The financial regulatory framework in the United States was built over more than a century, largely in response to crises and significant market developments. As a result, the regulatory system is complex and fragmented. While the Dodd-Frank Act has brought additional changes, including the creation of new regulatory entities and the consolidation of some regulatory responsibilities that had been shared by multiple agencies, the U.S. financial regulatory structure largely remains the same. It is a complex system of multiple federal and state regulators, as well as self-regulatory organizations, that operates largely along functional lines. The U.S. regulatory system is described as “functional” in that financial products or activities are generally regulated according to their function, no matter who offers the product or participates in the activity. In the banking industry, the specific regulatory configuration depends on the type of charter the banking institution chooses. Depository institution charter types include commercial banks, which originally focused on the banking needs of businesses but over time have broadened their services; thrifts, which include savings banks, savings associations, and savings and loans and were originally created to serve the needs— particularly the mortgage needs—of those not served by commercial banks; and credit unions, which are member-owned cooperatives run by member- elected boards with an historical emphasis on serving people of modest means. These charters may be obtained at the state or federal level. State regulators charter institutions and participate in their oversight, but all institutions that have federal deposit insurance have a federal prudential regulator. The federal prudential regulators—which generally may issue regulations and take enforcement actions against industry participants within their jurisdiction—are identified in table 1. The act eliminated the Office of Thrift Supervision (OTS) and transferred its regulatory responsibilities to OCC, the Federal Reserve, and FDIC. To achieve their safety and soundness goals, bank regulators establish capital requirements, conduct onsite examinations and off-site monitoring to assess a bank’s financial condition, and monitor compliance with banking laws. Regulators also issue regulations, take enforcement actions, and close banks they determine to be insolvent. Holding companies that own or control a bank or thrift are subject to supervision by the Federal Reserve. The Bank Holding Company Act of 1956 and the Home Owners’ Loan Act set forth the regulatory frameworks for bank holding companies and savings and loan (S&L) holding companies, respectively. Before the Dodd-Frank Act, S&L holding companies had been subject to supervision by OTS and a different set of regulatory requirements from those of bank holding companies. The Dodd-Frank Act made the Federal Reserve the regulator of S&L holding companies and amended the Home Owners’ Loan Act and the Bank Holding Company Act to create certain similar requirements for both bank holding companies and S&L holding companies. The Dodd-Frank Act also grants new authorities to FSOC to designate nonbank financial companies for supervision by the Federal Reserve. The securities and futures markets are regulated under a combination of self-regulation (subject to oversight by the appropriate federal regulator) and direct oversight by SEC and CFTC, respectively. SEC regulates the securities markets, including participants such as securities exchanges, broker-dealers, investment companies, and investment advisers. SEC’s mission is to protect investors; maintain fair, orderly, and efficient markets; and facilitate capital formation. In the securities industry, certain self-regulatory organizations—including the securities exchanges and the Financial Industry Regulatory Authority—have responsibility for overseeing the securities markets and their members; establishing the standards under which their members conduct business; monitoring business conduct; and bringing disciplinary actions against members for violating applicable federal statutes, SEC’s rules, and their own rules. CFTC is the primary regulator of futures markets, including futures exchanges and intermediaries, such as futures commission merchants. CFTC’s mission is to protect market users and the public from fraud, manipulation, abusive practices, and systemic risk related to derivatives that are subject to the Commodity Exchange Act, and to foster open, competitive, and financially sound futures markets. Like SEC, CFTC oversees the registration of intermediaries and relies on self-regulatory organizations, including the futures exchanges and the National Futures Association, to establish and enforce rules governing member behavior. In addition, Title VII of the Dodd-Frank Act expands regulatory responsibilities for CFTC and SEC by establishing a new regulatory framework for swaps. The act authorizes CFTC to regulate “swaps” and SEC to regulate “security-based swaps” with the goals of reducing risk, increasing transparency, and promoting market integrity in the financial system. The Dodd-Frank Act established CFPB as an independent bureau within the Federal Reserve System and provided it with rule-making, enforcement, supervisory, and other powers over many consumer financial products and services and many of the entities that sell them. Certain consumer financial protection functions from seven existing federal agencies were transferred to CFPB. Consumer financial products and services over which CFPB has primary authority include deposit taking, mortgages, credit cards and other extensions of credit, loan servicing, debt collection, and others. CFPB is authorized to supervise certain nonbank financial companies and large banks and credit unions with over $10 billion in assets and their affiliates for consumer protection purposes. CFPB does not have authority over most insurance activities or most activities conducted by firms regulated by SEC or CFTC. The Housing and Economic Recovery Act of 2008 (HERA) created FHFA to oversee the government-sponsored enterprises (GSE): Fannie Mae, Freddie Mac, and the Federal Home Loan Banks. Fannie Mae and Freddie Mac were created by Congress as private, federally chartered companies to provide, among other things, liquidity to home mortgage markets by purchasing mortgage loans, thus enabling lenders to make additional loans. The system of 12 Federal Home Loan Banks provides funding to support housing finance and economic development. Until enactment of HERA, Fannie Mae and Freddie Mac had been overseen since 1992 by the Office of Federal Housing Enterprise Oversight (OFHEO), an agency within the Department of Housing and Urban Development (HUD), and the Federal Home Loan Banks were subject to supervision by the Federal Housing Finance Board (FHFB), an independent regulatory agency. In July 2008, HERA created FHFA to establish more effective and more consistent oversight of the three housing GSEs. Given their precarious financial condition, Fannie Mae and Freddie Mac were placed in conservatorship in September 2008, with FHFA serving as the conservator under powers provided in HERA. While insurance activities are primarily regulated at the state level, the Dodd-Frank Act created the Federal Insurance Office within Treasury to monitor issues related to regulation of the insurance industry. The Federal Insurance Office is not a regulator or supervisor, and its responsibilities include identifying issues or gaps in the regulation of insurers that could contribute to a systemic crisis in the insurance industry or the U.S. financial system. The Dodd-Frank Act established FSOC to identify risks to the financial stability of the United States, promote market discipline, and respond to emerging threats to the stability of the U.S. financial system. The Dodd- Frank Act also established OFR within Treasury to serve FSOC and its member agencies by improving the quality, transparency, and accessibility of financial data and information; conducting and sponsoring research related to financial stability; and promoting best practices in risk management. FSOC’s membership consists of the Secretary of the Treasury, who chairs the council, and the heads of CFPB, CFTC, FDIC, the Federal Reserve, FHFA, the National Credit Union Administration, OCC, SEC, the directors of OFR and the Federal Insurance Office, representatives from state-level financial regulators, and an independent member with insurance experience. There is no universally accepted definition of a financial crisis. Some academic studies identify three major types of financial crises: banking crises, public debt crises, and currency crises. The most recent financial crisis in the United States is widely considered to have been a banking crisis. While researchers have defined banking crises in different ways, their definitions generally focus on indicators of severe stress on the financial system, such as runs on financial institutions or large-scale government assistance to the financial sector. The large increases in public debt that tend to follow the onset of a banking crisis can make a country more susceptible to a public debt crisis. Studies reviewing historical banking crises in the United States and other countries found that such crises were associated with large losses in output (the value of goods and services produced in the economy) and employment that can persist for years. A disruption to the financial system can have a ripple effect through the economy, harming the broader economy through several channels. For example, some studies identify ways that strains in the financial system can negatively impact the cost and availability of credit and, in turn, reduce total output. During the recent crisis, certain securitization markets collapsed and households and businesses faced tightened credit conditions. Higher funding costs for firms in the form of higher interest rates and lower equity prices can contribute to declines in investment. Furthermore, as asset prices fall, declines in the wealth and confidence of consumers, businesses, and investors also can contribute to output declines. Historically, governments have provided substantial assistance to financial institutions during banking crises to avert more severe disruptions to the key functions performed by the financial system. The causes of the 2007-2009 crisis are complex and remain subject to debate and ongoing research. According to many researchers, around mid-2007, losses in the mortgage market triggered a reassessment of financial risk in other debt instruments and sparked the financial crisis. Uncertainty about the financial condition and solvency of financial entities resulted in a liquidity and credit crunch that made the financing on which many businesses and individuals depend increasingly difficult to obtain. By late summer of 2008, the ramifications of the financial crisis ranged from the failure of financial institutions to increased losses of individual savings and corporate investments. Academics and others have identified a number of factors that may have helped set the stage for problems in the mortgage market and the broader financial system. These factors, in no particular order, include financial innovation in the form of asset securitization, which reduced mortgage originators’ incentives to be prudent in underwriting loans and made it difficult to understand the size and distribution of loss exposures throughout the system; imprudent business and risk management decisions based on the expectation of continued housing price appreciation; faulty assumptions in the models used by credit rating agencies to rate mortgage-related securities; gaps and weaknesses in regulatory oversight, which allowed financial institutions to take excessive risks by exploiting loopholes in capital rules and funding themselves increasingly with short-term liabilities; government policies to increase homeownership, including the role of Fannie Mae and Freddie Mac in supporting lending to higher-risk borrowers; and economic conditions, characterized by accommodative monetary policies, ample liquidity and availability of credit, and low interest rates that spurred housing investment. The United States periodically has experienced banking crises of varying severity. The financial crisis that began in 2007 was the most severe banking crisis experienced by the United States since the 1930s. While this most recent financial crisis may have had some new elements—such as the role of asset securitization in spreading risks across the financial system—studies have found that it followed patterns common to past crises in the United States and other countries. For example, experts have noted that the recent crisis, like many past crises, was preceded by an asset price boom that was accompanied by an excessive buildup in leverage. Another common pattern between the recent and past crises has been the buildup of risks and leverage in unregulated or less regulated financial institutions. While academic studies have used different criteria to identify and date banking crises, studies we reviewed identify the following episodes as U.S. banking crises since the Civil War: the banking panics of 1873, 1893, 1907, and the 1930s; the Savings and Loan Crisis that began in the1980s; and the 2007-2009 crisis. The studies do not consider the stock market crash of 1987 or the bursting of the technology bubble during 2000-2001 to be banking crises, because neither placed severe strains on the financial system that threatened the economy. Several studies measure the overall economic costs associated with past financial crises based on the decline in economic output (the value of goods and services produced in the economy) relative to some benchmark, such as the long-term trend in output. While using a variety of methods to quantify these output losses, the studies generally have found the losses from past financial crises to be very large. Some of these studies also analyze changes in unemployment, household wealth, and other economic indicators to show the effects of the crises at a more granular level. In addition, some studies use measures of fiscal costs— such as increases in government debt—to analyze the losses associated with financial crises. In the following section, we review what is known about the losses associated with the recent financial crisis based on these measures. The 2007-2009 financial crisis, like past financial crises, was associated with not only a steep decline in output but also the most severe economic downturn since the Great Depression of the 1930s (see fig. 1). According to a study, in the aftermath of past U.S. and foreign financial crises, output falls (from peak to trough) an average of over 9 percent and the associated recession lasts about 2 years on average. The length and severity of this economic downturn was roughly consistent with the experience of past financial crises. The U.S. economy entered a recession in December 2007, a few months after the start of the financial crisis. Between December 2007 and the end of the recession in June 2009, U.S. real gross domestic product (GDP) fell from $13.3 trillion to $12.7 trillion (in 2005 dollars), or by nearly 5 percent. As shown in figure 1, real GDP did not regain its pre-recession level until the third quarter of 2011. Although the decline in the U.S. economy’s real GDP during the recession may reflect some of the losses associated with the 2007-2009 financial crisis, the decline does not capture the cumulative losses from the crisis. To quantify the overall losses associated with past financial crises, researchers have estimated output losses as the cumulative shortfall between actual GDP and estimates of what GDP would have been if the crisis had not occurred. Measuring the shortfall in GDP in the aftermath of a crisis requires making a number of assumptions, and the measurement will vary depending on what assumptions are used. Figure 2 provides two examples to show how estimates of output losses vary depending on the assumptions used. The output shortfall is shown in the shaded areas of the two examples, with the output shortfall larger in example 2 than in example 1. Important assumptions include the following: Start date of the crisis: The first assumption involves selecting the date when the crisis began. The start date is shown as the vertical line in examples 1 and 2 and is assumed to be the same. However, researchers have used different assumptions to select the start date of the 2007-2009 financial crisis. The path real GDP would have followed if the crisis had not occurred: The second assumption involves estimating the counterfactual for the path of GDP—that is, the path that real GDP would have followed in the absence of a crisis. This counterfactual is not observable. Studies have used different assumptions to estimate this path and one approach is to assume that this path would follow a precrisis trend in real GDP growth. For example, one study estimated trend output paths based on average GDP growth for the three years and ten years before the crisis. In figure 2, example 1 assumes a much lower (or less steep) trend rate of GDP growth than example 2. Assuming a higher growth trend results in a larger estimate of output losses. Projections of actual GDP: The third assumption involves determining when GDP regained or will regain its estimated precrisis trend path. With respect to the recent crisis, some studies find that real GDP remains below the estimated precrisis trend. Researchers reach different conclusions about when or whether GDP will regain its long-term trend from before the crisis. Assumptions about the path of actual GDP and how it compares to the potential trend path can reflect different views on whether the output losses from the crisis are temporary or permanent. In contrast to example 1, where the economy regains its precrisis growth rate and level of output, example 2 assumes the economy regains its precrisis rate of output growth but remains permanently below the level of output projected by extrapolating the precrisis growth trend. As a result, output losses in example 2 extend farther into the future and are considerably larger than in example 1. Some studies describe reasons why financial crises could be associated with permanent output losses. For example, sharp declines in investment during and following the crisis could result in lower capital accumulation in the long-term. In addition, persistent high unemployment could substantially erode the skills of many U.S. workers and reduce the productive capacity of the U.S. economy. Research suggests that U.S. output losses associated with the 2007- 2009 financial crisis could range from several trillion to over $10 trillion. In January 2012, the Congressional Budget Office (CBO) estimated that the cumulative difference between actual GDP and estimated potential GDP following the crisis would amount to $5.7 trillion by 2018. CBO defined potential output as the output level that corresponds to a high rate of use of labor and capital. CBO reported that recessions following financial crises, like the most recent crisis, tend to reduce not only output below what it otherwise would have been but also the economy’s potential to produce output, even after all resources are productively employed. In its estimate, CBO assumed that GDP would recover to its potential level by 2018, noting that it does not attempt to predict business cycle fluctuations so far into the future. Other studies have reported a wide range of estimates for the output losses associated with past financial crises, with some suggesting that output losses from the recent crisis could persist beyond 2018 or be permanent. In an August 2010 study, a working group of the Basel Committee on Banking Supervision reviewed the literature estimating output losses. According to the Basel Committee working group’s review, studies calculating long-term output losses relative to a benchmark (such as an estimated trend in the level of GDP) estimated much larger losses than studies calculating output losses over a shorter time period. In a June 2012 working paper, International Monetary Fund (IMF) economists estimated the cumulative percentage difference between actual and trend real GDP for the 4 years following the start of individual banking crises in many countries. They found a median output loss of 23 percent of trend-level GDP for a historical set of banking crises and a loss of 31 percent for the 2007-2009 U.S. banking crisis. Other researchers who assume more persistent or permanent output losses from past financial crises estimate much larger output losses from these crises, potentially in excess of 100 percent of precrisis GDP. While such findings were based on crisis events before 2007, if losses from the 2007- 2009 crisis were to reach similar levels, the present value of cumulative output losses could exceed $13 trillion. Studies that estimate output losses can be useful in showing the rough magnitude of the overall costs associated with the 2007-2009 financial crisis, but their results have limitations. Importantly, real GDP is an imperfect proxy of overall social welfare. As discussed below, real GDP measures do not reveal the distributional impacts of the crisis, and the costs associated with a financial crisis can fall disproportionately on certain populations. In addition, it is difficult to separate out the economic costs attributable to the crisis from the costs attributable to other factors, such as federal government policy decisions before, during, and after the crisis. While studies often use output losses to measure the overall costs associated with financial crises, many researchers also discuss trends in unemployment, household wealth, and other economic indicators, such as the number of foreclosures, to provide a more granular picture of the effects of financial crises. As with trends in output losses, it is not possible to determine how much of the changes in these measures can be attributed to the financial crisis rather than to other factors. For example, analyzing the peak-to-trough changes in certain measures, such as home prices, can overstate the impacts associated with the crisis, as valuations before the crisis may have been inflated and unsustainable. The effects of the financial crisis have been wide-ranging, and we are not attempting to provide a comprehensive review of all components of the economic harm. Rather, the following highlights some of the most common types of measures used by academics and other researchers. As shown in figure 3, the unemployment rate rose substantially following the onset of the financial crisis and then declined, but it remains above the historical average as of November 2012. The monthly unemployment rate peaked at around 10 percent in October 2009 and remained above 8 percent for over 3 years, making this the longest stretch of unemployment above 8 percent in the United States since the Great Depression. The monthly long-term unemployment rate—measured as the share of the unemployed who have been looking for work for more than 27 weeks— increased above 40 percent in December 2009 and remained above 40 percent as of November 2012. Persistent, high unemployment has a range of negative consequences for individuals and the economy. First, displaced workers—those who permanently lose their jobs through no fault of their own—often suffer an initial decline in earnings and also can suffer longer-term losses in earnings. For example, one study found that workers displaced during the 1982 recession earned 20 percent less, on average, than their nondisplaced peers 15 to 20 years later. Reasons that unemployment can reduce future employment and earnings prospects for individuals include the stigma that some employers attach to long-term unemployment and the skill erosion that can occur as individuals lose familiarity with technical aspects of their occupation. Second, research suggests that the unemployed tend to be physically and psychologically worse off than their employed counterparts. For example, a review of 104 empirical studies assessing the impact of unemployment found that people who lost their job were more likely than other workers to report having stress-related health conditions, such as depression, stroke, heart disease, or heart attacks. Third, some studies find negative outcomes for health, earnings, and educational opportunities for the children of the unemployed. Fourth, periods of high unemployment can impact the lifetime earnings of people entering the workforce for the first time. For example, one study found that young people who graduate in a severe recession have lower lifetime earnings, on average, than those who graduate in normal economic conditions. In prior work, we reported that long-term unemployment can have particularly serious consequences for older Americans (age 55 and over) as their job loss threatens not only their immediate financial security but also their ability to support themselves during retirement. Persistent high unemployment can also increase budgetary pressures on federal, state, and local governments as expenditures on social welfare programs increase and individuals with reduced earnings pay less in taxes. According to the Federal Reserve’s Survey of Consumer Finances, median household net worth fell by $49,100 per family, or by nearly 39 percent, between 2007 and 2010. The survey found that this decline appeared to be driven most strongly by a broad collapse in home prices. Another major component of net worth that declined was the value of household financial assets, such as stocks and mutual funds. Economists we spoke with noted that precrisis asset prices may have reflected unsustainably high (or “bubble”) valuations and it may not be appropriate to consider the full amount of the overall decline in net worth as a loss associated with the crisis. Nevertheless, dramatic declines in net worth, combined with an uncertain economic outlook and reduced job security, can cause consumers to reduce spending. Reduced consumption, all else equal, further reduces aggregate demand and real GDP. As we reported in June 2012, decreases in home prices played a central role in the crisis and home prices continue to be well below their peak nationwide. According to CoreLogic’s Home Price Index, home prices across the country fell nearly 29 percent between their peak in April 2006 and the end of the recession in June 2009 (see fig. 4). This decline followed a 10-year period of significant home price growth, with the index more than doubling between April 1996 and 2006. Since 2009, home prices have fluctuated. Similarly, we also reported that homeowners have lost substantial equity in their homes, because home values have declined faster than home mortgage debt. As shown in figure 5, households collectively lost about $9.1 trillion (in constant 2011 dollars) in national home equity between 2005 and 2011, in part because of the decline in home prices. Figure 5 also shows that between 2006 and 2007, the steep decline in home values left homeowners collectively holding home mortgage debt in excess of the equity in their homes. This is the first time that aggregate home mortgage debt exceeded home equity since the data were kept in 1945. As of December 2011, national home equity was approximately $3.7 trillion less than total home mortgage debt. Declines in the value of household investments in stocks and mutual funds also contributed to significant declines in household wealth after the crisis began. In addition to experiencing a decline in the value of their stock and mutual fund investments, households also experienced a decline in their retirement funds. As shown in figure 6, the value of corporate equities held in retirement funds dropped sharply in late 2008. While equity prices and the value of retirement fund assets generally have recovered since 2009, investors and pension funds that sold assets at depressed prices experienced losses. For example, officials from a large pension fund told us that they were forced to sell equity securities at depressed prices during the crisis to meet their liquidity needs. Experts have different views on how the crisis may have changed investors’ attitudes towards risk-taking. To the extent that investors are more risk averse and demand higher returns for the risks associated with certain investments, businesses could face increased funding costs that could contribute to slower growth. In 2006, the percentage of loans in default or in foreclosure began to increase (see fig. 7). As we previously reported, a number of factors contributed to the increase in loan defaults and foreclosures, including a rapid decline in home prices throughout much of the nation and weak regional labor market conditions in some states where foreclosure rates were already elevated. During the 2007-2009 recession, the elevated unemployment rate and declining home prices worsened the financial circumstances for many families, along with their ability to make their mortgage payments. Foreclosures have been associated with a number of adverse effects on homeowners, communities, the housing market, and the overall economy. Homeowners involved in a foreclosure often are forced to move out and may see their credit ratings plummet, making it difficult to purchase another home. A large number of foreclosures can have serious consequences for neighborhoods. For example, research has shown that foreclosures depress the values of nearby properties in the local neighborhood. Creditors, investors, and servicers can incur a number of costs during the foreclosure process (e.g., maintenance and local taxes) and a net loss, if there is a shortfall between the ultimate sales price and the mortgage balance and carrying costs. Large numbers of foreclosures can significantly worsen cities’ fiscal circumstances, both by reducing property tax revenues and by raising costs to the local government associated with maintaining vacant and abandoned properties. Some studies consider measures of fiscal costs—such as increases in federal government debt—when analyzing the losses associated with financial crises. Like past financial crises, the 2007-2009 financial crisis has been associated with large increases in the federal government’s debt and heightened fiscal challenges for many state and local governments. Factors contributing to these challenges include decreased tax revenues from reduced economic activity and increased spending associated with government efforts to mitigate the effects of the recession. In prior work, we have reported that the economic downturn and the federal government’s response caused budget deficits to rise in recent years to levels not seen since World War II. While the structural imbalance between spending and revenue paths in the federal budget predated the financial crisis, the size and urgency of the federal government’s long-term fiscal challenges increased significantly following the crisis’s onset. From the end of 2007 to the end of 2010, federal debt held by the public increased from roughly 36 percent of GDP to roughly 62 percent. Key factors contributing to increased deficit and debt levels following the crisis included (1) reduced tax revenues, in part driven by declines in taxable income for consumers and businesses; (2) increased spending on unemployment insurance and other nondiscretionary programs that provide assistance to individuals impacted by the recession; (3) fiscal stimulus programs enacted by Congress to mitigate the recession, such as the American Recovery and Reinvestment Act of 2009 (Recovery Act); and (4) increased government assistance to stabilize financial institutions and markets. While deficits during or shortly after a recession can support an economic recovery, increased deficit and debt levels could have negative effects on economic growth. For example, rising federal debt can “crowd out” private investment in productive capital as the portion of savings that is used to buy government debt securities is not available to fund such investment. Lower levels of private investment can reduce future economic growth. In addition, increased debt increases the amount of interest the government pays to its lenders, all else equal. Policy alternatives to offsetting increased interest payments include increasing tax rates and reducing government benefits and services, which also can reduce economic growth. Moreover, increased fiscal challenges could make the United States more vulnerable to a fiscal crisis should investors lose confidence in the ability of the U.S. government to repay its debts. Such a crisis could carry enormous costs because the federal government would face a sharp increase in its borrowing costs. The following discussion focuses on the costs associated with the federal government’s actions to assist the financial sector. Fiscal stimulus programs, such as the Recovery Act, and the Federal Reserve’s monetary policy operations were major components of the federal government’s efforts to mitigate the recession that coincided with the 2007-2009 financial crisis. However, given our focus on the Dodd-Frank Act reforms, the potential short-term and long-term impacts of these efforts are beyond the scope of this report. Furthermore, our review did not consider the benefits or costs of government policy interventions relative to alternatives that were not implemented. With respect to the most significant government programs and other actions to assist the financial sector, the following discussion reviews (1) expert perspectives on how these policy responses could have reduced or increased the severity of the financial crisis and the associated economic losses; (2) the potential costs associated with increased moral hazard; and (3) the financial performance (including income and losses) of the largest of these policy interventions. Federal financial regulators and several academics and other experts we spoke with highlighted several interventions that they maintain likely helped to mitigate the severity of the 2007-2009 financial crisis. These interventions included providing emergency funding to support several key credit markets through the Federal Reserve’s emergency credit and liquidity programs; extending federal government guarantees to a broader range of private sector liabilities through FDIC’s Temporary Liquidity Guarantee Program (TLGP) and Treasury’s Money Market Fund Guarantee Program; recapitalizing financial firms through Treasury’s Troubled Asset Relief Program’s Capital Purchase Program; and taking actions with respect to individual firms, such as Fannie Mae, Freddie Mac, American International Group (AIG), Citigroup, and Bank of America, to avert further destabilization of financial markets. Many experts maintain that these large-scale interventions, in combination with other government actions, such as the stress tests, helped to restore confidence in the financial system and bring about a recovery in certain private credit markets in 2009. In contrast, other experts argue that certain federal government actions worsened, rather than mitigated, the severity of the financial crisis. For example, some experts maintain that the federal government’s rescue of Bear Stearns but not Lehman Brothers sent a conflicting signal to the market and contributed to a more severe panic. Some experts also have commented that government assistance to the financial and housing sectors may have slowed the economic recovery by preventing a full correction of asset prices. Many experts agree that several (if not all) of the federal government’s policy interventions likely averted a more severe crisis in the short-run and that the long-term implications of these interventions remain to be seen. Experts generally agree that the government actions to assist the financial sector may have increased moral hazard—that is, such actions may have encouraged market participants to expect similar emergency actions in the future, thus weakening private incentives to properly manage risks and creating the perception that some firms are too big to fail. Increased moral hazard could result in future costs for the government if reduced private sector incentives to manage risks contribute to a future financial crisis. Although the financial performance of the federal government’s assistance to the financial sector can be measured in different ways, most of the federal government’s major programs earned accounting income in excess of accounting losses and the net losses for some interventions are expected to be small relative to the overall increase in the federal debt. For example, the Federal Reserve reported that all loans made under its emergency programs that have closed were repaid with interest and does not project any losses on remaining loans outstanding. Under FDIC’s TLGP, program participants, which included insured depository institutions and their holding companies, paid fees on debt and deposits guaranteed by the program; these fees created a pool of funds to absorb losses. According to FDIC data, as of November 30, 2012, FDIC had collected $11.5 billion in TLGP fees and surcharges, and this amount is expected to exceed the losses from the program. In contrast, Treasury’s investments in Fannie Mae and Freddie Mac under the Senior Preferred Stock Purchase Agreements program represent the federal government’s single largest risk exposure remaining from its emergency actions to assist the financial sector. Cumulative cash draws by the GSEs under this program totaled $187.4 billion as of September 30, 2012, and Treasury reported a contingent liability of $316.2 billion for this program as of September 30, 2011. As of September 30, 2012, Fannie Mae and Freddie Mac had paid Treasury a total of $50.4 billion in dividends on these investments. The amount that Treasury will recoup from these investments is uncertain. Table 2 provides an overview of income and losses from selected federal government interventions to assist the financial sector. In our prior work, we have described how the national recession that coincided with the 2007-2009 financial crisis added to the fiscal challenges facing the state and local sectors. Declines in output, income, and employment caused state and local governments to collect less revenue at the same time that demand for social welfare services they provide was increasing. During the most recent recession, state and local governments experienced more severe and long-lasting declines in revenue than in past recessions. Because state governments typically face balanced budget requirements and other constraints, they adjust to this situation by raising taxes, cutting programs and services, or drawing down reserve funds, all but the last of which amplify short-term recessionary pressure on households and businesses. Local governments may make similar adjustments, unless they can borrow to make up for reduced revenue. The extent to which state and local governments took such actions was impacted by the federal government’s policy responses to moderate the downturn and restore economic growth. Under the Recovery Act, the federal government provided $282 billion in direct assistance to state and local governments to help offset significant declines in tax revenues. States have been affected differently by the 2007-2009 recession. For example, the unemployment rate in individual states increased by between 1.4 and 6.8 percentage points during the recession. Recent economic research suggests that while economic downturns within states generally occur around the same time as national recessions, their timing and duration vary. States’ differing characteristics, such as industrial structure, contribute to these differences in economic activity. Declines in state and local pension asset values stemming from the 2007- 2009 recession also could affect the sector’s long-term fiscal position. In March 2012, we reported that while most state and local government pension plans had assets sufficient to cover benefit payments to retirees for a decade or more, plans have experienced a growing gap between assets and liabilities. In response, state and local governments have begun taking a number of steps to manage their pension obligations, including reducing benefits and increasing member contributions. The Dodd-Frank Act contains several provisions that may benefit the financial system and the broader economy, but the realization of such benefits depends on a number of factors. Our review of the literature and discussions with a broad range of financial market regulators, participants, and observers revealed no clear consensus on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future crisis. Nevertheless, many of these experts identified a number of the same reforms that they expect to enhance financial stability, at least in principle, and help reduce the probability or severity of a future crisis. At the same time, such experts generally noted that the benefits are not assured and depend on, among other things, how regulators implement the provisions and whether the additional regulations result in financial activity moving to less regulated institutions or markets. Several experts also commented that the act also could enhance consumer and investor protections. While estimating the extent to which the act may reduce the probability of a future crisis is difficult and subject to limitations, studies have found statistical evidence suggesting that certain reforms are associated with a reduction in the probability of a crisis. Through our review of the literature and discussions with a broad range of financial market regulators, academics, and industry and public interest group experts, we found no clear consensus on the extent to which, if at all, the Dodd-Frank Act will help reduce the probability or severity of a future financial crisis. However, representatives of these groups identified many of the same provisions in the act that they expect to enhance financial stability, at least in principle, and help reduce the probability or severity of a future crisis. These provisions include the following: Creation of FSOC and OFR: The act created FSOC and OFR to monitor and address threats to financial stability. Heightened prudential standards for systemically important financial institutions (SIFI): The act requires that all SIFIs be subjected to Federal Reserve supervision and enhanced capital and other prudential standards. SIFIs include bank holding companies with $50 billion or more in total consolidated assets and nonbank financial companies designated by FSOC for such supervision. Orderly Liquidation Authority: The act provides regulators with new authorities and tools to manage the failure of a large financial company in a way designed to avoid taxpayer-funded bailouts and mitigate the potential for such failures to threaten the stability of the financial system. Regulation of swaps: The act establishes a comprehensive regulatory framework for swaps. Mortgage-related and other reforms: The act includes provisions to modify certain mortgage lending practices, increase regulation of asset-backed securitizations, and restrict proprietary trading by large depository institutions. Experts had differing views on these provisions, but many expect some or all of the provisions to improve the financial system’s resilience to shocks and reduce incentives for financial institutions to take excessive risks that could threaten the broader economy. While acknowledging these potential financial stability benefits, experts generally were cautious in their assessments for several reasons. Specifically, the effectiveness of certain provisions will depend not only on how regulators implement the provisions through rulemaking or exercise their new authorities but also on how financial firms react to the new rules, including whether currently regulated financial activity migrates to less regulated institutions or markets. In addition, a few experts with whom we spoke said that some of the act’s provisions could increase systemic risk and, thus, have adverse effects on financial stability. Further, it may be neither possible nor necessarily desirable for the Dodd-Frank Act or any other legislation to prevent all future financial crises, in part because of the tradeoff inherent between financial stability and economic growth. The 2007-2009 financial crisis highlighted the lack of an agency or mechanism responsible for monitoring and addressing risks across the financial system and a shortage of readily available information to facilitate that oversight. We reported in July 2009 that creating a new body or designating one or more existing regulators with the responsibility to oversee systemic risk could serve to address a significant gap in the current U.S. regulatory system. Before the Dodd-Frank Act’s passage, federal financial regulators focused their oversight more on individual financial firms (called microprudential regulation) and less on market stability and systemic risk (called macroprudential regulation). However, the recent crisis illustrated the potential for one financial firm’s distress to spill over into the broader financial system and economy. For example, the failures and near-failures of Lehman Brothers, AIG, Fannie Mae, Freddie Mac, and other large financial institutions contributed to the instability experienced in the financial system during the crisis. The crisis also illustrated the potential for systemic risk to be generated and propagated outside of the largest financial firms (such as by money market mutual funds), in part because of interconnections not only between firms but also between markets. According to some academics and other market observers, a significant market failure revealed by the recent crisis was that the market did not discourage individual financial firms from taking excessive risks that could impose costs on others, including the public. Such spillover costs imposed on others are known as negative externalities, and government intervention may be appropriate to address such externalities. The Dodd-Frank Act established FSOC to provide, for the first time, an entity charged with the responsibility for monitoring and addressing sources of systemic risk. The act also created OFR to support FSOC and Congress by providing financial research and data. FSOC is authorized, among other things, to collect information across the financial system from member agencies and other government agencies, so that regulators will be better prepared to address emerging threats; designate certain nonbank financial companies for supervision by the Federal Reserve and subject them to enhanced prudential standards; designate as systemically important certain financial market utilities and payment, clearing, or settlement activities, and subject them to enhanced regulatory oversight; recommend stricter standards for the large, interconnected bank holding companies and nonbank financial companies designated for enhanced supervision; vote on any determination by the Federal Reserve that action should be taken to break up a SIFI that poses a “grave threat” to U.S. financial stability; facilitate information sharing and coordination among the member agencies to eliminate gaps in the regulatory structure; and make recommendations to enhance the integrity, efficiency, competitiveness, and stability of U.S. financial markets, promote market discipline, and maintain investor confidence. Financial market regulators, academics, and industry and public interest groups with whom we spoke generally view the creation of FSOC and OFR as positive steps, in principle, to address systemic risk and help identify or mitigate a future crisis for several reasons. First, FSOC and its member agencies now have explicit responsibility for taking a macroprudential approach to regulation, along with tools and authority to help identify and address threats to the financial stability of the United States. For example, certain nonbank financial companies posed systemic risk during the crisis but were subject to less regulation than bank holding companies. To close this regulatory gap, FSOC has the authority to designate a nonbank financial company for supervision by the Federal Reserve and subject it to enhanced prudential standards, if the material distress of that firm could pose a risk to U.S. financial stability. In addition, although the Dodd-Frank Act does not address all sources of systemic risk, the act authorizes FSOC to make recommendations to address regulatory gaps or other issues that threaten U.S. financial stability. For example, FSOC’s 2011 and 2012 annual reports discuss financial stability threats not directly addressed by the Dodd-Frank Act (e.g., money market mutual funds, tri-party repurchase agreements, and the GSEs) and make recommendations to address some of them. Finally, OFR may play an important role in gathering and analyzing data that FSOC and its members will be able to use to identify and address emerging risks to the financial system. OFR may also facilitate data sharing among the regulators, which may enable regulators to identify risks in areas emerging from beyond their immediate jurisdictions. Market participants also may benefit from the ability to use OFR data to analyze risks. Experts also identified a number of factors that could limit FSOC’s or OFR’s effectiveness. First, it is inherently challenging for a regulator to identify and address certain sources of systemic risk. For example, while asset price bubbles often become clear in hindsight, when such risks appear to be building, policymakers may disagree over whether any intervention is warranted. Second, FSOC’s committee structure cannot fully resolve the difficulties inherent in the existing, fragmented regulatory structure. For example, FSOC could encounter difficulties coming to decisions or advancing a reform if it faces resistance from one or more of its members. In addition, FSOC’s committee structure, including the Treasury Secretary’s role as FSOC chair, could subject FSOC’s decision making to political influence. According to a number of experts, establishing FSOC and OFR as independent entities could have better insulated them from political pressures that could dissuade them from recommending or taking actions to promote long-term financial stability, if such actions imposed short-term political costs. On the other hand, the selection of the Treasury Secretary as FSOC chair reflects the Treasury Secretary’s traditional role in financial policy decisions. In a recent report, we identified a number of potential challenges for FSOC, some of which are similar to those discussed above. Specifically, we noted that key components of FSOC’s mission—to identify risks to U.S. financial stability and respond to emerging threats to stability—are inherently challenging. Risks to the stability of the U.S. financial system are difficult to identify because commonly used indicators, such as market prices, often do not reflect these risks and threats may not develop in precisely the same way as they did in past crises. Although the act created FSOC to provide for a more comprehensive view of threats to U.S. financial stability, it left most of the pre-existing fragmented and complex arrangement of independent federal and state regulators in place and generally preserved their statutory responsibilities. Further, we noted that FSOC does not have the authority to force agencies to coordinate or adopt compatible policies and procedures. However, we also reported that FSOC and OFR have made progress in establishing their operations and approaches for monitoring threats to financial stability, but these efforts could be strengthened. We made recommendations to strengthen the accountability and transparency of FSOC’s and OFR’s decisions and activities as well as to enhance collaboration among FSOC members and with external stakeholders. In response to our recommendations, Treasury emphasized the progress that FSOC and OFR have made since their creation and noted that more work remains, as they are relatively new organizations. The 2007-2009 financial crisis also revealed weaknesses in the existing regulatory framework for overseeing large, interconnected, and highly leveraged financial institutions. Such financial firms were subject to some form of federal supervision and regulation, but these forms of supervision and regulation proved inadequate and inconsistent. For example, fragmentation of supervisory responsibility allowed owners of banks and other insured depository institutions to choose their own regulator. In addition, regulators did not require firms to hold sufficient capital to cover their trading and other losses or to plan for a scenario in which liquidity was sharply curtailed. Moreover, the regulatory framework did not ensure that banks fully internalized the costs of the risks that their failure could impose on the financial system and broader economy. The Dodd-Frank Act requires the Federal Reserve to supervise and develop enhanced capital and other prudential standards for SIFIs, which include bank holding companies with $50 billion or more in consolidated assets and any nonbank financial company that FSOC designates. The act requires the enhanced prudential standards to be more stringent than standards applicable to other bank holding companies and financial firms that do not present similar risks to U.S. financial stability. The act further allows the enhanced standards to increase in stringency based on the systemic footprint and risk characteristics of each firm. The Federal Reserve plans to implement some of its enhanced standards in conjunction with its implementation of Basel III, a new capital regime developed by the Basel Committee on Banking Supervision. The act’s provisions related to SIFIs include the following: Risk-based capital requirements and leverage limits: The Federal Reserve must establish capital and leverage standards, which as proposed would include a requirement for SIFIs to develop capital plans to help ensure that they maintain capital ratios above specified standards, under both normal and adverse conditions. In addition, the Federal Reserve has announced its intention to apply capital surcharges to some or all SIFIs based on the risks SIFIs pose to the financial system. Liquidity requirements: The Federal Reserve must establish SIFI liquidity standards, which as proposed would include requirements for SIFIs to hold liquid assets that can be used to cover their cash outflows over short time periods. Single-counterparty credit limits: The Federal Reserve must propose rules that, in general, limit the total net credit exposure of a SIFI to any single unaffiliated company to 25 percent of its total capital stock and surplus. Risk management requirements: Publicly traded SIFIs must establish a risk committee and be subject to enhanced risk management standards. Stress testing requirements: The Federal Reserve is required to conduct an annual evaluation of whether SIFIs have sufficient capital to absorb losses that could arise from adverse economic conditions. Debt-to-equity limits: Certain SIFIs may be required to maintain a debt-to-equity ratio of no more than 15-to-1. Early remediation: The Federal Reserve is required to establish a regulatory framework for the early remediation of financial weaknesses of SIFIs in order to minimize the probability that such companies will become insolvent and the potential harm of such insolvencies to the financial stability of the United States. A broad range of financial market regulators, academics, and industry and public interest group experts generally expect the enhanced prudential standards to help increase the resilience of SIFIs and reduce the potential for a SIFI’s financial distress to spill over to the financial system and broader economy. Higher capital levels increase a firm’s resilience during times of financial stress because more capital is available to absorb unexpected losses. Similarly, increased liquidity (e.g., holding more liquid assets and reducing reliance on short-term funding sources) can reduce the likelihood that a firm will have to respond to temporary strains in credit markets by cutting back on new lending or selling assets at depressed prices. Increased capital and liquidity levels together can limit the potential for large, unexpected losses in the financial system to disrupt the provision of credit and other financial services to households and businesses, which occurred in the most recent financial crisis. Finally, limiting counterparty credit exposures also can help to minimize spillover effects. A number of experts viewed the act’s enhanced prudential standards for SIFIs as particularly beneficial, because such institutions pose greater risks to the orderly functioning of financial markets than less systemically significant institutions, and subjecting SIFIs to stricter standards can cause them to internalize the costs of the risks they pose to the system. For example, the Federal Reserve intends to issue a proposal that would impose capital surcharges on SIFIs based on a regulatory assessment of the systemic risk they pose, consistent with a framework agreed to by the Basel Committee. In addition, the Dodd-Frank Act’s enhanced prudential standards provisions allow federal regulators to impose more stringent risk management standards and oversight of SIFIs’ activities, including by conducting stress tests, to help ensure that weaknesses are addressed before they threaten the financial system. Experts noted that these stricter standards, including the surcharges, could serve as a disincentive to financial firms to become larger or otherwise increase the risks they pose to the broader financial system. Despite generally supporting an increase in the capital requirements, experts questioned the potential effectiveness of certain aspects of the enhanced prudential standards for SIFIs: Impact on “too-big-to-fail” perceptions: Experts suggested that the market may view SIFIs as too big to fail, paradoxically giving such firms an implicit promise of government support if they run into financial difficulties. As discussed below, perceptions that SIFIs are too big to fail can weaken incentives for creditors to restrain excessive risk-taking by SIFIs and could give such firms a funding advantage over their competitors. However, others noted that the heightened standards were specifically designed to address these issues and view the act as explicitly prohibiting federal government support for SIFIs. For example, the act revises the Federal Reserve Act to prohibit the Federal Reserve from providing support to individual institutions in financial distress and, as discussed below, the act creates a new option for liquidating such firms. Limits of Basel approach to capital standards: The Federal Reserve will base its enhanced regulatory capital standards, in part, on Basel’s approach, which several experts view as having limitations. They recognized that the Basel III standards address some of the limitations that the financial crisis revealed in the regulatory capital framework, but maintain that Basel III continues to place too much reliance on risk-based approaches to determining capital adequacy. During the 2007-2009 crisis, some banks experienced capital shortages, in part because they suffered large losses on assets that were assigned low risk weights under Basel’s standards but posed greater risk than their risk weights. The Basel III framework will increase risk weights for certain asset classes—and includes a leverage ratio as a safeguard against inaccurate risk weights—but experts noted that the potential remains for financial institutions to “game” the Basel risk weights by increasing holdings of assets that carry risk-weights that are lower than their actual risks. In addition, some experts maintain that the Basel standards overall may not provide a sufficient buffer to protect firms during times of stress. However, one regulator noted that the leverage ratio, and the higher requirements for common equity and tier 1 capital called for in the Basel III standards, represent a significant tightening of capital regulation (in combination with the imposition of some higher risk weights and better quality of capital). Implementation of these SIFI provisions is ongoing. In January 2012, the Federal Reserve proposed rules to implement the enhanced prudential standards, but has not yet finalized all of these rules. In addition, the Federal Reserve and other federal prudential regulators are continuing to work to implement Basel III. As of December 2012 FSOC had not yet designated any nonbank financial companies for Federal Reserve supervision; the Federal Reserve will subsequently be responsible for developing rules for the heightened capital and other prudential standards for these entities. Faced with the impending failure of a number of large financial companies during the 2007-2009 financial crisis, federal financial regulators generally had two options: (1) allowing these companies to file for bankruptcy at the risk of exacerbating the crisis (e.g., Lehman Brothers) or (2) providing such companies with emergency funding from the government at the risk of increasing moral hazard (e.g., AIG). As we previously reported, traditional bankruptcy may not be effective or appropriate for financial companies for a variety of reasons. For example, in bankruptcy proceedings for companies that hold derivatives or certain other qualified financial contracts, creditors may terminate such contracts, even though creditors generally may not terminate other contracts because they are subject to automatic stays. Termination of derivative contracts can lead to large losses for the failed firm and other firms through fire sales and other interconnections. For example, the insolvency of Lehman Brothers had a negative effect on financial stability by contributing to a run on money market mutual funds and disrupting certain swaps markets. Further, bankruptcy is a domestic legal process that varies by jurisdiction. Thus, the bankruptcy of a financial company with foreign subsidiaries, such as Lehman Brothers, can raise difficult international coordination challenges. In contrast to the Lehman case, the government provided support to some financial firms, such as AIG, because of concerns that their failures would further disrupt the broader financial system. A number of experts maintain this government assistance increased moral hazard by encouraging market participants to expect similar emergency actions in future crises for large, interconnected financial institutions—in effect, reinforcing perceptions that some firms are too big to fail. The perception of certain firms as too big to fail weakens market discipline by reducing the incentives of shareholders, creditors, and counterparties of these companies to discipline excessive risk taking. For example, creditors and shareholders may not demand that firms they view as too big to fail make adequate disclosures about these risks, which could further undermine market discipline. Perceptions that firms are too big to fail also can produce competitive distortions because companies perceived as ‘too big to fail’ may be able to fund themselves at a lower cost than their competitors. The Dodd-Frank Act’s Title II provides the federal government with a new option for resolving failing financial companies by creating a process under which FDIC has the authority to liquidate large financial companies, including nonbanks, outside of the bankruptcy process—called orderly liquidation authority (OLA). In general, under this authority, FDIC may be appointed receiver for a financial firm if the Treasury Secretary determines that the firm’s failure would have a serious adverse effect on U.S. financial stability. Under OLA, FDIC must maximize the value of the firm’s assets, minimize losses, mitigate systemic risk, and minimize moral hazard. OLA also establishes additional authorities for FDIC as receiver, such as the ability to set up a bridge financial company and to borrow funds from the Treasury to carry out the liquidation. FDIC can subsequently collect funding for the OLA process from the financial industry after a company has been liquidated. A range of financial market regulators, academics, and industry and public interest group experts identified a number of ways in which the Dodd-Frank Act’s OLA provisions could help mitigate threats to the financial system posed by the failure of SIFIs or other large, complex, interconnected financial companies. First, the OLA framework may be effective in addressing the limitations of the bankruptcy process. For example, experts noted that under OLA, FDIC will be able to control the liquidation process and can temporarily prevent creditors from terminating their qualified financial contracts, the termination of which could prompt fire sales that could be destabilizing. Second, under its rules, FDIC has indicated that it will ensure that creditors and shareholders of a company in OLA will bear the losses of the company. By helping to ensure that creditors and shareholders will bear losses in the event of a failure, OLA could strengthen incentives for creditors and shareholders to monitor these firms’ risks. Finally, OLA could help convince market participants that government support will no longer be available for SIFIs, which could increase investors’ incentives to demand that SIFIs become more transparent and refrain from taking excessive risks. Experts also identified a number of potential challenges and limitations of OLA. OLA is new and untested, and its effectiveness in reducing moral hazard will depend on the extent to which the market believes FDIC will use OLA to make creditors bear losses of any SIFI failure. Experts identified a conflict between OLA’s goal of eliminating government bailouts on one hand and minimizing systemic risk on the other. For example, if FDIC imposes losses on some creditors of a failed SIFI, these losses could cause other SIFIs to fail. In that regard, some experts observed that governments historically have not allowed potentially systemically important financial firms to fail during a crisis and question whether a different outcome can be expected in the future. Moreover, experts questioned whether FDIC has the capacity to use OLA to handle multiple SIFI failures, which might occur during a crisis. Another concern is that OLA will be applied to globally active financial institutions, and how FDIC and foreign regulators will handle the non-U.S. subsidiaries of a failed SIFI remains unclear. In addition, SIFIs must formulate and submit to their regulators resolution plans (or “living wills”) that detail how they could be resolved in bankruptcy should they encounter financial difficulties. Experts noted that resolution plans may provide regulators with critical information about a firm’s organizational structure that could aid the resolution process. The plans also could motivate SIFIs to simplify their structures, and this simplification could help facilitate an orderly liquidation. However, other experts commented that while resolution plans may assist regulators in gaining a better understanding of SIFI structures and activities, the plans may not be useful guides during an actual liquidation—in part because of the complex structures of the institutions or because the plans may not be helpful during a crisis. Resolution plans also may provide limited benefits in simplifying firm structures, in part because tax, jurisdictional, and other considerations may outweigh the benefits of simplification. FDIC has finalized key OLA rules and is engaged in a continuing process of clarifying how certain aspects of the OLA process would work. For example, FDIC officials have clarified that the OLA process will focus on the holding company level of the firm, and stated that the creation of the bridge institution will help ensure that solvent subsidiaries may continue to function. In addition, FDIC and the Federal Reserve are in the process of reviewing the first set of resolution plans, which were submitted in July 2012. Except for credit default swaps (CDS)—a type of derivative used to hedge or transfer credit risk—other over-the-counter (OTC) swaps and derivative contracts generally were not central to the systemwide problems encountered during the financial crisis, according to FSOC. Nonetheless, FSOC noted that OTC derivatives generally were a factor in the propagation of risks during the recent crisis because of their complexity and opacity, which contributed to excessive risk taking, a lack of clarity about the ultimate distribution of risks, and a loss in market confidence. In contrast to other OTC derivatives, credit default swaps exacerbated the 2007-2009 crisis, particularly because of AIG’s large holdings of such swaps, which were not well understood by regulators or other market participants. Furthermore, the concentration of most OTC derivatives trading among a small number of dealers created the risk that the failure of one of these dealers could expose counterparties to sudden losses and destabilize financial markets. While some standardized swaps, such as interest rate swaps, have traditionally been cleared through clearinghouses—which stand between counterparties in assuming the risk of counterparty default—most CDS and most other swaps have been traded in the OTC market where holders of derivatives contracts bear the risk of counterparty default. In addition, swaps traded in the OTC market have typically featured an exchange of margin collateral to cover current exposures between the two parties, but not “initial” margin to protect a nondefaulting party against the cost of replacing the contract if necessary. As of the end of the second quarter of 2012, the outstanding notional value of derivatives held by insured U.S. commercial banks and savings associations totaled more than $200 trillion. As noted earlier, Title VII of the Dodd-Frank Act, also known as the Wall Street Transparency and Accountability Act of 2010, establishes a new regulatory framework for swaps to reduce risk, increase transparency, and promote market integrity in swaps markets. Among other things, Title VII generally provides for the registration and regulation of swap dealers and major swap participants, including subjecting them to (1) prudential regulatory requirements, such as minimum capital and minimum initial and variation margin requirements and (2) business conduct requirements to address, among other things, interaction with counterparties, disclosure, and supervision; imposes mandatory clearing requirements on swaps but exempts certain end users that use swaps to hedge or mitigate commercial risk; requires swaps subject to mandatory clearing to be executed on an organized exchange or swap execution facility, which promotes pre- trade transparency (unless no facility offers the swap for trading); and requires all swaps to be reported to a registered swap data repository or, if no such repository will accept the swap, to CFTC or SEC, and subjects swaps to post-trade transparency requirements (real-time public reporting of swap data). Figure 8 illustrates some of the differences between swaps traded on exchanges and cleared through clearinghouses and swaps traded in the OTC market. A broad range of financial market regulators, participants, and observers expect various provisions under Title VII to help promote financial stability, but they also identified potential obstacles or challenges. Clearing through clearinghouses: According to experts, the clearing of swaps through clearinghouses could be beneficial. Clearing can reduce the vulnerability of the financial system to the failure of one or a few of the major swap dealers by transferring credit risk from the swap counterparties to the clearinghouse. By becoming the central counterparty in every trade, a clearinghouse can provide multilateral netting efficiencies to reduce counterparty credit and liquidity risks faced by market participants. Unlike dealers, clearinghouses do not take positions on the trades they clear and may have stronger incentives to develop effective risk management measures and monitor their members’ financial condition. In addition, clearinghouses have tools to mitigate counterparty credit risk, for instance, initial and variation margin, as well as the ability to assess their members for additional financial contributions. At the same time, experts have pointed out that clearinghouses concentrate credit risk and thus represent a potential source of systemic risk. For example, a former regulatory official told us that, in her opinion, clearinghouses essentially are too big to fail, given that the Dodd-Frank Act includes provisions mandating centralized clearing of standardized swaps and authorizing the Federal Reserve to provide emergency liquidity to systemically important clearinghouses provided certain conditions are met. Others commented that clearinghouses may be engaged in clearing less standardized or illiquid products, which could pose risk- management challenges for clearinghouses and expose them to greater risks. Margin requirements: Experts expect the margin requirements for uncleared swaps with swap dealers and major swap participants to help promote financial stability by helping to ensure that market participants have enough collateral to absorb losses. For example, imposing both initial and variation margin requirements on uncleared swaps could help prevent the type of build-up of large, uncollateralized exposures experienced by AIG. Some experts commented that margin requirements, depending how they are implemented, could have a negative impact on liquidity if there is not a sufficient supply of quality securities that can be posted as collateral to meet margin requirements. Reporting requirements: Many experts generally expect the swaps reforms that improve transparency to benefit the financial system. For example, the requirement for regulatory reporting of swaps transactions may provide regulators with a better understanding of the current risks in the swaps market and help enhance their oversight of the market. Similarly, public reporting of swap data could benefit market participants by providing them with data on prices and other details about swaps that they can use to better assess their risks. A number of industry representatives noted that the public reporting requirement could lead some market participants to reduce their participation out of fear that others can take advantage of such information. In their view, this could result in a loss of liquidity to the system. CFTC and SEC have finalized many of the regulations needed to implement Title VII, though several had yet to be finalized as of December 2012. OTC derivatives are globally traded, and many other jurisdictions are in the process of developing new regulatory regimes. However, the United States is one of the first jurisdictions to have enacted legislation in this area. Indeed, the implementation of at least one derivatives-related provision has already been delayed because of the importance of coordinating with international entities. The outcome of the reform process in other jurisdictions will determine the extent to which U.S. firms could be at a competitive advantage or disadvantage. (See app. II for a description of international coordination efforts.) While the previously discussed Dodd-Frank Act provisions were commonly cited as the most important ones for enhancing U.S. financial stability, several financial market regulators, participants, and observers we spoke with identified other provisions that they expect to help enhance financial stability. As with the provisions discussed above, certain key rules implementing the following provisions have not yet been finalized. Mortgage-related reforms: According to experts, problems in the mortgage market, particularly with subprime mortgages, played a central role in the recent financial crisis, and the act’s mortgage- related reforms may help prevent such problems in the future. Some bank and nonbank mortgage lenders weakened their underwriting standards and made mortgage loans to homebuyers who could not afford them or engaged in abusive lending practices before the crisis. These factors, along with the decline in housing prices, contributed to the increase in mortgage defaults and foreclosures. A number of the act’s provisions seek to reform the mortgage market—for example, by authorizing CFPB to supervise nonbank mortgage lenders and by prohibiting certain mortgage lending practices, such as issuing mortgage loans without making a reasonable and good faith effort to determine that the borrower has a reasonable ability to repay. Some industry representatives have expressed concerns that these reforms could prevent certain potential homebuyers from being able to obtain mortgage loans. However, other experts noted that before the crisis some loans had rates that did not fully reflect their risks, which contributed to an excess of credit, and the act’s reforms may help ensure that loans are accurately priced to reflect risks. Many of the Dodd-Frank Act’s mortgage reforms have not yet been implemented through rulemaking. Risk retention for asset securitizations: According to experts, the securitization of residential mortgages into mortgage-backed securities that subsequently were part of other securitizations also played a central role in the crisis, and the act contains provisions to reform the market. Experts also noted that institutions that created mortgage-backed securities in the lead-up to the crisis engaged in a number of practices that undermined the quality of their securities, including not adequately monitoring the quality of the mortgages underlying their securities, because they did not bear the risk of significant losses if those mortgages defaulted. The act contains provisions that require securitizers of asset-backed securities to retain some “skin in the game” in the form of a certain percentage of the credit risk in asset-backed securities they create. However, experts have different views on the extent to which the level of risk retention for securitizations was central to the problems encountered during the recent crisis, and a few do not view these provisions as potentially beneficial for financial stability. Regulators proposed implementing rules for the provision in 2011 but had yet to finalize the rules as of December 2012. The Volcker rule: The role that proprietary trading—trading activities conducted by banking entities for their own account as opposed to those of their clients—played in the recent crisis is a matter of debate. However, a number of experts maintain that the ability of banking entities to use federally insured deposits to seek profits for their own account provides incentives for them to take on excessive risks. In particular, some have noted that commercial banks that benefit from the federal financial safety net enjoy access to subsidized capital and thus do not bear the full risks of their proprietary trading activities. To address these concerns, section 619 of the Dodd-Frank Act, referred to as the Volcker rule, generally prohibits a banking entity from engaging in proprietary trading or acquiring or retaining more than a certain maximum percentage of any equity, partnership, or other ownership interest in, or sponsoring, a hedge fund or a private equity fund, among other restrictions involving transactions between covered banking entities and sponsored hedge funds and private equity funds. A number of experts view these restrictions as enhancing financial stability by discouraging excessive risk-taking by these institutions. Others, however, have noted that the Volcker rule, by prohibiting certain proprietary activities of these institutions, could have adverse effects on liquidity and, in turn, the unintended effect of undermining financial stability. In 2011, regulators proposed rules to implement the Volcker rule but had not yet finalized them as of December 2012. Financial market regulators, participants, and observers whom we interviewed also identified provisions that may result in benefits beyond increased financial stability. For example, the act may enhance consumer and investor protections and improve economic efficiency. As with the provisions previously noted, the realization of such benefits will depend, in part, on how regulators implement the provisions. Benefits beyond financial stability that experts highlighted include the following: Enhanced consumer protections: The Dodd-Frank Act’s Title X consolidates rulemaking and other authorities over consumer financial products and services under CFPB. The new agency assumes authority to implement consumer protection laws, such as the Truth in Lending Act and Home Ownership and Equity Protection Act of 1994. CFPB could assist consumers by improving their understanding of financial products and services. For example, experts noted that consumers could benefit from CFPB’s efforts, which include providing information on consumer financial products and simplifying disclosures for mortgages, credit cards, and other consumer financial products. Enhanced investor protections: Certain provisions in the act could provide shareholders with greater influence over, and insight into, the activities of publicly traded companies. For example, the act contains provisions that require shareholder advisory votes on executive compensation, disclosure of the ratio between the chief executive officer’s annual total compensation and median annual total compensation for all other employees, and clawback policies for erroneously awarded incentive-based compensation. Improving resource allocation in the economy: Some experts noted that mortgages and related credit instruments were not accurately priced before the crisis to reflect their risks. As a result, the economy experienced a credit bubble that facilitated a misallocation of resources to the housing sector. For example, one expert noted that residential housing construction during the 2000s was excessive and inefficient. To the extent that the act contributes to a more accurate pricing of credit, the economy could benefit from a more efficient allocation of resources across the broader economy. The Dodd-Frank Act’s potential benefit of reducing the probability or severity of a future financial crisis cannot be readily observed and this potential benefit is difficult to quantify. Any analyses must be based on assumptions about, or models of, the economy. Consequently, the results of such analyses are subject to substantial uncertainty. Nonetheless, as we noted previously in this report, a working group of the Basel Committee on Banking Supervision summarized several studies that analyze the costs of financial crises, and that used different macroeconomic models of the economy to estimate the impact of more stringent capital and liquidity standards on the annual likelihood of a financial crisis, and the benefits of avoiding associated output losses. The Basel Committee report suggests that increases in capital and liquidity ratios are associated with a reduction in the probability that a country will experience a financial crisis. Higher capital and liquidity requirements may generate social benefits by reducing the frequency and severity of banking crises and the consequent loss of economic output. The Basel Committee working group found that although there is considerable uncertainty about the exact magnitude of the effect, the evidence suggests that higher capital and liquidity requirements can reduce the probability of banking crises. For example, the models suggest, on average, that if the banking system’s capital ratio—as measured by the ratio of tangible common equity to risk-weighted assets—is 7 percent, then a 1 percentage point increase in the capital ratio is associated with a 1.6 percentage point reduction in the probability of a financial crisis—from 4.6 percent to 3.0 percent per year. The working group also found that if the capital ratio was 7 percent, then a 12.5 percent increase in the ratio of liquid assets to total assets in the banking system is associated with a 0.8 percentage point reduction in the probability of a crisis per year, on average. In addition, the incremental benefits of higher capital requirements are greater when bank capital ratios are increased from lower levels and they decline as standards become progressively more stringent. For example, the models suggest, on average, that the reduction in the likelihood of a crisis is three times larger when the capital ratio is increased from 7 percent to 8 percent than it is when the capital ratio is increased from 10 percent to 11 percent. The further away banks are from insolvency, the lower their marginal benefit is from additional protection. Estimates of the reduced probability of a financial crisis are subject to a number of limitations. For example, researchers note that the reduction in the probability of a crisis depends on the baseline assumptions about the average probability of a crisis before the policy changes—in this case, before the increase in capital requirements. In addition, overall economic conditions, or factors outside of the financial system, also may affect the probability of a financial crisis. The Basel Committee working group also summarized the studies’ estimates of the potential benefits from higher capital and liquidity requirements in terms of economic output gains that could result from a lower probability of a crisis. The studies used estimates of the costs of a crisis to estimate that a 1 percent decrease in the annual probability of a crisis could have a benefit of 0.2 percent to 1.6 percent per year of increased economic output, depending on the extent to which the crisis losses are temporary or permanent. If, for example, annual GDP were $15 trillion (around the size of U.S. GDP) these estimates suggest that the economic benefit in terms of increased GDP could range from approximately $29 billion to about $238 billion per year. These estimates also are subject to limitations, however. As we previously discussed in this report, estimates of financial crisis losses have varied widely depending on the assumptions made. In addition, these models did not take into account variations in responses to higher capital and liquidity requirements among institutions and regulatory environments. Given the difficulty of measuring the extent to which the Dodd-Frank Act may reduce the probability of a future crisis, a few academics have proposed a more conceptual approach for comparing the act’s potential benefits and costs. According to these experts, the benefits of the act can be framed by determining the percent by which the cost of a financial crisis needs to be reduced to be equal to the act’s costs. If the cost of a future crisis is expected to be in the trillions of dollars, then the act likely would need to reduce the probability of a future financial crisis by only a small percent for its expected benefit to equal the act’s expected cost. Although an academic told us this thought exercise helped put the benefits and costs of the Dodd-Frank Act into perspective, it provides no insight into whether the act reduces the probability of a future crisis by even a small percent. The Dodd-Frank Act requires federal agencies and the financial services industry to expend resources to implement or comply with its requirements, and some of its reforms are expected to impose costs on the economy. First, federal agencies are devoting resources to fulfill rule- making and other new regulatory responsibilities created by the act. A large portion of these agency resources are funded by fees paid by industry participants or other revenue sources outside of congressional appropriations, limiting the impact of these activities on the federal budget deficit. Second, the act contains a broad range of reforms that generally are imposing or will impose additional regulations and costs on a correspondingly broad range of financial institutions, including banks, broker-dealers, futures commission merchants, investment advisers, and nonbank financial companies. Given the act’s focus on enhancing financial stability, large, complex financial institutions will likely bear the greatest costs, but smaller financial institutions and other financial market participants also will incur costs. Third, by imposing costs on the financial services industry, the act also may impose costs on the broader economy and reduce output. For example, financial institutions may charge their customers more for credit or other financial services. While the act’s costs can be viewed as the price to be paid to achieve a more resilient financial system and other benefits, some industry representatives question whether the costs, individually or cumulatively, are excessive. Furthermore, observers have also expressed concerns about potential unintended consequences of the act, such as reducing the competiveness of U.S. financial institutions in the global financial marketplace. The amount of funding that 10 federal financial entities have reported as associated with their implementation of the Dodd-Frank Act varied significantly from 2010 through 2013, and the amounts have been increasing for some of these entities. Funding resources associated with the Dodd-Frank Act’s implementation from 2010 through 2012 ranged from a low of $4.3 million for FHFA to a high of $432.3 million for CFPB (see table 2). In addition, funding associated with the act’s implementation increased from 2011 through 2012 for all but one of the agencies, FHFA, and more than doubled for four entities: OFR, FSOC, CFPB, and OCC. Three of these four entities—OFR, FSOC, and CFPB— were created through the Dodd-Frank Act and thus are in the process of establishing management structures and mechanisms to carry out their missions. Likewise, according to CFPB and OFR, while some of their funding was used for recurring staffing costs, other funding was used for start-up costs, such as systems development, contractor support, and data purchases. According to FSOC and OFR, the increase in funding is directly proportional to the growth in their staffing and reflects an increase in the size and scope of their organizations. Some new funding resources reported by agencies may represent transfers between entities rather than new funding resources. For example, the large increase in Dodd- Frank-related funding for OCC between 2011 and 2012 reflects OCC’s integration of OTS responsibilities and staff, according to OCC officials. In addition, new funding resources for CFPB include some funding resources transferred from the Federal Reserve. In such cases, these new funding resources do not represent an incremental cost of the act’s implementation. To meet their Dodd-Frank-related responsibilities, federal entities reported that they have hired new staff, redirected staff from other areas, or used staff transferred from other entities. The number of full-time equivalents (FTE) reported by the 10 federal entities as associated with their implementation of the act also varied significantly from 2010 through 2013, and the amounts have been increasing for some entities (see table 3). The entities’ estimates of new FTEs related to implementing the Dodd- Frank provisions for 2010 through 2012 ranged from a low of 18 for FHFA to a high of 964 for the Federal Reserve. Some new FTEs reported by agencies represent transfers of staff between agencies rather than new hires. New FTEs for OCC in 2011 include staff transferred from OTS. In addition, new FTEs for CFPB include staff transferred from the agencies whose consumer protection responsibilities were transferred to CFPB. In such cases where new FTEs for an entity have resulted from a transfer of existing regulatory responsibilities between entities, these new FTEs do not represent an incremental cost of the act’s implementation. A large portion of the federal entities’ resources devoted to the act’s implementation are funded by fees paid by regulated institutions or other sources outside the congressional appropriations process, limiting the impact of these activities on the federal budget deficit. Seven of the entities (CFPB, FSOC, OFR, FDIC, FHFA, OCC, and the Federal Reserve) are funded in full through assessments, fees, or other revenue sources and, thus, have not received any congressional appropriations. Moreover, FSOC and OFR are funded by assessments on large bank holding companies and nonbank financial companies designated by FSOC for supervision by the Federal Reserve. SEC receives appropriations, but SEC collects transaction fees and assessments that are designed to recover the costs to the federal government of its annual appropriation. CFPB receives a mandatory transfer of funding from the Federal Reserve, subject to certain limits, but may request discretionary appropriations. Treasury and CFTC are funded through congressional appropriations. Although entities’ funding resources and staff have increased due to implementation of the act, these increases are not expected to have a significant impact on the federal deficit. In 2011, CBO estimated that the Dodd-Frank Act would reduce federal deficits by $3.2 billion over the period from 2010 to 2020. CBO projected that the act would increase revenues by $13.4 billion and increase direct spending by $10.2 billion over this period. While CBO’s analysis did not consider the potential impacts of the act’s reforms on economic growth, its estimates suggest that the size of the act’s direct impacts on federal spending is small relative to total federal net outlays of $3.6 trillion in fiscal year 2011. While fees and assessments paid by financial institutions to the federal entities help to limit the act’s direct impacts on the federal budget deficit, they represent a cost to these institutions and could have indirect impacts on the economy, as discussed later in this report. In collecting and analyzing this information, we found challenges and limitations that affected our efforts to aggregate the data. For example, agencies told us that their reported funding and FTE resources for 2013 reflect their best estimates of the level of resources required to implement existing and new responsibilities but stated that these estimates were uncertain. As shown in tables 3 and 4, a few agencies did not provide projections for 2013 resources related to the act’s implementation. In addition, not all of the federal entities are on a federal fiscal year, so the reported budgetary activities for some entities cover different time frames. Moreover, the entities may have used different approaches to estimate the funding and FTE resources, potentially making the figures harder to compare across entities. The Dodd-Frank Act’s provisions and regulations generally impose or are expected to impose costs on banks and other financial institutions. According to some academics and others, certain types of costs imposed by the act on financial institutions serve to make such institutions internalize costs that they impose on others through their risk-taking and thereby reduce the risk that they pose to the financial system. The extent to which the act imposes costs on financial institutions may vary among not only different types of financial firms (e.g., banks versus nonbank financial companies) but also among the same types of firms (e.g., large banks versus small banks). In discussions with regulators, industry representatives, and other experts, we identified two main categories of financial impacts on financial institutions: (1) increased regulatory compliance and other costs and (2) reduced revenue associated with new restrictions on certain activities. However, as commonly noted by financial firms in their annual reports, the Dodd-Frank Act’s full impact on their businesses, operations, and earnings remains uncertain, in part because of the rulemakings that still need to be completed. For example, in its 2012 annual report, one large bank holding company noted that it could not quantify the possible effects of the significant changes that were under way on its business and operations, given the status of the regulatory developments. Furthermore, even when the reforms have been fully implemented, it may not be possible to determine precisely the extent to which observed costs can be attributed to the act versus other factors, such as changes in the economy. No comprehensive data are readily available on the costs that the financial services industry is incurring to comply with the Dodd-Frank Act. Representatives from financial institutions and industry associations told us that firms generally do not track their incremental costs for complying with the act. Moreover, they said that the piecemeal way that the act is being implemented makes it difficult to measure their regulatory costs. Likewise, none of the industry associations we met with are tracking the incremental costs that their members are incurring to comply with the act. Regulators and others have collected some data on certain compliance costs. Specifically, federal agencies typically estimate the cost of complying with any recordkeeping and reporting requirements of their rules under the Paperwork Reduction Act, but these estimates do not capture other types of compliance costs, which can be more substantial. For example, an SEC rule on asset-backed securities requires issuers of such securities to conduct, or hire a third party to conduct, a review of the assets underlying the securities; this cost is not a paperwork-related cost and thus not included in the compliance costs captured under the Paperwork Reduction Act. In May 2012, the Treasury Secretary asked the Federal Reserve’s Federal Advisory Council, a group of bank executives, to prepare a study to provide regulators with more specific examples of the regulatory burdens imposed by the act’s reforms. A number of the Dodd-Frank Act provisions target large financial firms and are expected to increase their compliance or other costs more significantly than for other financial firms. In particular, several provisions specifically apply to SIFIs, which include bank holding companies with $50 billion or more in total consolidated assets (which we refer to as “bank SIFIs”) and nonbank financial companies designated by FSOC for supervision by the Federal Reserve. Examples of provisions targeting large financial institutions include the following: Enhanced prudential standards: Higher capital and liquidity requirements can increase funding costs for banks. Studies by the Basel Committee on Banking Supervision, IMF, and Organization for Economic Cooperation and Development estimated that increased capital and liquidity requirements would have modest impacts on funding costs for financial institutions. In contrast, a study by the International Institute of Finance, a global association of financial institutions, found much larger negative impacts. Differences in these studies’ estimates result from differences in certain assumptions. For example, the size of the estimated impact on funding costs depends on assumptions about how much of the increase in banks’ capital levels is due to regulatory reforms rather than other factors. Some researchers have noted that attributing all of the increase in banks’ capital levels to regulatory reforms may overstate the cost impacts of these reforms, because banks likely increased their capital levels, to some extent, in response to market forces after the crisis. Resolution plans: Regulators and industry officials stated that bank SIFIs have devoted significant staffing resources to developing the required resolution plans and that some plans submitted in July 2012 were thousands of pages in length. Regulators estimated that each bank SIFI required to complete a full resolution plan (20 banks) will spend, on average, 9,200 hours to complete the first plan and 2,561 hours to update the plan annually. Stress tests: In accordance with the act, the Federal Reserve, OCC, and FDIC have issued rules for stress testing requirements for certain bank holding companies, banks, thrift institutions, state member banks, savings and loan companies, and nonbank financial companies FSOC designates for supervision by the Federal Reserve. Bank holding companies with $50 billion or more in assets and nonbank financial companies designated by FSOC will be required to conduct company-run stress tests semi-annually, and the Federal Reserve will be required to conduct stress tests on these companies annually. Financial companies with more than $10 billion but less than $50 billion in assets will be required to conduct company-run stress tests annually as directed by their primary federal banking supervisor. According to industry representatives, stress testing requires newly covered firms to incur significant compliance costs associated with building information systems, contracting with outside vendors, recruiting experienced personnel, and developing stress testing models that are unique to their organization. Regulatory assessments: The Dodd-Frank Act also increases operating costs for SIFIs and certain large banks through new or higher regulatory assessments. First, under the act, large bank holding companies and nonbank financial companies designated by FSOC for supervision by the Federal Reserve must fund the Financial Research Fund, which funds the operating costs of FSOC and OFR, and certain expenses for the implementation of the orderly liquidation activities of FDIC, through a periodic assessment. The President’s fiscal year 2013 budget included estimates of about $158 million for the Financial Research Fund for fiscal year 2013. Second, pursuant to the act, FDIC issued a final rule changing the assessment base for the deposit insurance fund and the method for calculating the deposit insurance assessment rate. According to FDIC, the change in the assessment base shifted some of the overall assessment burden from community banks to the largest institutions, which rely less on domestic deposits for their funding than smaller institutions, but without affecting the overall amount of assessment revenue collected. According to FDIC data, following implementation of the new assessment base, from the first to the second quarter of 2011, total assessments for banks with $10 billion or more in assets increased by $413 million. In addition to increasing compliance costs for SIFIs and other large financial institutions, Title VII of the Dodd-Frank Act establishes a new regulatory framework for swaps, which is expected to impose substantial compliance and other costs on swap dealers, which generally include large banks, and other swap market participants. Business conduct standards: Swap dealers and major swap participants will face increased costs to comply with new business conduct standards under the act. These requirements address, among other things, interaction with counterparties, disclosure, reporting, recordkeeping, documentation, conflicts of interest, and avoidance of fraud and other abusive practices. Under CFTC’s final rules, swap dealers and major swap participants will need to adopt or amend written policies and procedures, obtain needed representations from counterparties, and determine whether existing counterparty relationship documents need to be otherwise changed or supplemented. Clearing, exchange trading, and data reporting: Changes to the market infrastructure for swaps—such as clearing and exchange- trading requirements—and real-time reporting requirements for designated major swap dealers or major swap participants will require firms to purchase or upgrade information systems. Industry representatives and regulators said that while some compliance costs of the derivatives reforms could be recurring, a large part of these costs will come from one-time upfront investments to update processes and technology. For example, according to industry groups and agency officials, the real-time reporting and swap execution facility technology upgrades for reporting are among the largest technology investment compliance cost areas for derivatives reforms, and costs to develop new reporting technology for firms may vary depending on the compatibility of the new reporting system with the prior system used. In its final rule on real-time reporting of swap data, CFTC estimated that the annual information collection burden on swap dealers and major swap participants would be approximately 260,000 hours. Margin rules: Swap dealers and end users will incur costs to post the additional collateral required under the new margin rules, including costs to borrow assets to pledge as collateral. For newly raised funds, the net cost would be the difference between the interest rate paid on the borrowed funds and the interest rate earned on the securities purchased to use as collateral. Estimating the incremental costs is difficult, in part because the incremental cost must take into account the extent to which swap dealers in the past, even if they did not require margin explicitly, may have charged end users more to price in a buffer to absorb losses. Although the Dodd-Frank Act reforms are directed primarily at large, complex U.S. financial institutions, many of the act’s provisions are expected to impose costs on other financial institutions as well. For example, we recently reported that the act’s reforms covering residential mortgages, securitizations, executive compensation, and other areas may impose additional requirements and, thus, costs on a broad range of financial institutions, but the magnitude of these costs will depend on, among other things, how the provisions are implemented. In addition to imposing compliance and other costs on financial institutions, the Dodd-Frank Act’s provisions may limit or restrict financial institutions’ business activities and reduce their revenue or revenue opportunities. Examples of such provisions include the following. Volcker rule: By generally prohibiting banks from engaging in proprietary trading and limiting their ability to sponsor or invest in hedge and private equity funds, the restrictions could eliminate past sources of trading and fee income for some banks. In addition, according to industry representatives, some banks currently holding private funds face the risk of incurring losses on the investments, if they are required to liquidate such investments at a substantial discount within an allotted period. Swaps reform: The provisions of the Dodd-Frank Act requiring central clearing and exchange trading of certain swaps could reduce the volume of dealers’ higher-profit margin swaps and thereby reduce their revenue. In addition, the margin requirements could reduce the ability of U.S. dealers to compete internationally, according to industry representatives. Single counterparty credit limit: Section 165(e) of the act directs the Federal Reserve to establish single-counterparty credit limits for SIFIs to limit the risks that the failure of any individual company could pose to a SIFI. According to industry representatives, the Federal Reserve’s proposed rule to implement credit limits would, among other things, require some SIFIs to reduce their derivatives and securities lending activities. Debit card interchange fees: Under section 1075 of the act (known as the Durbin amendment) the Federal Reserve issued a final rule that places a cap on debit card interchange fees charged by debit card issuers with at least $10 billion of assets. In their SEC filings, several large debit card issuers have estimated lost revenues from the Durbin amendment to be in the hundreds of millions of dollars annually. Similarly, we recently reported that large banks that issue debit cards initially have experienced a decline in their debit interchange fees as a result of the rule but that small banks generally have not. The reduction in debit interchange fees following the adoption of the rule likely has resulted or will result in savings for merchants. However, debit card issuers, payment card networks, and merchants are continuing to react to the rule; thus, the rule’s impact has not yet been fully realized. Financial markets can channel funds from savers and investors looking for productive investment opportunities to borrowers who have productive investment opportunities but not the funds to pursue them. By serving this financial intermediation function, financial markets can contribute to higher production and efficiency in the economy. Banks and other financial institutions can facilitate transactions between savers and borrowers and reduce the associated costs, as well as provide other financial services and products that contribute to economic growth. However, according to academics and industry representatives, by imposing higher costs on financial institutions, the Dodd-Frank Act may indirectly impose higher costs on businesses and households and reduce their investment and consumption with a consequent effect on economic output. Industry representatives, academics, and others generally expect the costs imposed by the act on the economy to be more significant than the act’s compliance costs for regulated institutions. At the same time, experts have noted that such costs can be viewed as part of the price to pay to realize the act’s potential financial stability and other benefits. For example, reforms that increase safety margins in the financial system— such as by requiring increased capital and collateral to absorb potential losses—represent a tradeoff between lower economic growth in the short term and a lower probability of a financial crisis in the long term. Furthermore, reforms may cause financial market participants to internalize costs that their failure could impose on others through, for example, triggering declines in asset prices and strains in funding markets; thus, such reforms could improve overall economic outcomes. Nevertheless, experts continue to debate whether the economic costs of the act’s reforms, individually and cumulatively, could be excessive relative to their potential benefits. One way through which the Dodd-Frank Act could impose costs on the broader economy is through its reforms that ultimately increase the cost or reduce the availability of credit for households and businesses. All else equal, when credit becomes more expensive or harder to obtain, households may reduce purchases and businesses may reduce investments that are funded by debt. These declines in consumption and investment can reduce GDP. According to academics, industry associations and firms, and others, reforms that could increase the cost or reduce the availability of credit include higher capital and liquidity requirements for financial institutions, the Volcker rule, counterparty credit limits, and mortgage-related provisions. Capital and liquidity requirements: Higher capital and liquidity requirements for banks can increase their funding and other costs. While banks can respond to these additional costs in a variety of ways, they generally are expected to pass on some of these costs to borrowers by charging higher interest rates on their loans, which could lead to a reduction in output. Some studies have assessed the potential short-term and long-term cost impacts of higher capital and liquidity requirements. Differences in estimates produced by different studies follow from differences in key modeling assumptions. With respect to short-term impacts, studies generally suggest that increasing capital and liquidity requirements for banks will likely be associated with short-term increases in interest rates for borrowers and short-term decreases in lending volumes, output, and economic growth rates during the period over which banks transition to these new requirements, but the magnitudes vary considerably across studies. For example, a Macroeconomic Assessment Group study summarized research by its members on the impact of the transition to the Basel III capital and liquidity requirements and found that interest rates for borrowers are likely to increase and lending volumes are likely to fall during the transition period, but that the ultimate reductions in output and growth are likely to be modest. Studies from the IMF and the Organization for Economic Cooperation and Development found broadly similar results. In contrast, a study by the Institute of International Finance estimated the impact of banks’ making the transition to meeting Basel III and additional country- specific requirements and found much larger short-term impacts on lending rates, lending volumes, output, and growth rates during the transition period. Studies also suggest that increasing capital and liquidity requirements for banks will likely be associated with long-term or permanent changes in lending rates and output. For example, a Basel Committee working group assessed the long-term impact of higher capital and liquidity requirements and found that they are likely to be associated with modest long-term increases in lending spreads and modest long-term reductions in output. An IMF study found similar results. Volcker rule: Some experts and industry representatives have expressed concern that the Volcker rule’s restriction on proprietary trading by banks could reduce market liquidity and increase the cost of raising funds in the securities markets and thus reduce output. As we previously reported, some market observers maintain that restrictions on proprietary trading by banks under the Volcker rule may reduce the amount of liquidity in the securities markets, depending on how the restrictions are implemented. For example, the rule could reduce the amount of market-making provided by banks for certain debt securities and ultimately result in higher borrowing rates for corporations, state and local governments, or others that use debt securities to help finance their activities. A study sponsored by an industry association estimated that the Volcker rule could increase annual borrowing costs for debt securities issuers by billions of dollars, and reduce liquidity in a wide range of markets, and consequently, to some extent, impede the ability of businesses to access capital through increases in cost of funds to borrowers. However, other experts have asserted that the study’s estimate is too high, in part because they believe it understates the potential for other firms to fill the gap left by banks and provide liquidity to the market. Single counterparty credit limit: According to industry representatives, the Federal Reserve’s proposed single counterparty credit limit rule could restrict the ability of SIFIs to engage in derivatives transactions with each other to hedge risk. In turn, such interference could reduce market liquidity and result in higher funding, hedging, and transaction costs for businesses. Mortgage-related reforms: The act’s provisions regulating the underwriting of mortgages also could restrict the availability of mortgage loans and raise mortgage costs for some homebuyers. For example, the act amends the Truth in Lending Act to prohibit lenders from making mortgage loans without regard to borrowers’ ability to repay them. As described earlier in this report, lenders may comply with the ability-to-repay standard by originating qualified mortgages that meet criteria that will be finalized by CFPB in rulemaking. In addition, securitized mortgages that meet certain criteria and which are referred to as “qualified residential mortgages” (QRM), are exempt from the act’s risk retention requirements. While there is general agreement that new Dodd-Frank rules should restrict certain types of risky loans and loan products that proliferated in the lead-up to the crisis, many market observers have expressed concern that these restrictions could go too far. For example, some mortgage industry representatives have raised concerns that including overly restrictive requirements for loan-to-value and debt service-to-income ratios in the qualified residential mortgage criteria could restrict the availability of mortgages to lower-income borrowers. Measuring the costs of financial regulation to the broader economy is challenging because of the multitude of intervening variables, the complexity of the global financial system, and data limitations. Many of the rules implementing the act’s reforms have not been finalized, and it is difficult to predict how regulated institutions will respond to the act’s reforms. For example, the extent to which regulated institutions pass on a portion of their increased costs to their customers may be impacted by competitive forces or other factors. Furthermore, even when the reforms have been fully implemented, it may not be possible to determine precisely the extent to which observed costs can be attributed to the act versus other factors, such as changes in the economy. Differences in assumptions about the appropriate baseline for comparison can lead to significant variation in estimates of the act’s impacts. As discussed below, other sources of uncertainty, such as the potential for regulatory arbitrage, add to the challenges of estimating the act’s potential costs. Some of the act’s reforms have the effect of transferring wealth across groups and may create economic costs if they result in resources being deployed less efficiently. For example, new assessments to fund the Financial Research Fund, which funds the operating costs of FSOC, OFR, and certain expenses for the implementation of the orderly liquidation activities of FDIC, represent an economic transfer from bank holding companies to the Financial Research Fund. In addition, as noted previously, changes in the deposit insurance fund assessment base shift some of the overall assessment burden from smaller banks to the largest institutions without affecting the overall amount of assessment revenue collected. Similarly, while the Durbin amendment has reduced revenues from interchange fees for large debit card issuers, these lost revenues will be offset to some extent by financial benefits to merchants who will pay lower interchange fees. Predicting the extent to which such transfers across groups could reduce economic growth is difficult, in part because how financial institutions will respond to these changes is unclear. For example, financial institutions could respond to increased assessment burdens or reduced revenue streams by cutting other expenses or increasing fees and other costs for their customers. Some market observers have noted that some financial institutions have increased fees on certain services, such as bank checking accounts, to compensate for lost revenues and increased fee assessments from the act. However, financial institutions’ business strategies are impacted by a wide range of factors, and determining the extent to which such increased fees can be attributed to the Dodd-Frank Act is difficult. Academics, industry representatives, and others we spoke with also have expressed concern about the potential for the Dodd-Frank Act’s reforms to have unintended consequences that could harm U.S. economic growth or the global competitiveness of U.S. financial markets. Experts have a wide range of views on the act’s potential to enhance financial stability, with some maintaining that certain reforms could make the financial system more vulnerable to a crisis. For example, some experts suggest that higher capital, liquidity, and collateral requirements will cause regulated institutions to increase significantly their holdings of relatively safe and liquid securities, such as U.S. Treasuries. Such an outcome could inflate the value of such securities and result in large losses if there were a sharp correction in the securities’ valuation. In addition, experts raised concerns about the potential for certain reforms to cause financial activities to shift to less regulated or unregulated markets and pose risks to U.S. financial stability. Of particular concern is the potential for increased regulation of U.S. financial markets to cause financial activities in the United States to move to foreign jurisdictions with less stringent regulations. For example, some academics and industry groups contend that if the United States imposes new margin requirements on swaps before other countries, the swap business could migrate to countries with lower margin requirements. Similarly, industry representatives have raised concerns about the potential for the Volcker rule and single counterparty credit limit to disadvantage U.S. financial institutions relative to foreign competitors that will be permitted to engage in proprietary trading activities outside the United States. While acknowledging these concerns and the need for harmonizing international regulatory standards, regulators noted that it can be advantageous for the United States to be the leader in implementing new regulatory safeguards. For example, when financial institutions are more resilient to unexpected shocks, they can continue to provide loans and other financial services that are important to economic growth, even during periods of market turmoil. These potential unintended consequences add to the challenge of assessing the costs and full impacts of the Dodd-Frank Act. Currently, the act is imposing costs on the financial services industry that could contribute to slower economic growth. At the same time, the act may help reduce the probability or severity of a future financial crisis, which would benefit the economy by preventing or mitigating crisis-related costs. However, the Dodd-Frank Act remains untested in a number of areas, has yet to be fully implemented, and leaves unresolved certain potential sources of system risk, such as money market funds and the tri-party repo market. As noted earlier, because the costs associated with a financial crisis can total trillions of dollars, the Dodd-Frank Act might need to reduce the probability of a crisis by only a small fraction for its benefits to equal its costs. Whether the act can achieve that outcome is unknown. As the impact of the act’s multitude of provisions, individually or cumulatively, materializes, their benefits and costs will become more fully known and understood—enabling policy makers and regulators to revise the requirements, as needed, to achieve the appropriate balance between the act’s benefits and costs to the U.S. economy. We provided a draft of this report to CFPB, CFTC, FDIC, the Federal Reserve, FSOC, OCC, OFR, Treasury, and SEC for their review and comment. We also provided excerpts of the draft report for technical comment to FHFA. All of the agencies provided technical comments, which we have incorporated, as appropriate. As agreed with your offices, unless you publicly announce the contents of this report earlier, we plan no further distribution until 30 days from the report date. At that time, we will send copies to CFPB, CFTC, FDIC, FHFA, the Federal Reserve, FSOC, OCC, OFR, Treasury, and SEC, interested congressional committees, members, and others. In addition, this report will be available at no charge on our web site at http://www.gao.gov. Should you or your staff have questions concerning this report, please contact me at (202) 512-8678 or clowersa@gao.gov. Contact points for our Offices of Congressional Relations and Public Affairs may be found on the last page of this report. Key contributors to this report are listed in appendix IV. The objectives of our report were to examine what is known about (1) the losses and related economic impacts associated with the 2007-2009 financial crisis; (2) the benefits of the Dodd-Frank Wall Street Reform and Consumer Protection Act (the Dodd-Frank Act), particularly its key financial stability provisions, for the U.S. financial system and broader economy; and (3) the costs associated with the act, particularly its key financial stability provisions. To address our first objective, we reviewed and analyzed studies by regulators and academics. We conducted searches of social science, economic, and federal research databases, including EconLit, Google Scholar, and JSTOR, to identify relevant studies that examine the losses associated with the 2007-2009 financial crisis. To help us identify relevant studies, we also relied on federal agencies and academic and other experts. Although we found these studies to be sufficiently reliable for the purposes of our report, the results should not necessarily be considered as definitive, given the potential methodological or data limitations contained in the studies individually or collectively. In addition, we reviewed our prior work that addresses economic impacts associated with the crisis, including the impacts on the fiscal challenges faced by federal, state, and local governments. We interviewed federal financial regulators, academics, industry associations, market participants and others to obtain their perspectives on how the recent financial crisis impacted the economy and what methods have been used to quantify the economic impacts associated with the crisis. Based on our literature review and interviews with experts, we identified approaches commonly used by experts to quantify or describe the economic losses associated with the crisis, and the limitations of these approaches. For example, we summarized approaches used by some researchers to quantify losses associated with the financial crisis in terms of lost gross domestic product, which measures the total goods and services produced in the economy. To describe trends in economic measures associated with the financial crisis, we collected and analyzed data from the Bureau of Economic Analysis, the Bureau of Labor Statistics, CoreLogic, the Federal Reserve Flow of Funds database, and the National Bureau of Economic Research. Lastly, we obtained and analyzed perspectives on the role of the federal government’s policy interventions in mitigating the costs of the financial crisis. We obtained and analyzed data from government financial statements and other reports on the income and losses for the most significant government programs to assist the financial sector, including the Troubled Asset Relief Program, the Board of Governors of the Federal Reserve System’s (Federal Reserve) emergency liquidity programs, the Temporary Liquidity Guarantee Program, and assistance provided to rescue individual institutions, such as American International Group, Inc. and the government-sponsored enterprises. Our review did not consider the potential short-term and long-term impacts of other federal policy responses to the recession that coincided with the financial crisis, including the American Recovery and Reinvestment Act of 2009. To address our second objective, we obtained and analyzed a broad range of perspectives on the potential economic benefits of the Dodd- Frank Act and factors that could impact the realization of these benefits. Using a literature search strategy similar to the one described under our first objective, we identified and analyzed academic and other studies that evaluate the potential benefits of one or more of the act’s reforms. In addition, we reviewed relevant reports and public statements by federal financial regulators, industry associations, and others. We obtained additional perspectives from regulators, academics, and representatives of industry and public interest groups through interviews and an expert roundtable we held with the assistance of the National Academy of Sciences (NAS). Based on our literature review, interviews, and expert roundtable, we identified provisions of the act that could have the most significant impacts on financial stability, and factors that could impact the effectiveness of these provisions. In addition, we obtained and summarized expert perspectives on potential benefits of the act beyond enhanced financial stability, such as increased consumer and investor protections. Finally, we reviewed and summarized approaches used by researchers to quantify potential benefits of the act’s reforms. Although we found these studies to be sufficiently reliable for the purposes of our report, the results should not necessarily be considered as definitive, given the potential methodological or data limitations contained in the studies individually or collectively. To address our third objective, we obtained and analyzed information on the costs of implementing the Dodd-Frank Act, including for the federal government, the financial sector, and the broader economy. We obtained and summarized data on the incremental budgetary costs associated with the act’s implementation for 10 federal entities (Board of Governors of the Federal Reserve System, Commodity Futures Trading Commission, Federal Deposit Insurance Corporation, Federal Housing Finance Agency, Office of the Comptroller of the Currency, Securities and Exchange Commission, Department of the Treasury, Consumer Financial Protection Bureau, Financial Stability Oversight Council, and the Office of Financial Research). We requested data on the entities’ estimates of their funding and full-time equivalents agency-wide and for activities related to the Dodd-Frank Act in 2010, 2011, 2012, and 2013. We also requested that the entities identify their sources of funding (appropriations, assessments of supervised institutions, revenue from investments or providing services, and transfers of funds from other agencies), and describe the extent to which new resources related to the Dodd-Frank Act would be funded on a one-time or recurring basis. We corroborated the information with other data, where available. In addition, we reviewed the Congressional Budget Office’s estimate of the act’s effect on the federal government’s direct spending and revenue and, in turn, deficit. To describe the potential costs for the financial sector and the broader economy, we reviewed published works, public statements, and other available analyses by financial regulators, industry representatives, academics, and other experts. We also obtained perspectives from representatives of these groups through interviews and the expert roundtable we held in coordination with NAS. We also had two financial markets experts review a draft of our report and incorporated their comments, as appropriate. To help inform our work on the second and third objectives, we contracted with NAS to convene a 1-day roundtable of 14 experts to discuss the potential benefits and potential costs of the Dodd-Frank Act. The group of experts was selected with the goal of obtaining a balance of perspectives and included former financial regulatory officials, representatives of financial institutions impacted by the act’s reforms, academic experts on financial regulation, a representative of a public interest group, and an industry analyst. The discussion was divided into three moderated sub-sessions. The sub-sessions addressed (1) the potential benefits of the act’s key financial stability reforms; (2) the potential costs of these key financial stability reforms; and (3) methodological approaches and challenges in measuring the impacts of the act’s reforms. For a list of the 14 experts, see appendix III. For parts of our methodology that involved the analysis of computer- processed data, we assessed the reliability of these data and determined that they were sufficiently reliable for our purposes. Data sets for which we conducted data reliability assessments include gross domestic product data from the Bureau of Economic Analysis; employment data from the Bureau of Labor Statistics; home price data from CoreLogic; Federal Reserve Flow of Funds data on retirement fund assets; loan default and foreclosure data from the Mortgage Bankers Association; and recession data from the National Bureau of Economic Research. We reviewed information on the statistical collection procedures and methods for these data sets to assess their reliability. In addition, we assessed the reliability of estimates federal entities provided for the funding resources and full-time equivalents associated with Dodd-Frank implementation by comparing these estimates to agency budget documents and interviewing agency staff about how the data were collected. Finally, for studies that present quantitative estimates of the economic impacts associated with financial crises or financial regulatory reforms, we assessed the reasonableness of the methodological approaches used to generate these estimates. Although we found certain studies to be sufficiently reliable for the purposes of our report, the results should not necessarily be considered definitive, given the potential methodological or data limitations contained in the studies, individually or collectively. We conducted this performance audit from November 2011 to January 2013 in accordance with generally accepted government auditing standards. Those standards require that we plan and perform the audit to obtain sufficient, appropriate evidence to provide a reasonable basis for our findings and conclusions based on our audit objectives. We believe that the evidence obtained provides a reasonable basis for our findings and conclusions based on our audit objectives. Many U.S. financial firms conduct business around the world and thus generally are subject to rules on banking, securities, and other financial market activities in multiple jurisdictions. In response to the financial crisis that began in 2007, the United States and other countries have taken steps to introduce financial reforms into their domestic legal and regulatory systems. In parallel with these domestic reform efforts, international organizations have issued new standards and principles to guide their members’ efforts. The goal of these international efforts is to harmonize and coordinate views and policies across different jurisdictions to minimize opportunities for regulatory arbitrage—the ability of market participants to profit from differences in regulatory regimes between one jurisdiction and another. Examples of some of these efforts include the following: The G20, a group that represents 20 of the largest global economies, created the Financial Stability Board (FSB) to coordinate and monitor international financial regulatory reform efforts, among other activities. The Basel Committee on Banking Supervision (BCBS)—hosted at the Bank for International Settlements (BIS)—has developed a new set of capital and, for the first time, liquidity requirements for banks. The Committee on Payment and Settlement Systems (CPSS), which is comprised of central banks, focuses on the efficiency and stability of payment, clearing, and settlement arrangements, including financial market infrastructures. Recently, CPSS has worked jointly with the International Organization of Securities Commissions (IOSCO) to produce a new set of prudential standards for financial market infrastructures. IOSCO, a multilateral organization of securities market regulators, has issued policy documents to guide national securities commissions’ regulatory reform efforts. Various other forums and groups, including the International Association of Insurance Supervisors (IAIS), are housed at BIS and cooperate on financial regulatory reform initiatives. For example, the Joint Forum—which includes representatives of IAIS, BCBS, and IOSCO—works to coordinate financial services reforms. Separately, multilateral organizations, such as the International Monetary Fund and Organization for Economic Cooperation and Development, have published research and analysis of international financial reforms. Table 5 summarizes selected international financial regulatory reform efforts. In addition to the contact named above, Richard Tsuhara (Assistant Director), William R. Chatlos, John Fisher, Catherine Gelb, G. Michael Mikota, Marc Molino, Courtney LaFountain, Robert Pollard, Jennifer Schwartz, Andrew J. Stephens, and Walter Vance made significant contributions to this report. Acharya, Viral V., Thomas F. Cooley, Matthew Richardson, and Ingo Walter. Regulating Wall Street: The Dodd-Frank Act and the New Architecture of Global Finance. Hoboken, New Jersey, John Wiley & Sons, 2011. Admati, Anat R., Peter M. DeMarzo, Martin F. Hellwig, and Paul Pfleiderer. “Fallacies, Irrelevant Facts, and Myths in the Discussion of Capital Regulation: Why Bank Equity is Not Expensive.” Stanford GSB Research Paper No. 2065. Stanford University: March 23, 2011. Basel Committee on Banking Supervision, The Transmission Channels Between the Financial and Real Sectors: A Critical Survey of the Literature, Bank for International Settlements (BIS) Working Paper No. 18. Basel, Switzerland, February 2011. Basel Committee on Banking Supervision, An Assessment of the Long- Term Economic Impact of Stronger Capital and Liquidity Requirements, BIS. Basel, Switzerland, August 2010. Boyd, John H., Sungkyu Kwak, and Bruce Smith, “The Real Output Losses Associated with Modern Banking Crises.” Journal of Money, Credit and Banking, vol. 37, no. 6. (December 2005): 977-999. Cecchetti, Stephen G., Marion Kohler, and Christian Upper, Financial Crises and Economic Activity. National Bureau of Economic Research (NBER), Working Paper 15379. Cambridge, MA, September 2009. Congressional Budget Office (CBO), Understanding and Responding to Persistently High Unemployment (February 2012). CBO, The Budget and Economic Outlook: Fiscal Years 2012 to 2022 (January 2012). Duffie, Darrell and Haoxing Zhu. “Does a Central Clearing Counterparty Reduce Counterparty Risk?” Review of Asset Pricing Studies, 1 (1) (July 18, 2011): 74-95. Elmendorf, Douglas W. Review of CBO’s Cost Estimate for the Dodd- Frank Wall Street Reform and Consumer Protection Act, Statement Before the Subcommittee on Oversight and Investigations, Committee on Financial Services, U.S. House of Representatives. March 30, 2011. Federal Financial Analytics, Inc., “Strategic Regulatory Landscape: Regulatory Intent versus Policy and Market Risk in Financial-Services Industry – Capital, Liquidity, Risk Management and Related Prudential Requirements,” October 2012. Financial Stability Oversight Council (FSOC), 2011 Annual Report. Washington, D.C. July 26, 2011. FSOC, 2012 Annual Report. July 24, 2012. Gorton, Gary and Andrew Metrick. “Regulating the Shadow Banking System,” Brookings Papers on Economic Activity. Fall 2010. Hanson, Samuel G., Anil K. Kashyap, and Jeremy C. Stein. “A Macroprudential Approach to Financial Regulation.” Journal of Economic Perspectives, vol. 25, no. 1 (Winter 2011): 3–28. Institute of International Finance, The Cumulative Impact on the Global Economy of Changes in the Financial Regulatory Framework, September 2011. Laevan, Luc and Fabian Valencia, Systemic Banking Crises Database: An Update, International Monetary Fund Working Paper 12/163. Washington, D.C. June 2012. Levine, Ross. The Governance of Financial Regulation: Reform Lessons from the Recent Crisis, BIS Working Paper No. 329, BIS Monetary and Economic Department. Basel, Switzerland. November 2010. Macroeconomic Assessment Group, Final Report: Assessing the Macroeconomic Impact of the Transition to Stronger Capital and Liquidity Requirements, Bank for International Settlements, Basel, Switzerland: December 2010. Office of Financial Research, 2012 Annual Report. July 20, 2012. Reinhart, Carmen M. and Kenneth S. Rogoff, The Aftermath of Financial Crises, NBER Working Paper 14656. January 2009. Santos, André Oliveira and Douglas Elliott, Estimating the Costs of Financial Regulation, IMF Staff Discussion Note. September 11, 2012. Schwarcz, Steven. “Systemic Risk.” Georgetown Law Journal (2008): 97:193. Skeel, David. The New Financial Deal: Understanding the Dodd-Frank Act and Its (Unintended) Consequences. John Wiley & Sons, Hoboken, New Jersey. 2011. The Squam Lake Group. The Squam Lake Report: Fixing the Financial System. Princeton University Press, Princeton, New Jersey. 2010. Community Banks and Credit Unions: Impact of the Dodd-Frank Act Depends Largely on Future Rule Makings. GAO-12-881. Washington, D.C.: September 13, 2012. Financial Stability: New Council and Research Office Should Strengthen the Accountability and Transparency of Their Decisions. GAO-12-886. Washington, D.C.: September 11, 2012. Bankruptcy: Agencies Continue Rulemakings for Clarifying Specific Provisions of Orderly Liquidation Authority. GAO-12-735. Washington, D.C.: July 12, 2012. Unemployed Older Workers: Many Experience Challenges Regaining Employment and Face Reduced Retirement Security. GAO-12-445. Washington, D.C.: April 25, 2012. State and Local Government Pension Plans: Economic Downturn Spurs Efforts to Address Costs and Sustainability. GAO-12-322. Washington, D.C.: March 2, 2012. Dodd-Frank Act Regulations: Implementation Could Benefit from Additional Analyses and Coordination. GAO-12-151. Washington, D.C.: November 10, 2011. Bankruptcy: Complex Financial Institutions and International Coordination Pose Challenges. GAO-11-707. Washington, D.C.: July 19, 2011. Mortgage Reform: Potential Impacts in the Dodd-Frank Act on Homebuyers and the Mortgage Market. GAO-11-656. Washington, D.C.: July 19, 2011. Dodd-Frank Act: Eleven Agencies’ Estimates of Resources for Implementing Regulatory Reform. GAO-11-808T. Washington, D.C.: July 14, 2011. Proprietary Trading: Regulators Will Need More Comprehensive Information to Fully Monitor Compliance with New Restrictions When Implemented. GAO-11-529. Washington, D.C.: July 13, 2011. State and Local Governments: Knowledge of Past Recessions Can Inform Future Federal Fiscal Assistance. GAO-11-401. Washington, D.C.: March 31, 2011. The Federal Government’s Long-Term Fiscal Outlook: January 2011 Update. GAO-11-451SP. Washington, D.C.: March 18, 2011. Financial Assistance: Ongoing Challenges and Guiding Principles Related to Government Assistance for Private Sector Companies. GAO-10-719. Washington, D.C.: August 3, 2010. Credit Cards: Rising Interchange Fees Have Increased Costs for Merchants, but Options for Reducing Fees Pose Challenges, GAO-10-45 Washington, D.C.: November 19, 2009. Financial Markets Regulation: Financial Crisis Highlights Need to Improve Oversight of Leverage at Financial Institutions and across System. GAO-09-739. Washington, D.C.: July 22, 2009. Systemic Risk: Regulatory Oversight and Recent Initiatives to Address Risk Posed by Credit Default Swaps. GAO-09-397T. Washington, D.C.: March 5, 2009. Financial Regulation: A Framework for Crafting and Assessing Proposals to Modernize the Outdated U.S. Financial Regulatory System. GAO-09-216. Washington, D.C.: January 8, 2009.

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