfall is shown in the  shaded areas of the two examples, with the output shortfall larger in  example 2 than in example 1. Important assumptions include the  following:
Start date of the crisis: The first assumption involves selecting the  date when the crisis began. The start date is shown as the vertical line  in examples 1 and 2 and is assumed to be the same. However,  researchers have used different assumptions to select the start date  of the 2007-2009 financial crisis.
The path real GDP would have followed if the crisis had not  occurred: The second assumption involves estimating the  counterfactual for the path of GDP—that is, the path that real GDP  would have followed in the absence of a crisis. This counterfactual is  not observable. Studies have used different assumptions to estimate  this path and one approach is to assume that this path would follow a  precrisis trend in real GDP growth. For example, one study estimated  trend output paths based on average GDP growth for the three years  and ten years before the crisis. In figure 2, example 1 assumes a  much lower (or less steep) trend rate of GDP growth than example 2.  Assuming a higher growth trend results in a larger estimate of output  losses.
Projections of actual GDP: The third assumption involves  determining when GDP regained or will regain its estimated precrisis  trend path. With respect to the recent crisis, some studies find that  real GDP remains below the estimated precrisis trend. Researchers  reach different conclusions about when or whether GDP will regain its  long-term trend from before the crisis. Assumptions about the path of  actual GDP and how it compares to the potential trend path can  reflect different views on whether the output losses from the crisis are  temporary or permanent. In contrast to example 1, where the  economy regains its precrisis growth rate and level of output, example  2 assumes the economy regains its precrisis rate of output growth but  remains permanently below the level of output projected by  extrapolating the precrisis growth trend. As a result, output losses in  example 2 extend farther into the future and are considerably larger  than in example 1. Some studies describe reasons why financial  crises could be associated with permanent output losses. For  example, sharp declines in investment during and following the crisis  could result in lower capital accumulation in the long-term. In addition,  persistent high unemployment could substantially erode the skills of  many U.S. workers and reduce the productive capacity of the U.S.  economy.
Research suggests that U.S. output losses associated with the 2007- 2009 financial crisis could range from several trillion to over $10 trillion. In  January 2012, the Congressional Budget Office (CBO) estimated that the  cumulative difference between actual GDP and estimated potential GDP  following the crisis would amount to $5.7 trillion by 2018. CBO defined  potential output as the output level that corresponds to a high rate of use  of labor and capital. CBO reported that recessions following financial  crises, like the most recent crisis, tend to reduce not only output below  what it otherwise would have been but also the economy’s potential to  produce output, even after all resources are productively employed. In its  estimate, CBO assumed that GDP would recover to its potential level by  2018, noting that it does not attempt to predict business cycle fluctuations  so far into the future. Other studies have reported a wide range of  estimates for the output losses associated with past financial crises, with  some suggesting that output losses from the recent crisis could persist  beyond 2018 or be permanent. In an August 2010 study, a working group  of the Basel Committee on Banking Supervision reviewed the literature  estimating output losses. According to the Basel Committee working  group’s review, studies calculating long-term output losses relative to a  benchmark (such as an estimated trend in the level of GDP) estimated  much larger losses than studies calculating output losses over a shorter  time period. In a June 2012 working paper, International Monetary Fund  (IMF) economists estimated the cumulative percentage difference  between actual and trend real GDP for the 4 years following the start of  individual banking crises in many countries. They found a median output  loss of 23 percent of trend-level GDP for a historical set of banking crises  and a loss of 31 percent for the 2007-2009 U.S. banking crisis. Other  researchers who assume more persistent or permanent output losses  from past financial crises estimate much larger output losses from these  crises, potentially in excess of 100 percent of precrisis GDP. While such  findings were based on crisis events before 2007, if losses from the 2007- 2009 crisis were to reach similar levels, the present value of cumulative  output losses could exceed $13 trillion.
Studies that estimate output losses can be useful in showing the rough  magnitude of the overall costs associated with the 2007-2009 financial  crisis, but their results have limitations. Importantly, real GDP is an  imperfect proxy of overall social welfare. As discussed below, real GDP  measures do not reveal the distributional impacts of the crisis, and the  costs associated with a financial crisis can fall disproportionately on  certain populations. In addition, it is difficult to separate out the economic  costs attributable to the crisis from the costs attributable to other factors,  such as federal government policy decisions before, during, and after the  crisis.
section_title: 2007-2009 Crisis Was Also Associated with Large Declines in Employment, Household Wealth, and Other Economic Indicators
paragraphs: While studies often use output losses to measure the overall costs  associated with financial crises, many researchers also discuss trends in  unemployment, household wealth, and other economic indicators, such  as the number of foreclosures, to provide a more granular picture of the  effects of financial crises. As with trends in output losses, it is not possible  to determine how much of the changes in these measures can be  attributed to the financial crisis rather than to other factors. For example,  analyzing the peak-to-trough changes in certain measures, such as home  prices, can overstate the impacts associated with the crisis, as valuations  before the crisis may have been inflated and unsustainable. The effects of  the financial crisis have been wide-ranging, and we are not attempting to  provide a comprehensive review of all components of the economic harm.  Rather, the following highlights some of the most common types of  measures used by academics and other researchers.
As shown in figure 3, the unemployment rate rose substantially following  the onset of the financial crisis and then declined, but it remains above  the historical average as of November 2012. The monthly unemployment  rate peaked at around 10 percent in October 2009 and remained above 8  percent for over 3 years, making this the longest stretch of unemployment  above 8 percent in the United States since the Great Depression. The  monthly long-term unemployment rate—measured as the share of the  unemployed who have been looking for work for more than 27 weeks— increased above 40 percent in December 2009 and remained above 40  percent as of November 2012.
Persistent, high unemployment has a range of negative consequences for  individuals and the economy. First, displaced workers—those who  permanently lose their jobs through no fault of their own—often suffer an  initial decline in earnings and also can suffer longer-term losses in  earnings. For example, one study found that workers displaced during  the 1982 recession earned 20 percent less, on average, than their  nondisplaced peers 15 to 20 years later. Reasons that unemployment  can reduce future employment and earnings prospects for individuals  include the stigma that some employers attach to long-term  unemployment and the skill erosion that can occur as individuals lose  familiarity with technical aspects of their occupation. Second, research  suggests that the unemployed tend to be physically and psychologically  worse off than their employed counterparts. For example, a review of 104  empirical studies assessing the impact of unemployment found that  people who lost their job were more likely than other workers to report  having stress-related health conditions, such as depression, stroke, heart  disease, or heart attacks. Third, some studies find negative outcomes  for health, earnings, and educational opportunities for the children of the  unemployed. Fourth, periods of high unemployment can impact the  lifetime earnings of people entering the workforce for the first time. For  example, one study found that young people who graduate in a severe  recession have lower lifetime earnings, on average, than those who  graduate in normal economic conditions. In prior work, we reported that  long-term unemployment can have particularly serious consequences for  older Americans (age 55 and over) as their job loss threatens not only  their immediate financial security but also their ability to support  themselves during retirement. Persistent high unemployment can also  increase budgetary pressures on federal, state, and local governments as  expenditures on social welfare programs increase and individuals with  reduced earnings pay less in taxes.
According to the Federal Reserve’s Survey of Consumer Finances,  median household net worth fell by $49,100 per family, or by nearly 39  percent, between 2007 and 2010. The survey found that this decline  appeared to be driven most strongly by a broad collapse in home prices.  Another major component of net worth that declined was the value of  household financial assets, such as stocks and mutual funds. Economists  we spoke with noted that precrisis asset prices may have reflected  unsustainably high (or “bubble”) valuations and it may not be appropriate  to consider the full amount of the overall decline in net worth as a loss  associated with the crisis. Nevertheless, dramatic declines in net worth,  combined with an uncertain economic outlook and reduced job security,  can cause consumers to reduce spending. Reduced consumption, all else  equal, further reduces aggregate demand and real GDP.
As we reported in June 2012, decreases in home prices played a central  role in the crisis and home prices continue to be well below their peak  nationwide. According to CoreLogic’s Home Price Index, home prices  across the country fell nearly 29 percent between their peak in April 2006  and the end of the recession in June 2009 (see fig. 4). This decline  followed a 10-year period of significant home price growth, with the index  more than doubling between April 1996 and 2006. Since 2009, home  prices have fluctuated.
Similarly, we also reported that homeowners have lost substantial equity  in their homes, because home values have declined faster than home  mortgage debt. As shown in figure 5, households collectively lost about  $9.1 trillion (in constant 2011 dollars) in national home equity between  2005 and 2011, in part because of the decline in home prices. Figure 5  also shows that between 2006 and 2007, the steep decline in home  values left homeowners collectively holding home mortgage debt in  excess of the equity in their homes. This is the first time that aggregate  home mortgage debt exceeded home equity since the data were kept in  1945. As of December 2011, national home equity was approximately  $3.7 trillion less than total home mortgage debt.
Declines in the value of household investments in stocks and mutual  funds also contributed to significant declines in household wealth after the  crisis began. In addition to experiencing a decline in the value of their  stock and mutual fund investments, households also experienced a  decline in their retirement funds. As shown in figure 6, the value of  corporate equities held in retirement funds dropped sharply in late 2008.  While equity prices and the value of retirement fund assets generally  have recovered since 2009, investors and pension funds that sold assets  at depressed prices experienced losses. For example, officials from a  large pension fund told us that they were forced to sell equity securities at  depressed prices during the crisis to meet their liquidity needs. Experts  have different views on how the crisis may have changed investors’  attitudes towards risk-taking. To the extent that investors are more risk  averse and demand higher returns for the risks associated with certain  investments, businesses could face increased funding costs that could  contribute to slower growth.
In 2006, the percentage of loans in default or in foreclosure began to  increase (see fig. 7). As we previously reported, a number of factors  contributed to the increase in loan defaults and foreclosures, including a  rapid decline in home prices throughout much of the nation and weak  regional labor market conditions in some states where foreclosure rates  were already elevated. During the 2007-2009 recession, the elevated  unemployment rate and declining home prices worsened the financial  circumstances for many families, along with their ability to make their  mortgage payments. Foreclosures have been associated with a number  of adverse effects on homeowners, communities, the housing market,  and the overall economy. Homeowners involved in a foreclosure often are  forced to move out and may see their credit ratings plummet, making it  difficult to purchase another home. A large number of foreclosures can  have serious consequences for neighborhoods. For example, research  has shown that foreclosures depress the values of nearby properties in  the local neighborhood. Creditors, investors, and servicers can incur a  number of costs during the foreclosure process (e.g., maintenance and  local taxes) and a net loss, if there is a shortfall between the ultimate  sales price and the mortgage balance and carrying costs. Large numbers  of foreclosures can significantly worsen cities’ fiscal circumstances, both  by reducing property tax revenues and by raising costs to the local  government associated with maintaining vacant and abandoned  properties.
Some studies consider measures of fiscal costs—such as increases in  federal government debt—when analyzing the losses associated with  financial crises. Like past financial crises, the 2007-2009 financial crisis  has been associated with large increases in the federal government’s  debt and heightened fiscal challenges for many state and local  governments. Factors contributing to these challenges include decreased  tax revenues from reduced economic activity and increased spending  associated with government efforts to mitigate the effects of the  recession.
In prior work, we have reported that the economic downturn and the  federal government’s response caused budget deficits to rise in recent  years to levels not seen since World War II. While the structural  imbalance between spending and revenue paths in the federal budget  predated the financial crisis, the size and urgency of the federal  government’s long-term fiscal challenges increased significantly following  the crisis’s onset. From the end of 2007 to the end of 2010, federal debt  held by the public increased from roughly 36 percent of GDP to roughly  62 percent. Key factors contributing to increased deficit and debt levels  following the crisis included (1) reduced tax revenues, in part driven by  declines in taxable income for consumers and businesses; (2) increased  spending on unemployment insurance and other nondiscretionary  programs that provide assistance to individuals impacted by the  recession; (3) fiscal stimulus programs enacted by Congress to mitigate  the recession, such as the American Recovery and Reinvestment Act of  2009 (Recovery Act); and (4) increased government assistance to  stabilize financial institutions and markets.
While deficits during or shortly after a recession can support an economic  recovery, increased deficit and debt levels could have negative effects on  economic growth. For example, rising federal debt can “crowd out” private  investment in productive capital as the portion of savings that is used to  buy government debt securities is not available to fund such investment.  Lower levels of private investment can reduce future economic growth. In  addition, increased debt increases the amount of interest the government  pays to its lenders, all else equal. Policy alternatives to offsetting  increased interest payments include increasing tax rates and reducing  government benefits and services, which also can reduce economic  growth. Moreover, increased fiscal challenges could make the United  States more vulnerable to a fiscal crisis should investors lose confidence  in the ability of the U.S. government to repay its debts. Such a crisis could  carry enormous costs because the federal government would face a  sharp increase in its borrowing costs.
The following discussion focuses on the costs associated with the federal  government’s actions to assist the financial sector. Fiscal stimulus  programs, such as the Recovery Act, and the Federal Reserve’s  monetary policy operations were major components of the federal  government’s efforts to mitigate the recession that coincided with the  2007-2009 financial crisis. However, given our focus on the Dodd-Frank  Act reforms, the potential short-term and long-term impacts of these  efforts are beyond the scope of this report. Furthermore, our review did  not consider the benefits or costs of government policy interventions  relative to alternatives that were not implemented.
With respect to the most significant government programs and other  actions to assist the financial sector, the following discussion reviews (1)  expert perspectives on how these policy responses could have reduced  or increased the severity of the financial crisis and the associated  economic losses; (2) the potential costs associated with increased moral  hazard; and (3) the financial performance (including income and losses)  of the largest of these policy interventions.
Federal financial regulators and several academics and other experts we  spoke with highlighted several interventions that they maintain likely  helped to mitigate the severity of the 2007-2009 financial crisis. These  interventions included providing emergency funding to support several key credit markets  through the Federal Reserve’s emergency credit and liquidity  programs; extending federal government guarantees to a broader range of  private sector liabilities through FDIC’s Temporary Liquidity  Guarantee Program (TLGP) and Treasury’s Money Market Fund  Guarantee Program;  recapitalizing financial firms through Treasury’s Troubled Asset Relief  Program’s Capital Purchase Program; and  taking actions with respect to individual firms, such as Fannie Mae,  Freddie Mac, American International Group (AIG), Citigroup, and  Bank of America, to avert further destabilization of financial markets.
Many experts maintain that these large-scale interventions, in  combination with other government actions, such as the stress tests,  helped to restore confidence in the financial system and bring about a  recovery in certain private credit markets in 2009. In contrast, other  experts argue that certain federal government actions worsened, rather  than mitigated, the severity of the financial crisis. For example, some  experts maintain that the federal government’s rescue of Bear Stearns  but not Lehman Brothers sent a conflicting signal to the market and  contributed to a more severe panic. Some experts also have commented  that government assistance to the financial and housing sectors may  have slowed the economic recovery by preventing a full correction of  asset prices. Many experts agree that several (if not all) of the federal  government’s policy interventions likely averted a more severe crisis in  the short-run and that the long-term implications of these interventions  remain to be seen.
Experts generally agree that the government actions to assist the  financial sector may have increased moral hazard—that is, such actions  may have encouraged market participants to expect similar emergency  actions in the future, thus weakening private incentives to properly  manage risks and creating the perception that some firms are too big to  fail. Increased moral hazard could result in future costs for the  government if reduced private sector incentives to manage risks  contribute to a future financial crisis.
Although the financial performance of the federal government’s  assistance to the financial sector can be measured in different ways, most  of the federal government’s major programs earned accounting income in  excess of accounting losses and the net losses for some interventions are  expected to be small relative to the overall increase in the federal debt.  For example, the Federal Reserve reported that all loans made under its  emergency programs that have closed were repaid with interest and does  not project any losses on remaining loans outstanding. Under FDIC’s  TLGP, program participants, which included insured depository  institutions and their holding companies, paid fees on debt and deposits  guaranteed by the program; these fees created a pool of funds to absorb  losses. According to FDIC data, as of November 30, 2012, FDIC had  collected $11.5 billion in TLGP fees and surcharges, and this amount is  expected to exceed the losses from the program. In contrast, Treasury’s  investments in Fannie Mae and Freddie Mac under the Senior Preferred  Stock Purchase Agreements program represent the federal government’s  single largest risk exposure remaining from its emergency actions to  assist the financial sector. Cumulative cash draws by the GSEs under  this program totaled $187.4 billion as of September 30, 2012, and  Treasury reported a contingent liability of $316.2 billion for this program  as of September 30, 2011. As of September 30, 2012, Fannie Mae and  Freddie Mac had paid Treasury a total of $50.4 billion in dividends on  these investments. The amount that Treasury will recoup from these  investments is uncertain. Table 2 provides an overview of income and  losses from selected federal government interventions to assist the  financial sector.
In our prior work, we have described how the national recession that  coincided with the 2007-2009 financial crisis added to the fiscal  challenges facing the state and local sectors. Declines in output,  income, and employment caused state and local governments to collect  less revenue at the same time that demand for social welfare services  they provide was increasing. During the most recent recession, state and  local governments experienced more severe and long-lasting declines in  revenue than in past recessions. Because state governments typically  face balanced budget requirements and other constraints, they adjust to  this situation by raising taxes, cutting programs and services, or drawing  down reserve funds, all but the last of which amplify short-term  recessionary pressure on households and businesses. Local  governments may make similar adjustments, unless they can borrow to  make up for reduced revenue. The extent to which state and local  governments took such actions was impacted by the federal  government’s policy responses to moderate the downturn and restore  economic growth. Under the Recovery Act, the federal government  provided $282 billion in direct assistance to state and local governments  to help offset significant declines in tax revenues.
States have been affected differently by the 2007-2009 recession. For  example, the unemployment rate in individual states increased by  between 1.4 and 6.8 percentage points during the recession. Recent  economic research suggests that while economic downturns within states  generally occur around the same time as national recessions, their timing  and duration vary. States’ differing characteristics, such as industrial  structure, contribute to these differences in economic activity.
Declines in state and local pension asset values stemming from the 2007- 2009 recession also could affect the sector’s long-term fiscal position. In  March 2012, we reported that while most state and local government  pension plans had assets sufficient to cover benefit payments to retirees  for a decade or more, plans have experienced a growing gap between  assets and liabilities. In response, state and local governments have  begun taking a number of steps to manage their pension obligations,  including reducing benefits and increasing member contributions.
section_title: The Dodd-Frank Act May Enhance Financial Stability and Provide Other Benefits, with the Extent of the Benefits Depending on a Number of Factors
paragraphs: The Dodd-Frank Act contains several provisions that may benefit the  financial system and the broader economy, but the realization of such  benefits depends on a number of factors. Our review of the literature and  discussions with a broad range of financial market regulators,  participants, and observers revealed no clear consensus on the extent to  which, if at all, the Dodd-Frank Act will help reduce the probability or  severity of a future crisis. Nevertheless, many of these experts identified a  number of the same reforms that they expect to enhance financial  stability, at least in principle, and help reduce the probability or severity of  a future crisis. At the same time, such experts generally noted that the  benefits are not assured and depend on, among other things, how  regulators implement the provisions and whether the additional  regulations result in financial activity moving to less regulated institutions  or markets. Several experts also commented that the act also could  enhance consumer and investor protections. While estimating the extent  to which the act may reduce the probability of a future crisis is difficult and  subject to limitations, studies have found statistical evidence suggesting  that certain reforms are associated with a reduction in the probability of a  crisis.
subsections: section_title: Several Dodd-Frank Provisions May Help Reduce the Probability or Severity of a Future Crisis, but Uncertainty Exists about Their Effectiveness
paragraphs: Through our review of the literature and discussions with a broad range of  financial market regulators, academics, and industry and public interest  group experts, we found no clear consensus on the extent to which, if at  all, the Dodd-Frank Act will help reduce the probability or severity of a  future financial crisis. However, representatives of these groups identified  many of the same provisions in the act that they expect to enhance  financial stability, at least in principle, and help reduce the probability or  severity of a future crisis. These provisions include the following:
Creation of FSOC and OFR: The act created FSOC and OFR to  monitor and address threats to financial stability.
Heightened prudential standards for systemically important  financial institutions (SIFI): The act requires that all SIFIs be  subjected to Federal Reserve supervision and enhanced capital and  other prudential standards. SIFIs include bank holding companies with  $50 billion or more in total consolidated assets and nonbank financial  companies designated by FSOC for such supervision.
Orderly Liquidation Authority: The act provides regulators with new  authorities and tools to manage the failure of a large financial  company in a way designed to avoid taxpayer-funded bailouts and  mitigate the potential for such failures to threaten the stability of the  financial system.
Regulation of swaps: The act establishes a comprehensive  regulatory framework for swaps.
Mortgage-related and other reforms: The act includes provisions to  modify certain mortgage lending practices, increase regulation of  asset-backed securitizations, and restrict proprietary trading by large  depository institutions.
Experts had differing views on these provisions, but many expect some or  all of the provisions to improve the financial system’s resilience to shocks  and reduce incentives for financial institutions to take excessive risks that  could threaten the broader economy. While acknowledging these  potential financial stability benefits, experts generally were cautious in  their assessments for several reasons. Specifically, the effectiveness of  certain provisions will depend not only on how regulators implement the  provisions through rulemaking or exercise their new authorities but also  on how financial firms react to the new rules, including whether currently  regulated financial activity migrates to less regulated institutions or  markets. In addition, a few experts with whom we spoke said that some of  the act’s provisions could increase systemic risk and, thus, have adverse  effects on financial stability. Further, it may be neither possible nor  necessarily desirable for the Dodd-Frank Act or any other legislation to  prevent all future financial crises, in part because of the tradeoff inherent  between financial stability and economic growth.
The 2007-2009 financial crisis highlighted the lack of an agency or  mechanism responsible for monitoring and addressing risks across the  financial system and a shortage of readily available information to  facilitate that oversight. We reported in July 2009 that creating a new  body or designating one or more existing regulators with the responsibility  to oversee systemic risk could serve to address a significant gap in the  current U.S. regulatory system. Before the Dodd-Frank Act’s passage,  federal financial regulators focused their oversight more on individual  financial firms (called microprudential regulation) and less on market  stability and systemic risk (called macroprudential regulation). However,  the recent crisis illustrated the potential for one financial firm’s distress to  spill over into the broader financial system and economy. For example,  the failures and near-failures of Lehman Brothers, AIG, Fannie Mae,  Freddie Mac, and other large financial institutions contributed to the  instability experienced in the financial system during the crisis. The crisis  also illustrated the potential for systemic risk to be generated and  propagated outside of the largest financial firms (such as by money  market mutual funds), in part because of interconnections not only  between firms but also between markets. According to some academics  and other market observers, a significant market failure revealed by the  recent crisis was that the market did not discourage individual financial  firms from taking excessive risks that could impose costs on others,  including the public. Such spillover costs imposed on others are known  as negative externalities, and government intervention may be  appropriate to address such externalities.
The Dodd-Frank Act established FSOC to provide, for the first time, an  entity charged with the responsibility for monitoring and addressing  sources of systemic risk. The act also created OFR to support FSOC  and Congress by providing financial research and data. FSOC is  authorized, among other things, to  collect information across the financial system from member agencies  and other government agencies, so that regulators will be better  prepared to address emerging threats; designate certain nonbank financial companies for supervision by the  Federal Reserve and subject them to enhanced prudential standards; designate as systemically important certain financial market utilities  and payment, clearing, or settlement activities, and subject them to  enhanced regulatory oversight;  recommend stricter standards for the large, interconnected bank  holding companies and nonbank financial companies designated for  enhanced supervision;  vote on any determination by the Federal Reserve that action should  be taken to break up a SIFI that poses a “grave threat” to U.S.  financial stability;  facilitate information sharing and coordination among the member  agencies to eliminate gaps in the regulatory structure; and make recommendations to enhance the integrity, efficiency,  competitiveness, and stability of U.S. financial markets, promote  market discipline, and maintain investor confidence.
Financial market regulators, academics, and industry and public interest  groups with whom we spoke generally view the creation of FSOC and  OFR as positive steps, in principle, to address systemic risk and help  identify or mitigate a future crisis for several reasons. First, FSOC and its  member agencies now have explicit responsibility for taking a  macroprudential approach to regulation, along with tools and authority to  help identify and address threats to the financial stability of the United  States. For example, certain nonbank financial companies posed  systemic risk during the crisis but were subject to less regulation than  bank holding companies. To close this regulatory gap, FSOC has the  authority to designate a nonbank financial company for supervision by the  Federal Reserve and subject it to enhanced prudential standards, if the  material distress of that firm could pose a risk to U.S. financial stability.  In addition, although the Dodd-Frank Act does not address all sources of  systemic risk, the act authorizes FSOC to make recommendations to  address regulatory gaps or other issues that threaten U.S. financial  stability. For example, FSOC’s 2011 and 2012 annual reports discuss  financial stability threats not directly addressed by the Dodd-Frank Act  (e.g., money market mutual funds, tri-party repurchase agreements, and  the GSEs) and make recommendations to address some of them.  Finally, OFR may play an important role in gathering and analyzing data  that FSOC and its members will be able to use to identify and address  emerging risks to the financial system. OFR may also facilitate data  sharing among the regulators, which may enable regulators to identify  risks in areas emerging from beyond their immediate jurisdictions. Market  participants also may benefit from the ability to use OFR data to analyze  risks.
Experts also identified a number of factors that could limit FSOC’s or  OFR’s effectiveness. First, it is inherently challenging for a regulator to  identify and address certain sources of systemic risk. For example, while  asset price bubbles often become clear in hindsight, when such risks  appear to be building, policymakers may disagree over whether any  intervention is warranted. Second, FSOC’s committee structure cannot  fully resolve the difficulties inherent in the existing, fragmented regulatory  structure. For example, FSOC could encounter difficulties coming to  decisions or advancing a reform if it faces resistance from one or more of  its members. In addition, FSOC’s committee structure, including the  Treasury Secretary’s role as FSOC chair, could subject FSOC’s decision  making to political influence. According to a number of experts,  establishing FSOC and OFR as independent entities could have better  insulated them from political pressures that could dissuade them from  recommending or taking actions to promote long-term financial stability, if  such actions imposed short-term political costs. On the other hand, the  selection of the Treasury Secretary as FSOC chair reflects the Treasury  Secretary’s traditional role in financial policy decisions.
In a recent report, we identified a number of potential challenges for  FSOC, some of which are similar to those discussed above. Specifically,  we noted that key components of FSOC’s mission—to identify risks to  U.S. financial stability and respond to emerging threats to stability—are  inherently challenging. Risks to the stability of the U.S. financial system  are difficult to identify because commonly used indicators, such as market  prices, often do not reflect these risks and threats may not develop in  precisely the same way as they did in past crises. Although the act  created FSOC to provide for a more comprehensive view of threats to  U.S. financial stability, it left most of the pre-existing fragmented and  complex arrangement of independent federal and state regulators in  place and generally preserved their statutory responsibilities. Further, we  noted that FSOC does not have the authority to force agencies to  coordinate or adopt compatible policies and procedures. However, we  also reported that FSOC and OFR have made progress in establishing  their operations and approaches for monitoring threats to financial  stability, but these efforts could be strengthened. We made  recommendations to strengthen the accountability and transparency of  FSOC’s and OFR’s decisions and activities as well as to enhance  collaboration among FSOC members and with external stakeholders. In  response to our recommendations, Treasury emphasized the progress  that FSOC and OFR have made since their creation and noted that more  work remains, as they are relatively new organizations.
The 2007-2009 financial crisis also revealed weaknesses in the existing  regulatory framework for overseeing large, interconnected, and highly  leveraged financial institutions. Such financial firms were subject to some  form of federal supervision and regulation, but these forms of supervision  and regulation proved inadequate and inconsistent. For example,  fragmentation of supervisory responsibility allowed owners of banks and  other insured depository institutions to choose their own regulator. In  addition, regulators did not require firms to hold sufficient capital to cover  their trading and other losses or to plan for a scenario in which liquidity  was sharply curtailed. Moreover, the regulatory framework did not ensure  that banks fully internalized the costs of the risks that their failure could  impose on the financial system and broader economy.
The Dodd-Frank Act requires the Federal Reserve to supervise and  develop enhanced capital and other prudential standards for SIFIs, which  include bank holding companies with $50 billion or more in consolidated  assets and any nonbank financial company that FSOC designates. The  act requires the enhanced prudential standards to be more stringent than  standards applicable to other bank holding companies and financial firms  that do not present similar risks to U.S. financial stability. The act further  allows the enhanced standards to increase in stringency based on the  systemic footprint and risk characteristics of each firm. The Federal  Reserve plans to implement some of its enhanced standards in  conjunction with its implementation of Basel III, a new capital regime  developed by the Basel Committee on Banking Supervision. The act’s  provisions related to SIFIs include the following:
Risk-based capital requirements and leverage limits: The Federal  Reserve must establish capital and leverage standards, which as  proposed would include a requirement for SIFIs to develop capital  plans to help ensure that they maintain capital ratios above specified  standards, under both normal and adverse conditions. In addition, the  Federal Reserve has announced its intention to apply capital  surcharges to some or all SIFIs based on the risks SIFIs pose to the  financial system.
Liquidity requirements: The Federal Reserve must establish SIFI  liquidity standards, which as proposed would include requirements for  SIFIs to hold liquid assets that can be used to cover their cash  outflows over short time periods.
Single-counterparty credit limits: The Federal Reserve must  propose rules that, in general, limit the total net credit exposure of a  SIFI to any single unaffiliated company to 25 percent of its total capital  stock and surplus.
Risk management requirements: Publicly traded SIFIs must  establish a risk committee and be subject to enhanced risk  management standards.
Stress testing requirements: The Federal Reserve is required to  conduct an annual evaluation of whether SIFIs have sufficient capital  to absorb losses that could arise from adverse economic conditions.
Debt-to-equity limits: Certain SIFIs may be required to maintain a  debt-to-equity ratio of no more than 15-to-1.
Early remediation: The Federal Reserve is required to establish a  regulatory framework for the early remediation of financial  weaknesses of SIFIs in order to minimize the probability that such  companies will become insolvent and the potential harm of such  insolvencies to the financial stability of the United States.
A broad range of financial market regulators, academics, and industry  and public interest group experts generally expect the enhanced  prudential standards to help increase the resilience of SIFIs and reduce  the potential for a SIFI’s financial distress to spill over to the financial  system and broader economy. Higher capital levels increase a firm’s  resilience during times of financial stress because more capital is  available to absorb unexpected losses. Similarly, increased liquidity (e.g.,  holding more liquid assets and reducing reliance on short-term funding  sources) can reduce the likelihood that a firm will have to respond to  temporary strains in credit markets by cutting back on new lending or  selling assets at depressed prices. Increased capital and liquidity levels  together can limit the potential for large, unexpected losses in the  financial system to disrupt the provision of credit and other financial  services to households and businesses, which occurred in the most  recent financial crisis. Finally, limiting counterparty credit exposures also  can help to minimize spillover effects.
A number of experts viewed the act’s enhanced prudential standards for  SIFIs as particularly beneficial, because such institutions pose greater  risks to the orderly functioning of financial markets than less systemically  significant institutions, and subjecting SIFIs to stricter standards can  cause them to internalize the costs of the risks they pose to the system.  For example, the Federal Reserve intends to issue a proposal that would  impose capital surcharges on SIFIs based on a regulatory assessment of  the systemic risk they pose, consistent with a framework agreed to by the  Basel Committee. In addition, the Dodd-Frank Act’s enhanced  prudential standards provisions allow federal regulators to impose more  stringent risk management standards and oversight of SIFIs’ activities,  including by conducting stress tests, to help ensure that weaknesses are  addressed before they threaten the financial system. Experts noted that  these stricter standards, including the surcharges, could serve as a  disincentive to financial firms to become larger or otherwise increase the  risks they pose to the broader financial system.
Despite generally supporting an increase in the capital requirements,  experts questioned the potential effectiveness of certain aspects of the  enhanced prudential standards for SIFIs:  Impact on “too-big-to-fail” perceptions: Experts suggested that the  market may view SIFIs as too big to fail, paradoxically giving such  firms an implicit promise of government support if they run into  financial difficulties. As discussed below, perceptions that SIFIs are  too big to fail can weaken incentives for creditors to restrain excessive  risk-taking by SIFIs and could give such firms a funding advantage  over their competitors. However, others noted that the heightened  standards were specifically designed to address these issues and  view the act as explicitly prohibiting federal government support for  SIFIs. For example, the act revises the Federal Reserve Act to  prohibit the Federal Reserve from providing support to individual  institutions in financial distress and, as discussed below, the act  creates a new option for liquidating such firms.
Limits of Basel approach to capital standards: The Federal Reserve  will base its enhanced regulatory capital standards, in part, on Basel’s  approach, which several experts view as having limitations. They  recognized that the Basel III standards address some of the  limitations that the financial crisis revealed in the regulatory capital  framework, but maintain that Basel III continues to place too much  reliance on risk-based approaches to determining capital adequacy.  During the 2007-2009 crisis, some banks experienced capital  shortages, in part because they suffered large losses on assets that  were assigned low risk weights under Basel’s standards but posed  greater risk than their risk weights. The Basel III framework will  increase risk weights for certain asset classes—and includes a  leverage ratio as a safeguard against inaccurate risk weights—but  experts noted that the potential remains for financial institutions to  “game” the Basel risk weights by increasing holdings of assets that  carry risk-weights that are lower than their actual risks. In addition,  some experts maintain that the Basel standards overall may not  provide a sufficient buffer to protect firms during times of stress.  However, one regulator noted that the leverage ratio, and the higher  requirements for common equity and tier 1 capital called for in the  Basel III standards, represent a significant tightening of capital  regulation (in combination with the imposition of some higher risk  weights and better quality of capital).
Implementation of these SIFI provisions is ongoing. In January 2012, the  Federal Reserve proposed rules to implement the enhanced prudential  standards, but has not yet finalized all of these rules. In addition, the  Federal Reserve and other federal prudential regulators are continuing to  work to implement Basel III. As of December 2012 FSOC had not yet  designated any nonbank financial companies for Federal Reserve  supervision; the Federal Reserve will subsequently be responsible for  developing rules for the heightened capital and other prudential standards  for these entities.
Faced with the impending failure of a number of large financial companies  during the 2007-2009 financial crisis, federal financial regulators generally  had two options: (1) allowing these companies to file for bankruptcy at the  risk of exacerbating the crisis (e.g., Lehman Brothers) or (2) providing  such companies with emergency funding from the government at the risk  of increasing moral hazard (e.g., AIG). As we previously reported,  traditional bankruptcy may not be effective or appropriate for financial  companies for a variety of reasons. For example, in bankruptcy  proceedings for companies that hold derivatives or certain other qualified  financial contracts, creditors may terminate such contracts, even though  creditors generally may not terminate other contracts because they are  subject to automatic stays. Termination of derivative contracts can lead to  large losses for the failed firm and other firms through fire sales and other  interconnections. For example, the insolvency of Lehman Brothers had  a negative effect on financial stability by contributing to a run on money  market mutual funds and disrupting certain swaps markets. Further,  bankruptcy is a domestic legal process that varies by jurisdiction. Thus,  the bankruptcy of a financial company with foreign subsidiaries, such as  Lehman Brothers, can raise difficult international coordination challenges.
In contrast to the Lehman case, the government provided support to  some financial firms, such as AIG, because of concerns that their failures  would further disrupt the broader financial system. A number of experts  maintain this government assistance increased moral hazard by  encouraging market participants to expect similar emergency actions in  future crises for large, interconnected financial institutions—in effect,  reinforcing perceptions that some firms are too big to fail. The perception  of certain firms as too big to fail weakens market discipline by reducing  the incentives of shareholders, creditors, and counterparties of these  companies to discipline excessive risk taking. For example, creditors  and shareholders may not demand that firms they view as too big to fail  make adequate disclosures about these risks, which could further  undermine market discipline. Perceptions that firms are too big to fail  also can produce competitive distortions because companies perceived  as ‘too big to fail’ may be able to fund themselves at a lower cost than  their competitors.
The Dodd-Frank Act’s Title II provides the federal government with a new  option for resolving failing financial companies by creating a process  under which FDIC has the authority to liquidate large financial companies,  including nonbanks, outside of the bankruptcy process—called orderly  liquidation authority (OLA). In general, under this authority, FDIC may be  appointed receiver for a financial firm if the Treasury Secretary  determines that the firm’s failure would have a serious adverse effect on  U.S. financial stability. Under OLA, FDIC must maximize the value of the  firm’s assets, minimize losses, mitigate systemic risk, and minimize moral  hazard. OLA also establishes additional authorities for FDIC as receiver,  such as the ability to set up a bridge financial company and to borrow  funds from the Treasury to carry out the liquidation. FDIC can  subsequently collect funding for the OLA process from the financial  industry after a company has been liquidated.
A range of financial market regulators, academics, and industry and  public interest group experts identified a number of ways in which the  Dodd-Frank Act’s OLA provisions could help mitigate threats to the  financial system posed by the failure of SIFIs or other large, complex,  interconnected financial companies. First, the OLA framework may be  effective in addressing the limitations of the bankruptcy process. For  example, experts noted that under OLA, FDIC will be able to control the  liquidation process and can temporarily prevent creditors from terminating  their qualified financial contracts, the termination of which could prompt  fire sales that could be destabilizing. Second, under its rules, FDIC has  indicated that it will ensure that creditors and shareholders of a company  in OLA will bear the losses of the company. By helping to ensure that  creditors and shareholders will bear losses in the event of a failure, OLA  could strengthen incentives for creditors and shareholders to monitor  these firms’ risks. Finally, OLA could help convince market participants  that government support will no longer be available for SIFIs, which could  increase investors’ incentives to demand that SIFIs become more  transparent and refrain from taking excessive risks.
Experts also identified a number of potential challenges and limitations of  OLA. OLA is new and untested, and its effectiveness in reducing moral  hazard will depend on the extent to which the market believes FDIC will  use OLA to make creditors bear losses of any SIFI failure. Experts  identified a conflict between OLA’s goal of eliminating government  bailouts on one hand and minimizing systemic risk on the other. For  example, if FDIC imposes losses on some creditors of a failed SIFI, these  losses could cause other SIFIs to fail. In that regard, some experts  observed that governments historically have not allowed potentially  systemically important financial firms to fail during a crisis and question  whether a different outcome can be expected in the future. Moreover,  experts questioned whether FDIC has the capacity to use OLA to handle  multiple SIFI failures, which might occur during a crisis. Another concern  is that OLA will be applied to globally active financial institutions, and how  FDIC and foreign regulators will handle the non-U.S. subsidiaries of a  failed SIFI remains unclear.
In addition, SIFIs must formulate and submit to their regulators resolution  plans (or “living wills”) that detail how they could be resolved in  bankruptcy should they encounter financial difficulties. Experts noted  that resolution plans may provide regulators with critical information about  a firm’s organizational structure that could aid the resolution process. The  plans also could motivate SIFIs to simplify their structures, and this  simplification could help facilitate an orderly liquidation. However, other  experts commented that while resolution plans may assist regulators in  gaining a better understanding of SIFI structures and activities, the plans  may not be useful guides during an actual liquidation—in part because of  the complex structures of the institutions or because the plans may not be  helpful during a crisis. Resolution plans also may provide limited benefits  in simplifying firm structures, in part because tax, jurisdictional, and other  considerations may outweigh the benefits of simplification.
FDIC has finalized key OLA rules and is engaged in a continuing process  of clarifying how certain aspects of the OLA process would work. For  example, FDIC officials have clarified that the OLA process will focus on  the holding company level of the firm, and stated that the creation of the  bridge institution will help ensure that solvent subsidiaries may continue  to function. In addition, FDIC and the Federal Reserve are in the process  of reviewing the first set of resolution plans, which were submitted in July  2012.
Except for credit default swaps (CDS)—a type of derivative used to hedge  or transfer credit risk—other over-the-counter (OTC) swaps and derivative  contracts generally were not central to the systemwide problems  encountered during the financial crisis, according to FSOC.  Nonetheless, FSOC noted that OTC derivatives generally were a factor in  the propagation of risks during the recent crisis because of their  complexity and opacity, which contributed to excessive risk taking, a lack  of clarity about the ultimate distribution of risks, and a loss in market  confidence. In contrast to other OTC derivatives, credit default swaps  exacerbated the 2007-2009 crisis, particularly because of AIG’s large  holdings of such swaps, which were not well understood by regulators or  other market participants. Furthermore, the concentration of most OTC  derivatives trading among a small number of dealers created the risk that  the failure of one of these dealers could expose counterparties to sudden  losses and destabilize financial markets. While some standardized  swaps, such as interest rate swaps, have traditionally been cleared  through clearinghouses—which stand between counterparties in  assuming the risk of counterparty default—most CDS and most other  swaps have been traded in the OTC market where holders of derivatives  contracts bear the risk of counterparty default. In addition, swaps traded  in the OTC market have typically featured an exchange of margin  collateral to cover current exposures between the two parties, but not  “initial” margin to protect a nondefaulting party against the cost of  replacing the contract if necessary. As of the end of the second quarter of  2012, the outstanding notional value of derivatives held by insured U.S.  commercial banks and savings associations totaled more than $200  trillion.
As noted earlier, Title VII of the Dodd-Frank Act, also known as the Wall  Street Transparency and Accountability Act of 2010, establishes a new  regulatory framework for swaps to reduce risk, increase transparency,  and promote market integrity in swaps markets. Among other things, Title  VII generally provides for the registration and regulation of swap dealers and major  swap participants, including subjecting them to (1) prudential  regulatory requirements, such as minimum capital and minimum initial  and variation margin requirements and (2) business conduct  requirements to address, among other things, interaction with  counterparties, disclosure, and supervision;  imposes mandatory clearing requirements on swaps but exempts  certain end users that use swaps to hedge or mitigate commercial  risk;  requires swaps subject to mandatory clearing to be executed on an  organized exchange or swap execution facility, which promotes pre- trade transparency (unless no facility offers the swap for trading);  and  requires all swaps to be reported to a registered swap data repository  or, if no such repository will accept the swap, to CFTC or SEC, and  subjects swaps to post-trade transparency requirements (real-time  public reporting of swap data).
Figure 8 illustrates some of the differences between swaps traded on  exchanges and cleared through clearinghouses and swaps traded in the  OTC market.
A broad range of financial market regulators, participants, and observers  expect various provisions under Title VII to help promote financial  stability, but they also identified potential obstacles or challenges.
Clearing through clearinghouses: According to experts, the  clearing of swaps through clearinghouses could be beneficial.  Clearing can reduce the vulnerability of the financial system to the  failure of one or a few of the major swap dealers by transferring credit  risk from the swap counterparties to the clearinghouse. By becoming  the central counterparty in every trade, a clearinghouse can provide  multilateral netting efficiencies to reduce counterparty credit and  liquidity risks faced by market participants. Unlike dealers,  clearinghouses do not take positions on the trades they clear and may  have stronger incentives to develop effective risk management  measures and monitor their members’ financial condition. In addition,  clearinghouses have tools to mitigate counterparty credit risk, for  instance, initial and variation margin, as well as the ability to assess  their members for additional financial contributions. At the same time,  experts have pointed out that clearinghouses concentrate credit risk  and thus represent a potential source of systemic risk. For example,  a former regulatory official told us that, in her opinion, clearinghouses  essentially are too big to fail, given that the Dodd-Frank Act includes  provisions mandating centralized clearing of standardized swaps and  authorizing the Federal Reserve to provide emergency liquidity to  systemically important clearinghouses provided certain conditions are  met. Others commented that clearinghouses may be engaged in  clearing less standardized or illiquid products, which could pose risk- management challenges for clearinghouses and expose them to  greater risks.
Margin requirements: Experts expect the margin requirements for  uncleared swaps with swap dealers and major swap participants to  help promote financial stability by helping to ensure that market  participants have enough collateral to absorb losses. For example,  imposing both initial and variation margin requirements on uncleared  swaps could help prevent the type of build-up of large,  uncollateralized exposures experienced by AIG. Some experts  commented that margin requirements, depending how they are  implemented, could have a negative impact on liquidity if there is not a  sufficient supply of quality securities that can be posted as collateral  to meet margin requirements.
Reporting requirements: Many experts generally expect the swaps  reforms that improve transparency to benefit the financial system. For  example, the requirement for regulatory reporting of swaps  transactions may provide regulators with a better understanding of the  current risks in the swaps market and help enhance their oversight of  the market. Similarly, public reporting of swap data could benefit  market participants by providing them with data on prices and other  details about swaps that they can use to better assess their risks. A  number of industry representatives noted that the public reporting  requirement could lead some market participants to reduce their  participation out of fear that others can take advantage of such  information. In their view, this could result in a loss of liquidity to the  system.
CFTC and SEC have finalized many of the regulations needed to  implement Title VII, though several had yet to be finalized as of  December 2012. OTC derivatives are globally traded, and many other  jurisdictions are in the process of developing new regulatory regimes.  However, the United States is one of the first jurisdictions to have enacted  legislation in this area. Indeed, the implementation of at least one  derivatives-related provision has already been delayed because of the  importance of coordinating with international entities. The outcome of the  reform process in other jurisdictions will determine the extent to which  U.S. firms could be at a competitive advantage or disadvantage. (See  app. II for a description of international coordination efforts.)
While the previously discussed Dodd-Frank Act provisions were  commonly cited as the most important ones for enhancing U.S. financial  stability, several financial market regulators, participants, and observers  we spoke with identified other provisions that they expect to help enhance  financial stability. As with the provisions discussed above, certain key  rules implementing the following provisions have not yet been finalized.
Mortgage-related reforms: According to experts, problems in the  mortgage market, particularly with subprime mortgages, played a  central role in the recent financial crisis, and the act’s mortgage- related reforms may help prevent such problems in the future. Some  bank and nonbank mortgage lenders weakened their underwriting  standards and made mortgage loans to homebuyers who could not  afford them or engaged in abusive lending practices before the crisis.  These factors, along with the decline in housing prices, contributed to  the increase in mortgage defaults and foreclosures. A number of the  act’s provisions seek to reform the mortgage market—for example, by  authorizing CFPB to supervise nonbank mortgage lenders and by  prohibiting certain mortgage lending practices, such as issuing  mortgage loans without making a reasonable and good faith effort to  determine that the borrower has a reasonable ability to repay. Some  industry representatives have expressed concerns that these reforms  could prevent certain potential homebuyers from being able to obtain  mortgage loans. However, other experts noted that before the crisis  some loans had rates that did not fully reflect their risks, which  contributed to an excess of credit, and the act’s reforms may help  ensure that loans are accurately priced to reflect risks. Many of the  Dodd-Frank Act’s mortgage reforms have not yet been implemented  through rulemaking.
Risk retention for asset securitizations: According to experts, the  securitization of residential mortgages into mortgage-backed  securities that subsequently were part of other securitizations also  played a central role in the crisis, and the act contains provisions to  reform the market. Experts also noted that institutions that created  mortgage-backed securities in the lead-up to the crisis engaged in a  number of practices that undermined the quality of their securities,  including not adequately monitoring the quality of the mortgages  underlying their securities, because they did not bear the risk of  significant losses if those mortgages defaulted. The act contains  provisions that require securitizers of asset-backed securities to retain  some “skin in the game” in the form of a certain percentage of the  credit risk in asset-backed securities they create. However, experts  have different views on the extent to which the level of risk retention  for securitizations was central to the problems encountered during the  recent crisis, and a few do not view these provisions as potentially  beneficial for financial stability. Regulators proposed implementing  rules for the provision in 2011 but had yet to finalize the rules as of  December 2012.
The Volcker rule: The role that proprietary trading—trading activities  conducted by banking entities for their own account as opposed to  those of their clients—played in the recent crisis is a matter of  debate. However, a number of experts maintain that the ability of  banking entities to use federally insured deposits to seek profits for  their own account provides incentives for them to take on excessive  risks. In particular, some have noted that commercial banks that  benefit from the federal financial safety net enjoy access to subsidized  capital and thus do not bear the full risks of their proprietary trading  activities. To address these concerns, section 619 of the Dodd-Frank  Act, referred to as the Volcker rule, generally prohibits a banking  entity from engaging in proprietary trading or acquiring or retaining  more than a certain maximum percentage of any equity, partnership,  or other ownership interest in, or sponsoring, a hedge fund or a  private equity fund, among other restrictions involving transactions  between covered banking entities and sponsored hedge funds and  private equity funds. A number of experts view these restrictions as  enhancing financial stability by discouraging excessive risk-taking by  these institutions. Others, however, have noted that the Volcker rule,  by prohibiting certain proprietary activities of these institutions, could  have adverse effects on liquidity and, in turn, the unintended effect of  undermining financial stability. In 2011, regulators proposed rules to  implement the Volcker rule but had not yet finalized them as of  December 2012.
section_title: Other Dodd-Frank Provisions May Lead to Additional Consumer and Investor Benefits
paragraphs: Financial market regulators, participants, and observers whom we  interviewed also identified provisions that may result in benefits beyond  increased financial stability. For example, the act may enhance consumer  and investor protections and improve economic efficiency. As with the  provisions previously noted, the realization of such benefits will depend,  in part, on how regulators implement the provisions. Benefits beyond  financial stability that experts highlighted include the following:
Enhanced consumer protections: The Dodd-Frank Act’s Title X  consolidates rulemaking and other authorities over consumer financial  products and services under CFPB. The new agency assumes  authority to implement consumer protection laws, such as the Truth in  Lending Act and Home Ownership and Equity Protection Act of 1994.  CFPB could assist consumers by improving their understanding of  financial products and services. For example, experts noted that  consumers could benefit from CFPB’s efforts, which include providing  information on consumer financial products and simplifying  disclosures for mortgages, credit cards, and other consumer financial  products.
Enhanced investor protections: Certain provisions in the act could  provide shareholders with greater influence over, and insight into, the  activities of publicly traded companies. For example, the act contains  provisions that require shareholder advisory votes on executive  compensation, disclosure of the ratio between the chief executive  officer’s annual total compensation and median annual total  compensation for all other employees, and clawback policies for  erroneously awarded incentive-based compensation.
Improving resource allocation in the economy: Some experts  noted that mortgages and related credit instruments were not  accurately priced before the crisis to reflect their risks. As a result, the  economy experienced a credit bubble that facilitated a misallocation of  resources to the housing sector. For example, one expert noted that  residential housing construction during the 2000s was excessive and  inefficient. To the extent that the act contributes to a more accurate  pricing of credit, the economy could benefit from a more efficient  allocation of resources across the broader economy.
section_title: Quantifying Potential Benefits Is Difficult, but Some Approaches May Provide Useful Insights
paragraphs: The Dodd-Frank Act’s potential benefit of reducing the probability or  severity of a future financial crisis cannot be readily observed and this  potential benefit is difficult to quantify. Any analyses must be based on  assumptions about, or models of, the economy. Consequently, the results  of such analyses are subject to substantial uncertainty. Nonetheless, as  we noted previously in this report, a working group of the Basel  Committee on Banking Supervision summarized several studies that  analyze the costs of financial crises, and that used different  macroeconomic models of the economy to estimate the impact of more  stringent capital and liquidity standards on the annual likelihood of a  financial crisis, and the benefits of avoiding associated output losses.
The Basel Committee report suggests that increases in capital and  liquidity ratios are associated with a reduction in the probability that a  country will experience a financial crisis. Higher capital and liquidity  requirements may generate social benefits by reducing the frequency and  severity of banking crises and the consequent loss of economic output.  The Basel Committee working group found that although there is  considerable uncertainty about the exact magnitude of the effect, the  evidence suggests that higher capital and liquidity requirements can  reduce the probability of banking crises. For example, the models  suggest, on average, that if the banking system’s capital ratio—as  measured by the ratio of tangible common equity to risk-weighted  assets—is 7 percent, then a 1 percentage point increase in the capital  ratio is associated with a 1.6 percentage point reduction in the probability  of a financial crisis—from 4.6 percent to 3.0 percent per year. The  working group also found that if the capital ratio was 7 percent, then a  12.5 percent increase in the ratio of liquid assets to total assets in the  banking system is associated with a 0.8 percentage point reduction in the  probability of a crisis per year, on average. In addition, the incremental  benefits of higher capital requirements are greater when bank capital  ratios are increased from lower levels and they decline as standards  become progressively more stringent. For example, the models suggest,  on average, that the reduction in the likelihood of a crisis is three times  larger when the capital ratio is increased from 7 percent to 8 percent than  it is when the capital ratio is increased from 10 percent to 11 percent. The  further away banks are from insolvency, the lower their marginal benefit is  from additional protection.
Estimates of the reduced probability of a financial crisis are subject to a  number of limitations. For example, researchers note that the reduction in  the probability of a crisis depends on the baseline assumptions about the  average probability of a crisis before the policy changes—in this case,  before the increase in capital requirements. In addition, overall economic  conditions, or factors outside of the financial system, also may affect the  probability of a financial crisis.
The Basel Committee working group also summarized the studies’  estimates of the potential benefits from higher capital and liquidity  requirements in terms of economic output gains that could result from a  lower probability of a crisis. The studies used estimates of the costs of a  crisis to estimate that a 1 percent decrease in the annual probability of a  crisis could have a benefit of 0.2 percent to 1.6 percent per year of  increased economic output, depending on the extent to which the crisis  losses are temporary or permanent. If, for example, annual GDP were  $15 trillion (around the size of U.S. GDP) these estimates suggest that  the economic benefit in terms of increased GDP could range from  approximately $29 billion to about $238 billion per year. These estimates  also are subject to limitations, however. As we previously discussed in  this report, estimates of financial crisis losses have varied widely  depending on the assumptions made. In addition, these models did not  take into account variations in responses to higher capital and liquidity  requirements among institutions and regulatory environments.
Given the difficulty of measuring the extent to which the Dodd-Frank Act  may reduce the probability of a future crisis, a few academics have  proposed a more conceptual approach for comparing the act’s potential  benefits and costs. According to these experts, the benefits of the act  can be framed by determining the percent by which the cost of a financial  crisis needs to be reduced to be equal to the act’s costs. If the cost of a  future crisis is expected to be in the trillions of dollars, then the act likely  would need to reduce the probability of a future financial crisis by only a  small percent for its expected benefit to equal the act’s expected cost.  Although an academic told us this thought exercise helped put the  benefits and costs of the Dodd-Frank Act into perspective, it provides no  insight into whether the act reduces the probability of a future crisis by  even a small percent.
section_title: Significance of the Act’s Costs Is Not Fully Known
paragraphs: The Dodd-Frank Act requires federal agencies and the financial services  industry to expend resources to implement or comply with its  requirements, and some of its reforms are expected to impose costs on  the economy. First, federal agencies are devoting resources to fulfill rule-  making and other new regulatory responsibilities created by the act. A  large portion of these agency resources are funded by fees paid by  industry participants or other revenue sources outside of congressional  appropriations, limiting the impact of these activities on the federal budget  deficit. Second, the act contains a broad range of reforms that generally  are imposing or will impose additional regulations and costs on a  correspondingly broad range of financial institutions, including banks,  broker-dealers, futures commission merchants, investment advisers, and  nonbank financial companies. Given the act’s focus on enhancing  financial stability, large, complex financial institutions will likely bear the  greatest costs, but smaller financial institutions and other financial market  participants also will incur costs. Third, by imposing costs on the  financial services industry, the act also may impose costs on the broader  economy and reduce output. For example, financial institutions may  charge their customers more for credit or other financial services. While  the act’s costs can be viewed as the price to be paid to achieve a more  resilient financial system and other benefits, some industry  representatives question whether the costs, individually or cumulatively,  are excessive. Furthermore, observers have also expressed concerns  about potential unintended consequences of the act, such as reducing the  competiveness of U.S. financial institutions in the global financial  marketplace.
subsections: section_title: Resources Devoted to the Dodd-Frank Act’s Implementation Vary Widely across Federal Agencies
paragraphs: The amount of funding that 10 federal financial entities have reported as  associated with their implementation of the Dodd-Frank Act varied  significantly from 2010 through 2013, and the amounts have been  increasing for some of these entities. Funding resources associated with  the Dodd-Frank Act’s implementation from 2010 through 2012 ranged  from a low of $4.3 million for FHFA to a high of $432.3 million for CFPB  (see table 2). In addition, funding associated with the act’s  implementation increased from 2011 through 2012 for all but one of the  agencies, FHFA, and more than doubled for four entities: OFR, FSOC,  CFPB, and OCC. Three of these four entities—OFR, FSOC, and CFPB— were created through the Dodd-Frank Act and thus are in the process of  establishing management structures and mechanisms to carry out their  missions. Likewise, according to CFPB and OFR, while some of their  funding was used for recurring staffing costs, other funding was used for  start-up costs, such as systems development, contractor support, and  data purchases. According to FSOC and OFR, the increase in funding is  directly proportional to the growth in their staffing and reflects an increase  in the size and scope of their organizations. Some new funding resources  reported by agencies may represent transfers between entities rather  than new funding resources. For example, the large increase in Dodd- Frank-related funding for OCC between 2011 and 2012 reflects OCC’s  integration of OTS responsibilities and staff, according to OCC officials. In  addition, new funding resources for CFPB include some funding  resources transferred from the Federal Reserve. In such cases, these  new funding resources do not represent an incremental cost of the act’s  implementation.
To meet their Dodd-Frank-related responsibilities, federal entities  reported that they have hired new staff, redirected staff from other areas,  or used staff transferred from other entities. The number of full-time  equivalents (FTE) reported by the 10 federal entities as associated with  their implementation of the act also varied significantly from 2010 through  2013, and the amounts have been increasing for some entities (see table  3). The entities’ estimates of new FTEs related to implementing the Dodd- Frank provisions for 2010 through 2012 ranged from a low of 18 for FHFA  to a high of 964 for the Federal Reserve. Some new FTEs reported by  agencies represent transfers of staff between agencies rather than new  hires. New FTEs for OCC in 2011 include staff transferred from OTS. In  addition, new FTEs for CFPB include staff transferred from the agencies  whose consumer protection responsibilities were transferred to CFPB. In  such cases where new FTEs for an entity have resulted from a transfer of  existing regulatory responsibilities between entities, these new FTEs do  not represent an incremental cost of the act’s implementation.
A large portion of the federal entities’ resources devoted to the act’s  implementation are funded by fees paid by regulated institutions or other  sources outside the congressional appropriations process, limiting the  impact of these activities on the federal budget deficit. Seven of the  entities (CFPB, FSOC, OFR, FDIC, FHFA, OCC, and the Federal  Reserve) are funded in full through assessments, fees, or other revenue  sources and, thus, have not received any congressional appropriations.  Moreover, FSOC and OFR are funded by assessments on large bank  holding companies and nonbank financial companies designated by  FSOC for supervision by the Federal Reserve. SEC receives  appropriations, but SEC collects transaction fees and assessments that  are designed to recover the costs to the federal government of its annual  appropriation. CFPB receives a mandatory transfer of funding from the  Federal Reserve, subject to certain limits, but may request discretionary  appropriations. Treasury and CFTC are funded through congressional  appropriations. Although entities’ funding resources and staff have  increased due to implementation of the act, these increases are not  expected to have a significant impact on the federal deficit. In 2011, CBO  estimated that the Dodd-Frank Act would reduce federal deficits by $3.2  billion over the period from 2010 to 2020. CBO projected that the act  would increase revenues by $13.4 billion and increase direct spending by  $10.2 billion over this period. While CBO’s analysis did not consider the  potential impacts of the act’s reforms on economic growth, its estimates  suggest that the size of the act’s direct impacts on federal spending is  small relative to total federal net outlays of $3.6 trillion in fiscal year 2011.  While fees and assessments paid by financial institutions to the federal  entities help to limit the act’s direct impacts on the federal budget deficit,  they represent a cost to these institutions and could have indirect impacts  on the economy, as discussed later in this report.
In collecting and analyzing this information, we found challenges and  limitations that affected our efforts to aggregate the data. For example,  agencies told us that their reported funding and FTE resources for 2013  reflect their best estimates of the level of resources required to implement  existing and new responsibilities but stated that these estimates were  uncertain. As shown in tables 3 and 4, a few agencies did not provide  projections for 2013 resources related to the act’s implementation. In  addition, not all of the federal entities are on a federal fiscal year, so the  reported budgetary activities for some entities cover different time frames.  Moreover, the entities may have used different approaches to estimate  the funding and FTE resources, potentially making the figures harder to  compare across entities.
section_title: The Act Imposes Costs on the Financial Services Industry but Limited Data Exist on the Magnitude of the Costs
paragraphs: The Dodd-Frank Act’s provisions and regulations generally impose or are  expected to impose costs on banks and other financial institutions.  According to some academics and others, certain types of costs imposed  by the act on financial institutions serve to make such institutions  internalize costs that they impose on others through their risk-taking and  thereby reduce the risk that they pose to the financial system. The extent  to which the act imposes costs on financial institutions may vary among  not only different types of financial firms (e.g., banks versus nonbank  financial companies) but also among the same types of firms (e.g., large  banks versus small banks). In discussions with regulators, industry  representatives, and other experts, we identified two main categories of  financial impacts on financial institutions: (1) increased regulatory  compliance and other costs and (2) reduced revenue associated with new  restrictions on certain activities. However, as commonly noted by  financial firms in their annual reports, the Dodd-Frank Act’s full impact on  their businesses, operations, and earnings remains uncertain, in part  because of the rulemakings that still need to be completed. For example,  in its 2012 annual report, one large bank holding company noted that it  could not quantify the possible effects of the significant changes that were  under way on its business and operations, given the status of the  regulatory developments. Furthermore, even when the reforms have been  fully implemented, it may not be possible to determine precisely the  extent to which observed costs can be attributed to the act versus other  factors, such as changes in the economy.
No comprehensive data are readily available on the costs that the  financial services industry is incurring to comply with the Dodd-Frank Act.  Representatives from financial institutions and industry associations told  us that firms generally do not track their incremental costs for complying  with the act. Moreover, they said that the piecemeal way that the act is  being implemented makes it difficult to measure their regulatory costs.  Likewise, none of the industry associations we met with are tracking the  incremental costs that their members are incurring to comply with the act.  Regulators and others have collected some data on certain compliance  costs. Specifically, federal agencies typically estimate the cost of  complying with any recordkeeping and reporting requirements of their  rules under the Paperwork Reduction Act, but these estimates do not  capture other types of compliance costs, which can be more  substantial. For example, an SEC rule on asset-backed securities  requires issuers of such securities to conduct, or hire a third party to  conduct, a review of the assets underlying the securities; this cost is not a  paperwork-related cost and thus not included in the compliance costs  captured under the Paperwork Reduction Act. In May 2012, the  Treasury Secretary asked the Federal Reserve’s Federal Advisory  Council, a group of bank executives, to prepare a study to provide  regulators with more specific examples of the regulatory burdens imposed  by the act’s reforms.
A number of the Dodd-Frank Act provisions target large financial firms  and are expected to increase their compliance or other costs more  significantly than for other financial firms. In particular, several provisions  specifically apply to SIFIs, which include bank holding companies with  $50 billion or more in total consolidated assets (which we refer to as  “bank SIFIs”) and nonbank financial companies designated by FSOC for  supervision by the Federal Reserve. Examples of provisions targeting  large financial institutions include the following:
Enhanced prudential standards: Higher capital and liquidity  requirements can increase funding costs for banks. Studies by the  Basel Committee on Banking Supervision, IMF, and Organization for  Economic Cooperation and Development estimated that increased  capital and liquidity requirements would have modest impacts on  funding costs for financial institutions. In contrast, a study by the  International Institute of Finance, a global association of financial  institutions, found much larger negative impacts. Differences in these  studies’ estimates result from differences in certain assumptions. For  example, the size of the estimated impact on funding costs depends  on assumptions about how much of the increase in banks’ capital  levels is due to regulatory reforms rather than other factors. Some  researchers have noted that attributing all of the increase in banks’  capital levels to regulatory reforms may overstate the cost impacts of  these reforms, because banks likely increased their capital levels, to  some extent, in response to market forces after the crisis.
Resolution plans: Regulators and industry officials stated that bank  SIFIs have devoted significant staffing resources to developing the  required resolution plans and that some plans submitted in July 2012  were thousands of pages in length. Regulators estimated that each  bank SIFI required to complete a full resolution plan (20 banks) will  spend, on average, 9,200 hours to complete the first plan and 2,561  hours to update the plan annually.
Stress tests: In accordance with the act, the Federal Reserve, OCC,  and FDIC have issued rules for stress testing requirements for certain  bank holding companies, banks, thrift institutions, state member  banks, savings and loan companies, and nonbank financial  companies FSOC designates for supervision by the Federal  Reserve. Bank holding companies with $50 billion or more in assets  and nonbank financial companies designated by FSOC will be  required to conduct company-run stress tests semi-annually, and the  Federal Reserve will be required to conduct stress tests on these  companies annually. Financial companies with more than $10 billion  but less than $50 billion in assets will be required to conduct  company-run stress tests annually as directed by their primary federal  banking supervisor. According to industry representatives, stress  testing requires newly covered firms to incur significant compliance  costs associated with building information systems, contracting with  outside vendors, recruiting experienced personnel, and developing  stress testing models that are unique to their organization.
Regulatory assessments: The Dodd-Frank Act also increases  operating costs for SIFIs and certain large banks through new or  higher regulatory assessments. First, under the act, large bank  holding companies and nonbank financial companies designated by  FSOC for supervision by the Federal Reserve must fund the Financial  Research Fund, which funds the operating costs of FSOC and OFR,  and certain expenses for the implementation of the orderly liquidation  activities of FDIC, through a periodic assessment. The President’s  fiscal year 2013 budget included estimates of about $158 million for  the Financial Research Fund for fiscal year 2013. Second, pursuant  to the act, FDIC issued a final rule changing the assessment base for  the deposit insurance fund and the method for calculating the deposit  insurance assessment rate. According to FDIC, the change in the  assessment base shifted some of the overall assessment burden from  community banks to the largest institutions, which rely less on  domestic deposits for their funding than smaller institutions, but  without affecting the overall amount of assessment revenue collected.  According to FDIC data, following implementation of the new  assessment base, from the first to the second quarter of 2011, total  assessments for banks with $10 billion or more in assets increased by  $413 million.
In addition to increasing compliance costs for SIFIs and other large  financial institutions, Title VII of the Dodd-Frank Act establishes a new  regulatory framework for swaps, which is expected to impose substantial  compliance and other costs on swap dealers, which generally include  large banks, and other swap market participants.
Business conduct standards: Swap dealers and major swap  participants will face increased costs to comply with new business  conduct standards under the act. These requirements address,  among other things, interaction with counterparties, disclosure,  reporting, recordkeeping, documentation, conflicts of interest, and  avoidance of fraud and other abusive practices. Under CFTC’s final  rules, swap dealers and major swap participants will need to adopt or  amend written policies and procedures, obtain needed  representations from counterparties, and determine whether existing  counterparty relationship documents need to be otherwise changed or  supplemented.
Clearing, exchange trading, and data reporting: Changes to the  market infrastructure for swaps—such as clearing and exchange- trading requirements—and real-time reporting requirements for  designated major swap dealers or major swap participants will require  firms to purchase or upgrade information systems. Industry  representatives and regulators said that while some compliance costs  of the derivatives reforms could be recurring, a large part of these  costs will come from one-time upfront investments to update  processes and technology. For example, according to industry groups  and agency officials, the real-time reporting and swap execution  facility technology upgrades for reporting are among the largest  technology investment compliance cost areas for derivatives reforms,  and costs to develop new reporting technology for firms may vary  depending on the compatibility of the new reporting system with the  prior system used. In its final rule on real-time reporting of swap data,  CFTC estimated that the annual information collection burden on  swap dealers and major swap participants would be approximately  260,000 hours.
Margin rules: Swap dealers and end users will incur costs to post the  additional collateral required under the new margin rules, including  costs to borrow assets to pledge as collateral. For newly raised  funds, the net cost would be the difference between the interest rate  paid on the borrowed funds and the interest rate earned on the  securities purchased to use as collateral. Estimating the incremental  costs is difficult, in part because the incremental cost must take into  account the extent to which swap dealers in the past, even if they did  not require margin explicitly, may have charged end users more to  price in a buffer to absorb losses.
Although the Dodd-Frank Act reforms are directed primarily at large,  complex U.S. financial institutions, many of the act’s provisions are  expected to impose costs on other financial institutions as well. For  example, we recently reported that the act’s reforms covering residential  mortgages, securitizations, executive compensation, and other areas may  impose additional requirements and, thus, costs on a broad range of  financial institutions, but the magnitude of these costs will depend on,  among other things, how the provisions are implemented.
In addition to imposing compliance and other costs on financial  institutions, the Dodd-Frank Act’s provisions may limit or restrict financial  institutions’ business activities and reduce their revenue or revenue  opportunities. Examples of such provisions include the following.
Volcker rule: By generally prohibiting banks from engaging in  proprietary trading and limiting their ability to sponsor or invest in  hedge and private equity funds, the restrictions could eliminate past  sources of trading and fee income for some banks. In addition,  according to industry representatives, some banks currently holding  private funds face the risk of incurring losses on the investments, if  they are required to liquidate such investments at a substantial  discount within an allotted period.
Swaps reform: The provisions of the Dodd-Frank Act requiring  central clearing and exchange trading of certain swaps could reduce  the volume of dealers’ higher-profit margin swaps and thereby reduce  their revenue. In addition, the margin requirements could reduce the  ability of U.S. dealers to compete internationally, according to industry  representatives.
Single counterparty credit limit: Section 165(e) of the act directs  the Federal Reserve to establish single-counterparty credit limits for  SIFIs to limit the risks that the failure of any individual company could  pose to a SIFI. According to industry representatives, the Federal  Reserve’s proposed rule to implement credit limits would, among  other things, require some SIFIs to reduce their derivatives and  securities lending activities.
Debit card interchange fees: Under section 1075 of the act (known  as the Durbin amendment) the Federal Reserve issued a final rule  that places a cap on debit card interchange fees charged by debit  card issuers with at least $10 billion of assets. In their SEC filings,  several large debit card issuers have estimated lost revenues from the  Durbin amendment to be in the hundreds of millions of dollars  annually. Similarly, we recently reported that large banks that issue  debit cards initially have experienced a decline in their debit  interchange fees as a result of the rule but that small banks generally  have not. The reduction in debit interchange fees following the  adoption of the rule likely has resulted or will result in savings for  merchants. However, debit card issuers, payment card networks, and  merchants are continuing to react to the rule; thus, the rule’s impact  has not yet been fully realized.
section_title: While the Dodd-Frank Act Could Impose Costs on the Economy, Quantifying Such Costs Is Difficult
paragraphs: Financial markets can channel funds from savers and investors looking  for productive investment opportunities to borrowers who have productive  investment opportunities but not the funds to pursue them. By serving this  financial intermediation function, financial markets can contribute to  higher production and efficiency in the economy. Banks and other  financial institutions can facilitate transactions between savers and  borrowers and reduce the associated costs, as well as provide other  financial services and products that contribute to economic growth.
However, according to academics and industry representatives, by  imposing higher costs on financial institutions, the Dodd-Frank Act may  indirectly impose higher costs on businesses and households and reduce  their investment and consumption with a consequent effect on economic  output.
Industry representatives, academics, and others generally expect the  costs imposed by the act on the economy to be more significant than the  act’s compliance costs for regulated institutions. At the same time,  experts have noted that such costs can be viewed as part of the price to  pay to realize the act’s potential financial stability and other benefits. For  example, reforms that increase safety margins in the financial system— such as by requiring increased capital and collateral to absorb potential  losses—represent a tradeoff between lower economic growth in the short  term and a lower probability of a financial crisis in the long term.  Furthermore, reforms may cause financial market participants to  internalize costs that their failure could impose on others through, for  example, triggering declines in asset prices and strains in funding  markets; thus, such reforms could improve overall economic outcomes.  Nevertheless, experts continue to debate whether the economic costs of  the act’s reforms, individually and cumulatively, could be excessive  relative to their potential benefits.
One way through which the Dodd-Frank Act could impose costs on the  broader economy is through its reforms that ultimately increase the cost  or reduce the availability of credit for households and businesses. All else  equal, when credit becomes more expensive or harder to obtain,  households may reduce purchases and businesses may reduce  investments that are funded by debt. These declines in consumption and  investment can reduce GDP. According to academics, industry  associations and firms, and others, reforms that could increase the cost  or reduce the availability of credit include higher capital and liquidity  requirements for financial institutions, the Volcker rule, counterparty credit  limits, and mortgage-related provisions.
Capital and liquidity requirements: Higher capital and liquidity  requirements for banks can increase their funding and other costs.  While banks can respond to these additional costs in a variety of  ways, they generally are expected to pass on some of these costs to  borrowers by charging higher interest rates on their loans, which could  lead to a reduction in output. Some studies have assessed the  potential short-term and long-term cost impacts of higher capital and  liquidity requirements. Differences in estimates produced by different  studies follow from differences in key modeling assumptions. With  respect to short-term impacts, studies generally suggest that  increasing capital and liquidity requirements for banks will likely be  associated with short-term increases in interest rates for borrowers  and short-term decreases in lending volumes, output, and economic  growth rates during the period over which banks transition to these  new requirements, but the magnitudes vary considerably across  studies. For example, a Macroeconomic Assessment Group study  summarized research by its members on the impact of the transition  to the Basel III capital and liquidity requirements and found that  interest rates for borrowers are likely to increase and lending volumes  are likely to fall during the transition period, but that the ultimate  reductions in output and growth are likely to be modest. Studies  from the IMF and the Organization for Economic Cooperation and  Development found broadly similar results. In contrast, a study by  the Institute of International Finance estimated the impact of banks’  making the transition to meeting Basel III and additional country- specific requirements and found much larger short-term impacts on  lending rates, lending volumes, output, and growth rates during the  transition period. Studies also suggest that increasing capital and  liquidity requirements for banks will likely be associated with long-term  or permanent changes in lending rates and output. For example, a  Basel Committee working group assessed the long-term impact of  higher capital and liquidity requirements and found that they are likely  to be associated with modest long-term increases in lending spreads  and modest long-term reductions in output. An IMF study found  similar results.
Volcker rule: Some experts and industry representatives have  expressed concern that the Volcker rule’s restriction on proprietary  trading by banks could reduce market liquidity and increase the cost  of raising funds in the securities markets and thus reduce output. As  we previously reported, some market observers maintain that  restrictions on proprietary trading by banks under the Volcker rule  may reduce the amount of liquidity in the securities markets,  depending on how the restrictions are implemented. For example,  the rule could reduce the amount of market-making provided by banks  for certain debt securities and ultimately result in higher borrowing  rates for corporations, state and local governments, or others that use  debt securities to help finance their activities. A study sponsored by  an industry association estimated that the Volcker rule could increase  annual borrowing costs for debt securities issuers by billions of  dollars, and reduce liquidity in a wide range of markets, and  consequently, to some extent, impede the ability of businesses to  access capital through increases in cost of funds to borrowers.  However, other experts have asserted that the study’s estimate is too  high, in part because they believe it understates the potential for other  firms to fill the gap left by banks and provide liquidity to the market.
Single counterparty credit limit: According to industry  representatives, the Federal Reserve’s proposed single counterparty  credit limit rule could restrict the ability of SIFIs to engage in  derivatives transactions with each other to hedge risk. In turn, such  interference could reduce market liquidity and result in higher funding,  hedging, and transaction costs for businesses.
Mortgage-related reforms: The act’s provisions regulating the  underwriting of mortgages also could restrict the availability of  mortgage loans and raise mortgage costs for some homebuyers.
For example, the act amends the Truth in Lending Act to prohibit  lenders from making mortgage loans without regard to borrowers’  ability to repay them. As described earlier in this report, lenders may  comply with the ability-to-repay standard by originating qualified  mortgages that meet criteria that will be finalized by CFPB in  rulemaking. In addition, securitized mortgages that meet certain  criteria and which are referred to as “qualified residential mortgages”  (QRM), are exempt from the act’s risk retention requirements. While  there is general agreement that new Dodd-Frank rules should restrict  certain types of risky loans and loan products that proliferated in the  lead-up to the crisis, many market observers have expressed concern  that these restrictions could go too far. For example, some mortgage  industry representatives have raised concerns that including overly  restrictive requirements for loan-to-value and debt service-to-income  ratios in the qualified residential mortgage criteria could restrict the  availability of mortgages to lower-income borrowers.
Measuring the costs of financial regulation to the broader economy is  challenging because of the multitude of intervening variables, the  complexity of the global financial system, and data limitations. Many of  the rules implementing the act’s reforms have not been finalized, and it is  difficult to predict how regulated institutions will respond to the act’s  reforms. For example, the extent to which regulated institutions pass on a  portion of their increased costs to their customers may be impacted by  competitive forces or other factors. Furthermore, even when the reforms  have been fully implemented, it may not be possible to determine  precisely the extent to which observed costs can be attributed to the act  versus other factors, such as changes in the economy. Differences in  assumptions about the appropriate baseline for comparison can lead to  significant variation in estimates of the act’s impacts. As discussed below,  other sources of uncertainty, such as the potential for regulatory  arbitrage, add to the challenges of estimating the act’s potential costs.
Some of the act’s reforms have the effect of transferring wealth across  groups and may create economic costs if they result in resources being  deployed less efficiently. For example, new assessments to fund the  Financial Research Fund, which funds the operating costs of FSOC,  OFR, and certain expenses for the implementation of the orderly  liquidation activities of FDIC, represent an economic transfer from bank  holding companies to the Financial Research Fund. In addition, as noted  previously, changes in the deposit insurance fund assessment base shift  some of the overall assessment burden from smaller banks to the largest  institutions without affecting the overall amount of assessment revenue  collected. Similarly, while the Durbin amendment has reduced revenues  from interchange fees for large debit card issuers, these lost revenues will  be offset to some extent by financial benefits to merchants who will pay  lower interchange fees. Predicting the extent to which such transfers  across groups could reduce economic growth is difficult, in part because  how financial institutions will respond to these changes is unclear. For  example, financial institutions could respond to increased assessment  burdens or reduced revenue streams by cutting other expenses or  increasing fees and other costs for their customers. Some market  observers have noted that some financial institutions have increased fees  on certain services, such as bank checking accounts, to compensate for  lost revenues and increased fee assessments from the act. However,  financial institutions’ business strategies are impacted by a wide range of  factors, and determining the extent to which such increased fees can be  attributed to the Dodd-Frank Act is difficult.
section_title: The Potential for Unintended Consequences Adds to Challenges of Assessing Benefits and Costs
paragraphs: Academics, industry representatives, and others we spoke with also have  expressed concern about the potential for the Dodd-Frank Act’s reforms  to have unintended consequences that could harm U.S. economic growth  or the global competitiveness of U.S. financial markets. Experts have a  wide range of views on the act’s potential to enhance financial stability,  with some maintaining that certain reforms could make the financial  system more vulnerable to a crisis. For example, some experts suggest  that higher capital, liquidity, and collateral requirements will cause  regulated institutions to increase significantly their holdings of relatively  safe and liquid securities, such as U.S. Treasuries. Such an outcome  could inflate the value of such securities and result in large losses if there  were a sharp correction in the securities’ valuation.
In addition, experts raised concerns about the potential for certain reforms  to cause financial activities to shift to less regulated or unregulated  markets and pose risks to U.S. financial stability. Of particular concern is  the potential for increased regulation of U.S. financial markets to cause  financial activities in the United States to move to foreign jurisdictions with  less stringent regulations. For example, some academics and industry  groups contend that if the United States imposes new margin  requirements on swaps before other countries, the swap business could  migrate to countries with lower margin requirements. Similarly, industry  representatives have raised concerns about the potential for the Volcker  rule and single counterparty credit limit to disadvantage U.S. financial  institutions relative to foreign competitors that will be permitted to engage  in proprietary trading activities outside the United States. While  acknowledging these concerns and the need for harmonizing international  regulatory standards, regulators noted that it can be advantageous for the  United States to be the leader in implementing new regulatory  safeguards. For example, when financial institutions are more resilient to  unexpected shocks, they can continue to provide loans and other  financial services that are important to economic growth, even during  periods of market turmoil.
These potential unintended consequences add to the challenge of  assessing the costs and full impacts of the Dodd-Frank Act. Currently, the  act is imposing costs on the financial services industry that could  contribute to slower economic growth. At the same time, the act may help  reduce the probability or severity of a future financial crisis, which would  benefit the economy by preventing or mitigating crisis-related costs.  However, the Dodd-Frank Act remains untested in a number of areas,  has yet to be fully implemented, and leaves unresolved certain potential  sources of system risk, such as money market funds and the tri-party  repo market. As noted earlier, because the costs associated with a  financial crisis can total trillions of dollars, the Dodd-Frank Act might need  to reduce the probability of a crisis by only a small fraction for its benefits  to equal its costs. Whether the act can achieve that outcome is unknown.  As the impact of the act’s multitude of provisions, individually or  cumulatively, materializes, their benefits and costs will become more fully  known and understood—enabling policy makers and regulators to revise  the requirements, as needed, to achieve the appropriate balance between  the act’s benefits and costs to the U.S. economy.
section_title: Agency Comments
paragraphs: We provided a draft of this report to CFPB, CFTC, FDIC, the Federal  Reserve, FSOC, OCC, OFR, Treasury, and SEC for their review and  comment. We also provided excerpts of the draft report for technical  comment to FHFA. All of the agencies provided technical comments,  which we have incorporated, as appropriate.
As agreed with your offices, unless you publicly announce the contents of  this report earlier, we plan no further distribution until 30 days from the  report date. At that time, we will send copies to CFPB, CFTC, FDIC,  FHFA, the Federal Reserve, FSOC, OCC, OFR, Treasury, and SEC,  interested congressional committees, members, and others. In addition,  this report will be available at no charge on our web site at  http://www.gao.gov.
Should you or your staff have questions concerning this report, please  contact me at (202) 512-8678 or clowersa@gao.gov. Contact points for  our Offices of Congressional Relations and Public Affairs may be found  on the last page of this report. Key contributors to this report are listed in  appendix IV.
section_title: Appendix I: Objectives, Scope, and Methodology
paragraphs: The objectives of our report were to examine what is known about (1) the  losses and related economic impacts associated with the 2007-2009  financial crisis; (2) the benefits of the Dodd-Frank Wall Street Reform and  Consumer Protection Act (the Dodd-Frank Act), particularly its key  financial stability provisions, for the U.S. financial system and broader  economy; and (3) the costs associated with the act, particularly its key  financial stability provisions.
To address our first objective, we reviewed and analyzed studies by  regulators and academics. We conducted searches of social science,  economic, and federal research databases, including EconLit, Google  Scholar, and JSTOR, to identify relevant studies that examine the losses  associated with the 2007-2009 financial crisis. To help us identify relevant  studies, we also relied on federal agencies and academic and other  experts. Although we found these studies to be sufficiently reliable for the  purposes of our report, the results should not necessarily be considered  as definitive, given the potential methodological or data limitations  contained in the studies individually or collectively. In addition, we  reviewed our prior work that addresses economic impacts associated with  the crisis, including the impacts on the fiscal challenges faced by federal,  state, and local governments. We interviewed federal financial regulators,  academics, industry associations, market participants and others to  obtain their perspectives on how the recent financial crisis impacted the  economy and what methods have been used to quantify the economic  impacts associated with the crisis. Based on our literature review and  interviews with experts, we identified approaches commonly used by  experts to quantify or describe the economic losses associated with the  crisis, and the limitations of these approaches. For example, we  summarized approaches used by some researchers to quantify losses  associated with the financial crisis in terms of lost gross domestic product,  which measures the total goods and services produced in the economy.  To describe trends in economic measures associated with the financial  crisis, we collected and analyzed data from the Bureau of Economic  Analysis, the Bureau of Labor Statistics, CoreLogic, the Federal Reserve  Flow of Funds database, and the National Bureau of Economic Research.  Lastly, we obtained and analyzed perspectives on the role of the federal  government’s policy interventions in mitigating the costs of the financial  crisis. We obtained and analyzed data from government financial  statements and other reports on the income and losses for the most  significant government programs to assist the financial sector, including  the Troubled Asset Relief Program, the Board of Governors of the  Federal Reserve System’s (Federal Reserve) emergency liquidity  programs, the Temporary Liquidity Guarantee Program, and assistance  provided to rescue individual institutions, such as American International  Group, Inc. and the government-sponsored enterprises. Our review did  not consider the potential short-term and long-term impacts of other  federal policy responses to the recession that coincided with the financial  crisis, including the American Recovery and Reinvestment Act of 2009.
To address our second objective, we obtained and analyzed a broad  range of perspectives on the potential economic benefits of the Dodd- Frank Act and factors that could impact the realization of these benefits.  Using a literature search strategy similar to the one described under our  first objective, we identified and analyzed academic and other studies that  evaluate the potential benefits of one or more of the act’s reforms. In  addition, we reviewed relevant reports and public statements by federal  financial regulators, industry associations, and others. We obtained  additional perspectives from regulators, academics, and representatives  of industry and public interest groups through interviews and an expert  roundtable we held with the assistance of the National Academy of  Sciences (NAS). Based on our literature review, interviews, and expert  roundtable, we identified provisions of the act that could have the most  significant impacts on financial stability, and factors that could impact the  effectiveness of these provisions. In addition, we obtained and  summarized expert perspectives on potential benefits of the act beyond  enhanced financial stability, such as increased consumer and investor  protections. Finally, we reviewed and summarized approaches used by  researchers to quantify potential benefits of the act’s reforms. Although  we found these studies to be sufficiently reliable for the purposes of our  report, the results should not necessarily be considered as definitive,  given the potential methodological or data limitations contained in the  studies individually or collectively.
To address our third objective, we obtained and analyzed information on  the costs of implementing the Dodd-Frank Act, including for the federal  government, the financial sector, and the broader economy. We obtained  and summarized data on the incremental budgetary costs associated with  the act’s implementation for 10 federal entities (Board of Governors of the  Federal Reserve System, Commodity Futures Trading Commission,  Federal Deposit Insurance Corporation, Federal Housing Finance  Agency, Office of the Comptroller of the Currency, Securities and  Exchange Commission, Department of the Treasury, Consumer Financial  Protection Bureau, Financial Stability Oversight Council, and the Office of  Financial Research). We requested data on the entities’ estimates of their  funding and full-time equivalents agency-wide and for activities related to  the Dodd-Frank Act in 2010, 2011, 2012, and 2013. We also requested  that the entities identify their sources of funding (appropriations,  assessments of supervised institutions, revenue from investments or  providing services, and transfers of funds from other agencies), and  describe the extent to which new resources related to the Dodd-Frank Act  would be funded on a one-time or recurring basis. We corroborated the  information with other data, where available. In addition, we reviewed the  Congressional Budget Office’s estimate of the act’s effect on the federal  government’s direct spending and revenue and, in turn, deficit. To  describe the potential costs for the financial sector and the broader  economy, we reviewed published works, public statements, and other  available analyses by financial regulators, industry representatives,  academics, and other experts. We also obtained perspectives from  representatives of these groups through interviews and the expert  roundtable we held in coordination with NAS. We also had two financial  markets experts review a draft of our report and incorporated their  comments, as appropriate.
To help inform our work on the second and third objectives, we  contracted with NAS to convene a 1-day roundtable of 14 experts to  discuss the potential benefits and potential costs of the Dodd-Frank Act.  The group of experts was selected with the goal of obtaining a balance of  perspectives and included former financial regulatory officials,  representatives of financial institutions impacted by the act’s reforms,  academic experts on financial regulation, a representative of a public  interest group, and an industry analyst. The discussion was divided into  three moderated sub-sessions. The sub-sessions addressed (1) the  potential benefits of the act’s key financial stability reforms; (2) the  potential costs of these key financial stability reforms; and (3)  methodological approaches and challenges in measuring the impacts of  the act’s reforms. For a list of the 14 experts, see appendix III.
For parts of our methodology that involved the analysis of computer- processed data, we assessed the reliability of these data and determined  that they were sufficiently reliable for our purposes. Data sets for which  we conducted data reliability assessments include gross domestic  product data from the Bureau of Economic Analysis; employment data  from the Bureau of Labor Statistics; home price data from CoreLogic;  Federal Reserve Flow of Funds data on retirement fund assets; loan  default and foreclosure data from the Mortgage Bankers Association; and  recession data from the National Bureau of Economic Research. We  reviewed information on the statistical collection procedures and methods  for these data sets to assess their reliability. In addition, we assessed the  reliability of estimates federal entities provided for the funding resources  and full-time equivalents associated with Dodd-Frank implementation by  comparing these estimates to agency budget documents and interviewing  agency staff about how the data were collected. Finally, for studies that  present quantitative estimates of the economic impacts associated with  financial crises or financial regulatory reforms, we assessed the  reasonableness of the methodological approaches used to generate  these estimates. Although we found certain studies to be sufficiently  reliable for the purposes of our report, the results should not necessarily  be considered definitive, given the potential methodological or data  limitations contained in the studies, individually or collectively.
We conducted this performance audit from November 2011 to January  2013 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: International Financial Reform Efforts
paragraphs: Many U.S. financial firms conduct business around the world and thus  generally are subject to rules on banking, securities, and other financial  market activities in multiple jurisdictions. In response to the financial crisis  that began in 2007, the United States and other countries have taken  steps to introduce financial reforms into their domestic legal and  regulatory systems. In parallel with these domestic reform efforts,  international organizations have issued new standards and principles to  guide their members’ efforts. The goal of these international efforts is to  harmonize and coordinate views and policies across different jurisdictions  to minimize opportunities for regulatory arbitrage—the ability of market  participants to profit from differences in regulatory regimes between one  jurisdiction and another.
Examples of some of these efforts include the following:
The G20, a group that represents 20 of the largest global economies,  created the Financial Stability Board (FSB) to coordinate and monitor  international financial regulatory reform efforts, among other activities.
The Basel Committee on Banking Supervision (BCBS)—hosted at the  Bank for International Settlements (BIS)—has developed a new set of  capital and, for the first time, liquidity requirements for banks.
The Committee on Payment and Settlement Systems (CPSS), which  is comprised of central banks, focuses on the efficiency and stability  of payment, clearing, and settlement arrangements, including financial  market infrastructures. Recently, CPSS has worked jointly with the  International Organization of Securities Commissions (IOSCO) to  produce a new set of prudential standards for financial market  infrastructures.
IOSCO, a multilateral organization of securities market regulators, has  issued policy documents to guide national securities commissions’  regulatory reform efforts.
Various other forums and groups, including the International  Association of Insurance Supervisors (IAIS), are housed at BIS and  cooperate on financial regulatory reform initiatives. For example, the  Joint Forum—which includes representatives of IAIS, BCBS, and  IOSCO—works to coordinate financial services reforms.
Separately, multilateral organizations, such as the International  Monetary Fund and Organization for Economic Cooperation and  Development, have published research and analysis of international  financial reforms.
Table 5 summarizes selected international financial regulatory reform  efforts.
section_title: Appendix III: Experts Participating in the GAO Roundtable on the Benefits and Costs of the Dodd-Frank Act
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: GAO Contact
section_title: Staff Acknowledgments
paragraphs: In addition to the contact named above, Richard Tsuhara (Assistant  Director), William R. Chatlos, John Fisher, Catherine Gelb, G. Michael  Mikota, Marc Molino, Courtney LaFountain, Robert Pollard, Jennifer  Schwartz, Andrew J. Stephens, and Walter Vance made significant  contributions to this report.
section_title: Bibliography
paragraphs: Acharya, Viral V., Thomas F. Cooley, Matthew Richardson, and Ingo  Walter. Regulating Wall Street: The Dodd-Frank Act and the New  Architecture of Global Finance. Hoboken, New Jersey, John Wiley &  Sons, 2011.
Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig, and Paul  Pfleiderer. “Fallacies, Irrelevant Facts, and Myths in the Discussion of  Capital Regulation: Why Bank Equity is Not Expensive.” Stanford GSB  Research Paper No. 2065. Stanford University: March 23, 2011.
Basel Committee on Banking Supervision, The Transmission Channels  Between the Financial and Real Sectors: A Critical Survey of the  Literature, Bank for International Settlements (BIS) Working Paper No.  18. Basel, Switzerland, February 2011.
Basel Committee on Banking Supervision, An Assessment of the Long- Term Economic Impact of Stronger Capital and Liquidity Requirements,  BIS. Basel, Switzerland, August 2010.
Boyd, John H., Sungkyu Kwak, and Bruce Smith, “The Real Output  Losses Associated with Modern Banking Crises.” Journal of Money,  Credit and Banking, vol. 37, no. 6. (December 2005): 977-999.
Cecchetti, Stephen G., Marion Kohler, and Christian Upper, Financial  Crises and Economic Activity. National Bureau of Economic Research  (NBER), Working Paper 15379. Cambridge, MA, September 2009.
Congressional Budget Office (CBO), Understanding and Responding to  Persistently High Unemployment (February 2012).
CBO, The Budget and Economic Outlook: Fiscal Years 2012 to 2022  (January 2012).
Duffie, Darrell and Haoxing Zhu. “Does a Central Clearing Counterparty  Reduce Counterparty Risk?” Review of Asset Pricing Studies, 1 (1)   (July 18, 2011): 74-95.
Elmendorf, Douglas W. Review of CBO’s Cost Estimate for the Dodd- Frank Wall Street Reform and Consumer Protection Act, Statement  Before the Subcommittee on Oversight and Investigations, Committee on  Financial Services, U.S. House of Representatives. March 30, 2011.
Federal Financial Analytics, Inc., “Strategic Regulatory Landscape:  Regulatory Intent versus Policy and Market Risk in Financial-Services  Industry – Capital, Liquidity, Risk Management and Related Prudential  Requirements,” October 2012.
Financial Stability Oversight Council (FSOC), 2011 Annual Report.  Washington, D.C. July 26, 2011.
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Gorton, Gary and Andrew Metrick. “Regulating the Shadow Banking  System,” Brookings Papers on Economic Activity. Fall 2010.
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Laevan, Luc and Fabian Valencia, Systemic Banking Crises Database:  An Update, International Monetary Fund Working Paper 12/163.  Washington, D.C. June 2012.
Levine, Ross. The Governance of Financial Regulation: Reform Lessons  from the Recent Crisis, BIS Working Paper No. 329, BIS Monetary and  Economic Department. Basel, Switzerland. November 2010.
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section_title: Related GAO Products
paragraphs: Community Banks and Credit Unions: Impact of the Dodd-Frank Act  Depends Largely on Future Rule Makings. GAO-12-881. Washington,  D.C.: September 13, 2012.
Financial Stability: New Council and Research Office Should Strengthen  the Accountability and Transparency of Their Decisions. GAO-12-886.  Washington, D.C.: September 11, 2012.
Bankruptcy: Agencies Continue Rulemakings for Clarifying Specific  Provisions of Orderly Liquidation Authority. GAO-12-735. Washington,  D.C.: July 12, 2012.
Unemployed Older Workers: Many Experience Challenges Regaining  Employment and Face Reduced Retirement Security. GAO-12-445.  Washington, D.C.: April 25, 2012.
State and Local Government Pension Plans: Economic Downturn Spurs  Efforts to Address Costs and Sustainability. GAO-12-322. Washington,  D.C.: March 2, 2012.
Dodd-Frank Act Regulations: Implementation Could Benefit from  Additional Analyses and Coordination. GAO-12-151. Washington, D.C.:  November 10, 2011.
Bankruptcy: Complex Financial Institutions and International Coordination  Pose Challenges. GAO-11-707. Washington, D.C.: July 19, 2011.
Mortgage Reform: Potential Impacts in the Dodd-Frank Act on  Homebuyers and the Mortgage Market. GAO-11-656. Washington, D.C.:  July 19, 2011.
Dodd-Frank Act: Eleven Agencies’ Estimates of Resources for  Implementing Regulatory Reform. GAO-11-808T. Washington, D.C.:   July 14, 2011.
Proprietary Trading: Regulators Will Need More Comprehensive  Information to Fully Monitor Compliance with New Restrictions When  Implemented. GAO-11-529. Washington, D.C.: July 13, 2011.
State and Local Governments: Knowledge of Past Recessions Can  Inform Future Federal Fiscal Assistance. GAO-11-401. Washington, D.C.:  March 31, 2011.
The Federal Government’s Long-Term Fiscal Outlook: January 2011  Update. GAO-11-451SP. Washington, D.C.: March 18, 2011.
Financial Assistance: Ongoing Challenges and Guiding Principles  Related to Government Assistance for Private Sector Companies.   GAO-10-719. Washington, D.C.: August 3, 2010.
Credit Cards: Rising Interchange Fees Have Increased Costs for  Merchants, but Options for Reducing Fees Pose Challenges, GAO-10-45  Washington, D.C.: November 19, 2009.
Financial Markets Regulation: Financial Crisis Highlights Need to Improve  Oversight of Leverage at Financial Institutions and across System.   GAO-09-739. Washington, D.C.: July 22, 2009.
Systemic Risk: Regulatory Oversight and Recent Initiatives to Address  Risk Posed by Credit Default Swaps. GAO-09-397T. Washington, D.C.:  March 5, 2009.
Financial Regulation: A Framework for Crafting and Assessing Proposals  to Modernize the Outdated U.S. Financial Regulatory System.   GAO-09-216. Washington, D.C.: January 8, 2009.