Financial Regulation: Industry Trends Continue to Challenge the Federal Regulatory Structure
Published: 2007-10-12T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: As the financial services industry has become increasingly concentrated in a number of large, internationally active firms offering an array of products and services, the adequacy of the U.S. financial regulatory system has been questioned. GAO has identified the need to modernize the financial regulatory system as a challenge to be addressed in the 21st century. This report, mandated by the Financial Services Regulatory Relief Act of 2006, discusses (1) measurements of regulatory costs and benefits and efforts to avoid excessive regulatory burden, (2) the challenges posed to financial regulators by trends in the industry, and (3) options to enhance the efficiency and effectiveness of the federal financial regulatory structure. GAO convened a Comptroller General's Forum (Forum) with supervisors and leading industry experts, reviewed regulatory agency policies, and summarized prior reports to meet these objectives.
section_title: What GAO Found
paragraphs: The inherent problems of measuring the costs and benefits of regulation make it difficult to assess the extent to which regulations may be unduly burdensome to U.S. financial services firms, particularly in comparison to firms in other countries. Additionally, it is difficult to separate the costs of complying with regulation from other costs and thus determine regulatory burden. Regulatory agencies, however, have undertaken several initiatives to reduce regulatory burden; these efforts contributed to the Financial Services Regulatory Relief Act of 2006. While noting that regulation contributes to confidence in financial institutions and markets, participants in the Forum agreed regulators have opportunities to further reduce regulatory burden and suggested regulators better measure the results of implemented regulations. GAO also recently recommended regulatory agencies consider whether and how to measure the performance of regulation during the process of promulgating the regulation and improving the communication of regulatory reviews to the public. The current regulatory structure, with multiple agencies that oversee segments of the financial services industry, is challenged by a number of industry trends. The development of large, complex, internationally active firms whose product offerings span the jurisdiction of several agencies creates the potential for inconsistent regulatory treatment of similar products, gaps in consumer and investor protection, or duplication among regulators. Regulatory agencies have made efforts to collaborate in responding to these trends and avoid inconsistencies, gaps, and duplication. However, challenges remain; until recently, the Office of Thrift Supervision and the Securities and Exchange Commission, for instance, had not sought to resolve potentially duplicative and inconsistent regulation of several financial services conglomerates for which both agencies have jurisdiction. Finally, despite the challenges posed by the industry's dynamic environment, accountability for addressing issues that span agencies' jurisdiction is not clearly assigned. These issues have led GAO to suggest in prior work that the federal regulatory structure should be modernized. GAO and others have recommended several options to accomplish modernization of the federal financial regulatory structure; these include consolidating certain regulatory functions as well as having a single regulator for large, complex firms. There also are potential lessons that can be learned from the experience of other nations that have restructured their financial regulators. Several Forum participants, for instance, suggested that one important lesson the United States could learn from the United Kingdom's Financial Services Authority was the value of setting principles or goals for regulators. The Department of the Treasury's recently announced plan to propose a restructured regulatory system provides an opportunity to take the first step toward modernization by providing clear and consistent goals for the regulatory agencies.

section_title: Letter
paragraphs: The financial services industry—including the banking, securities, and  futures sectors— has changed significantly over the last several decades.  Firms today are generally fewer and larger, provide more and varied  services, offer similar products, and operate in increasingly global  markets. These developments have both benefits and risks for the overall  U.S. economy. Despite these changes, the U.S. financial regulatory  structure has largely remained the same. It is a complex system of multiple  federal and state regulators as well as self-regulatory organizations (SROs)  that operate largely along functional lines, even as these lines have  become increasingly blurred in the industry. Regulated financial  institutions have learned to operate and thrive under the existing  regulatory system. However, concerns about inefficient overlaps in  responsibility, undue regulatory burden, and possible gaps in oversight  raise questions about whether the current structure is best suited to meet  the nation’s needs.
We identified a need to modernize the financial regulatory system as a  challenge to be addressed in the 21st century, noting that although  multiple specialized regulators bring critical skills to bear in their areas of  expertise, they have difficulty identifying and responding to risks that  cross industry lines. We asked whether it is time to modernize the  financial regulatory system to promote a more coherent and integrated  structure and specify goals more clearly. Such concerns also have been  recently raised by the International Monetary Fund (IMF). In a statement  regarding its review of U.S. economic developments, IMF concluded that  rapid innovation in the U.S. financial industry had created new regulatory  challenges for a system disadvantaged by its overlapping regulatory  oversight. IMF stated that emphasis should be placed on strategies to  improve regulatory effectiveness, such as implementing general regulatory  principles or goals to ease interagency coordination and shorten reaction  times to industry developments. Similarly, the Department of the Treasury  has undertaken an initiative to examine the regulatory structure  associated with financial institutions, partly in response to concerns that  the current structure may make U.S. financial markets less competitive.  Treasury expects to develop a plan by early 2008 to identify a regulatory  structure with improved oversight, increased efficiency, reduced overlap,  and the ability to adapt to financial market participants’ constantly  changing strategies and tools.
Debate about modernizing the current financial regulatory structure is not  new. However, there is continuing value in reexamining the current  regulatory system and structure and considering ways in which it could be  more efficient and effective.
In response to a mandate in the Financial Services Regulatory Relief Act of  2006, this report    describes measurements of the costs and benefits of financial regulation in  general and current efforts to avoid excessive regulatory burden;    describes financial industry trends and the challenges that these pose to  the federal financial regulatory structure; and   discusses various options to enhance the efficiency and effectiveness of  the federal financial regulatory structure.
To meet our objectives, we convened a Comptroller General’s Forum  (Forum) on June 11, 2007, that brought together leading experts from the  financial services industry, the regulatory agencies, and academia to  discuss issues relative to our objectives. The Forum agenda covered three  broad topics: (1) balancing regulatory costs and benefits, (2) financial  services regulation in a dynamic environment, and (3) assessing options  for enhancing the financial regulatory system. Forum participants were  selected to provide perspectives from different segments of the industry  and different regulatory agencies. To encourage a free exchange of  information and viewpoints, no specific statements or opinions expressed  by Forum participants are attributed to any participant. To meet our  objectives, we also met with federal regulators to discuss our objectives  and reviewed regulatory agency documents and reports. We also reviewed  and summarized relevant analysis, conclusions, and recommendations  from our earlier reports on financial regulation. (These reports are  referenced in footnotes or noted in Related GAO Products at the end of  this report.) We conducted our work between January 2007 and October  2007 in Chicago, Illinois, and Washington, D.C., in accordance with  generally accepted government auditing standards. Appendix I provides a  list of Forum participants.
subsections: section_title: Background
paragraphs: In the banking industry, the specific regulatory configuration depends on  the type of charter the banking institution chooses. Bank charter types  include    commercial banks, which originally focused on the banking needs of  businesses, but then over time broadened their services; thrifts, which include savings banks, savings associations, and savings and  loans, were originally created to serve the needs—particularly the  mortgage needs—of those not served by commercial banks;   credit unions, which are member-owned cooperatives run by member- elected boards with a historic emphasis on serving people of modest  means; and industrial loan companies (ILCs), also known as industrial banks, which  are state-chartered financial institutions that have grown from small,  limited-purpose institutions to a diverse industry that includes some of the  nation’s largest and more complex financial institutions.
These charters may be obtained at the state or national level for all except  ILCs, which are only chartered at the state level. State regulators charter  institutions and participate in the oversight of those institutions; however,  all of these institutions have a primary federal regulator if they offer  federal deposit insurance. The primary federal regulators are the  following:    The Office of the Comptroller of the Currency (OCC), which charters and  supervises national banks. As of December 30, 2006, there were 1,715  commercial banks with a national bank charter. These banks held the  dominant share of bank assets, about $6.829 trillion.
The Federal Reserve, which serves as the regulator for state-chartered  banks that opt to be members of the Federal Reserve System. As of  December 30, 2006, the Federal Reserve supervised 902 state member  banks, with total assets of $1.406 trillion.
The Federal Deposit Insurance Corporation (FDIC), which supervises all  other state-chartered commercial banks with federally insured deposits, as  well as federally insured state savings banks. As of December 30, 2006,  there were 4,785 state-chartered banks and 435 state-chartered savings  banks, with $1.855 trillion and $306 billion in total assets, respectively. In  addition, FDIC has certain backup supervisory authority for federally  insured banks and savings institutions.
The Office of Thrift Supervision (OTS), which charters and supervises  federally chartered savings institutions. As of December 30, 2006, OTS  supervised 844 institutions with $1.464 trillion in total assets.
The National Credit Union Administration (NCUA), which charters and  supervises federally chartered credit unions. As of December 30, 2006,  8,362 credit unions hold $710 billion in assets.
These federal regulators have established capital requirements for the  depository institutions they supervise, conduct onsite examinations and  offsite monitoring to assess an institution’s financial condition, and  monitor and enforce compliance with banking and consumer laws.  Regulators also issue regulations, take enforcement actions, and close  institutions they determine to be insolvent.
The securities and futures industries are regulated under a combination of  self-regulation (subject to oversight of the appropriate federal regulator)  and direct oversight by the Securities and Exchange Commission (SEC)  and the Commodity Futures Trading Commission (CFTC), respectively. In  the securities industry, the self-regulatory organizations (SROs) have  responsibility for oversight of the securities markets and their participants  by establishing the standards under which their members conduct  business; monitoring business conduct; and bringing disciplinary actions  against their members for violating applicable federal statutes, SEC’s  rules, and their own rules. SEC oversees SROs by inspecting their  operations and reviewing their rule proposals and appeals of final  disciplinary proceedings. In the futures industry, SROs include the futures  exchanges and the National Futures Association. Futures SROs are  responsible for establishing and enforcing rules governing member  conduct and trading; providing for the prevention of market manipulation,  including monitoring trading activity; ensuring that futures industry  professionals meet qualifications; and examining members for financial  strength and other regulatory purposes. The Commodity Futures Trading  Commission (CFTC) independently monitors, among other things,  exchange trading activity, large trader positions, and certain market  participants’ financial conditions.
The U.S. regulatory system for financial services is described as  “functional” so that financial products or activities generally are regulated  according to their function, no matter who offers the product or  participates in the activity. Broker-dealer activities, for instance, are  generally subject to SEC’s jurisdiction, whether the broker-dealer is a  subsidiary of a bank holding company subject to Federal Reserve  supervision or a subsidiary of an investment bank. The functional  regulator approach is intended to provide consistency in regulation, focus  regulatory restrictions on the relevant functions area, and avoid the  potential need for regulatory agencies to develop expertise in all aspects  of financial regulation.
Many of the largest financial legal entities are part of holding company  structures—companies that hold stock in one or more subsidiaries—and  conduct business and manage risks on a consolidated basis. Many of these  companies are subject to consolidated supervision that provides a basis  for examining the financial and operating risks faced by holding  companies and the controls in place to manage those risks at a  consolidated, or holding company-wide, level. Companies that own or  control banks are regulated and supervised by the Federal Reserve as  bank holding companies, and their nonbanking activities generally are  limited to those the Federal Reserve has determined to be closely related  to banking. Under the Gramm-Leach-Bliley Act, bank holding companies  can qualify as financial holding companies and thereby engage in a range  of financial activities broader than those permitted for “traditional” bank  holding companies. Savings and loan or thrift holding companies (thrift  holding companies), that own or control one or more savings associations  (but not a bank) are subject to supervision by OTS and, depending upon  certain circumstances, may not face the types of activities’ restrictions  imposed on bank holding companies. Certain holding companies that own  large broker-dealers can elect to be supervised by SEC as consolidated  supervised entities (CSE). SEC provides group-wide oversight of these  entities unless they are determined to already be subject to  “comprehensive, consolidated supervision” by another principal regulator.  While holding company supervisors oversee the holding company, the  appropriate functional regulator remains primarily responsible for  supervising any functionally regulated subsidiary within the holding  company.
In prior reports, we have noted that characteristics of the U.S. regulatory  structure can have positive effects. Specialization by regulatory agencies  allows them to better understand the risks associated with particular  activities or products. Competition among regulators helps to account for  regulatory innovation, providing businesses with a method to move to  regulators whose approaches better match businesses’ operations. We also  have noted that the system is complex, with a single large firm subject to  oversight by multiple federal and state agencies, as figure 1 illustrates.
The Federal Reserve and the Department of the Treasury (Treasury) also  share responsibility for maintaining financial stability. Treasury also  represents the United States on international financial market issues and,  in consultation with the President, also may approve special resolution  options for insolvent financial institutions whose failure could threaten the  stability of the financial system. Two-thirds of the Federal Reserve’s Board  of Governors and FDIC’s Board of Directors must approve any  extraordinary coverage.
section_title: Measuring the Costs and Benefits of Regulation Has Been Difficult, Complicating Efforts to Reduce Regulatory Burden
paragraphs: Measuring the costs and benefits of financial regulation has posed a  challenge to regulators and the financial services industry. Though precise  measurement remains a challenge, many claim regulation has become  more burdensome over time. Regulators have responded to these  concerns by reviewing existing regulations to identify ways to reduce  unnecessary regulatory burdens. Such reviews have, in some cases,  assisted in identifying the costs and benefits of regulation and removing  unnecessary burden. However, some groups still assert regulatory burden  has increased significantly over time and regulators should do more to  address such burdens. Forum participants agreed with these assertions,  suggesting regulators improve measurements of the results of  implemented regulations as a way to promote their own regulatory  accountability. We recently recommended several steps that agencies  should take to ensure they conduct effective and transparent reviews of  regulations, including consideration of whether and how to measure the  performance of regulation during the process of promulgating the  regulation and steps to improve the communication of regulatory reviews  to the public.
subsections: section_title: Regulators and the Financial Services Industry Face Challenges Measuring Regulatory Costs and Benefits
paragraphs: The difficulty of reliably estimating the costs of regulation to the industry  and to the nation has long been recognized, and the benefits of regulation  are generally regarded as even more difficult to measure. This situation  presents challenges for regulators that attempt to estimate the anticipated  costs of regulations, and also for industry to substantiate claims about  regulatory burden. For example, a 1998 Federal Reserve staff study  concluded that it had insufficient information to reliably estimate the total  cost of regulations for commercial banks.
One limitation of efforts to measure regulatory costs is the difficulty that  businesses have in separating the costs of regulatory compliance from  other costs related to risk management or recordkeeping. For instance,  bank capital adequacy regulation provides an example of the inherent  difficulty of assessing the value of regulation. Our work on the  implementation of the Basel II risk-based capital framework noted that  banks often could not separate out costs related directly to the  implementation of the framework, as systems often served multiple  purposes, such as reporting for many kinds of regulations and also for  internal, risk management purposes. Similarly, an analysis of financial  regulation in the United Kingdom found that firms tend not to separate out  costs for complying with regulations, and firms could not estimate  hypothetical savings if certain regulations were removed.
While regulation provides a broad assurance of the strength of financial  markets, it is difficult to measure those benefits, in part because  regulations seeking to ensure financial stability aim to prevent low- probability, high-cost events.
section_title: Concerns Exist that Regulation Could Hinder Market Efficiency
paragraphs: Recent reports by industry participants, academics, and policymakers also  have suggested that regulatory burden may be lessening U.S. securities  markets’ viability and challenging their competitiveness. A number of  factors have been asserted as contributing to a perceived loss in U.S.  competitiveness, with one potential factor being the litigious environment  of the United States. Some industry representatives, market analysts, and  academics argue that this environment creates concerns for firms about  potential class action and other lawsuits that may impact their decision to  engage in business in the United States. Another factor is the often limited  coordination among regulators that at times results in overlapping  regulatory jurisdictions and confusing regulations. Additionally, questions  regarding the jurisdiction over some financial products raise doubts for  firms about how such products will be regulated. For example, the U.S.  Chamber of Commerce has questioned whether CFTC should have  jurisdiction over securities futures products, and recommended that  jurisdiction be shifted to the SEC. In our work we also have noted that  SEC and CFTC share overlapping jurisdiction on financial products that  have the features of both securities and futures, which can inhibit market  innovation by potentially causing market participants to design products  based on how they might be regulated. However, some argue that  regulatory competition helps bring about innovation in regulatory  approaches, as one Forum participant noted.
section_title: U.S. Regulators Have Reviewed Existing Regulations
paragraphs: U.S. regulatory agencies have undertaken several efforts to lessen  regulatory burden and cost of existing regulations. Federal banking  agencies have undertaken a major initiative to address the regulatory  burden of depository institutions in response to the Economic Growth and  Regulatory Paperwork Reduction Act of 1996 (EGRPRA). The act requires  federal banking regulators to review their regulations at least once every  10 years and to identify and eliminate outdated, unnecessary, or unduly  burdensome regulatory requirements, as appropriate. Agencies also are  required to report to Congress on regulatory burdens that must be  addressed through legislative action.
Bank regulatory agencies have made changes to regulation and reporting  requirements as part of the EGRPRA process. Bank agencies modernized  their call report procedures, for instance, and sought comments and  suggestions on outdated, unnecessary, or overly burdensome regulations.  In response to these comments, for example, OCC published a Notice of  Proposed Rulemaking soliciting comments on proposed amendments to  OCC regulations that, among other changes, would eliminate or streamline  existing requirements or procedures. Another outcome of the EGRPRA  process was the development of proposals that were incorporated into the  Financial Services Regulatory Relief Act of 2006.
section_title: Forum Participants Shared Concerns Regarding Regulatory Burden
paragraphs: A majority of Forum participants held the view that regulations had  become more burdensome over the past decade. However, one participant  noted that while some regulations may be considered burdensome to  industry, they may be necessary to ensure public confidence. Others noted  the importance of considering legislation’s contribution to regulatory  burden. In addition, some participants shared the opinion that federal  regulation has hurt the competitiveness of U.S. securities markets.
Some Forum participants agreed that cost-benefit analysis presents a  number of measurement challenges, primarily because some costs are  easier to measure than benefits. One participant, for instance, noted the  benefits from legislation or regulation could include enhanced confidence  in markets, something that cannot be valued. Forum participants  suggested measurement should focus on outcomes and results, and  regulators should improve measurements for their own regulatory  accountability. One participant noted the Bank Secrecy Act (BSA), for  example, has resulted in filing many currency transaction reports and  suspicious activity reports, but the benefits of such filings are sometimes  unclear to banks. The participant added that regulators should consider  whether the BSA is providing the intended results and outcomes,  considering the costs.
To improve the measurement of costs and benefits, some Forum  participants thought a good practice to adopt from the U.K.’s Financial  Services Authority (FSA) would be its conduct of cost-benefit analyses. To  assure that FSA accomplishes its regulatory goals efficiently, it is required  to submit cost-benefit analyses for its proposals. In addition, FSA must  report annually on its costs relative to the costs of regulation in other  countries and must provide its next fiscal year budget for public comment  3 months prior to the end of the current fiscal year.
While regulators have attempted to address concerns about regulatory  burden by issuing guidance, assessing the level of regulatory burden, and  conducting retrospective reviews, a majority of Forum participants also  believed regulatory bodies could take advantage of additional  opportunities to reduce the regulatory burden placed on financial firms.  One participant noted that the London Stock Exchange’s Alternative  Investment Market (AIM) is an example of a market that has little  regulation and might demonstrate how lighter regulatory approaches  could be implemented. This participant also noted, however, that such  approaches have been criticized for not providing adequate investor  protection.
section_title: We Have Recommended Improved Review of Regulations
paragraphs: Retrospective reviews such as those conducted under EGRPRA and other  legislation and guidance assist in assessing the effectiveness of how  regulations were implemented and help identify opportunities to reduce  regulatory burdens and validate regulatory cost and benefit estimates.  The EGRPRA process, for example, provided an opportunity for the  financial industry to suggest ways to improve upon and simplify  regulations applicable to federally-insured depository institutions.  Regulatory agency officials reported that similar retrospective reviews  have resulted in cost savings to their agencies and to regulated parties. For  example, the agencies noted that modernized call report processing would  decrease the cost of data collection and verification for all parties.
In a 2007 report, we recommended that agencies improve the effectiveness  and transparency of retrospective regulatory reviews and identify  opportunities for Congress to revise and consolidate existing  requirements. We found that though agencies have conducted many such  reviews, the public generally remains unaware of the scope and frequency  of such reviews, and agencies can be better prepared to undertake reviews  by planning how they will collect relevant performance data on  regulations before promulgating the regulation, or prior to the review.
section_title: Developments in a Dynamic Financial Industry Environment Pose Challenges to the Federal Financial Regulatory Structure
paragraphs: Strengths of the current regulatory structure—including regulatory  competition, regulatory specialization, and charter choice—have  contributed to the development of a strong U.S. financial system.  However, the structure is not always well-suited to handle challenges and  emerging issues in the financial industry. Industry developments, including  the trends of consolidation and globalization, as well as legislative  changes, challenge regulators to provide consistent regulatory guidance  and treatment of similar firms. Further, increased convergence in product  offerings and increased concentration of assets in large, complex firms  pose a challenge for regulatory agencies to act consistently in responding  to risks that cut across the functional lines that define the regulatory  structure. While the regulatory agencies have taken action to work  collaboratively in response to the industry’s trends, we have noted in the  past that it is difficult to collaborate within the fragmented U.S. regulatory  system and concluded that the structure of the federal regulatory system  should be reexamined.
subsections: section_title: Aspects of the Current Regulatory Structure Have Contributed to a Strong Financial System but also Create Challenges
paragraphs: The current regulatory structure has contributed to the development of  U.S. financial markets and to overall economic growth and stability.  However, this structure, characterized by specialization of and  competition among multiple regulatory agencies, has both strengths and  weaknesses. On the positive side, specialization allows regulators to better  understand the risks associated with particular activities or products and  to better represent the views of all segments of the industry. Moreover,  regulators have developed skilled staff with specialized knowledge of  particular industries that can be brought to bear during supervisory  examinations. Competition among regulators helps to account for  regulatory innovation by providing businesses with a choice among  regulators whose approaches better match the businesses’ operations.  Regulated financial institutions have learned to operate and even thrive  under the existing regulatory system. Banks, for example, note the benefit  of having multiple charter options that serve different business needs.  Competition among the banking regulators, especially the Federal Reserve  and OCC, is credited with prompting certain changes in regulation. These  changes include the removal of prohibitions against securities firms,  banks, and insurance companies operating in a single holding company  structure and increased regulatory attention to the provision of loans in  certain minority areas.
At the same time, these very characteristics may hinder the effective and  efficient oversight of large, complex, internationally active firms that  compete across sectors and national boundaries. The specialized and  differential oversight of holding companies by different regulators has the  potential to create competitive imbalances among firms based on  regulatory differences alone. Specifically, although holding companies in  different sectors may offer similar services and therefore have similar risk  profiles, they may not be subject to the same supervision and regulation.  For example, under the new CSE rules, some firms could be subject to  both SEC and OTS holding company oversight, and as OTS pointed out in  its response to the CSE proposal, perhaps subject to conflicting regulatory  requirements.
section_title: Key Trends Have Changed the Financial Services Industry
paragraphs: Legislative and industry developments have brought about four key  interrelated and ongoing trends in the financial services industry:  consolidation: fewer firms comprise the industry than in the past;    conglomeration: firms have merged or acquired one another, creating  fewer, often larger firms in terms of asset size;    convergence: banking, securities, and futures firms offer similar products;  and   globalization: firms have expanded throughout the country and the world.
The financial services industry, generally, has seen an increased  concentration of assets in the largest firms, combined with a decrease in  the overall number of firms. This trend is most dramatic in the banking  sector of the financial services industry. During the 10-year period  between 1996 and 2006, banking institutions merged or acquired each  other to such an extent that 24 percent fewer institutions existed in 2006  than 10 years earlier (decreasing from 11,480 to 8,683 institutions). At the  same time, the share of banking assets held by the largest 25 banks grew  from about 34 percent to about 58 percent (see fig. 2.).
Small institutions, such as small credit unions and state-chartered banks,  are the most numerous, though the number of all institutions under the  various charters has decreased over time. Consolidation has been  pronounced in national banks. The number of national banks has  decreased by 37 percent, from 2,726 to 1,715, and their assets increased  nearly three-fold, from $2.5 trillion to $6.8 trillion (see fig. 3). The increase  in assets from 1996 through the end of 2006 has been significant for other  institutions as well, with assets at least doubling among state-chartered  commercial banks that are not members of the Federal Reserve (from  $925 billion to $1.9 trillion), federally chartered savings banks (from $614  billion to $1.3 trillion), and credit unions (from $327 billion to $710 billion).
The securities and futures segments also have seen substantial growth in  volume. Since 1996, assets among securities firms have increased about 70  percent—from about $1.8 trillion to about $5.9 trillion, according to the  Securities Industry and Financial Markets Association. The securities  industry has long been concentrated, with the assets of the largest 10 firms  exceeding 50 percent since at least 1996. Similarly, the annual volume of  active trading in futures contracts increased from about 499 million  contracts to more than 2.5 billion between 1996 and 2006, according to the  CFTC.
The conglomeration of firms and convergence of products offered by firms  across sectors increasingly have come to characterize the large players in  the industry. With regard to increased conglomeration, a research report  by International Monetary Fund (IMF) staff—based on a worldwide  sample of the largest 500 financial services firms in terms of assets— shows that the percentage of U.S. financial institutions in the sample  engaged to some significant degree in at least two of the functional sectors  of banking, securities, and insurance increased from 42 percent in 1995 to  61.5 percent in 2000. In addition, the conglomerates included in the IMF  review held 73 percent of the assets of all of the U.S. firms included in the  sample.
As a result of conglomeration, financial institutions have converged in  their products, increasingly offering products that are less distinct than in  the past. For example, banks, broker-dealers, and investment companies  all offer variable annuities. In addition, these institutions offer accounts or  services that are legally distinct but function in similar ways, such as  checking accounts, cash management accounts, and money market mutual  funds.
Banks and securities firms have greatly extended their reach throughout  the world, comprising an industry that has global operations. Such  international presence has brought about links among markets, as  evidenced by recent negative impacts on German and French banks as a  result of subprime mortgage defaults in the United States. Increasingly,  non-U.S. operations also form a substantial percentage of revenues for  U.S.-based financial services firms. For example, Goldman Sachs reported  to SEC that in the first half of 2007, it had earned the majority of its  revenues (over 50 percent) from non-U.S. operations. Similarly, Citigroup  reported that about 44 percent of its income came from regions other than  the United States. U.S.-based financial services firms have also increased  their operational presence in other countries over time, with some firms  booking most of their credit derivative trades, for example, in major  markets such as London.
section_title: Recent Legislative Changes Have Affected the Financial Services Industry
paragraphs: The financial services industry and the manner in which it is regulated  have changed in recent decades as a result of legislative action. The  legislation both responded and contributed to the industry trends. For  example, while banking and securities activities had generally been  separated in the United States after the Glass-Steagall Act of 1933, the  Gramm-Leach-Bliley Act of 1999 eased many of the restrictions limiting the  ability of banks and securities firms to affiliate with one another; some  restrictions, however, had been gradually eased as a result of regulatory  interpretations of prior law.
As figure 4 indicates, changes in legislation have affected business  practices of the financial services industry as well as its regulatory  oversight. In many cases, legislation responded to a crisis. The Financial  Institutions Reform, Recovery, and Enforcement Act of 1989 and the  Federal Deposit Insurance Corporation Improvement Act (FDICIA) of  1991 responded, in large part, to the savings and loan crisis of that period.  FDICIA, for instance, mandated that the agencies take “prompt corrective  action” when a bank’s capital falls below specified thresholds; this  responded to concerns that regulatory forbearance with troubled  institutions was excessive and contributed to further problems.
In addition, legislation over the past two decades has created new  reporting requirements for firms, such as disclosures required by the  Home Mortgage Disclosure Act and enhanced antiterrorism and  antimoney-laundering requirements, such as those imposed by the USA  Patriot Act.
These laws, however, have not led to comprehensive changes in the  federal financial regulatory structure. For example, the landmark Gramm- Leach-Bliley Act in some ways recognized the blurring of distinctions  among banking, securities, and insurance activities that had already  happened in the marketplace and codified regulatory decisions that had  been made to deal with these industry changes. While recognizing industry  and regulatory changes, that act changed neither the number of regulatory  agencies nor, in most cases, the primary objectives and responsibilities of  the existing agencies.
section_title: Recent Industry Changes Demonstrate the Challenges Confronting Financial Regulators
paragraphs: The industry’s trends, coupled with legislative changes, challenge  regulatory agencies to provide adequate regulatory oversight while  ensuring that regulation does not place any segment of the industry at a  disadvantage relative to the others. The current structure—with its  multiple regulators and charters—is further challenged by the need to  recognize sector differences and simultaneously provide similar regulatory  treatment for similar products. Regulatory agencies do collaborate to  ensure consistent treatment of similar activities across institutional  charters and legal entities, as well as in consolidated supervision of large,  complex organizations. However, our prior work involving (1)  consolidated supervision of holding companies, (2) the ILC charter, (3)  U.S. capital adequacy regulation, (4) charter choice and OCC preemption  rules, and (5) the regulation of securities and futures markets found  instances where regulatory differences could lead to unequal treatment of  firms.
subsections: section_title: Consolidated Supervision of Holding Companies
paragraphs: Consolidated supervision—holding company supervision at the top tier  or ultimate holding company in a financial enterprise—has become more  important in light of changes in the financial services industry, particularly  with respect to the increased importance of enterprise risk management of  large, complex financial services firms. The Gramm-Leach-Bliley Act  recognized the blurring of distinctions among the banking, securities and  insurance activities happening in the marketplace, and recognized  consolidated supervision as a basis for regulators to oversee the risks of  financial services firms on the same level that the firms manage those  risks. In March 2007, we reported that many large U.S. financial  institutions were being supervised on a consolidated basis and that this  was consistent with international standards that focus on having  regulators familiar with the organizational structure, risk management and  controls, and capital adequacy of these enterprises.
In this prior work, however, we found some evidence of duplication and  inconsistency when different agencies are responsible for consolidated  and primary supervision, suggesting that opportunities remain for  enhanced collaboration to promote greater consistency. For example, we  found that while the Federal Reserve and OCC have and generally follow  procedures to resolve differences, a large, complex banking organization  initially received conflicting information from the Federal Reserve, its  consolidated supervisor, and OCC, its primary bank supervisor, about the  firm’s business continuity provisions. Also, SEC and OTS both have  consolidated supervisory authority for some of the same firms but we  found they did not have an effective mechanism for collaborating to  prevent duplication and ensure consistency. In response, the Director of  OTS said that he would take steps to develop an effective mechanism for  OTS and SEC to work together.
In order to ensure that consolidated supervisors, specifically the Federal  Reserve, SEC, and OTS, are promoting consistency with primary bank and  other supervisors and not duplicating efforts, we recommended in March  2007 that these agencies identify additional ways to more effectively  collaborate with primary bank and functional supervisors (e.g., developing  appropriate mechanisms to better define responsibilities and to monitor,  evaluate, and report jointly on results). To take advantage of  opportunities to promote better accountability and limit the potential for  duplication and regulatory gaps, we recommended that these agencies  foster more systematic collaboration among themselves to promote  supervisory consistency, particularly for firms that provide similar  services. In particular, we recommended that OTS and SEC clarify  accountability when the agencies both had jurisdiction over a single  company. Systematic collaboration would help to limit duplication, ensure  that all regulatory areas are effectively covered, and ensure that resources  are focused most effectively on the greatest risks across the regulatory  system.
section_title: ILC Holding Company Regulation
paragraphs: In 2005 we reported that the parent companies of ILCs were not being  overseen at the consolidated level by bank supervisors with clear  authority for consolidated supervision. ILCs typically are owned or  controlled by a holding company that also may own other entities, and  thus pose risks to the deposit insurance fund that are similar to those  presented by other parents of depository institutions. However, FDIC, the  primary bank supervisor for ILCs, has less extensive authority to supervise  ILC holding companies than the Federal Reserve or OTS, the consolidated  supervisors of bank and thrift holding companies, respectively. In  addition, the parents of some ILCs—because they are exempt from the  Bank Holding Company Act—are able to mix banking and commerce to a  greater extent than the parents of other insured depository institutions.  Because of these inconsistencies, we (and the FDIC Office of the Inspector  General) concluded that ILCs in a holding company structure may pose  more risk to the deposit insurance fund than other types of insured  depository institutions operating in a holding company. We recommended  that Congress consider (1) options that would better ensure supervisors of  institutions with similar risks have similar authorities and (2) the  advantages and disadvantages of a greater mixing of banking and  commerce by ILCs or other financial institutions. In July 2006, FDIC  announced a moratorium on ILC applications from commercial entities for  6 months. On February 5, 2007, the agency extended the moratorium for  another year.
section_title: Basel II Implementation
paragraphs: Efforts to revise capital adequacy regulations for U.S. banks and bank  holding companies also highlight the challenges regulatory agencies have  in treating institutions consistently while also respecting their differences.  Current capital adequacy regulations are based on a 1988 international  accord to establish a common framework and reduce competitive  inequalities among international banks. Advances in risk management  strategies and other developments since 1988, however, have prompted an  effort through the Basel Committee on Banking Supervision to present a  new framework—commonly called Basel II—that would reflect these  developments.
Applying Basel II in the United States has raised serious concerns,  however. Because each federal regulator oversees a different set of  institutions and has different perspectives and goals, reaching consensus  on some issues in developing the Basel II framework has been difficult  even though all of the agencies generally agree that limitations in the  current Basel I framework have rendered it increasingly inadequate for  supervising the capital adequacy of the largest, most complex banks. For  example, officials from FDIC have been concerned about the use of banks’  risk-based capital models under Basel II because, while these models have  been used for internal risk assessment and management for years, with the  exception of certain market risk models, they are relatively unproven as a  regulatory capital tool, and questions remain about the reliability of data  underlying the models. To address some of these concerns, agencies have  proposed a number of safeguards in the proposed Basel II rule. Officials  from the Federal Reserve and OCC—as the regulators of the vast majority  of core banks that would be required to adopt Basel II’s “advanced  approach”— acknowledged data limitations and the uncertain impact on  capital requirements, but highlighted the limitations of Basel I, the  increased risk sensitivity of Basel II, the advances in risk management at  large banks, the safeguards to ensure capital adequacy, and regulator  experience in reviewing economic capital models as reasons to proceed  with implementing Basel II. Further, regulatory agencies noted concerns  about potential competitive inequities between large and small banks in  the United States, if small banks are required to hold more regulatory  capital than large banks for some similar risks. Finally, U.S. banks  implementing Basel II’s advanced approach have expressed concerns that  the U.S. leverage requirement would put them at a competitive  disadvantage against international financial institutions that do not face  such a requirement.
On September 25, 2006, the regulators issued a joint Notice of Proposed  Rulemaking (NPR) that proposed a new risk-based capital adequacy  framework that would require some and permit other qualifying banks to  use an internal ratings-based approach to calculate regulatory credit risk  capital requirements and advanced measurement approaches to calculate  regulatory operational risk capital requirements. According to the NPR,  the framework is intended to produce more risk-sensitive capital  requirements than currently used by the agencies. The framework also  seeks to build upon improvements to risk assessment approaches adopted  by a number of large banks over the last decade. However, concern  remained that applying different capital adequacy regulations to different  institutions, even though it is intended to respect differences among  institutions, may lead to competitive inequities. In our report, we made  several recommendations to the agencies to improve the transparency of  the process of developing new regulations. On July 20, 2007, the agencies  announced an agreement regarding implementation of Basel II and to  finalize rules implementing the advanced approaches for computing large  banks’ risk-based capital requirements expeditiously.
section_title: OCC Preemption and Charter Choice
paragraphs: Bank regulatory agencies and others have argued that charter choice,  allowing for differences in the regulation of financial institutions, is a  central element in promoting an efficient U.S. financial services industry.  This choice permits institutions to not only select the charter that best  corresponds to their business plans and organization but also to protect  themselves against arbitrary regulation. Differences in regulation reflect,  at least in part, differences between the types of charters. In turn,  regulatory competition has prompted changes to modernize the regulatory  structure and allow financial institutions to offer a diverse range of  products and services to meet the needs of their customers. However,  such diversity challenges regulatory agencies to ensure supervisory and  regulatory differences are based on legitimate differences in business  plans and intended markets among the institutions under supervision and  not an attempt to give one type of institution a competitive advantage over  others.
The recent debate regarding OCC’s interpretation of its authority to  preempt state laws brought particular attention to the question of  regulatory consistency, charter choice, and safety and soundness. In  January 2004, OCC issued two final rules that are jointly referred to as the  preemption rules. The “bank activities” rule addressed the applicability of  state laws to national banking activities, while the “visitorial powers” rule  set forth OCC’s view of its authority to inspect, examine, supervise, and  regulate national banks and their operating subsidiaries. The rules  addressed OCC’s authority to preempt state laws that applied to operating  subsidiaries of national banks if those operating subsidiaries were  conducting banking activities permitted for the national bank itself.  However, the rules do not fully resolve uncertainties about the  applicability of state consumer protection laws, particularly those aimed at  preventing unfair and deceptive acts and practices. National banks are  subject to federal consumer protection laws, including the Federal Trade  Commission Act’s prohibition of unfair or deceptive acts or practices. OCC  supervises national banks and helps to enforce their compliance with  these federal requirements. Opponents of OCC’s position stated such  preemption would weaken consumer protections and the rules could  undermine the dual banking system, because state-chartered banks would  have an incentive to change their charters from state to federal since  national banks do not have to comply with state laws that apply to banking  activities and, to the extent that compliance with federal law is less costly  or burdensome than state regulation, the federal charter provides for  lower regulatory costs and easier access to markets. Supporters of the  rules asserted that providing consistent regulation for national banks,  rather than differing state regulatory regimes, was necessary to ensure  efficient nationwide operation of national banks. Recently, the Supreme  Court upheld OCC authority under the National Bank Act to preempt state  regulation of the mortgage lending activities of a national bank’s operating  subsidiary.
In our review of OCC’s preemption rulemaking, we recommended that the  Comptroller of the Currency clarify the characteristics of state consumer  protection laws that would make them subject to federal preemption. OCC  responded that the Consumer Financial Protection Forum, chaired by the  U.S. Department of the Treasury, was established to bring federal and  state regulators together to focus exclusively on consumer protection  issues and to provide a permanent forum for communication on those  issues. OCC believes this will provide an opportunity for federal and state  regulators to better understand their differing perspectives, but what  effect the Consumer Financial Protection Forum will have remains to be  determined.
section_title: SEC and CFTC Joint Jurisdiction over Certain Products
paragraphs: Securities and futures markets, regulated by SEC and CFTC respectively,  have become increasingly interconnected, raising the question whether  separate regulatory agencies over these markets remain appropriate. SEC  has authority over securities trading and the securities markets, whose  primary purpose historically has been to facilitate capital formation. CFTC  has authority over futures trading and the futures markets, which have  primarily been used for risk management purposes. However, distinction  between a financial product as a security or a future has become  increasingly difficult as more and more products are developed that  combine characteristics of both securities and futures. Derivatives— including security-based futures and options as well as traditional  commodity-based contracts—have grown dramatically in recent years.  There is concern that the split in regulatory responsibility between SEC  and CFTC could result in uncertainty about regulatory jurisdiction over  some types of derivative products and possibly encourage companies to  structure new products and activities so they avoid oversight completely.
We have long reported that the differences in U.S. securities and futures  laws and markets will continue to require both SEC’s and CFTC’s  regulatory staff to have some specialized expertise. However, the two  agencies also have had to work together to clarify their joint jurisdiction  over certain products, such as futures on single stocks and certain stock  indexes. Concerns that restrictions in a 1981 agreement between CFTC  and SEC to prevent such trading on futures exchanges may have limited  investor choice led to calls to repeal the restrictions. These calls were  countered by concerns about doing so without first resolving applicable  differences between securities and commodities laws and regulations,  including the lack of comparable insider trading restrictions and consumer  protection requirements. We recommended that CFTC and SEC work  together and with Congress to develop and implement an appropriate legal  and regulatory framework for removing the restrictions. In 2000, CFTC  and SEC reached agreement to jointly regulate single stock futures under a  framework aimed at promoting competition, maintaining market integrity,  and protecting customers. In turn, Congress codified the agreement in the  Commodity Futures Modernization Act of 2000.
section_title: Regulators Have Often Collaborated to Respond to Regulatory Challenges but More Could Be Done
paragraphs: Under the current structure, financial regulatory agencies often have  collaborated to achieve their goals. For example, in 2007, we reported on a  joint regulatory initiative of bank and securities regulators that recently  facilitated the monitoring of industry-wide progress on reducing  confirmation backlogs in the regulation of over-the-counter credit  derivatives. In 2006, we reported that in an effort to establish greater  consistency in their examination procedures and oversight directed at  preventing, detecting, and prosecuting money laundering, the federal  banking regulators, with participation from the Financial Crimes  Enforcement Network, jointly developed and issued an interagency  examination procedures manual describing the risk assessments for Bank  Secrecy Act (BSA) examinations. To further strengthen BSA oversight,  the agencies said that they were committed to ongoing interagency  coordination. The bank regulatory agencies and NCUA also participate in  the Federal Financial Institutions Examination Council, established in  1979 as a formal interagency communication vehicle for prescribing  uniform supervisory standards. A representative of state banking  authorities was added to this council as a full voting member by the  Financial Services Regulatory Relief Act of 2006. FDIC, the Federal  Reserve, and OCC also work collaboratively under the Shared National  Credit Program (a joint review of large, syndicated loans shared by banks  that may have different supervisors) and the Interagency Country  Exposure Review Committee (a joint determination of the level of risk for  credit exposures to various countries). Moreover, both the Comptroller of  the Currency and the Director of OTS are members of the FDIC Board of  Directors.
More broadly, federal financial regulators have been involved in  interagency efforts, including the President’s Working Group, which  provides a framework for coordinating policies and actions that cross  agency jurisdictional lines. We have reported, however, that the Group is  not well suited to orchestrate a consistent set of goals or objectives that  would direct the work of the different agencies. We noted that agency  officials involved with the Group were “generally adverse to any  formalization of the group and said that it functions well as an informal  coordinating body.”
While the agencies do exchange information, they have opportunities to  improve collaboration. We have noted in the past that it is difficult to  collaborate within the fragmented U.S. regulatory system and have  recommended that Congress modernize or consolidate the regulatory  system. However, we previously have reported that under the current  system, agencies have opportunities to collaborate more systematically  and thus ensure that institutions operating under the oversight of multiple  financial supervisors receive consistent guidance and face minimal  supervisory burden. In our consolidated supervision report, we made  recommendations to the Federal Reserve, OTS, and SEC to improve  efforts to collaborate and increase consistency in their consolidated  supervision program. In addition, we recommended that agencies foster  more systematic collaboration among their agencies to promote  supervisory consistency, particularly for firms that provide similar  services. In particular, we recommended that OTS and SEC clarify  accountability for holding companies that operate under both agencies’  jurisdictions. (The agencies have reported subsequent actions to improve  their programs in these regards.)
section_title: Accountability for Identifying and Responding to Risks that Span Financial Sectors Is Not Clearly Defined
paragraphs: Because our regulatory structure relies on having clear-cut boundaries  between the “functional” areas, industry changes that have caused those  boundaries to blur have placed strains on the regulatory framework, and  accountability for addressing risks that cross boundaries is not clearly  defined. While diversification across activities and locations may have  lowered the risks faced by some large, complex, internationally active  firms, understanding and overseeing them also has become a much more  complex undertaking, requiring staff who can evaluate the risk portfolio of  these institutions and their management systems and performance.  Regulators must be able to ensure effective risk management without  needlessly restraining risk taking, which would hinder economic growth.  Similarly, because firms are taking on similar risks across “functional”  areas, to understand the risks of a given institution or those that span  institutions or industries, regulators need a more complete picture of the  risk portfolio of the financial services industry as a whole, both in the  United States and abroad.
As we have discussed above, some of the means by which U.S. regulators  collaborate across sectors do not provide for the systematic sharing of  information, making it more difficult for regulators to identify emerging  threats to financial stability. These means also do not allow for a  satisfactory assessment of risks that cross traditional regulatory and  industry boundaries and therefore may inhibit the ability to detect and  contain certain financial crises, as can be seen in the following:    With regard to the President’s Working Group, we reported in 2000 that  although it has served as a mechanism to share information during  unfolding crises, its activities generally have not included such matters as  routine surveillance of risks that cross markets or of information sharing  that is specific enough to help identify potential crises. The Group has  served as an informal mechanism for coordination and cooperation rather  than as a mechanism to ensure accountability for issues that span agency  jurisdiction.
In reviewing the near collapse of Long-Term Capital Management  (LTCM)—one of the largest U.S. hedge funds—in 1998, we reported that  regulators continued to focus on individual firms and markets but failed to  address interrelationships across industries; accountability for those  relationships was not clearly defined. Thus, federal financial regulators did  not identify the extent of weaknesses in bank, securities, and futures firm  risk management practices until after LTCM’s near collapse and had not  sufficiently considered the systemic threats that can arise from  unregulated entities.
In reviewing responses to the events of September 11, 2001, we reported  that the multiple agency structure of U.S. financial services regulation has  slowed the development of a strategy that would ensure continuity of  business for financial markets in the event of a terrorist attack.
In a recent review of interagency communication regarding enforcement  actions taken by the regulatory agencies against individuals and firms, we  reported that while information sharing among financial regulators is a  key defense against fraud and market abuses, regulators do not have ready  access to all relevant data related to regulatory enforcement actions taken  against individuals or firms. We also reported that many financial  regulators do not share relevant consumer complaint data amongst  themselves on certain hybrid products such as variable annuities  (products that contain characteristics of both securities and insurance  products) in a routine, systematic fashion, compounding the problem that  consumers may have in identifying the relevant regulator.
Through its supervision of bank and financial holding companies, the  Federal Reserve has oversight responsibility for a substantial share of the  financial services industry. The scope of its oversight, however, is limited  to bank and financial holding companies. While each agency develops its  own strategic plan for meeting its mission, no government agency has the  authority to identify and address issues in the financial system as a whole,  and monitor the ability of regulators to meet their objectives on an  ongoing basis. We repeatedly have noted that regulators could do more to  share information and monitor risks across markets or “functional” areas  to identify potential systemic crises and limit opportunities for fraud and  abuse.
From an overall perspective the system is not proactive, but instead reacts  in a piecemeal, ad hoc fashion—often when there is a crisis. During a  crisis, or in anticipation of one, no one has the authority and there is no  formal cooperative mechanism to conduct risk analyses, prioritize tasks,  or allocate resources across agencies, although the Office of Management  and Budget may perform some of these tasks for agencies funded by  federal appropriations. Several Forum participants, for instance, suggested  that Congress establish an agency with authority to set regulatory  standards and goals and to hold regulators accountable to those goals.
The federal financial regulatory agencies face challenges posed by the  dynamic financial environment: the industry’s trends of consolidation,  conglomeration, convergence, and globalization have created an  environment that differs substantially from the prevailing environment  when agencies were formed and their goals set by legislation. In particular,  the fact that different agencies have jurisdiction over large, complex firms  that offer similar services to their customers creates the potential for  inconsistent and inequitable treatment. Differences, even subtle ones,  among the agencies’ goals exacerbate the potential for inconsistency.
Several Forum participants noted that subtle differences among agency  goals can be significant. Further, despite the changes posed by the  industry’s dynamic environment, clear accountability for addressing issues  that span agencies’ jurisdiction is not clearly assigned in the current  system. These issues have led us to suggest that modernizing the federal  financial regulatory system is a key challenge facing the United States in  the 21st century.
section_title: Options to Change the Federal Financial Regulatory Structure
paragraphs: In our previous work, we suggested options for Congress to consider to  modernize the current regulatory system. Additionally, others have  recommended changes, frequently intended to simplify the complex  multiagency structure. The financial regulatory structure, however, has  remained largely the same despite changes in the financial services  industry. Forum participants and others have suggested that some lessons  could be learned from the principles-based approach to regulation of the  United Kingdom’s Financial Services Authority (FSA). However,  participants also noted that the lessons should be considered in light of  the differences between the United States and the United Kingdom and the  limited experience of FSA, particularly the fact that it had not dealt, at the  time of the Forum, with a significant economic crisis or downturn.  Defining clear and consistent goals for regulatory agencies would be a  significant step toward modernizing the regulatory structure.
subsections: section_title: Modernizing the Financial Regulatory System Remains a Challenge
paragraphs: As early as 1994, we voiced our support for modernizing the federal  financial regulatory structure. More recently, we provided various options  for Congress to consider, including    consolidating the regulatory structure within the “functional” areas;    moving to a regulatory structure based on regulation by objective (a “twin  peaks” model);   combining all financial regulators into a single entity; or    creating or authorizing a single entity to oversee all large, complex,  internationally active firms, while leaving the rest of the structure in place.
Each of these options would provide potential improvements, as well as  some risks and costs. Consolidating the regulatory structure within  “functional” areas, such as banking and securities, would provide a central  point of communication for a sector’s issues and could reduce barriers to  communication and coordination among the regulatory agencies; it also  could remove opportunities for regulatory experimentation and the other  positive aspects of regulatory competition. A “twin peaks model” would  involve setting up one safety and soundness regulatory entity and one  conduct-of-business regulatory entity charged with ensuring compliance  with the full range of conduct-of-business issues, including consumer and  investor protection, disclosure, money laundering, and some governance  issues. On the positive side, this could ensure that conduct-of-business  issues are not subordinated to safety and soundness issues, as some fear.  However, this structure would not facilitate regulators’ understanding of  linkages between safety and soundness and conduct-of-business, such as a  financial services firm’s reputational risk. A single regulator, like FSA,  would have the ability to evaluate such linkages, but ensuring the  accountability of such a large agency to consumers or industry would be  difficult. Finally, a single agency charged with oversight of large, complex  firms could be able to provide consistent regulatory treatment and to  identify and respond to issues that cross current regulatory agency  boundaries. However, it might be difficult to find and maintain an  appropriate balance between the interests of the large, internationally  active firms and smaller entities; this option, further, might add another  agency to a regulatory system that already has many agencies.
IMF noted these options in suggesting that the United States review the  rationalization for its financial regulation.
As we previously have noted, the specifics of a regulatory structure,  including the number of regulatory agencies and roles assigned to each,  may not be the critical determinant in whether a regulatory system is  successful. The skills of the people working in the regulatory system, the  clarity of its objectives, its independence, and its management systems are  also critical to the success of financial regulation.
Others also have proposed changes to modernize the financial regulatory  system, including the following:    1994 Treasury proposal. This proposal would have realigned the federal  banking agencies by core policy functions—that is, bank supervision and  regulation function, central bank function, and deposit insurance function.  Generally, this proposal would have combined OCC, OTS, and certain  functions of the Federal Reserve and FDIC into a new independent  agency, the Federal Banking Commission, that would have been  responsible for bank supervision and regulation. FDIC would have  continued to be responsible for administering federal deposit insurance,  and the Federal Reserve would have retained central bank responsibilities  for monetary policy, liquidity lending, and the payments system. Although  FDIC and the Federal Reserve would have lost most bank supervisory  rule-making powers, each would have been allowed access to all  information of the new agency, as well as retain limited secondary or  backup enforcement authority. In addition, the Federal Reserve would be  authorized to examine a cross section of large and small banking  organizations jointly with the new agency. FDIC would have continued to  oversee activities of state banks and thrifts that could pose risks to the  insurance funds and to resolve failures of insured banks.
H.R. 1227 (1993). This proposal would have consolidated OCC and OTS in  an independent Federal Bank Agency and aligned responsibilities among  the new and existing agencies. It also would have reduced the multiplicity  of regulators to which a single banking organization could be subject while  avoiding the concentration of regulatory power of a single federal agency.  The role of the Federal Financial Institution Examination Council would  have been strengthened; it would have seen to the uniformity of  examinations, regulation, and supervision among the three remaining  supervisors. According to a Congressional Research Service (CRS)  analysis, this proposal would have put the Federal Reserve in charge of  more than 40 percent of banking organization assets, with the rest divided  between the new agency and a reorganized FDIC.   1994 LaWare proposal. The LaWare proposal was outlined in  congressional testimony but never presented as a formal legislative  proposal, according to Federal Reserve officials. It called for a division of  responsibilities defined by charter class and a merging of OCC and OTS  responsibilities. The two primary agencies under the proposal would have  been an independent Federal Banking Commission and the Federal  Reserve, which would have supervised all independent state banks and  depository institutions in any holding company whose lead institution was  a state-chartered bank. The new agency would have supervised all  independent national banks and thrifts and depository institutions in any  banking organization whose lead institution was a national bank or thrift.  FDIC would not have examined financially healthy institutions, but would  have been authorized to join in examination of problem banking  institutions. Based on estimates of assets of commercial banks and thrifts  performed by CRS, the LaWare proposal would have put the new agency in  charge of more commercial bank assets than the Federal Reserve.   2002 FDIC Chairman proposal. Donald E. Powell, then Chairman of the  FDIC, proposed to design a new regulatory system that would reflect the  modern financial services marketplace. Three federal financial services  regulators would carry out federal supervision: one would be responsible  for regulating the banking industry, another for the securities industry, and  a third for insurance companies that choose a federal charter.
Similarly, proposals have been made to restructure futures and securities  regulation. In particular, proposals have been made to consolidate SEC  and CFTC, partly in response to increasing convergence in new financial  instrument and trading strategies of the securities and futures markets.
section_title: Some Lessons May Be Learned from the United Kingdom’s FSA Model which Emphasizes a Principles-based Approach to Regulation
paragraphs: Beginning in 1997, the United Kingdom consolidated its financial services  regulatory structure, combining nine different regulatory bodies, including  SROs, into the FSA. While FSA is the sole supervisor for all financial  services, other government agencies, especially the Bank of England and  Her Majesty’s Treasury, still play some role in the regulation and  supervision of financial services.
FSA government officials and experts on the model cited important  changes in the financial services industry as some of the reasons for  consolidating the regulatory bodies that oversee banking, securities, and  insurance activities. These included the blurring of the distinctions  between different kinds of financial services businesses, and the growth of  large, conglomerate, financial services firms that allocate capital and  manage risk on a groupwide basis. Other reasons for consolidating  included some recognition of regulatory weaknesses in certain areas and  enhancing the United Kingdom’s power in the European Union and other  international deliberations.
A number of participants in the Forum believed that lessons can be  learned from the FSA’s single regulator model. Specifically, some  participants noted that FSA’s establishment and use of regulatory goals  through its principles-based approach to regulation may help to improve  the effectiveness of the U.S. regulatory structure. In particular, several  participants suggested adopting a principles-based approach to prudential  regulation.
According to FSA, principles-based regulation means, where possible,  moving away from dictating industry behavior through detailed,  prescriptive rules and supervisory actions describing how firms should  operate their business. Instead, the FSA established 11 high-level  principles that give firms the responsibility to decide how best to align  their business objectives and processes with regulatory outcomes that  have been specified.
Some Forum participants noted that in the United States, such principles  or goals would work best if established for regulators rather than for the  industry since rules provide a safe harbor effect that principles for  industry behavior would not provide. Specifically, one participant noted  that the litigious business environment in the United States makes  specificity in rules essential so that firms know explicitly what behavior is  acceptable in the market. Similarly, consumers and investors of financial  products in the United States may feel most comfortable with an industry  regulated by rules since they may provide greater assurance that violators  will be prosecuted. Some participants said principles would be more  appropriate in guiding prudential or safety and soundness regulation than  they would be for consumer protection or conduct-of-business regulation.  Another participant stated that principles-based regulation may provide  some benefits, but benefits may not result in cost savings and must be  considered carefully in relation to the U.S. financial regulatory system. In  fact, most Forum participants stated that a move toward principles-based  regulation in the United States would have a small or moderate impact on  lowering regulatory costs. In addition, some participants cautioned against  wholesale adoption of the FSA’s model of principles-based regulation  noting that the UK’s regulatory system had not yet been tested by an  economic downturn or the failure of a large institution at the time of the  Forum. Finally, one Forum participant noted that the FSA’s focus on  regulatory outcomes would be a good practice to adopt in the United  States.
According to CFTC officials, the agency currently uses a principles-based  approach to supervising the futures industry. Under the Commodity  Exchange Act (CEA), exchanges and clearing houses must adhere to a set  of statutory “core principles.” According to CFTC, the agency may set out  acceptable practices that serve as safe-harbors for the industry’s  compliance with each principle. Conversely, the CEA allows for the  industry and SROs to formulate their own acceptable practices and submit  them to the CFTC for approval. CFTC officials noted that, with a few  exceptions, there are no longer prescriptive regulations that dictate  exclusive means of compliance; rather, exchanges have the choice of  following CFTC-approved acceptable practices or adopting their own  measures for complying with the overarching principle.
section_title: Clear, Consistent Regulatory Goals Are Important Steps to Improve Regulatory Effectiveness
paragraphs: In addition to suggesting options to modernize the federal financial  regulatory structure, our prior work also has identified the importance of  clear and consistent goals for financial regulation. Such goals would  facilitate consideration of options to modernize the regulatory structure.  In 1996, we identified the following four goals:1.  Consolidated and comprehensive oversight, with coordinated  regulation and supervision of individual components. The Basel  Committee, for example, indicates in its core principles, that “an  essential element of banking supervision is that supervisors supervise  the banking group on a consolidated basis, adequately monitoring and,  as appropriate, applying prudential norms to all aspects of the business  conducted by the group worldwide.” Regulators would rely upon  functional regulators for information and supervision of individual  components, but remain responsible for ascertaining the safety and  soundness of the consolidated organization as a whole.  2.  Independence from undue political pressure, balanced by appropriate  accountability and adequate congressional oversight. Effective  regulatory oversight would recognize the need to guard against undue  political influence by incorporating appropriate checks and balances.  3.  Consistent rules, consistently applied for similar activities. Effective  regulatory oversight would ensure that institutions conducting the  same lines of business or offering equivalent products are generally  subject to similar rules, standards, or guidelines for those lines of  business or products.  4.  Enhanced efficiency and reduced regulatory burden. By establishing  consolidated, comprehensive, and coordinated oversight and applying  consistent rules across similar activities, inefficiencies such as  duplication of effort and regulatory burden caused by reporting similar  data to multiple regulators, could be eliminated or reduced.
A review of our work suggests three additional goals that would also be  important to improve regulatory effectiveness:  1.  Transparency in rule making. Transparency in rule making in an  environment where multiple regulators bring multiple goals and  perspectives would entail the maximum possible disclosure regarding  the intended goals of proposed regulations, the basis for the selection  of the regulatory approach, and planned evaluation of the implemented  regulation. This would help reduce industry uncertainty about, and  possible opposition to, proposed rules and their impact on the  industry. Transparency also would help to ensure consistent  expectations of regulators and the industry.  2.  Commitment to consumer and investor protection. Currently,  consumer protection (including consumers as investors) is  administered by a variety of agencies and can result in differential  regulation and the inequitable treatment of firms competing in the  same market. In addition, consumers can suffer if they receive  different levels of protection when they purchase different products  and services from different types of financial firms. Equal treatment  and equal access to credit also are important objectives.  3.  Ensuring safety and soundness. Ensuring a safe and sound banking  system and promoting financial system stability require a balance  between the need for effective regulatory oversight and the possibility  that too much oversight could hinder competition. Fulfilling this goal  also requires developing a system that limits the extension of the  federal safety net in order to encourage market as well as regulatory  discipline.
Other organizations have noted the importance of clearly specified  regulatory goals for regulatory effectiveness. The Basel Committee on  Banking Supervision developed 25 core principles for effective banking  supervision that have been used by countries as a benchmark for assessing  the quality of their supervisory systems and for identifying a baseline level  of sound supervisory practices. The core principles are a framework of  minimum standards for sound supervisory practices and are considered  universally applicable. The first of the principles states that an effective  system of banking supervision will have clear responsibilities and  objectives for each authority involved in the supervision of banks.
In August 2007, IMF issued a report regarding the findings of its  consultation with the United States as part of its mission to review U.S.  economic developments. IMF concluded that while the U.S. economy  continues to show remarkable dynamism and resilience, it faced important  challenges, such as the need to maintain a robust financial system. IMF  found that the current structure’s multiple federal and state regulators  overseeing the evolving financial market system may limit regulatory  effectiveness and slow responses to pressing issues. Therefore, IMF  suggested the United States increase the use of general principles or goals  to guide financial regulation. According to IMF, general regulatory goals  may ease interagency coordination and shorten reaction times to industry  developments.
section_title: Treasury Has Announced Plans to Consider Regulatory Structure Modernization
paragraphs: The Secretary of the Treasury recently announced an action plan that will  consider reforms to modernize the U.S. financial regulatory structure as  part of a plan to maintain the global leadership of U.S. capital markets.  According to Treasury’s press release, the plan seeks a modern regulatory  structure with improved oversight, increased efficiency, reduced overlap,  and the ability to adapt to market participants’ constantly changing  strategies and tools. Treasury officials noted they recognize that  designing such a system is a long-term endeavor. They said, however, they  will seek to propose first steps that would begin the process. Treasury  intends to publish the result of its study in early 2008.
section_title: Agency Comments and Our Evaluation
paragraphs: We provided the Secretary of the Treasury and the heads of CFTC, the  Federal Reserve, FDIC, NCUA, OCC, OTS, and SEC with drafts of this  report for their comment. We received written comments from the  Chairman of the Board of Governors of the Federal Reserve System and  the Chairman of NCUA who generally agreed with the thrust of our report;  these are reprinted in appendixes II and III. In particular, the Federal  Reserve concurred with GAO’s emphasis on periodically reviewing the  financial regulatory framework for potential modifications and the  importance of continued federal oversight of financial services firms on a  consolidated, group-wide basis. We also received technical comments  from the staffs at the Treasury, the Federal Reserve, CFTC, FDIC, NCUA,  OCC, OTS, and SEC that we have incorporated in the report.
We are sending copies of this report to other interested congressional  committees and to the Secretary of the Treasury, the Chairman of the  Board of Governors of the Federal Reserve System, the Chairman of the  Federal Deposit Insurance Corporation, the Comptroller of the Currency,  the Chairman of the Securities Exchange Commission, the Chairman of  the Commodities and Futures Trading Commission, the Director of the  Office of Thrift Supervision, and the Chairman of the National Credit  Union Administration. We will also make copies available to others upon  request. In addition, the report will be available at no charge on the GAO  Web site at http://www.gao.gov.
If you or your staffs have any questions about this report, please contact  me at (202) 512-8678 or jonesy@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 are acknowledged in appendix IV.
section_title: Appendix I: Participants in the June 11, 2007, Comptroller General’s Forum
subsections: section_title: Moderator
paragraphs: Fordham University School of Law  Goldman, Sachs & Co.
section_title: Appendix II: Comments from the Chairman of the Board of Governors of the Federal Reserve System
section_title: Appendix III: Comments from the Chairman of the National Credit Union Administration
section_title: Appendix IV: GAO Contact and Staff Acknowledgments
subsections: section_title: Staff Acknowledgments
paragraphs: In addition to the individual named above, James McDermott, Assistant  Director; Emily Chalmers; Tiffani Humble; Clarette Kim; Robert E. Lee;  and Marc Molino made key contributions to this report.
section_title: Related GAO Products
paragraphs: Credit Unions: Greater Transparency Needed on Who Credit Unions  Serve and on Senior Executive Compensation Arrangements. GAO-07-29.  Washington, D.C.: November 30, 2006.
Industrial Loan Corporations: Recent Asset Growth and Commercial  Interest Highlight Differences in Regulatory Authority. GAO-06-961T.  Washington, D.C.: July 12, 2006.
Bank Secrecy Act: Opportunities Exist for FinCEN and the Banking  Regulators to further Strengthen the Framework for Consistent BSA  Oversight. GAO-06-386. Washington, D.C.: April 28, 2006.
Sarbanes-Oxley Act: Consideration of Key Principles Needed in  Addressing Implementation for Smaller Public Companies. GAO-06-361.  Washington, D.C.: April 13, 2006.
Mutual Fund Industry: SEC’s Revised Examination Approach Offers  Potential Benefits, but Significant Oversight Challenges Remain. GAO- 05-415. Washington, D.C.: August 17, 2005.
Mutual Fund Trading Abuses: Lessons Can Be Learned from SEC Not  Having Detected Violations at an Earlier Stage. GAO-05-313. Washington,  D.C.: April 20, 2005.
Credit Unions: Financial Condition Has Improved, but Opportunities  Exist to Enhance Oversight and Share Insurance Management. GAO-04- 91. Washington, D.C.: October 27, 2003.
Securities Markets: Competition and Multiple Regulators Heighten  Concerns about Self-Regulation. GAO-02-362. Washington, D.C.: May 3,  2002.
Large Bank Mergers: Fair Lending Review Could be Enhanced with  Better Coordination. GAO/GGD-00-16, Washington, D.C.: November 3,  1999.
Bank Oversight Structure: U.S. and Foreign Experience May Offer  Lessons for Modernizing U.S. Structure. GAO/GGD-97-23. Washington,  D.C.: November 20, 1996.