Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System
Published: 2010-05-06T00:00:00

Fast Facts:

Highlights:
section_title: Why GAO Did This Study
paragraphs: In 2009 GAO conducted a study on the role of leverage in the recent financial crisis and federal oversight of leverage, as mandated by the Emergency Economic Stabilization Act. This testimony presents the results of that study, and discusses (1) how leveraging and deleveraging by financial institutions may have contributed to the crisis, (2) how federal financial regulators limit the buildup of leverage; and (3) the limitations the crisis has revealed in regulatory approaches used to restrict leverage and regulatory proposals to address them. To meet these objectives, GAO built on its existing body of work, reviewed relevant laws and regulations and academic and other studies, and interviewed regulators and market participants.
section_title: What GAO Found
paragraphs: Some studies suggested that leverage steadily increased in the financial sector before the crisis began in mid-2007 and created vulnerabilities that have increased the severity of the crisis. In addition, subsequent disorderly deleveraging by financial institutions may have compounded the crisis. First, the studies suggested that the efforts taken by financial institutions to deleverage by selling financial assets could cause prices to spiral downward during times of market stress and exacerbate a financial crisis. Second, the studies suggested that deleveraging by restricting new lending could slow economic growth. However, other theories also provide possible explanations for the sharp price declines observed in certain assets. As the crisis is complex, no single theory is likely to fully explain what occurred or rule out other explanations. Regulators and market participants we interviewed had mixed views about the effects of deleveraging. Some officials told us that they generally have not seen asset sales leading to downward price spirals, but others said that asset sales have led to such spirals. Federal regulators impose capital and other requirements on their regulated institutions to limit leverage and ensure financial stability. Federal bank regulators impose minimum risk-based capital and leverage ratios on banks and thrifts and supervise the capital adequacy of such firms through on-site examinations and off-site monitoring. Bank holding companies are subject to similar capital requirements as banks, but capital levels of thrift holding companies are individually evaluated based on each company's risk profile. The Securities and Exchange Commission uses its net capital rule to limit broker-dealer leverage and used to require certain broker-dealer holding companies to report risk-based capital ratios and meet certain liquidity requirements. Other important market participants, such as hedge funds, also use leverage. Hedge funds typically are not subject to regulatory capital requirements, but market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage. The crisis has revealed limitations in regulatory approaches used to restrict leverage. First, regulatory capital measures did not always fully capture certain risks, which resulted in some institutions not holding capital commensurate with their risks and facing capital shortfalls when the crisis began. Federal regulators have called for reforms, including through international efforts to revise the Basel II capital framework. The planned U.S. implementation of Basel II would increase reliance on risk models for determining capital needs for certain large institutions. The crisis underscored concerns about the use of such models for determining capital adequacy, but regulators have not assessed whether proposed Basel II reforms will address these concerns. Such an assessment is critical to ensure that changes to the regulatory framework address the limitations the crisis had revealed. Second, regulators face challenges in counteracting cyclical leverage trends and are working on reform proposals. Finally, the crisis has revealed that with multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effects of the buildup of systemwide leverage or the collective effect of institutions' deleveraging activities.

section_title: Letter
paragraphs: I appreciate the opportunity to participate in today’s hearing to discuss  debt and leverage in financial markets in the context of the recent  financial crisis. As you know, the buildup of leverage during a market  expansion and the rush to reduce leverage, or “deleverage,” when market  conditions deteriorated was common to the recent and prior financial  crises. Leverage traditionally has referred to the use of debt, instead of  equity, to fund an asset and has been measured by the ratio of total assets  to equity on the balance sheet. But as witnessed in the recent crisis,  leverage also can be used to increase an exposure to a financial asset  without using debt, such as by using derivatives. In that regard, leverage  can be defined broadly as the ratio between some measure of risk  exposure and capital that can be used to absorb unexpected losses from  the exposure. However, because leverage can be achieved through many  different strategies, no single measure can capture all aspects of leverage.  Federal financial regulators are responsible for establishing regulations  that restrict the use of leverage by financial institutions under their  authority and supervising their institutions’ compliance with such  regulations.
My statement today is based on our July 2009 report on the role of  leverage and deleveraging by financial institutions in the recent crisis and  federal oversight of leverage. We completed this work in response to a  mandate contained in section 117 of the Emergency Economic  Stabilization Act of 2008. Specifically, I will discuss (1) how leveraging  and deleveraging by financial institutions may have contributed to the  crisis; (2) how federal financial regulators limit the buildup of leverage;  and (3) the limitations the crisis has revealed in regulatory approaches to  restrict leverage and regulatory proposals to address them.
To address our objectives, we reviewed and analyzed (1) academic and  other studies assessing the buildup of leverage prior to the recent financial  crisis and the economic mechanisms that possibly helped the mortgage- related losses spread to other markets and expand into the recent crisis;  (2) relevant laws and regulations, and other regulatory guidance and  materials, related to the oversight of financial institutions’ use of leverage  by the Federal Reserve, Federal Deposit Insurance Corporation (FDIC),  Office of the Comptroller of the Currency (OCC), Office of Thrift  Supervision (OTS), and Securities and Exchange Commission (SEC); and  (3) various data to illustrate leverage and other relevant trends. We  assessed the reliability of the data and found that they were sufficiently  reliable for our purposes. We also reviewed and analyzed studies done by  U.S. and international regulators and others identifying limitations in the  regulatory framework used to restrict leverage and proposals to address  such limitations. Finally, we reviewed prior GAO work on the financial  regulatory system. In addition, we interviewed staff from these federal  financial regulators and officials from two securities firms, a bank, and a  credit rating agency.
We conducted our work between February and July 2009 in accordance  with generally accepted government auditing standards. Those standards  require that we plan and perform the audit to obtain sufficient, appropriate  evidence to provide a reasonable basis for our findings and conclusions  based on our audit objectives. We believe that the evidence obtained  provides a reasonable basis for our findings and conclusions based on our  audit objectives.
subsections: section_title: Background
paragraphs: Many financial institutions use leverage to expand their ability to invest or  trade in financial assets and to increase their return on equity. A firm can  use leverage through a number of strategies, including by using debt to  finance an asset or entering into derivatives. Greater financial leverage, as  measured by lower proportions of capital relative to assets, can increase  the firm’s market risk, because leverage magnifies gains and losses relative  to equity. Leverage also can increase a firm’s liquidity risk, because a  leveraged firm may be forced to sell assets under adverse market  conditions to reduce its exposure. Although commonly used as a leverage  measure, the ratio of assets to equity captures only on-balance sheet assets  and treats all assets as equally risky. Moreover, the ratio of assets to equity  helps to measure the extent to which a change in total assets would affect  equity but provides no information on the probability of such a change  occurring. Finally, a leveraged position may not be more risky than a non- leveraged position, when other aspects of the position are not equal. For  example, a non-leveraged position in a highly risky asset could be more  risky than a leveraged position in a low risk asset.
During the 1980s, banking regulators became concerned that simple  leverage measures—such as the ratio of assets to equity or debt to  equity—required too much capital for less-risky assets and not enough for  riskier assets and that such measures did not require capital for growing  portfolios of off-balance sheet items. In response to these concerns, the  Basel Committee on Banking Supervision adopted Basel I, an international  framework for risk-based capital that required banks to meet minimum  risk-based capital ratios, in 1988. By 1992, U.S. regulators had fully  implemented Basel I; and in 1996, they and supervisors from other Basel  Committee member countries amended the framework to include explicit  capital requirements for market risk from trading activity (called the  Market Risk Amendment). In response to the views of bankers and many  regulators that innovation in financial markets and advances in risk  management have revealed limitations in the existing Basel I risk-based  capital framework, especially for large, complex banks, the Basel  Committee released the Basel II international accord in 2004. Since then,  individual countries have been implementing national rules based on the  principles and detailed framework. In a prior report, we discussed the  status of efforts by U.S. regulators to implement the Basel II accord.
section_title: Research Suggests Leverage Increased before the Crisis and Subsequent Deleveraging Could Have Contributed to the Crisis
paragraphs: Studies we reviewed suggest that leverage within the financial sector  increased before the crisis and that subsequent deleveraging by financial  institutions could have contributed to the recent crisis. The causes of the  recent financial crisis are complex and multifaceted and remain subject to  debate and ongoing research. Given our mandate, our review of the  economic literature focused narrowly on deleveraging as one of the  potential economic mechanisms contributing to the crisis. The studies we  reviewed do not provide definitive findings about the role of deleveraging  relative to other mechanisms, and we relied on our interpretation and  reasoning to develop insights from the studies we reviewed.
subsections: section_title: Leverage within the Financial Sector Increased before the Financial Crisis, and Financial Institutions Sought to Deleverage When the Crisis Began
paragraphs: Leverage steadily increased in the financial sector before the crisis began  around mid-2007 and created vulnerabilities that increased the severity of  the crisis, according to studies we reviewed. As mentioned earlier,  leverage can take many different forms, and no single measure of leverage  exists. In that regard, the studies we reviewed generally identified a range  of sources that aided in the buildup of leverage before the crisis. One such  source was the reliance on short-term funding by financial institutions,  which made them vulnerable to a decline in the availability of such credit.  Another source of leverage was special purpose entities (SPE), which  some banks created to buy and hold mortgage-related and other assets  that the banks did not want to hold on their balance sheets. SPEs often  borrowed by issuing shorter-term instruments, exposing them to the risk  of not being able to renew their debt. Other sources of leverage included  collateralized debt obligations (CDOs) and credit default swaps, a type of  OTC derivative. For securities firms, hedge funds, and other financial  intermediaries that operate mainly through the capital markets, their  balance sheet leverage, or ratio of total assets to equity, tends to be  procyclical. Historically, such institutions tended to increase their  leverage when asset prices rose and decrease their leverage when asset  prices fell. Consistent with this trend, the ratio of assets to equity for five  large broker-dealer holding companies, in aggregate, increased from an  average ratio of around 22 to 1 in 2002 to around 30 to 1 in 2007 (see   fig. 1).
In contrast, the ratio of assets to equity for five large bank holding  companies, in aggregate, was relatively flat during this period (see fig. 2).  As discussed in the background, the ratio of assets to equity as a measure  of leverage treats all assets as equally risky and does not capture off- balance sheet risks.
As their mortgage-related and other losses grew after the onset of the  crisis, banks, securities firms, hedge funds, and other financial institutions  have attempted to deleverage and reduce their risk. Deleveraging can  cover a range of strategies, including raising new equity, reducing dividend  payouts, diversifying sources of funds, selling assets, and reducing lending.  After the crisis began, U.S. banks and securities firms initially deleveraged  by raising more than $200 billion in new capital from private sources and  sovereign wealth funds. However, raising capital began to be increasingly  difficult in the subsequent period, and financial institutions have  deleveraged by selling assets, including financial instruments and noncore  businesses. For example, in the fourth quarter of 2008, broker-dealers  reduced assets by nearly $785 billion and banks reduced bank credit by  nearly $84 billion.
section_title: Some Studies Suggested That Deleveraging by Financial Institutions by Selling Financial Assets and Restricting New Lending Could Have Contributed to the Crisis
paragraphs: Some studies we reviewed highlighted the possibility that deleveraging  through asset sales by financial institutions could trigger downward  spirals in asset prices and contribute to a financial crisis. In times of  market stress, a sharp decline in an asset’s price can become self- sustaining and lead to a financial market crisis. Following a sharp decline  in an asset’s price, investors normally will buy the asset after they deem its  price has dropped enough and help stabilize the market, but in times of  crisis, investors are unable or unwilling to buy the asset. As the asset’s  price declines, more investors sell and push the price lower. For leveraged  institutions holding the asset, the impact of their losses on capital will be  magnified. To lower their leverage or risk, the institutions may sell more of  their assets, which can cause the asset’s price to drop even more and  induce another round of selling. In other words, when market liquidity is  low, namely in times of market stress, asset sales establish lower market  prices and result in financial institutions marking down their positions— potentially creating a reinforcing cycle of deleveraging. In the extreme,  this downward asset spiral could cause the asset’s price to be set below its  fundamental value, or at a “fire sale” price. In addition, a decline in a  financial asset’s price could trigger sales when the asset is used as  collateral for a loan. In such a case, the borrower could be required to post  additional collateral for its loan, but if the borrower could not do so, the  lender could take ownership of the collateral and then sell it, which could  cause the asset’s price to decline further.
Importantly, other theories that do not involve asset spirals caused by  deleveraging through asset sales provide possible explanations for the  sharp price declines in mortgage-related securities and other financial  instruments. Moreover, as the crisis is complex, no single theory likely is  to explain in full what occurred or necessarily rule out other explanations.  First, given the default characteristics of the mortgages underlying their  related securities and falling housing prices, low market prices may result  from asset prices reverting to more reasonable values after a period of  overvaluation. Second, the low prices of mortgage-related securities and  other financial instruments may have resulted from the uncertainty  surrounding their true value. This theory holds that investors may lack the  information needed to distinguish between the good and bad securities  and, as a result, discount the prices of the good securities. These two  theories and the deleveraging hypothesis may provide some insight into  how the financial crisis has unfolded and are not mutually exclusive.  Nonetheless, at this juncture, it is difficult to determine whether a return  to fundamentals, uncertainty, or forced asset sales played a larger causal  role.
In addition, some studies we reviewed suggested that deleveraging by  restricting new lending could contribute to the crisis by slowing economic  growth. In short, the concern is that banks, because of their leverage, will  need to cut back their lending by a multiple of their credit losses to restore  their balance sheets or capital-to-asset ratios. The contraction in bank  lending can lead to a decline in consumption and investment spending,  which reduces business and household incomes and negatively affects the  real economy. Moreover, rapidly declining asset prices can inhibit the  ability of borrowers to raise money in the securities markets.
section_title: Regulators and Market Participants Had Mixed Views about the Effects of Deleveraging in the Recent Crisis
paragraphs: Officials from federal financial regulators, two securities firms, a bank,  and a credit rating agency whom we interviewed had mixed views about  the effects of deleveraging by financial institutions in the recent crisis.  Nearly all of the officials told us that large banks and securities firms  generally have sought to reduce their risk exposures since late 2007, partly  in response to liquidity pressures. The institutions have used a number of  strategies to deleverage, including raising new capital; curtailing certain  lines of business; and selling assets, including trading assets, loans, and  noncore businesses. Regulatory officials said that hedge funds and other  asset managers also deleveraged by selling assets to meet redemptions or  margin calls. According to officials at a securities firm, raising capital and  selling financial assets was easier in the beginning of the recent crisis, but  both became harder to do as the crisis continued. Regulatory and credit  rating agency officials also said that financial institutions have faced  challenges in selling mortgages and other loans that they planned to  securitize, because the securitization markets essentially had shut down  during the crisis.
The regulators and market participants we interviewed had mixed views  on whether sales of financial assets contributed to a downward price  spiral. Officials from one bank and the Federal Reserve staff we  interviewed said that due to the lack of market liquidity for some  instruments and the unwillingness of many market participants to sell  them, declines in prices that may be attributed to market-driven asset  spirals generally resulted from the use of models to price assets in the  absence of any sales. Federal Reserve staff also said that it is hard to  attribute specific factors as a cause of an observed asset spiral because of  the difficulty in disentangling the interacting factors that can cause  financial asset prices to move down. In contrast, officials from two  securities firms and a credit rating agency, and staff from SEC and OCC  told us that asset spirals occurred in certain mortgage and other debt  markets. Officials from one securities firm said that financial institutions,  such as hedge funds, generally sought to sell first those financial assets  that were hardest to finance, which eventually caused these markets to  become illiquid. The absence of observable prices for such assets then  caused their prices to deteriorate even more. According to the securities  firm officials, firms that needed to sell assets to cover losses or meet  margin calls helped to drive such asset sales.
FDIC and OCC staff and officials from a credit rating agency told us that  some banks tightened their lending standards for certain types of loans,  namely those with less-favorable risk-adjusted returns. Such loans include  certain types of residential and commercial mortgages, leverage loans, and  loans made to hedge funds. According to credit rating officials, banks  essentially have set a target of slower growth for higher-risk loans that  have performed poorly and deteriorated their loan portfolios. In addition,  OCC and credit rating officials said that the largest banks rely heavily on  their ability to securitize loans to help them make such loans. To that end,  they said that the securitization markets need to open up and provide  funding.
section_title: Regulators Limit Financial Institutions’ Use of Leverage Primarily Through Regulatory Capital Requirements
paragraphs: Federal financial regulators (Federal Reserve, FDIC, OCC, and OTS)  generally have imposed capital and other requirements on their regulated  institutions as a way to limit excessive use of leverage and ensure the  stability of the financial system and markets. Federal banking and thrift  regulators have imposed minimum risk-based capital and non-risk-based  leverage ratios on their regulated institutions. Risk-based capital ratios are  broadly intended to require banks to hold more capital for higher-risk  assets. Leverage ratios provide a cushion against risks not explicitly  covered in the risk-based capital requirements, such as operational  weaknesses and model risk. In addition, the regulators supervise the  capital adequacy of their regulated institutions through ongoing  monitoring, including on-site examinations and off-site tools. Bank holding  companies are subject to capital and leverage ratio requirements similar to  those for banks. Thrift holding companies are not subject to such  requirements; rather, capital levels of thrift holding companies are  individually evaluated based on each company’s risk profile. SEC primarily  uses its net capital rule to limit the use of leverage by broker-dealers.  According to SEC officials, firms that had participated in SEC’s now  defunct Consolidated Supervised Entities program calculated their risk- based capital ratios at the holding company level in a manner generally  consistent with the method banks used.
Other financial institutions, such as hedge funds, use leverage but, unlike  banks and broker-dealers, typically are not subject to regulatory capital  requirements; instead, market discipline plays a primary role in limiting  leverage. Finally, the Federal Reserve regulates the use of securities as  collateral to finance security purchases, but federal financial regulators  told us that such credit did not play a significant role in the buildup of  leverage leading to the recent crisis.
section_title: Regulators Are Considering Reforms to Address Limitations the Crisis Revealed in Regulatory Framework for Restricting Leverage
paragraphs: The financial crisis has revealed limitations in existing regulatory  approaches that serve to restrict leverage. Although regulators have  proposed changes to improve the risk coverage of the regulatory capital  framework, limit cyclical leverage trends and better address sources of  systemic risk, they have not yet fully evaluated the extent to which these  proposals would address these limitations. First, regulatory capital  measures did not always fully capture certain risks, particularly those  associated with some mortgage-related securities held on and off balance  sheets. As a result, a number of financial institutions did not hold capital  commensurate with their risks and some lacked adequate capital or  liquidity to withstand the market stresses of the crisis. Federal financial  regulators have acknowledged the need to improve the risk coverage of  the regulatory capital reform and are considering reforms to better align  capital requirements with risk, but have not formally assessed the extent  to which these reforms may address risk-evaluation concerns the crisis  highlighted with respect to Basel II approaches. Such an assessment is  critical to ensure that Basel II changes that would increase reliance on  complex risk models and banks’ own risk estimates do not exacerbate  regulatory limitations revealed by the crisis.
Second, the recent crisis illustrated how the existing regulatory  framework, along with other factors, might have contributed to cyclical  leverage trends that potentially exacerbated the recent crisis. For  example, according to regulators, minimum regulatory capital  requirements may not provide adequate incentives for banks to build loss- absorbing capital buffers in benign markets when it would be less  expensive to do so. When market conditions deteriorated, minimum  capital requirements became binding for many institutions that lacked  adequate buffers to absorb losses and faced sudden pressures to  deleverage. Regulators are considering several options to counteract  potentially harmful cyclical leverage trends, but implementation of these  proposals presents challenges.
Finally, the financial crisis has illustrated the potential for financial market  disruptions, not just firm failures, to be a source of systemic risk. With  multiple regulators primarily responsible for individual markets or  institutions, none of the financial regulators has clear responsibility to  assess the potential effects of the buildup of systemwide leverage or the  collective activities of the industry for the financial system. As a result,  regulators may be limited in their ability to prevent or mitigate future  financial crises.
To ensure that there is a systemwide approach to addressing leverage- related issues across the financial system, we have asked Congress to  consider, as it moves toward the creation of a systemic risk regulator, the  merits of tasking this entity with the responsibility for measuring and  monitoring systemwide leverage and evaluating options to limit  procyclical leverage trends. Furthermore, we made a recommendation to  the financial regulators to assess the extent to which Basel II reforms may  address risk evaluation and regulatory oversight concerns associated with  advanced modeling approaches used for capital purposes. In their  comments on our report, the Federal Reserve, FDIC, OCC, and SEC  generally agreed with our recommendations.
Mr. Chairman, Ranking Member Biggert, and Members of the  Subcommittee, this completes my prepared statement. I am prepared to  respond to any questions you or other Members of the Subcommittee may  have at this time.
section_title: Contacts
paragraphs: For further information on this testimony, please contact Orice Williams  Brown on (202) 512-8678 or williamso@gao.gov. Contact points for our  Congressional Relations and Public Affairs offices may be found on the  last page of this statement.
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