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

Letter

Background

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.

Research Suggests Leverage Increased before the Crisis and Subsequent Deleveraging Could Have Contributed to the Crisis

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.

Leverage within the Financial Sector Increased before the Financial Crisis, and Financial Institutions Sought to Deleverage When the Crisis Began

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.

Some Studies Suggested That Deleveraging by Financial Institutions by Selling Financial Assets and Restricting New Lending Could Have Contributed to the Crisis

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.

Regulators and Market Participants Had Mixed Views about the Effects of Deleveraging in the Recent Crisis

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.

Regulators Limit Financial Institutions’ Use of Leverage Primarily Through Regulatory Capital Requirements

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.

Regulators Are Considering Reforms to Address Limitations the Crisis Revealed in Regulatory Framework for Restricting Leverage

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.

Contacts

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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