Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System
Published: 2009-01-21T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: This testimony discusses GAO's January 8, 2009, report that provides a framework for modernizing the outdated U.S. financial regulatory system. GAO prepared this work under the authority of the Comptroller General to help policymakers weigh various regulatory reform proposals and consider ways in which the current regulatory system could be made more effective and efficient. This testimony (1) describes how regulation has evolved in banking, securities, thrifts, credit unions, futures, insurance, secondary mortgage markets and other important areas; (2) describes several key changes in financial markets and products in recent decades that have highlighted significant limitations and gaps in the existing regulatory system; and (3) presents an evaluation framework that can be used by Congress and others to shape potential regulatory reform efforts.
section_title: What GAO Found
paragraphs: The current U.S. financial regulatory system has relied on a fragmented and complex arrangement of federal and state regulators--put into place over the past 150 years--that has not kept pace with major developments in financial markets and products in recent decades. Today, almost a dozen federal regulatory agencies, numerous self-regulatory organizations, and hundreds of state financial regulatory agencies share responsibility for overseeing the financial services industry. As the nation finds itself in the midst of one of the worst financial crises ever, it has become apparent that the regulatory system is ill-suited to meet the nation's needs in the 21st century. Several key changes in financial markets and products in recent decades have highlighted significant limitations and gaps in the existing regulatory system. First, regulators have struggled, and often failed, to mitigate the systemic risks posed by large and interconnected financial conglomerates and to ensure they adequately manage their risks. Second, regulators have had to address problems in financial markets resulting from the activities of large and sometimes less-regulated market participants--such as nonbank mortgage lenders, hedge funds, and credit rating agencies--some of which play significant roles in today's financial markets. Third, the increasing prevalence of new and more complex investment products has challenged regulators and investors, and consumers have faced difficulty understanding new and increasingly complex retail mortgage and credit products. Fourth, standard setters for accounting and financial regulators have faced growing challenges in ensuring that accounting and audit standards appropriately respond to financial market developments, and in addressing challenges arising from the global convergence of accounting and auditing standards. Finally, as financial markets have become increasingly global, the current fragmented U.S. regulatory structure has complicated some efforts to coordinate internationally with other regulators. These significant developments have outpaced a fragmented and outdated regulatory structure, and, as a result, significant reforms to the U.S. regulatory system are critically and urgently needed. The current system has significant weaknesses that, if not addressed, will continue to expose the nation's financial system to serious risks. Our report offers a framework for crafting and evaluating regulatory reform proposals consisting of nine characteristics that should be reflected in any new regulatory system. By applying the elements of the framework, the relative strengths and weaknesses of any reform proposal should be better revealed, and policymakers should be able to focus on identifying trade-offs and balancing competing goals. Similarly, the framework could be used to craft proposals, or to identify aspects to be added to existing proposals to make them more effective and appropriate for addressing the limitations of the current system.

section_title: Letter
paragraphs: I am pleased to be here today to discuss our January 8, 2009, report that  provides a framework for modernizing the outdated U.S. financial  regulatory system. We prepared this work under the authority of the  Comptroller General to help policymakers weigh various regulatory  reform proposals and consider ways in which the current regulatory  system could be made more effective and efficient. My statement today is  based on our report, which (1) describes how regulation has evolved in  banking, securities, thrifts, credit unions, futures, insurance, secondary  mortgage markets and other important areas; (2) describes several key  changes in financial markets and products in recent decades that have  highlighted significant limitations and gaps in the existing regulatory  system; and (3) presents an evaluation framework that can be used by  Congress and others to shape potential regulatory reform efforts. To do  this work, we synthesized existing GAO work and other studies and met  with representatives of financial regulatory agencies, industry  associations, consumer advocacy organizations, and others. The work  upon which the report is based was conducted in accordance with  generally accepted government auditing standards. Those standards  require that we plan and perform the audit to obtain sufficient, appropriate  evidence to provide a reasonable basis for our findings and conclusions  based on our audit objectives. We believe that the evidence obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives. This work was conducted between April 2008 and  December 2008.
The report was enhanced by input from representatives of 29 agencies and  other organizations, including federal and state financial regulatory  agencies, consumer advocacy groups, and financial service industry trade  associations, who reviewed and commented on a draft of the report prior  to its release. A list of organizations that reviewed the draft report is  included at the end of my statement. In general, reviewers commented that  the report represented an important and thorough review of the issues  related to regulatory reform.
subsections: section_title: Today’s Financial Regulatory System Was Built over the Course of More Than a Century, Largely in Response to Crises or Market Developments
paragraphs: As a result of 150 years of changes in financial regulation in the United  States, the regulatory system has become complex and fragmented. Today,  responsibilities for overseeing the financial services industry are shared  among almost a dozen federal banking, securities, futures, and other  regulatory agencies, numerous self-regulatory organizations, and hundreds  of state financial regulatory agencies. In particular, five federal agencies— including the Federal Deposit Insurance Corporation, the Federal Reserve,  the Office of the Comptroller of the Currency, the Office of Thrift  Supervision, and the National Credit Union Administration—and multiple  state agencies oversee depository institutions. Securities activities are  overseen by the Securities and Exchange Commission and state  government entities, as well as by private sector organizations performing  self-regulatory functions. Futures trading is overseen by the Commodity  Futures Trading Commission and also by industry self-regulatory  organizations. Insurance activities are primarily regulated at the state level  with little federal involvement. Other federal regulators also play  important roles in the financial regulatory system, such as the Public  Company Accounting Oversight Board, which oversees the activities of  public accounting firms, and the Federal Trade Commission, which acts as  the primary federal agency responsible for enforcing compliance with  federal consumer protection laws for financial institutions, such as finance  companies, which are not overseen by another financial regulator.
Much of this structure has developed as the result of statutory and  regulatory changes that were often implemented in response to financial  crises or significant developments in the financial services sector. For  example, the Federal Reserve System was created in 1913 in response to  financial panics and instability around the turn of the century, and much of  the remaining structure for bank and securities regulation was created as  the result of the Great Depression turmoil of the 1920s and 1930s. Changes  in the types of financial activities permitted for depository institutions and  their affiliates have also shaped the financial regulatory system over time.  For example, under the Glass-Steagall provisions of the Banking Act of  1933, financial institutions were prohibited from simultaneously offering  commercial and investment banking services, but with the passage of the  Gramm-Leach-Bliley Act of 1999 (GLBA), Congress permitted financial  institutions to fully engage in both types of activities.
section_title: Changes in Financial Institutions and Their Products Have Significantly Challenged the U.S. Financial Regulatory System
paragraphs: Several key developments in financial markets and products in the past  few decades have significantly challenged the existing financial regulatory  structure. (See fig. 1.) First, the last 30 years have seen waves of mergers  among financial institutions within and across sectors, such that the  United States, while still having large numbers of financial institutions,  also has several very large globally active financial conglomerates that  engage in a wide range of activities that have become increasingly  interconnected. Regulators have struggled, and often failed, to mitigate the  systemic risks posed by these conglomerates, and to ensure they  adequately manage their risks. The portion of firms that conduct activities  across the financial sectors of banking, securities, and insurance increased  significantly in recent years, but none of the regulators is tasked with  assessing the risks posed across the entire financial system.
A second dramatic development in U.S. financial markets in recent  decades has been the increasingly critical roles played by less-regulated  entities. In the past, consumers of financial products generally dealt with  entities such as banks, broker-dealers, and insurance companies that were  regulated by a federal or state regulator. However, in the last few decades,  various entities—nonbank lenders, hedge funds, credit rating agencies,  and special-purpose investment entities—that are not always subject to  full regulation by such authorities have become important participants in  our financial services markets. These unregulated or less regulated entities  can sometimes provide substantial benefits by supplying information or  allowing financial institutions to better meet demands of consumers,  investors or shareholders, but pose challenges to regulators that do not  fully or cannot oversee their activities. For example, significant  participation in the subprime mortgage market by generally less-regulated  nonbank lenders contributed to a dramatic loosening in underwriting  standards leading up to the current financial crisis.
A third development that has revealed limitations in the current regulatory  structure has been the proliferation of more complex financial products.  In particular, the increasing prevalence of new and more complex  investment products has challenged regulators and investors, and  consumers have faced difficulty understanding new and increasingly  complex retail mortgage and credit products. Regulators failed to  adequately oversee the sale of mortgage products that posed risks to  consumers and the stability of the financial system.
Fourth, standard setters for accounting and financial regulators have faced  growing challenges in ensuring that accounting and audit standards  appropriately respond to financial market developments, and in  addressing challenges arising from the global convergence of accounting  and auditing standards.
Finally, with the increasingly global aspects of financial markets, the  current fragmented U.S. regulatory structure has complicated some efforts  to coordinate internationally with other regulators. For example, the  current system has complicated the ability of financial regulators to  convey a single U.S. position in international discussions, such the Basel  Accords process for developing international capital standards, and  international officials have also indicated that the lack of a single point of  contact on, for example, insurance issues has complicated regulatory  decision making.
section_title: A Framework for Crafting and Assessing Alternatives for Reforming the U.S. Financial Regulatory System
paragraphs: As a result of significant market developments in recent decades that have  outpaced a fragmented and outdated regulatory structure, significant  reforms to the U.S. regulatory system are critically and urgently needed.  The current system has important weaknesses that, if not addressed, will  continue to expose the nation’s financial system to serious risks. As early  as 1994, we identified the need to examine the federal financial regulatory  structure, including the need to address the risks from new unregulated  products. Since then, we have described various options for Congress to  consider, each of which provides potential improvements, as well as some  risks and potential costs. Our report offers a framework for crafting and  evaluating regulatory reform proposals; it consists of the following nine  characteristics that should be reflected in any new regulatory system. By  applying the elements of this framework, the relative strengths and  weaknesses of any reform proposal should be better revealed, and  policymakers should be able to focus on identifying trade-offs and  balancing competing goals. Similarly, the framework could be used to  craft proposals, or to identify aspects to be added to existing proposals to  make them more effective and appropriate for addressing the limitations  of the current system.  1.  Clearly defined regulatory goals. A regulatory system should  have goals that are clearly articulated and relevant, so that  regulators can effectively conduct activities to implement their  missions.
A critical first step to modernizing the regulatory system and enhancing its  ability to meet the challenges of a dynamic financial services industry is to  clearly define regulatory goals and objectives. In the background of our  report, we identified four broad goals of financial regulation that  regulators have generally sought to achieve. These include ensuring  adequate consumer protections, ensuring the integrity and fairness of  markets, monitoring the safety and soundness of institutions, and acting to  ensure the stability of the overall financial system. However, these goals  are not always explicitly set in the federal statutes and regulations that  govern these regulators. Having specific goals clearly articulated in  legislation could serve to better focus regulators on achieving their  missions with greater certainty and purpose, and provide continuity over  time.
Given some of the key changes in financial markets discussed in our  report—particularly the increased interconnectedness of institutions, the  increased complexity of products, and the increasingly global nature of  financial markets—Congress should consider the benefits that may result  from re-examining the goals of financial regulation and making explicit a  set of comprehensive and cohesive goals that reflect today’s environment.  For example, it may be beneficial to have a clearer focus on ensuring that  products are not sold with unsuitable, unfair, deceptive, or abusive  features; that systemic risks and the stability of the overall financial  system are specifically addressed; or that U.S. firms are competitive in a  global environment. This may be especially important given the history of  financial regulation and the ad hoc approach through which the existing  goals have been established.
We found varying views about the goals of regulation and how they should  be prioritized. For example, representatives of some regulatory agencies  and industry groups emphasized the importance of creating a competitive  financial system, whereas members of one consumer advocacy group  noted that reforms should focus on improving regulatory effectiveness  rather than addressing concerns about market competitiveness. In  addition, as the Federal Reserve notes, financial regulatory goals often will  prove interdependent and at other times may conflict.
Revisiting the goals of financial regulation would also help ensure that all  involved entities—legislators, regulators, institutions, and consumers—are  able to work jointly to meet the intended goals of financial regulation.  Such goals and objectives could help establish agency priorities and define  responsibility and accountability for identifying risks, including those that  cross markets and industries. Policymakers should also carefully define  jurisdictional lines and weigh the advantages and disadvantages of having  overlapping authorities. While ensuring that the primary goals of financial  regulation—including system soundness, market integrity, and consumer  protection—are better articulated for regulators, policymakers will also  have to ensure that regulation is balanced with other national goals,  including facilitating capital raising, innovation, and other benefits that  foster long-term growth, stability, and welfare of the United States.
Once these goals are agreed upon, policymakers will need to determine  the extent to which goals need to be clarified and specified through rules  and requirements, or whether to avoid such specificity and provide  regulators with greater flexibility in interpreting such goals. Some reform  proposals suggest “principles-based regulation” in which regulators apply  broad-based regulatory principles on a case-by-case basis. Such an  approach offers the potential advantage of allowing regulators to better  adapt to changing market developments. Proponents also note that such  an approach would prevent institutions in a more rules-based system from  complying with the exact letter of the law while still engaging in unsound  or otherwise undesirable financial activities. However, such an approach  has potential limitations. Opponents note that regulators may face  challenges to implement such a subjective set of principles. A lack of clear  rules about activities could lead to litigation if financial institutions and  consumers alike disagree with how regulators interpreted goals.  Opponents of principles-based regulation note that industry participants  who support such an approach have also in many cases advocated for  bright-line standards and increased clarity in regulation, which may be  counter to a principles-based system. The most effective approach may  involve both a set of broad underlying principles and some clear technical  rules prohibiting specific activities that have been identified as  problematic.
Key issues to be addressed:    Clarify and update the goals of financial regulation and provide  sufficient information on how potentially conflicting goals might be  prioritized.
Determine the appropriate balance of broad principles and specific  rules that will result in the most effective and flexible  implementation of regulatory goals.  2.  Appropriately comprehensive. A regulatory system should  ensure that financial institutions and activities are regulated in  a way that ensures regulatory goals are fully met. As such,  activities that pose risks to consumer protection, financial  stability, or other goals should be comprehensively regulated,  while recognizing that not all activities will require the same  level of regulation.
A financial regulatory system should effectively meet the goals of financial  regulation, as articulated as part of this process, in a way that is  appropriately comprehensive. In doing so, policymakers may want to  consider how to ensure that both the breadth and depth of regulation are  appropriate and adequate. That is, policymakers and regulators should  consider how to make determinations about which activities and products,  both new and existing, require some aspect of regulatory involvement to  meet regulatory goals, and then make determinations about how extensive  such regulation should be. As we noted in our report, gaps in the current  level of federal oversight of mortgage lenders, credit rating agencies, and  certain complex financial products such as CDOs and credit default swaps  likely have contributed to the current crisis. Congress and regulators may  also want to revisit the extent of regulation for entities such as banks that  have traditionally fallen within full federal oversight but for which existing  regulatory efforts, such as oversight related to risk management and  lending standards, have been proven in some cases inadequate by recent  events. However, overly restrictive regulation can stifle the financial  sectors’ ability to innovate and stimulate capital formation and economic  growth. Regulators have struggled to balance these competing objectives,  and the current crisis appears to reveal that the proper balance was not in  place in the regulatory system to date.
Key issues to be addressed:  Identify risk-based criteria, such as a product’s or institution’s  potential to harm consumers or create systemic problems, for  determining the appropriate level of oversight for financial activities  and institutions.
Identify ways that regulation can provide protection but avoid  hampering innovation, capital formation, and economic growth.  3.  Systemwide focus. A regulatory system should include a  mechanism for identifying, monitoring, and managing risks to  the financial system regardless of the source of the risk or the  institutions in which it is created.
A regulatory system should focus on risks to the financial system, not just  institutions. As noted in our report, with multiple regulators primarily  responsible for individual institutions or markets, none of the financial  regulators is tasked with assessing the risks posed across the entire  financial system by a few institutions or by the collective activities of the  industry. The collective activities of a number of entities—including  mortgage brokers, real estate professionals, lenders, borrowers, securities  underwriters, investors, rating agencies and others—likely all contributed  to the recent market crisis, but no one regulator had the necessary scope  of oversight to identify the risks to the broader financial system. Similarly,  once firms began to fail and the full extent of the financial crisis began to  become clear, no formal mechanism existed to monitor market trends and  potentially stop or help mitigate the fallout from these events.
Having a single entity responsible for assessing threats to the overall  financial system could prevent some of the crises that we have seen in the  past. For example, in its Blueprint for a Modernized Financial  Regulatory Structure, Treasury proposed expanding the responsibilities of  the Federal Reserve to create a “market stability regulator” that would  have broad authority to gather and disclose appropriate information,  collaborate with other regulators on rulemaking, and take corrective  action as necessary in the interest of overall financial market stability.  Such a regulator could assess the systemic risks that arise at financial  institutions, within specific financial sectors, across the nation, and  globally. However, policymakers should consider that a potential  disadvantage of providing the agency with such broad responsibility for  overseeing nonbank entities could be that it may imply an official  government support or endorsement, such as a government guarantee, of  such activities, and thus encourage greater risk taking by these financial  institutions and investors.
Regardless of whether a new regulator is created, all regulators under a  new system should consider how their activities could better identify and  address systemic risks posed by their institutions. As the Federal Reserve  Chairman has noted, regulation and supervision of financial institutions is  a critical tool for limiting systemic risk. This will require broadening the  focus from individual safety and soundness of institutions to a systemwide  oversight approach that includes potential systemic risks and weaknesses.
A systemwide focus should also increase attention on how the incentives  and constraints created by regulations affects risk taking throughout the  business cycle, and what actions regulators can take to anticipate and  mitigate such risks. However, as the Federal Reserve Chairman has noted,  the more comprehensive the approach, the more technically demanding  and costly it would be for regulators and affected institutions.
Key issues to be addressed:  Identify approaches to broaden the focus of individual regulators or  establish new regulatory mechanisms for identifying and acting on  systemic risks.
Determine what additional authorities a regulator or regulators  should have to monitor and act to reduce systemic risks. 4.  Flexible and adaptable. A regulatory system should be  adaptable and forward-looking such that regulators can readily  adapt to market innovations and changes and include a  mechanism for evaluating potential new risks to the system.
A regulatory system should be designed such that regulators can readily  adapt to market innovations and changes and include a formal mechanism  for evaluating the full potential range of risks of new products and  services to the system, market participants, and customers. An effective  system could include a mechanism for monitoring market developments— such as broad market changes that introduce systemic risk, or new  products and services that may pose more confined risks to particular  market segments—to determine the degree, if any, to which regulatory  intervention might be required. The rise of a very large market for credit  derivatives, while providing benefits to users, also created exposures that  warranted actions by regulators to rescue large individual participants in  this market. While efforts are under way to create risk-reducing clearing  mechanisms for this market, a more adaptable and responsive regulatory  system might have recognized this need earlier and addressed it sooner.  Some industry representatives have suggested that principles-based  regulation would provide such a mechanism. Designing a system to be  flexible and proactive also involves determining whether Congress,  regulators, or both should make such determinations, and how such an  approach should be clarified in laws or regulations.
Important questions also exist about the extent to which financial  regulators should actively monitor and, where necessary, approve new  financial products and services as they are developed to ensure the least  harm from inappropriate products. Some individuals commenting on this  framework, including industry representatives, noted that limiting  government intervention in new financial activities until it has become  clear that a particular activity or market poses a significant risk and  therefore warrants intervention may be more appropriate. As with other  key policy questions, this may be answered with a combination of both  approaches, recognizing that a product approval approach may be  appropriate for some innovations with greater potential risk, while other  activities may warrant a more reactive approach.
Key issues to be addressed:    Determine how to effectively monitor market developments to  identify potential risks; the degree, if any, to which regulatory  intervention might be required; and who should hold such a  responsibility.
Consider how to strike the right balance between overseeing new  products as they come onto the market to take action as needed to  protect consumers and investors, without unnecessarily hindering  innovation.  5.  Efficient and effective. A regulatory system should provide  efficient oversight of financial services by eliminating  overlapping federal regulatory missions, where appropriate,  and minimizing regulatory burden while effectively achieving  the goals of regulation.
A regulatory system should provide for the efficient and effective oversight  of financial services. Accomplishing this in a regulatory system involves  many considerations. First, an efficient regulatory system is designed to  accomplish its regulatory goals using the least amount of public resources.  In this sense, policymakers must consider the number, organization, and  responsibilities of each agency, and eliminate undesirable overlap in  agency activities and responsibilities. Determining what is undesirable  overlap is a difficult decision in itself. Under the current U.S. system,  financial institutions often have several options for how to operate their  business and who will be their regulator. For example, a new or existing  depository institution can choose among several charter options. Having  multiple regulators performing similar functions does allow for these  agencies to potentially develop alternative or innovative approaches to  regulation separately, with the approach working best becoming known  over time. Such proven approaches can then be adopted by the other  agencies. On the other hand, this could lead to regulatory arbitrage, in  which institutions take advantage of variations in how agencies implement  regulatory responsibilities in order to be subject to less scrutiny. Both  situations have occurred under our current structure.
With that said, recent events clearly have shown that the fragmented U.S.  regulatory structure contributed to failures by the existing regulators to  adequately protect consumers and ensure financial stability. As we note in  our report, efforts by regulators to respond to the increased risks  associated with new mortgage products were sometimes slowed in part  because of the need for five federal regulators to coordinate their  response. The Chairman of the Federal Reserve has similarly noted that  the different regulatory and supervisory regimes for lending institutions  and mortgage brokers made monitoring such institutions difficult for both  regulators and investors. Similarly, we noted in our report that the current  fragmented U.S. regulatory structure has complicated some efforts to  coordinate internationally with other regulators.
One first step to addressing such problems is to seriously consider the  need to consolidate depository institution oversight among fewer  agencies. Since 1996, we have been recommending that the number of  federal agencies with primary responsibilities for bank oversight be  reduced. Such a move would result in a system that was more efficient  and improve consistency in regulation, another important characteristic of  an effective regulatory system. In addition, Congress could consider the  advantages and disadvantages of providing a federal charter option for  insurance and creating a federal insurance regulatory entity. We have not  studied the issue of an optional federal charter for insurers, but have  through the years noted difficulties with efforts to harmonize insurance  regulation across states through the NAIC-based structure. The  establishment of a federal insurance charter and regulator could help  alleviate some of these challenges, but such an approach could also have  unintended consequences for state regulatory bodies and for insurance  firms as well.
Also, given the challenges associated with increasingly complex  investment and retail products as discussed earlier, policymakers will  need to consider how best to align agency responsibilities to better ensure  that consumers and investors are provided with clear, concise, and  effective disclosures for all products.
Organizing agencies around regulatory goals as opposed to the existing  sector-based regulation may be one way to improve the effectiveness of  the system, especially given some of the market developments discussed  earlier. Whatever the approach, policymakers should seek to minimize  conflict in regulatory goals across regulators, or provide for efficient  mechanisms to coordinate in cases where goals inevitably overlap. For  example, in some cases, the safety and soundness of an individual  institution may have implications for systemic risk, or addressing an unfair  or deceptive act or practice at a financial institution may have implications  on the institution’s safety and soundness by increasing reputational risk. If  a regulatory system assigns these goals to different regulators, it will be  important to establish mechanisms for them to coordinate.
Proposals to consolidate regulatory agencies for the purpose of promoting  efficiency should also take into account any potential trade-offs related to  effectiveness. For example, to the extent that policymakers see value in  the ability of financial institutions to choose their regulator, consolidating  certain agencies may reduce such benefits. Similarly, some individuals  have commented that the current system of multiple regulators has led to  the development of expertise among agency staff in particular areas of  financial market activities that might be threatened if the system were to  be consolidated. Finally, policymakers may want to ensure that any  transition from the current financial system to a new structure should  minimize as best as possible any disruption to the operation of financial  markets or risks to the government, especially given the current  challenges faced in today’s markets and broader economy.
A financial system should also be efficient by minimizing the burden on  regulated entities to the extent possible while still achieving regulatory  goals. Under our current system, many financial institutions, and  especially large institutions that offer services that cross sectors, are  subject to supervision by multiple regulators. While steps toward  consolidated supervision and designating primary supervisors have helped  alleviate some of the burden, industry representatives note that many  institutions face significant costs as a result of the existing financial  regulatory system that could be lessened. Such costs, imposed in an effort  to meet certain regulatory goals such as safety and soundness and  consumer protection, can run counter to other goals of a financial system  by stifling innovation and competitiveness. In addressing this concern, it is  also important to consider the potential benefits that might result in some  cases from having multiple regulators overseeing an institution. For  example, representatives of state banking and other institution regulators,  and consumer advocacy organizations, note that concurrent jurisdiction— between two federal regulators or a federal and state regulator—can  provide needed checks and balances against individual financial regulators  who have not always reacted appropriately and in a timely way to address  problems at institutions. They also note that states may move more quickly  and more flexibly to respond to activities causing harm to consumers.  Some types of concurrent jurisdiction, such as enforcement authority, may  be less burdensome to institutions than others, such as ongoing  supervision and examination.
Key issues to be addressed:    Consider the appropriate role of the states in a financial regulatory  system and how federal and state roles can be better harmonized.
Determine and evaluate the advantages and disadvantages of having  multiple regulators, including nongovernmental entities such as  SROs, share responsibilities for regulatory oversight.
Identify ways that the U.S. regulatory system can be made more  efficient, either through consolidating agencies with similar roles or  through minimizing unnecessary regulatory burden.
Consider carefully how any changes to the financial regulatory  system may negatively impact financial market operations and the  broader economy, and take steps to minimize such consequences.  6.  Consistent consumer and investor protection. A regulatory  system should include consumer and investor protection as part  of the regulatory mission to ensure that market participants  receive consistent, useful information, as well as legal  protections for similar financial products and services,  including disclosures, sales practice standards, and suitability  requirements.
A regulatory system should be designed to provide high-quality, effective,  and consistent protection for consumers and investors in similar  situations. In doing so, it is important to recognize important distinctions  between retail consumers and more sophisticated consumers such as  institutional investors, where appropriate considering the context of the  situation. Different disclosures and regulatory protections may be  necessary for these different groups. Consumer protection should be  viewed from the perspective of the consumer rather than through the  various and sometimes divergent perspectives of the multitude of federal  regulators that currently have responsibilities in this area.
As discussed in our report, many consumers that received loans in the last  few years did not understand the risks associated with taking out their  loans, especially in the event that housing prices would not continue to  increase at the rate they had in recent years. In addition, increasing  evidence exists that many Americans are lacking in financial literacy, and  the expansion of new and more complex products will continue to create  challenges in this area. Furthermore, regulators with existing authority to  better protect consumers did not always exercise that authority  effectively. In considering a new regulatory system, policymakers should  consider the significant lapses in our regulatory system’s focus on  consumer protection and ensure that such a focus is prioritized in any  reform efforts. For example, policymakers should identify ways to  improve upon the existing, largely fragmented, system of regulators that  must coordinate to act in these areas. This should include serious  consideration of whether to consolidate regulatory responsibilities to  streamline and improve the effectiveness of consumer protection efforts.  Another way that some market observers have argued that consumer  protections could be enhanced and harmonized across products is to  extend suitability requirements—which require securities brokers making  recommendations to customers to have reasonable grounds for believing  that the recommendation is suitable for the customer—to mortgage and  other products. Additional consideration could also be given to  determining whether certain products are simply too complex to be well  understood and make judgments about limiting or curtailing their use.
Key issues to be addressed:    Consider how prominent the regulatory goal of consumer  protection should be in the U.S. financial regulatory system.
Determine what amount, if any, of consolidation of responsibility  may be necessary to enhance and harmonize consumer protections,  including suitability requirements and disclosures across the  financial services industry.
Consider what distinctions are necessary between retail and  wholesale products, and how such distinctions should affect how  they are regulated.
Identify opportunities to protect and empower consumers through  improving their financial literacy.  7.  Regulators provided with independence, prominence,  authority, and accountability. A regulatory system should  ensure that regulators have independence from inappropriate  influence; have sufficient resources, clout, and authority to  carry out and enforce statutory missions; and are clearly  accountable for meeting regulatory goals.
A regulatory system should ensure that any entity responsible for financial  regulation is independent from inappropriate influence; has adequate  prominence, authority, and resources to carry out and enforce its statutory  mission; and is clearly accountable for meeting regulatory goals. With  respect to independence, policymakers may want to consider advantages  and disadvantages of different approaches to funding agencies, especially  to the extent that agencies might face difficulty remaining independent if  they are funded by the institutions they regulate. Under the current  structure, for example, the Federal Reserve primarily is funded by income  earned from U.S. government securities that it has acquired through open  market operations and does not assess charges to the institutions it  oversees. In contrast, OCC and OTS are funded primarily by assessments  on the firms they supervise. Decision makers should consider whether  some of these various funding mechanisms are more likely to ensure that a  regulator will take action against its regulated institutions without regard  to the potential impact on its own funding.
With respect to prominence, each regulator must receive appropriate  attention and support from top government officials. Inadequate  prominence in government may make it difficult for a regulator to raise  safety and soundness or other concerns to Congress and the  administration in a timely manner. Mere knowledge of a deteriorating  situation would be insufficient if a regulator were unable to persuade  Congress and the administration to take timely corrective action. This  problem would be exacerbated if a regulated institution had more political  clout and prominence than its regulator because the institution could  potentially block action from being taken.
In considering authority, agencies must have the necessary enforcement  and other tools to effectively implement their missions to achieve  regulatory goals. For example, in a 2007 report we expressed concerns  over the appropriateness of having OTS oversee diverse global financial  firms given the size of the agency relative to the institutions for which it  was responsible. It is important for a regulatory system to ensure that  agencies are provided with adequate resources and expertise to conduct  their work effectively. A regulatory system should also include adequate  checks and balances to ensure the appropriate use of agency authorities.  With respect to accountability, policymakers may also want to consider  different governance structures at agencies—the current system includes a  combination of agency heads and independent boards or commissions— and how to ensure that agencies are recognized for successes and held  accountable for failures to act in accordance with regulatory goals.
Key issues to be addressed:    Determine how to structure and fund agencies to ensure each has  adequate independence, prominence, tools, authority and  accountability.
Consider how to provide an appropriate level of authority to an  agency while ensuring that it appropriately implements its mission  without abusing its authority.
Ensure that the regulatory system includes effective mechanisms  for holding regulators accountable. 8.  Consistent financial oversight. A regulatory system should  ensure that similar institutions, products, risks, and services  are subject to consistent regulation, oversight, and  transparency, which should help minimize negative competitive  outcomes while harmonizing oversight, both within the United  States and internationally.
A regulatory system should ensure that similar institutions, products, and  services posing similar risks are subject to consistent regulation,  oversight, and transparency. Identifying which institutions and which of  their products and services pose similar risks is not easy and involves a  number of important considerations. Two institutions that look very  similar may in fact pose very different risks to the financial system, and  therefore may call for significantly different regulatory treatment.  However, activities that are done by different types of financial institutions  that pose similar risks to their institutions or the financial system should  be regulated similarly to prevent competitive disadvantages between  institutions.
Streamlining the regulation of similar products across sectors could also  help prepare the United States for challenges that may result from  increased globalization and potential harmonization in regulatory  standards. Such efforts are under way in other jurisdictions. For example,  at a November 2008 summit in the United States, the Group of 20 countries  pledged to strengthen their regulatory regimes and ensure that all financial  markets, products, and participants are consistently regulated or subject  to oversight, as appropriate to their circumstances. Similarly, a working  group in the European Union is slated by the spring of 2009 to propose  ways to strengthen European supervisory arrangements, including  addressing how their supervisors should cooperate with other major  jurisdictions to help safeguard financial stability globally. Promoting  consistency in regulation of similar products should be done in a way that  does not sacrifice the quality of regulatory oversight.
As we noted in a 2004 report, different regulatory treatment of bank and  financial holding companies, consolidated supervised entities, and other  holding companies may not provide a basis for consistent oversight of  their consolidated risk management strategies, guarantee competitive  neutrality, or contribute to better oversight of systemic risk. Recent  events further underscore the limitations brought about when there is a  lack of consistency in oversight of large financial institutions. As such,  Congress and regulators will need to seriously consider how best to  consolidate responsibilities for oversight of large financial conglomerates  as part of any reform effort.
Key issues to be addressed:  Identify institutions and products and services that pose similar  risks.
Determine the level of consolidation necessary to streamline  financial regulation activities across the financial services industry.
Consider the extent to which activities need to be coordinated  internationally.  9.  Minimal taxpayer exposure. A regulatory system should have  adequate safeguards that allow financial institution failures to  occur while limiting taxpayers’ exposure to financial risk.
A regulatory system should have adequate safeguards that allow financial  institution failures to occur while limiting taxpayers’ exposure to financial  risk. Policymakers should consider identifying the best safeguards and  assignment of responsibilities for responding to situations where  taxpayers face significant exposures, and should consider providing clear  guidelines when regulatory intervention is appropriate. While an ideal  system would allow firms to fail without negatively affecting other firms— and therefore avoid any moral hazard that may result—policymakers and  regulators must consider the realities of today’s financial system. In some  cases, the immediate use of public funds to prevent the failure of a  critically important financial institution may be a worthwhile use of such  funds if it ultimately serves to prevent a systemic crisis that would result  in much greater use of public funds in the long run. However, an effective  regulatory system that incorporates the characteristics noted previously,  especially by ensuring a systemwide focus, should be better equipped to  identify and mitigate problems before it become necessary to make  decisions about whether to let a financial institution fail.
An effective financial regulatory system should also strive to minimize  systemic risks resulting from interrelationships between firms and  limitations in market infrastructures that prevent the orderly unwinding of  firms that fail. Another important consideration in minimizing taxpayer  exposure is to ensure that financial institutions provided with a  government guarantee that could result in taxpayer exposure are also  subject to an appropriate level of regulatory oversight to fulfill their  responsibilities.
Key issues to be addressed:  Identify safeguards that are most appropriate to prevent systemic  crises while minimizing moral hazard.
Consider how a financial system can most effectively minimize  taxpayer exposure to losses related to financial instability.
Finally, although significant changes may be required to modernize the  U.S. financial regulatory system, policymakers should consider carefully  how best to implement the changes in such a way that the transition to a  new structure does not hamper the functioning of the financial markets,  individual financial institutions’ ability to conduct their activities, and  consumers’ ability to access needed services. For example, if the changes  require regulators or institutions to make systems changes, file  registrations, or other activities that could require extensive time to  complete, the changes could be implemented in phases with specific target  dates around which the affected entities could formulate plans. In  addition, our past work has identified certain critical factors that should  be addressed to ensure that any large-scale transitions among government  agencies are implemented successfully. Although all of these factors are  likely important for a successful transformation for the financial  regulatory system, Congress and existing agencies should pay particular  attention to ensuring there are effective communication strategies so that  all affected parties, including investors and consumers, clearly understand  any changes being implemented. In addition, attention should be paid to  developing a sound human capital strategy to ensure that any new or  consolidated agencies are able to retain and attract additional quality staff  during the transition period. Finally, policymakers should consider how  best to retain and utilize the existing skills and knowledge base within  agencies subject to changes as part of a transition.
Mr. Chairman and Members of the Committee, I appreciate the  opportunity to discuss these critically important issues and would be  happy to answer any questions that you may have. Thank you.
section_title: Contacts
paragraphs: For further information on this testimony, please contact Orice M.  Williams at (202) 512-8678 or williamso@gao.gov, or Richard J. Hillman at  (202) 512-8678 or hillmanr@gao.gov.
section_title: Appendix I: Agencies and Other Organizations That Reviewed the Draft Report
section_title: Related GAO Products
paragraphs: Financial Regulation: A Framework for Crafting and Assessing  Proposals to Modernize the Outdated U.S. Financial Regulatory System.  GAO-09-216. Washington, D.C.: January 8, 2009.
Troubled Asset Relief Program: Additional Actions Needed to Better  Ensure Integrity, Accountability, and Transparency. GAO-09-161.  Washington, D.C.: December 2, 2008.
Hedge Funds: Regulators and Market Participants Are Taking Steps to  Strengthen Market Discipline, but Continued Attention Is Needed.  GAO-08-200. Washington, D.C.: January 24, 2008.
Information on Recent Default and Foreclosure Trends for Home  Mortgages and Associated Economic and Market Developments.  GAO-08-78R. Washington, D.C.: October 16, 2007.
Financial Regulation: Industry Trends Continue to Challenge the  Federal Regulatory Structure. GAO-08-32. Washington, D.C.: October 12,  2007.
Financial Market Regulation: Agencies Engaged in Consolidated  Supervision Can Strengthen Performance Measurement and  Collaboration. GAO-07-154. Washington, D.C.: March 15, 2007.
Alternative Mortgage Products: Impact on Defaults Remains Unclear,  but Disclosure of Risks to Borrowers Could Be Improved. GAO-06-1021.  Washington, D.C.: September 19, 2006.
Credit Cards: Increased Complexity in Rates and Fees Heightens Need  for More Effective Disclosures to Consumers. GAO-06-929. Washington,  D.C.: September 12, 2006.
Financial Regulation: Industry Changes Prompt Need to Reconsider U.S.  Regulatory Structure. GAO-05-61. Washington, D.C.: October 6, 2004.
Consumer Protection: Federal and State Agencies Face Challenges in  Combating Predatory Lending. GAO-04-280. Washington, D.C.: January  30, 2004.
Long-Term Capital Management: Regulators Need to Focus Greater  Attention on Systemic Risk. GAO/GGD-00-3. Washington, D.C.: October  29, 1999.
Bank Oversight: Fundamental Principles for Modernizing the U.S.  Structure. GAO/T-GGD-96-117. Washington, D.C.: May 2, 1996.
Financial Derivatives: Actions Needed to Protect the Financial System.  GAO/GGD-94-133. Washington, D.C.: May 18, 1994.
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