    Financial Regulation: Industry Changes Prompt Need to Reconsider
    U.S. Regulatory Structure (06-OCT-04, GAO-05-61).

    In light of the passage of the 1999 Gramm-Leach-Bliley Act and
    increased competition within the financial services industry at
    home and abroad, GAO was asked to report on the current state of
    the U.S. financial services regulatory structure. This report
    describes the changes to the financial services industry,
    focusing on banking, securities, futures, and insurance; the
    structure of the U.S. and other regulatory systems; changes in
    regulatory and supervisory approaches; efforts to foster
    communication and cooperation among U.S. and other regulators;
    and the strengths and weaknesses of the current regulatory
    structure.
    -------------------------Indexing Terms-------------------------
    REPORTNUM:   GAO-05-61
        ACCNO:   A12936
      TITLE:     Financial Regulation: Industry Changes Prompt Need to
    Reconsider U.S. Regulatory Structure
         DATE:   10/06/2004
      SUBJECT:   Banking law
    	     Banking regulation
    	     Federal regulations
    	     Financial institutions
    	     Independent regulatory commissions
    	     Insurance regulation
    	     Interagency relations
    	     International economic relations
    	     Regulatory agencies
    	     Securities regulation
    	     Consolidation
    	     Financial services industry
    	     Australia
    	     Germany
    	     Japan
    	     Netherlands
    	     United Kingdom

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    GAO-05-61

    United States Government Accountability Office

     GAO	Report to the Chairman, Committee on Banking, Housing, and Urban Affairs,
                                      U.S. Senate

    October 2004

    FINANCIAL REGULATION

          Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure

                                           a

    GAO-05-61

    Highlights of GAO-05-61, a report to the Chairman, Committee on Banking,
    Housing, and Urban Affairs, U.S. Senate

    In light of the passage of the 1999 Gramm-Leach-Bliley Act and increased
    competition within the financial services industry at home and abroad, GAO
    was asked to report on the current state of the U.S. financial services
    regulatory structure. This report describes the changes to the financial
    services industry, focusing on banking, securities, futures, and
    insurance; the structure of the U.S. and other regulatory systems; changes
    in regulatory and supervisory approaches; efforts to foster communication
    and cooperation among U.S. and other regulators; and the strengths and
    weaknesses of the current regulatory structure.

    While GAO is not recommending a specific alternative regulatory structure,
    Congress may wish to consider ways to improve the regulatory structure for
    financial services, especially the oversight of complex, internationally
    active firms. Options to consider include consolidating within regulatory
    areas and creating an entity primarily to oversee complex, internationally
    active firms, while leaving the rest of the regulatory structure in place.
    Federal financial regulators provided comments on these options.

    www.gao.gov/cgi-bin/getrpt?GAO-05-61.

    To view the full product, including the scope and methodology, click on
    the link above. For more information, contact Thomas J. McCool at (202)
    512-8678 or mccoolt@gao.gov.

    October 2004

    FINANCIAL REGULATION

    Industry Changes Prompt Need to Reconsider U.S. Regulatory Structure

    The financial services industry has changed significantly over the last
    several decades. Firms are now generally fewer and larger, provide more
    and varied services, offer similar products, and operate in increasingly
    global markets. These developments have both benefits and risks, both for
    individual institutions and for the regulatory system as a whole. Actions
    that are being taken to harmonize regulations across countries, especially
    the Basel Accords and European Union Financial Services Action Plan, are
    also affecting U.S. firms and regulators. While the financial services
    industry and the international regulatory framework have changed, the
    regulatory structure for overseeing the U.S. financial services industry
    has not. Specialized regulators still oversee separate functions-banking,
    securities, futures, and insurance-and while some regulators do oversee
    complex institutions at the holding company level, they generally rely on
    functional regulators for information about the activities of
    subsidiaries. In addition, no one agency or mechanism looks at risks that
    cross markets or industry segments or at the system and its risks as a
    whole.

    Although a number of proposals for changing the U.S. regulatory system
    have been put forth, the United States has chosen not to consolidate its
    regulatory structure. At the same time, some industrial countries-notably
    the United Kingdom-have consolidated their financial regulatory
    structures, partly in response to industry changes. Absent fundamental
    change in the overall regulatory structure, U.S. regulators have initiated
    some changes in their regulatory approaches. For example, starting with
    large, complex institutions, bank regulators, in the 1990s, sought to make
    their supervision more efficient and effective by focusing on the areas of
    highest risk. And partly in response to changes in European Union
    requirements, SEC has issued rules to provide consolidated supervision of
    certain internationally active securities firms on a voluntary basis.
    Regulators are also making efforts to communicate in national and
    multinational forums, but efforts to cooperate have not fully addressed
    the need to monitor risks across markets, industry segments, and national
    borders. And from time to time regulators engage in jurisdictional
    disputes that can distract them from focusing on their primary missions.

    GAO found that the U.S. regulatory structure worked well on some levels
    but not on others. The strength and vitality of the U.S. financial
    services industry demonstrate that the regulatory structure has not
    failed. But some have questioned whether a fragmented regulatory system is
    appropriate in today's environment, particularly with large, complex firms
    managing their risks on a consolidated basis. While the structure of the
    agencies alone cannot ensure that regulators achieve their goals-agencies
    also need the right people, tools, and policies and procedures-it can
    hinder or facilitate their efforts to provide consistent, comprehensive
    regulation that protects consumers and enhances the delivery of financial
    services.

    Contents

    Letter 1

      Executive Summary 3

    Purpose 3
    Background 4
    Results in Brief 6
    GAO's Analysis 11
    Matter for Congressional Consideration 19
    Agency Comments and Our Evaluation 23

    Chapter 1 25

    Introduction Traditionally, Financial Institutions Served as
    Intermediaries and
    Transferred Some Risks 26
    The Financial Services Industry Faces Risks at the Institutional

    Level and Systemwide 29
    U.S. Financial Services Regulation Has Multiple Goals 30
    U.S. Financial Regulatory System Includes a Variety of Regulatory

    Bodies 31
    The United States Participates in International Organizations
    Dealing with Regulatory Issues 39
    Objectives, Scope, and Methodology 41

    Chapter 2 44

    Financial Services Have Played an Integral Part in Globalization 44
    The Financial Services Large Institutions Have Become Larger through
    Consolidation and
    Industry Has Conglomeration 46
    Undergone Dramatic Roles of Large Financial Services Firms Have Changed
    and Financial

    Products Have Converged, but Some Differences Remain 51
    Changes As Financial Services Institutions Have Diversified, Introduced
    New
    Products, and Become More Complex, Risks Have Changed 56

                                        Contents

    Chapter 3
    While Some Countries
    Have Consolidated
    Regulatory Structures,
    the United States Has
    Chosen to Maintain Its
    Structure

    62 Some Countries and States Have Consolidated Their Regulatory Structures
    62 United States Has Chosen to Maintain the Federal Regulatory Structure,
    although Proposals Have Been Made to Change It 73

    Chapter 4 Regulators Are Adapting Regulatory and Supervisory Approaches in
    Response to Industry Changes

    83 New Basel II Structure and EU Requirements Will Likely Affect Oversight
    of U.S. Financial Institutions 83

    U.S. Regulators Have Made or Considered Some Other Changes to Their
    Regulatory and Supervisory Approaches in Response to Industry Changes 89

    Chapter 5 97

    Regulators U.S. Financial Regulators Communicate and Coordinate with Other
    Regulators in Their Sectors, but Sometimes Find It Difficult to
    Communicate and Cooperate 97 Coordinate in Multiple Financial Services
    Regulators Also Communicate across Financial

    Sectors, but Do Not Effectively Identify Some Risks, Fraud, andWays, but
    Concerns Abuse That Cross Sectors 105

    Remain

    Chapter 6 113 The U.S. Regulatory U.S. Financial Services Regulatory
    System Has Generally Been

    Successful but Lacks Overall Direction 113 System Has Strengths, Structure
    of U.S. Financial Services Regulatory System May Not

    Facilitate Oversight of Large, Complex Firms 117but Its Structure May
    Structure of U.S. Financial Services Regulatory System May NotHinder
    Effective Facilitate Response to Increased Globalization 122

    Regulation

                                        Contents

    Regulators Provide Some Other Benefits by Specializing in Particular
    Industry Segments or Geographic Units, but Specialization Has Costs As
    Well 123

    Chapter 7 Congress May Want to Consider Changes to the U.S. Regulatory
    Structure

     Matter for Congressional Consideration 128 Agency Comments and Our Evaluation
                                          132

    Appendixes

    Appendix I:

    Appendix II:

    Appendix III:

                                            Appendix IV: Appendix V: Appendix VI:

    Comments from the Board of Governors of the Federal Reserve System

    Comments from the Federal Deposit Insurance Corporation

    Comments from the Office of the Comptroller of the Currency

    Comments from the Office of Thrift Supervision

    Comments from the Securities and Exchange Commission

    GAO Contacts and Staff Acknowledgments

    GAO Contacts
    Staff Acknowledgments

    137

    140

    143

    146

    159

    161 161 161

    Related GAO Products

    Table Table 1:	Selected Retail Products by Financial Institution and
    Function

               Figure 1: Figure        Traditional Role of Financial
    Figures               2:      Intermediaries International Debt      26 45
                                           Securities, 1987-2004
                      Figure 3:  Share of Assets in Each Sector Controlled
                                               by 10 Largest
                                             Firms, 1996-2002                  47
                      Figure 4:        Merger Activity among Banking
                                          Organizations, January
                                              1990-June 2004                   49
                                    Number of Futures Contracts Traded,        54
                      Figure 5:                  1995-2003

    Contents

    Figure 6: Structure of a Hypothetical Financial Holding

    Company 57 Figure 7: The Three Pillars of Basel II 85 Figure 8: United
    States-EU Regulatory Dialogue 109 Figure 9: Regulators for a Hypothetical
    Financial Holding

    Company 120

    Abbreviations

    AFM Netherlands Authority for the Financial Markets
    APRA Australian Prudential Regulation Authority
    ASIC Australian Securities and Investments Commission
    BaFin German Federal Financial Supervisory Authority (Die

    Bundesanstalt fu:r Finanzdienstleistungsaufsicht) CESR Committee of
    European Securities Regulators CFMA Commodity Futures Modernization Act
    CFTC Commodity Futures Trading Commission CRS Congressional Research
    Service CSE consolidated supervised entity EU European Union FBIIC
    Financial and Banking Information Infrastructure

    Committee FCM futures commission merchant FDIC Federal Deposit Insurance
    Corporation FFIEC Federal Financial Institutions Examination Council FSF
    Financial Stability Forum GLBA Gramm-Leach-Bliley Act IAIS International
    Association of Insurance Supervisors ILC industrial loan companies IMF
    International Monetary Fund IOSCO International Organization of Securities
    Commissions ISG Intermarket Surveillance Group Japan-FSA Financial
    Services Authority of Japan LTCM Long-Term Capital Management NAIC
    National Association of Insurance Commissioners NASDAQ Nasdaq Stock Market
    Inc. NCUA National Credit Union Administration NFA National Futures
    Association NYSE New York Stock Exchange OCC Office of the Comptroller of
    the Currency

    Contents

    OTC over the counter
    OTS Office of Thrift Supervision
    SEC Securities and Exchange Commission
    SIA Securities Industry Association
    SIBHC supervised investment bank holding company
    SRO self-regulatory organization
    UK-FSA Financial Services Authority of the United Kingdom

    This is a work of the U.S. government and is not subject to copyright
    protection in the United States. It may be reproduced and distributed in
    its entirety without further permission from GAO. However, because this
    work may contain copyrighted images or other material, permission from the
    copyright holder may be necessary if you wish to reproduce this material
    separately.

    A

    United States Government Accountability Office Washington, D.C. 20548

    October 6, 2004

    The Honorable Richard C. Shelby
    Chairman
    Committee on Banking, Housing, and Urban Affairs
    United States Senate

    Dear Mr. Chairman:

    This report responds to your request that we analyze the present financial
    services regulatory structure. As you requested, this report (1) describes
    the changes in the financial services industry over recent decades, (2)
    describes changes that have occurred in the U.S. regulatory structure and
    those of other industrialized countries, (3) describes major changes in
    U.S.
    financial market regulation, (4) discusses efforts to communicate,
    coordinate, and cooperate across agencies in the present system, and (5)
    assesses the strengths and weaknesses of the present financial regulatory
    structure. This report includes a Matter for Congressional Consideration.

    As agreed with your office, unless you publicly announce its contents
    earlier, we plan no further distribution of this report until 30 days from
    its
    issue date. We will then send copies to the Ranking Minority Member of the
    Committee on Banking, Housing, and Urban Affairs; the Chairman and
    Ranking Minority Member of the House Committee on Financial Services;
    the Secretary of the Department of the Treasury; the Chairman of the Board
    of Governors of the Federal Reserve System; the Chairman of the Federal
    Deposit Insurance Corporation; the Comptroller of the Currency; the
    Director of the Office of Thrift Supervision; the Chairman of the
    Securities
    and Exchange Commission; the Chairman of the Commodity Futures
    Trading Commission; the President of the National Association of
    Insurance Commissioners; and other interested parties. Copies will also be
    made available to others upon request. In addition, this report will be
    available at no charge on the GAO Web site at http://www.gao.gov.

    This report was prepared under the direction of James M. McDermott,
    Assistant Director. Please contact Mr. McDermott at (202) 512-5373 or me
    at (202) 512-8678 if you or your staff have any questions about this
    report. Major contributors to this report are listed in appendix VI.

    Sincerely yours,

    Thomas J. McCool Managing Director, Financial Markets and Community
    Investment

    Executive Summary

    Purpose	It is 5 years since Congress passed the landmark
    Gramm-Leach-Bliley Act (GLBA). In some ways, this act recognized the
    blurring of distinctions among banking, securities, and insurance
    activities that had already happened in the marketplace and codified
    regulatory decisions that had been made to deal with these industry
    changes. While recognizing industry and regulatory changes, that act
    changed neither the number of regulatory agencies nor, in most cases, the
    primary objectives and responsibilities of the existing agencies. The
    result of the blurring of distinctions among the traditional financial
    services sectors, recognized by GLBA, has enlarged the number and types of
    competitors facing any firm, both domestically and internationally. Thus,
    what is happening abroad from a regulatory perspective could impact the
    competitive position of U.S. financial services institutions and the
    ability of U.S. regulators to achieve their objectives. On this front,
    many other industrialized countries are consolidating their financial
    regulatory structures, and international forums are nearing completion of
    important efforts to harmonize regulation across countries.

    To better understand the effectiveness of the U.S. regulatory system in
    this changing environment, the Chairman of the Committee on Banking,
    Housing, and Urban Affairs requested an analysis of the present regulatory
    structure. In particular, this report

    o 	describes the changes in the financial services industry over recent
    decades;

    o 	describes changes that have occurred in the U.S. regulatory structure
    and those of other industrialized countries;

    o  describes major changes in U.S. financial market regulation;

    o 	discusses efforts to communicate, coordinate, and cooperate across
    agencies in the present system; and

    o 	assesses the strengths and weaknesses of the present financial
    regulatory structure.

    To meet these objectives GAO drew on its past work, reviewed other
    relevant literature, conducted interviews with officials of federal and
    state regulatory agencies, financial services industry representatives,
    and other experts in the United States, the United Kingdom, Belgium, and
    Germany and collected and analyzed data on industry changes and regulatory

                                   Executive Summary

    activities. We conducted our work between June 2003 and July 2004 in
    accordance with generally accepted government auditing standards in
    Washington, D.C.; Boston; Chicago; New York City; Brussels, Belgium;
    London; and Berlin, Bonn, and Frankfurt, Germany.

    Background	An efficient and effective financial services sector promotes
    economic growth through the optimum allocation of financial capital.
    Achieving that outcome rests primarily with the industry; however, in some
    cases the market may not produce the most desirable outcomes and some form
    of regulatory intervention is needed. In the United States, laws define
    the roles and missions of the various regulators, which, to some extent,
    are similar across the regulatory bodies. Regulators generally have three
    objectives: (1) ensuring that institutions do not take on excessive risk;
    (2) making sure that institutions conduct themselves in ways that limit
    opportunities for fraud and abuse and provide consumers and investors with
    accurate information and other protections that may not be provided by the
    market; and (3) promoting financial stability by limiting the
    opportunities for problems to spread from one institution to another.
    However, laws and regulatory agency policies can set a greater priority on
    some roles and missions than others. In addition, the goals and objectives
    of the regulatory agencies have developed somewhat differently over time,
    such that bank regulators generally focus on the safety and soundness of
    banks, securities and futures regulators focus on market integrity and
    investor protection, and insurance regulators focus on the ability of
    insurance firms to meet their commitments to the insured.

    Generally, banking and securities activities are regulated at both the
    state and federal levels, while futures are regulated primarily at the
    federal level and insurance at the state level. For banking activities,
    the Federal Reserve System (Federal Reserve)-including the Board of
    Governors and the 12 Federal Reserve Banks-the Office of the Comptroller
    of the Currency (OCC), the Office of Thrift Supervision (OTS), the Federal
    Deposit Insurance Corporation (FDIC), and the National Credit Union
    Administration (NCUA) are the primary federal regulators. For securities
    activities, the Securities and Exchange Commission (SEC) is the primary
    federal regulator, and for futures products, the Commodity Futures Trading
    Commission (CFTC) is the primary regulator. In addition, self-regulatory
    organizations under SEC or CFTC jurisdiction provide oversight of
    securities and futures dealers and exchanges. State regulators also
    provide oversight of banking, securities, and insurance. For commercial
    and savings banks with state bank charters, state banking departments
    charter

    Executive Summary

    the entity and have supervisory responsibilities, while the Federal
    Reserve or FDIC serve as the primary federal supervisor for these banks.1
    For securities, states generally provide oversight to protect fraud and
    abuse against within their jurisdictions. In contrast to these products or
    activities, which are either regulated primarily at the federal level or
    through a dual system of state and federal regulation, insurance products
    are regulated primarily at the state level. Organizationally, some
    regulatory agencies (OCC and OTS) are part of the Department of the
    Treasury (Treasury), while the others are independent entities or
    commissions. While OCC and OTS are part of Treasury, their heads are
    appointed by the President and approved by the Congress for fixed terms to
    ensure their independence.

    The U.S. regulatory system for financial services is described as
    "functional," so that financial products or activities are generally
    regulated according to their function, no matter who offers the product or
    participates in the activity. Broker-dealer activities, for instance, are
    generally subject to SEC's jurisdiction, whether the broker-dealer is a
    subsidiary of a bank holding company subject to Federal Reserve
    supervision or a subsidiary of an investment bank. The functional
    regulator approach is intended to provide consistency in regulation and
    avoid the potential need for regulatory agencies to develop expertise in
    all aspects of financial regulation.

    Some firms engaged in the provision of banking, insurance, securities, or
    futures products and activities in the United States are also required by
    statute to be regulated at the holding company level. These include bank
    holding and financial holding companies that are regulated by the Federal
    Reserve, and thrift holding companies that are regulated by OTS. In
    addition, SEC has statutory authority to oversee investment bank holding
    companies, if they choose to be overseen in that way.

    U.S. regulators conduct their activities within a broad array of
    international forums and agencies. Some, such as the Basel Committee on
    Banking Supervision (Basel Committee), International Organization of
    Securities Commissions, and International Association of Insurance
    Supervisors, are voluntary organizations of supervisors from a number of
    countries. In addition, activities in the European Union-a treaty-based
    organization of European countries in which those countries cede some of
    their

    1OTS is the supervisor for state-chartered saving associations that belong
    to the Savings Association Insurance Fund.

                                   Executive Summary

    sovereignty so that decisions on specific matters of joint interest can be
    made democratically at the European level-often impact U.S. firms and
    regulators.

    Results in Brief	Over the last few decades, the environment in which the
    financial services industry operates and the industry itself have
    undergone dramatic changes that include globalization, consolidation
    within traditional sectors, conglomeration across sectors, and convergence
    of institutional roles and products. As a result of these changes, a
    relatively small number of very large, diversified financial companies now
    compete globally to meet a broad range of customer needs. Moreover, the
    complexity of these firms and the products and services they offer and use
    are changing the kinds and extent of risks in the financial services
    industry. With regard to some risk, such as credit risk, diversification
    across products, services, and markets might be expected to reduce the
    risk faced by an individual institution. However, it may not reduce the
    extent of risk in the system as a whole. The increased sophistication in
    and interconnections throughout the industry now make it difficult to
    determine the location and extent of that risk. In addition, the
    difficulty of managing these large, complex, globally active firms may
    expose them to greater operational risk in that it is more difficult to
    impose adequate controls to prevent fraud and abuse or some other
    operational problem at home or in some small far-flung subsidiary. While
    there are fewer financial services firms, the U.S. financial services
    industry retains a large number of smaller entities that compete in more
    traditional segmented markets, where they generally offer less complex or
    varied services than the large, consolidated firms and compete more
    locally against institutions in their sector.

    For some time, the United States has chosen not to change its regulatory
    structure substantially; however, since the mid-1990s, several other
    industrialized countries and some U.S. states have consolidated their
    regulatory structures, partially in response to changes in the industry.
    Today, instead of an array of government agencies and self-regulatory
    bodies, the countries GAO studied have one or two supervisory agencies.
    Germany, Japan, and the United Kingdom each have merged their regulatory
    structures into a single agency, while Australia and the Netherlands have
    consolidated their regulatory structures by assigning two of the major
    objectives of regulation-the safety and soundness of institutions and
    conduct-of-business, which includes market conduct, market integrity, and
    some aspects of corporate governance-to different regulatory agencies.
    Within these structures, the attainment of the third

    Executive Summary

    major regulatory objective, financial stability, is shared with the
    central bank, which may also share regulatory responsibilities. Those
    countries that have consolidated their regulatory structures differ in
    some important respects from the United States in that their economies and
    financial sectors are smaller and generally less diverse. Several U.S.
    states have similarly consolidated their regulatory agencies to better
    deal with changes in the industry. Officials in the states GAO talked to
    said that they are better able to meet the needs of consumers and to
    cooperate across traditional industry lines; however, they report that
    they have also sought to maintain the specialized knowledge regulators
    brought from their respective agencies. Over the years, proposals have
    also been made to consolidate various aspects of the U.S. regulatory
    structure, but the United States has not chosen to adopt those changes in
    any substantive way.

    While the U.S. financial services regulatory structure has changed little,
    regulators have modified their regulatory and supervisory approaches to
    respond to market changes. For example, during the 1990s, the bank
    regulatory agencies began risk-focused supervision of large, complex
    banks, focusing supervisory attention on management policies and
    procedures for areas believed to be the highest risk for the banking
    organizations rather than trying to cover all aspects of bank management;
    this risk-focused approach now applies to all banking organizations.
    Somewhat earlier, the National Association of Insurance Commissioners
    (NAIC) began to conduct groupwide financial analyses for nationally
    significant insurance companies-companies that are large or operate in
    several states. Some of the most pronounced changes in regulatory approach
    have or are coming about as a result of efforts to harmonize supervision
    across national boundaries. These efforts include the Basel Committee
    negotiations to update capital requirements for banks, generally referred
    to as Basel II,2 and the European Union's Financial Services Action Plan,
    especially the Financial Conglomerates Directive, which requires most
    large, complex firms doing business in European Union countries to apply
    Basel capital standards and become subject to consolidated supervision
    sometime in 2005. These activities are leading to changes in the
    regulation and supervision of some large or complex U.S. financial
    services firms that are active in Europe. For example, SEC has,

    2The Basel Committee, a group of central bankers and regulators from 13
    countries, adopted the Basel II capital standards in June 2004. Different
    countries will implement these standards at different times and to varying
    degrees. In addition, regulatory agencies in the United States that
    oversee different functional areas may implement these standards
    differently.

    Executive Summary

    for the first time, adopted rules to provide holding company oversight for
    certain large securities firms on a voluntary basis. These rules
    incorporate some of the Basel II framework for capital adequacy
    regulation.

    Congress and the regulators themselves have recognized the need for
    regulators in the U.S. system to communicate and coordinate activities
    within and across the traditional financial services sectors. Several
    formal and informal mechanisms exist to facilitate communication, both
    within and across sectors, but problems remain. For example, at the
    federal level, bank regulators coordinate examination and supervisory
    policy, including many rule-making initiatives, through the Federal
    Financial Institutions Examination Council and communicate internationally
    through the Basel Committee. Officials serving in the regional offices of
    the various federal bank regulators also reported that they communicate
    formally and informally with each other and with the state banking
    regulators in their region on a regular basis. However, problems between
    OTS and FDIC and between OCC and FDIC hindered a coordinated supervisory
    approach in bank failures in 2001 and 1999, respectively, and questions
    have arisen concerning the efficacy of having several U.S. bank regulators
    present different positions at Basel Committee negotiations. With regard
    to concerns about Basel II, the regulators say that the process was
    necessarily complex, they are required to air any disagreements through a
    transparent, public process and, in the end, all of the provisions the
    various U.S. bank regulators wanted were included in Basel II when it was
    adopted in June 2004. Similarly, securities regulators at the state and
    federal levels say they regularly coordinate enforcement actions, but in
    certain high-profile cases, some disagreements have emerged concerning the
    appropriateness and effectiveness of state and federal actions. With
    regard to coordination across sectors, regulators have taken some actions
    themselves, but have often been directed to coordinate by Congress or the
    President, especially in response to crises such as the stock market crash
    of 1987, the events of September 11, 2001, and recent corporate scandals.
    In a number of reports evaluating these cross sector efforts, GAO has
    noted that no mechanism exists for the monitoring of cross market or cross
    industry risks and that information sharing has not been sufficient for
    identifying and heading off potential crises. For example, in our report
    issued in 2000 on the President's Working Group, which includes the heads
    of the Federal Reserve, Treasury, SEC, and CFTC, GAO reported that
    although this group has served as a mechanism to share information during
    unfolding crises, its activities generally have not included such matters
    as routine surveillance of risks that cross markets or of information
    sharing that is specific enough to help identify potential crises.

    Executive Summary

    Experts generally agree that the regulatory structure alone does not
    determine whether regulatory objectives are achieved. Having an adequate
    number of people with the right skills, clear objectives, appropriate
    policies and procedures, and independence are probably more important.
    However, the regulatory structure can often facilitate or hinder the
    attainment of regulatory objectives. U.S. regulators and financial market
    participants GAO spoke with generally emphasized that the current
    regulatory structure has contributed to the development of U.S. capital
    markets and overall economic growth and stability. Industry participants
    also noted that regulators are generally of a high quality. With the
    adoption of holding company supervision for a broader segment of firms,
    some regulators may be better able to understand and prepare for the risks
    that cut across functional areas within a given holding company. In
    addition, in conjunction with agency specific strategic planning
    activities, regulators may better monitor risks that cut across the
    industry segments they oversee. However, no agency or mechanism has the
    responsibility for monitoring risks that cut more broadly across
    functional areas. Further, no agency has the responsibility for analyzing
    the risks to the financial system as a whole or planning strategically to
    address those risks and problems that may develop in the future; there
    also is no mechanism for agencies to cooperate effectively to perform
    these tasks. Some characteristics of the U.S. regulatory
    structure-specialization of and competition among the agencies-facilitate
    the attainment of some regulatory objectives and hinder the attainment of
    others. On the positive side, specialization allows regulators to better
    understand the risks associated with particular activities or products and
    to better represent the views of all segments of the industry. And
    competition among regulators helps to account for regulatory innovation
    and vigilance, by providing businesses with a method to move to regulators
    whose approaches better match the businesses' operations. However, these
    very characteristics may hinder the effective and efficient oversight of
    large, complex, internationally active firms that compete across sectors
    and national boundaries. In addition, the specialized and differential
    oversight of holding companies in the different sectors has the potential
    to create competitive imbalances among firms in those sectors based on
    regulatory differences alone. Further, competition among the regulators
    may limit the ability to negotiate international agreements that would
    broadly be to the advantage of U.S. firms. Similarly, some legal experts
    and regulators note that because large, complex firms are managed
    centrally, regulators that specialize in understanding risks specific to
    their "functional" sector may not have the ability or authority to oversee
    the complex risks that span financial sectors or the risk management
    methodologies employed by these firms. Moreover, they note

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    that competition among supervisory authorities poses the risk that
    financial firms may well engage in a form of regulatory arbitrage that
    involves the placement of particular financial services or products in
    that part of the financial conglomerate in which supervisory oversight is
    the least intrusive.

    In this report, GAO recognizes that the specifics of a regulatory
    structure may not be the critical determinant in whether a regulatory
    system is successful because skilled regulators with the appropriate
    policies and procedures could potentially overcome any impediments of the
    structure through better communication and coordination across agencies.
    However, because the structure may hinder the attainment of certain
    regulatory goals, GAO suggests that Congress may want to consider ways to
    consolidate the regulatory structure to (1) better address the risks posed
    by large, complex firms and their consolidated risk management approaches,
    (2) promote competition domestically and internationally, and (3) contain
    systemic risk. Some of these ways may require that the lines that now
    define regulatory responsibility change to recognize the changed
    environment of financial services. This could be done in several ways,
    including making relatively small changes such as consolidating the bank
    regulators and, if Congress wishes to provide an optional federal charter
    for insurance, creating a federal insurance regulator, or making more
    dramatic changes such as creating a single regulatory agency.
    Alternatively, a small agency could be created to facilitate the oversight
    of all large, internationally active firms. Each alternative has potential
    benefits and costs. For example, consolidation could facilitate, but won't
    necessarily ensure, that regulators communicate and coordinate, provide
    for regulatory neutrality, and monitor risks across markets. However,
    larger regulatory agencies could be less accountable to consumers or the
    industry, possibly damaging the diversity that enriches our economy, or
    could lose expertise critical to overseeing certain aspects of the
    industry. In addition, change itself has certain costs, such as the costs
    of rewriting the various laws that support the current regulatory
    structure and any unintended consequences that could result during the
    movement from the current structure to a new structure.

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    GAO's Analysis

    The Financial Services Industry Has Undergone Dramatic Changes

    The environment in which the financial services industry operates and the
    industry itself have undergone dramatic changes. First, globalization has
    become a predominant characteristic of modern economic life and has
    affected and been affected by the financial services sector. Capital moves
    across national boundaries, and many financial services firms operate
    globally. For example, foreign firms increasingly own U.S. life insurers
    and many U.S. banks and securities firms are internationally active. In
    addition, Citigroup has a significant retail banking business in Germany,
    while ING, a Dutch firm, seeks to attract deposits in its U.S. thrift.
    Second, consolidation of firms within the "functional" areas of banking,
    securities, and insurance and conglomeration of firms across these areas
    have increasingly come to characterize the large players in the industry.
    Since 1995, 40 large banking organizations have merged or acquired each
    other to such an extent that today just 6 very large institutions remain.
    Similarly, the number of securities and futures firms and the number of
    insurance companies have also declined while generally the industry has
    grown. With regard to increased conglomeration, a research report by
    International Monetary Fund staff-based on a worldwide sample of the
    largest 500 financial services firms in terms of assets-shows that the
    percentage of U.S. financial institutions in the sample that were engaged
    to some significant degree in at least two of the functional sectors of
    banking, securities, and insurance increased from 42 percent in 1995 to
    61.5 percent in 2000, and that these conglomerates held 73 percent of the
    assets of all of the U.S. firms included in the sample. Commonly, large
    firms will seek to use their size to meet a wider array of customer demand
    for different financial products and services and to diversify an
    individual firm's risk profile. Third, the roles of financial institutions
    and the products and services they offer have converged, so that many of
    these institutions are competing to offer similar services to customers.
    While these changes are occurring, the U.S. economy still has a large
    number of smaller entities that compete in more traditional segmented
    markets, where they generally offer less complex or varied services than
    the large, consolidated firms and compete more locally against
    institutions in their sector.

    As a result of changes in the industry, as well as the development of
    complex financial products, the financial services industry has become
    more complex, and thus the kinds and extent of risks the industry faces
    are changing. It is generally agreed that banks can better withstand
    defaults by

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    segments of their creditors, because they now serve a range of geographic
    markets and types of creditors. In addition, by securitizing assets,
    certain institutions have generally been able to reduce certain kinds of
    risks within an institution by passing them off to other financial
    institutions or investors. However, the overall risk to the industry may
    not have been reduced. Institutions that have purchased securitized
    assets, for instance, may not have risk management systems designed for
    the acquired risks. Further, the relationships between institutions that
    securitize assets and those buying these securitized assets range across
    regulatory and governmental jurisdictions. Changes in the industry,
    especially the growth of large institutions, have also affected the level
    and management of operational and reputation risk. Large, complex firms
    pose new risks for global financial stability because they can be brought
    down by fraud and abuse or some other operational problem in some small
    far-flung subsidiary. For example, the collapse of Barings, a British bank
    with global operations, demonstrates the potential vulnerability of firms
    to operational risk. In this case, management did not effectively
    supervise a trader in Singapore, and his actions brought down the whole
    bank.

    While Some Countries Have Consolidated Regulatory Structures, the United
    States Has Chosen to Maintain Its Structure

    Partly in response to industry changes, since the mid-1990s several major
    industrial countries have consolidated their regulatory structures.
    Germany, Japan, and the United Kingdom have each consolidated their
    regulatory structures so that they rely primarily on a single agency. The
    United Kingdom's move from nine regulatory bodies, including
    selfregulatory organizations (SRO), to a single agency, the Financial
    Services Authority (UK-FSA), is the most dramatic. UK-FSA focuses
    strategically on achieving a small number of statutory
    objectives-maintaining confidence in the financial system, promoting
    public understanding of the financial system, securing the appropriate
    degree of protection for consumers, and reducing the potential for
    financial services firms to be used for a purpose connected with financial
    crime-across a broad range of financial institutions and activities. In
    pursuing these goals, UK-FSA is required to take account of additional
    obligations, including achieving its goals in the most efficient and
    effective way and not damaging the competitive position of the United
    Kingdom internationally. To achieve its objectives under these proscribed
    constraints, UK-FSA focuses on the largest firms and on the needs of
    retail consumers. In addition, UK-FSA has taken actions to break down the
    traditional industry silos and to ensure that large, complex firms are
    overseen in consistent ways. While UK-FSA has sole responsibility for the
    safety and soundness of financial institutions and conduct-of-business, a
    tripartite group that includes the central bank and

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    Her Majesty's Treasury pursues the goal of financial stability. The German
    single regulator, which is still quite new, maintains the traditional
    silos of banking, securities, and insurance, adding crosscutting groups to
    handle conglomerate supervision and international issues. In addition, the
    new supervisory body shares some supervisory responsibilities with
    Germany's central bank. Because of persistent problems in the Japanese
    economy, especially in its banking sector, the Japanese experiment with a
    single regulator illustrates the point that a country's financial services
    regulatory structure alone is not the determining factor in promoting
    economic growth through the optimum allocation of financial capital.

    GAO also reviewed documents for two other countries-Australia and the
    Netherlands-that have consolidated their regulatory structures into two
    agencies that have responsibility for a single regulatory objective. In
    each country, one agency is responsible for prudential regulation of all
    financial institutions and the other for ensuring that financial firms and
    markets conduct their businesses properly. These structures are based on
    the belief that government agencies should have a single focus, so that
    one objective will not take precedence over another. In the Netherlands,
    the Dutch central bank has become the prudential regulator, while in
    Australia, the prudential regulator is independent. In both cases, the
    central bank has the primary responsibility for achieving the objective of
    financial stability.

    Some U.S. states have consolidated their structures in response to
    industry changes as well. The states GAO spoke with had created a single
    regulator structure, in part, because of the blurring of traditional
    boundaries in the industry. These states said they are better able to
    share information and cooperate across the sectors, but that maintaining
    expertise in the traditional sectors is still important. In addition,
    state officials said that while they did not consolidate to reduce the
    cost of regulation, consolidation had reduced costs.

    The United States, which differs from the other countries that have
    consolidated their structures in significant ways, such as having a much
    larger and more diverse financial sector, has not consolidated its
    regulatory structure. While GLBA substantially removed many of the
    barriers that had previously separated commercial banking from investment
    banking and insurance underwriting, GLBA did not substantially change the
    U.S. regulatory structure. Over the years, however, many proposals have
    been made to change the U.S. regulatory structure, and these proposals
    continued to be made throughout the 1990s and early 2000s. These include
    proposals to consolidate the bank regulators, merge SEC and CFTC,

                                   Executive Summary

    change the self-regulatory organization structure for securities, and
    create a federal insurance regulator to oversee those companies opting for
    the proposed federal insurance charter. Proposals have also been made that
    cut across sectors, including ones for a single federal regulator in each
    area, an oversight board, and a fully consolidated regulator.

    Regulators Are Adapting Regulatory and Supervisory Approaches in Response
    to Industry Changes

    Partly as a response to efforts to harmonize regulation internationally,
    regulators are adapting regulatory and supervisory approaches to industry
    changes. The major international efforts include the culmination of
    negotiations at the Basel Committee to update the framework for capital
    adequacy requirements for banks and bank holding companies, resulting in
    the Basel II framework, and European Union implementation of the Financial
    Conglomerates Directive, which will require most internationally active
    U.S. financial firms be subject to consolidated supervision. U.S.
    regulators will be implementing the Basel II requirements for large
    banking organizations over the next several years. Basel II has three
    pillars: the first concerns setting of minimum capital requirements, the
    second focuses on supervisory review of and action in response to banks'
    capital adequacy, and the third requires banks to publicly disclose
    information about their risk profile, risk assessment processes, and the
    adequacy of their capital levels to foster greater market discipline. The
    Financial Conglomerates Directive requires that non-European financial
    conglomerates, certain securities firms, and bank and financial holding
    companies operating in the European Union have adequate consolidated
    supervision, which includes application of Basel capital standards. Under
    the directive, which is expected to go into effect in 2005, a non-European
    financial conglomerate, securities firm, or bank or financial holding
    company that is not considered to be supervised on a consolidated basis by
    an equivalent home country supervisor would be subject to additional
    supervision by regulators in European Union member states. As a result,
    some major U.S. companies will need to demonstrate that they have
    consolidated home country supervision. Some companies that own thrift
    institutions may seek to meet these requirements by choosing OTS, which
    has the authority to oversee thrift holding companies, as their home
    country consolidated supervisor. For others, SEC has adopted rules for
    voluntary oversight of certain holding companies with large broker-dealers
    that are to be called Consolidated Supervised Entities. SEC is pursuing
    some changes to the Basel II standards that would make those requirements
    more relevant to securities activities undertaken by U.S. firms.

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    U.S. regulators have adapted other regulatory and supervisory approaches
    in response to industry changes. Beginning in the mid-1990s, OCC and the
    Federal Reserve adopted new supervisory protocols for large, complex
    institutions. Under this approach, examiners are assigned full time to a
    bank (and are often on-site) so that they can continually monitor and
    assess a banking organization's financial condition and risk management
    systems through the review of a variety of management reports and frequent
    meetings with key bank officials. Examiners focus examinations on a bank's
    internal control and risk-management systems; this risk-based approach is
    now used for banks of all sizes. Securities regulators had repeatedly
    revised their supervision protocols and had taken other actions to better
    understand derivatives activities of securities firms. The Commodity
    Futures Modernization Act of 2000-which had the primary goals of
    addressing changes in market conditions, such as the introduction of a
    wider variety of products-revamped many of the processes and goals of
    CFTC. And, NAIC adopted risk-based capital requirements and began
    analyzing significant insurance companies that do business in several
    states to identify issues that could affect groups across state lines.

    Regulators Communicate and Coordinate in Multiple Ways, but Concerns
    Remain

    Most of the communication among U.S. regulators takes place within a
    "functional" area. Within each of the four areas-banking, securities,
    insurance, and futures-federal regulators have established interagency
    groups to facilitate coordination and also communicate informally on a
    variety of issues. Generally, within sectors, these regulators communicate
    with each other, SROs, relevant state regulators, and their international
    counterparts. In insurance, NAIC is the primary vehicle for state
    regulators to communicate with each other and to coordinate with insurance
    regulators abroad. While regulators report frequent and regular meetings
    within their area, coordinated responses are not always reached on some
    major issues.

    Bank regulators coordinate examination and supervisory policy, including
    many rule-making initiatives, through the Federal Financial Institutions
    Examination Council and communicate internationally through the Basel
    Committee. They also hold formal meetings at the national and regional
    levels and communicate informally on a regular basis.

    Despite these practices, problems persist. In the 2001 failure of Superior
    Bank, FSB, problems between OTS, the primary supervisor, and FDIC hindered
    a coordinated supervisory approach, especially OTS's refusal to let FDIC
    participate in examinations. The failure resulted in a substantial

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    loss to the deposit insurance fund. Similarly, problems between OCC and
    FDIC were identified in the failure of the First National Bank of Keystone
    (West Virginia), which failed in 1999. (Regulators note that subsequent
    changes in policies should avoid similar problems in the future.) On the
    international front, several U.S. regulators joined the Basel II
    negotiations or presented their views late in the process. Regulators said
    that this ensured that concerns from all industry sectors were addressed
    in the negotiations, that a transparent process was used, and that the
    United States regulators obtained all of the provisions they wanted in the
    international agreement, reached in June 2004. Critics complain that
    having multiple regulators, particularly at the latest stages of
    negotiations, needlessly complicated the process and could have affected
    the outcome.

    While SEC and state securities regulators told us that they coordinate
    activities, including enforcement actions, some high-profile cases have
    resulted in disagreements. SEC and state securities regulators have
    brought several enforcement actions together; however, SEC and the states
    have sometimes disagreed on what is an appropriate role for each, and on
    how effective each has been. Similarly, in the insurance area, where NAIC
    is a highly structured forum for communication, some critics have noted
    that NAIC does not have the power to force state regulators to adopt
    similar positions, while other critics have noted that, as a
    quasigovernmental body, NAIC has too much power over state insurance
    regulation.

    Regulators themselves have identified the need to communicate across
    sectors. For example, nine securities SROs created the Intermarket
    Surveillance Group in 1983, and since then, futures SROs and foreign
    exchanges have joined as affiliated members. The purpose of this group is
    to coordinate and develop programs and procedures designed to assist in
    identifying possible fraudulent and manipulative acts and practices across
    markets and to share information. SEC and CFTC also jointly developed
    regulations implementing portions of the Commodity Futures Modernization
    Act, which lifted the ban on securities futures, but the process was
    difficult. Prior to the passage of the act, staff of both regulators had
    at times claimed sole jurisdiction over single stock futures,
    necessitating development of a memorandum of understanding that clarified
    joint oversight responsibilities for these instruments.

    Congress and the President have often seen the need to direct regulators
    to communicate across "functional" areas, sometimes in response to crises.
    On a number of occasions, Congress has directed regulators to

                                   Executive Summary

    communicate across "functional" areas. For example, in GLBA, Congress
    directed regulators to communicate to better oversee the risks of
    diversified holding companies; and following recent corporate and
    accounting scandals, Congress directed them to collectively draft guidance
    on complex structured finance transactions. Similarly, the President has
    issued executive orders directing regulators to form the President's
    Working Group and the Financial and Banking Information Infrastructure
    Committee. The former was created to address issues related to the 1987
    stock market crash and was formally reactivated in 1994 to consider other
    issues, including the 1997 market decline and threats to critical
    infrastructure. The latter was created after the events of September 11,
    2001, to coordinate federal and state financial regulatory efforts to
    improve the reliability and security of the U.S. financial system.

    In evaluating these and other efforts of financial regulators to
    communicate and coordinate, GAO has found that these ways do not allow for
    a satisfactory assessment of risks that cross traditional regulatory and
    industry boundaries and therefore may inhibit the ability to detect and
    contain certain financial crises. In addition, the existing ways
    regulators communicate and coordinate do not provide for the systematic
    sharing of information on enforcement actions across sectors, making it
    more difficult for regulators to identify potential fraud and abuse, and
    for consumers to identify the relevant regulator.

    The U.S. Regulatory System Has Strengths, but Its Structure May Hinder
    Effective Regulation

    Financial markets exist to serve the needs of businesses, households, and
    government, and financial regulation is judged, in part, by how well
    markets meet the needs of these users. U.S. regulators and financial
    market participants GAO spoke with generally emphasized that the current
    regulatory structure has contributed to the development of U.S. capital
    markets and overall growth and stability in the U.S. economy. Industry
    participants also noted that regulators are generally of a high quality.
    With the adoption of holding company supervision for a broader segment of
    firms, some regulators may be better able to understand and prepare for
    the risks that cut across functional areas within a given holding company.
    In addition, in conjunction with agency specific strategic planning
    activities, regulators may better monitor risks that cut across the
    industry segments they oversee. However, no agency or mechanism has the
    responsibility for monitoring risks that cut more broadly across
    functional areas. Further, no agency has the responsibility for analyzing
    the risks to the financial system as a whole or planning strategically to
    address those risks and problems that may develop in the future; there
    also is no

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    mechanism for agencies to cooperate effectively to perform these tasks.
    Agency structure alone does not determine whether regulators do their jobs
    efficiently and effectively, but it can facilitate or hinder achieving
    those goals. Experts outside the regulatory system and some foreign
    regulators have suggested that the U.S. regulatory system does not
    facilitate and may hinder the efficient and effective oversight of large,
    complex, internationally active firms. In particular, critics have noted
    that "functional" regulation-focusing the oversight of different
    regulators on specific activities within a financial services firm-is
    inconsistent with these firms' centralized risk management. U.S. firms and
    regulators are also likely to be affected by efforts to harmonize
    regulation internationally. Large, internationally active firms say these
    efforts are critical to providing financial services in a cost-effective
    manner; however, the fragmented nature of the U.S. regulatory system may
    hinder these negotiations. In addition, the increasing need for a global
    perspective in the insurance industry where U.S. insurers are increasingly
    foreign-owned is difficult within the state insurance regulatory system.

    While large U.S. firms compete across sectors, important differences
    remain among banking, insurance, securities, and futures businesses. In
    addition, many smaller firms operate only in a single sector or single
    local market. As a result, the regulatory system benefits from the
    specialized knowledge regulators acquire within their specialized
    agencies. Regulatory agencies, however, may become "captives" of the
    industries they are supposed to regulate and not be able to benefit from
    economies of scale and scope related to the need for skills that cut
    across regulatory agencies. In addition, the existence of specialized
    agencies affords firms the opportunity to conduct transactions in those
    parts of its organization with the least intrusive regulation.

    Congress May Want to Consider Changes to the U.S. Regulatory Structure

    The financial services industry is critical to the health and vitality of
    the U.S. economy. While the industry itself bears primary responsibility
    to effectively manage its risks, the importance of the industry and the
    nature of those risks have created a need for government regulation as
    well. While the specifics of a regulatory structure, including the number
    of regulatory agencies and the roles assigned to each, may not be the
    critical determinant in whether a regulatory system is successful, the
    structure can facilitate or hinder the attainment of regulatory goals. The
    skills of the people working in the regulatory system, the clarity of its
    objectives, its independence, and its management systems are critical to
    the success of financial regulation.

                                   Executive Summary

    Because our regulatory structure relies on having clear-cut boundaries
    between the "functional" areas, industry changes that have caused those
    boundaries to blur have placed strains on the regulatory framework. While
    diversification across activities and locations may have lowered the risks
    being faced by some large, complex, internationally active firms,
    understanding and overseeing them have also become a much more complex
    undertaking, requiring staff that can evaluate the risk portfolio of these
    institutions and their management systems and performance. Regulators must
    be able to ensure effective risk management without needlessly restraining
    risk taking, which would hinder economic growth. Similarly, because firms
    are taking on similar risks across "functional" areas, to understand the
    risks of a given institution or those that span institutions or
    industries, regulators need a more complete picture of the risk portfolio
    of the financial services industry both in the United States and abroad.

    Recognizing that regulators could potentially overcome the impediments of
    a fragmented regulatory structure through better communication and
    coordination across agencies, Congress has created mechanisms for
    coordination and on a number of specific issues has directed agencies to
    coordinate their activities. In addition, GAO has repeatedly recommended
    that federal regulators improve communication and coordination. While GAO
    continues to support these recommendations, it recognizes that the sheer
    number of regulatory bodies, their underlying competitive nature, and
    differences in their regulatory philosophies will continue to make the
    sharing of information difficult and true coordination and cooperation in
    the most important or most visible areas problematic as well. Therefore,
    Congress might want to consider some changes to the U.S. financial
    services regulatory structure that address weaknesses and potential
    vulnerabilities in our current system, while maintaining its strengths.

    Matter for Congressional Consideration

    While maintaining sector expertise and ensuring that financial
    institutions comply with the law, Congress may want to consider some
    consolidation or modification of the existing regulatory structure to (1)
    better address the risks posed by large, complex, internationally active
    firms and their consolidated risk management approaches; (2) promote
    competition domestically and internationally; and (3) contain systemic
    risk. If so, our work has identified several options that Congress may
    wish to consider:

    o  consolidating the regulatory structure within the "functional" areas;

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    o 	moving to a regulatory structure based on a regulation by objective or
    twin peaks model;

    o  combining all financial regulators into a single entity; or

    o 	creating or authorizing a single entity to oversee all large, complex,
    internationally active firms, while leaving the rest of the structure in
    place.

    If Congress does wish to consider these or other options, it may want to
    ensure that legislative goals are clearly set out for any changed
    regulatory structure and that the agencies affected by any change are
    given clear direction on the priorities that should be set for achieving
    these goals. In addition, any change in the regulatory structure would
    entail changing laws that currently govern financial services oversight to
    conform to the new structure.

    The first option would be to consolidate the regulatory structure within
    "functional" areas-banking, securities, insurance, and futures-so that at
    the federal level there would be a primary point of contact for each. The
    two major changes to accomplish this at the federal level would be
    consolidation of the bank regulators and, if Congress wishes to provide a
    federal charter option for insurance, the creation of an insurance
    regulatory entity. The bank regulatory consolidation could be achieved
    within an existing banking agency or with the creation of a new agency. In
    1996, we recommended that the number of federal agencies with primary
    responsibilities for bank oversight be reduced. However, we noted that in
    the new structure, FDIC should have the necessary authority to protect the
    deposit insurance fund and that the Federal Reserve and Treasury should
    continue to be involved in bank oversight, with access to supervisory
    information, so that they could carry out their responsibilities for
    promoting financial stability. We have not studied the issue of an
    optional federal charter for insurers, but have through the years noted
    difficulties with efforts to harmonize insurance regulation across states
    through the NAIC-based structure. Having a primary federal entity for each
    of the functional sectors would likely improve communications and
    coordination across sectors because it would reduce the number of entities
    that would need to be consulted on any issue. Similarly, it would provide
    a central point of communication for issues within a sector. Fewer bank
    regulators might reduce the cost of regulation and the opportunities for
    regulatory arbitrage, choosing charters so that transactions have the
    least amount of oversight. In addition, issues related to the independence
    of a regulator

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    from the firms they oversee with a given kind of charter would be
    alleviated. However, consolidating the banking regulators and establishing
    a federal insurance regulator would raise concerns as well. While improved
    communication and cooperation within sectors would help to achieve the
    objectives outlined above, it would not directly address many of them. In
    addition, some constituencies, such as thrifts, might feel they were not
    getting proper attention for their concerns; and opportunities for
    regulatory experimentation and the other positive aspects of competition
    in banking could be reduced. Further, while this option represents a more
    evolutionary change than some of the others, it might still entail some
    costs associated with change, including unintended consequences that would
    undoubtedly erupt as various banking agencies and their staff jockeyed for
    position within the new banking regulator. Similarly, the establishment of
    a federal insurance regulator might have unintended consequences for state
    regulatory bodies and for insurance firms as well.

    Another option would be consolidating the regulatory structure using a
    regulation by objective, or twin peaks model. The twin peaks model would
    involve setting up one safety and soundness regulatory entity and one
    conduct-of-business regulatory entity. The former would oversee safety and
    soundness issues for insurers, banks, securities, and futures activities,
    while the latter would ensure compliance with the full range of
    conduct-ofbusiness issues, including consumer and investor protection,
    disclosure, money laundering, and some governance issues. This could be
    accomplished by changing the tasks assigned to existing agencies or by
    restructuring the agencies or creating new ones. On the positive side,
    this option would directly address many of the regulatory objectives
    related to larger, more complex institutions, such as allowing for
    consolidated supervision, competitive neutrality, understanding of the
    linkages within the safety and soundness and conduct-of-business spheres,
    and regulatory independence. In addition, conduct-of-business issues would
    not become subservient to safety and soundness issues, as some fear. On
    the negative side, in addition to the issues raised by any change in the
    structure, this structure would not allow regulators to oversee the
    linkages between safety and soundness and conduct-of-business. As
    reputational risk has become more important, the linkages between these
    activities have become more evident. In addition, if the controls and
    processes for conduct-of-business issues and safety and soundness issues
    are coming from the top of the organization, they are probably closely
    related. Finally, combining regulators into multifunctional units might
    not allow the regulatory system to maintain some of the advantages it now
    has, including

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    specialized expertise and the benefits of regulatory competition and
    experimentation.

    The most radical option would combine all financial regulators into a
    single entity, similar to UK-FSA. The benefits of the single regulator are
    that one body is accountable for all regulatory endeavors. It can more
    easily evaluate the linkages within and across firms, including those
    between conduct-of-business and safety and soundness considerations, plan
    strategically across sectors, and facilitate the allocation of resources
    to their highest priority use. However, achieving these goals would depend
    on having the right people and skills, clear regulatory objectives,
    effective tools, and appropriate policies and procedures. While the UK-FSA
    model is intriguing, this option raises some concerns for the United
    States. First, because of the size of the U.S. economy and the number of
    financial institutions, this entity would have to be very large and, thus,
    could be unwieldy and costly. UK-FSA has about 2,300 employees, while
    estimates of the number of regulators currently in the United States range
    from about 30,000 to 40,000. In addition, officials at UK-FSA have
    commented about the difficulty of setting priorities when a large number
    of issues have to be dealt with. Prioritizing these issues for the United
    States would be particularly difficult. Further, an entity with this scope
    and size might have difficulty responding to smaller players and might
    therefore damage the diversity that has enriched the U.S. financial
    industry. Also, staff at such an entity might lose or not develop the
    specialized skills needed to understand both large and small companies and
    risks that are specific to the different "functional" sectors. And,
    without careful oversight, such a large and allpowerful entity might not
    be accountable to consumers or the industry.

    A more evolutionary change would be to have a single entity with
    responsibility for the oversight of all large, complex, or internationally
    active financial services firms that manage risk centrally, compete with
    each other within and across sectors, and, by their size and presence in a
    wide range of markets, pose systemic risks. Having a single regulatory
    entity for large, complex, or internationally active firms could be
    accomplished by giving this responsibility to an existing regulator or by
    creating a new entity. A new entity might consist of a small staff that
    would rely on the expertise of staff at existing regulatory agencies to
    accomplish supervisory tasks.

    Having a single regulatory entity for large, complex, or internationally
    active firms would have the advantage of addressing industry changes,
    while leaving much of the U.S. regulatory structure unchanged. A single

                                   Executive Summary

    regulatory entity for large, complex holding companies would have
    responsibilities that more closely align with the businesses' approach to
    risk than the current regulatory structure. In addition, this entity could
    promote competition between these firms by ensuring, to the greatest
    extent possible, that oversight is competitively neutral. A single
    regulatory entity for internationally active firms would also be better
    positioned to help coordinate the views of the United States in
    international forums, so that the U.S. firms are not competitively
    disadvantaged during negotiations. Finally, this entity would be better
    able to appraise the linkages across large, complex, internationally
    active firms and, thus, with the aid of the Federal Reserve and Treasury,
    could contribute to promoting financial stability. These potential
    improvements could be obtained without losing the advantages afforded by
    our current specialized regulators, who would continue to supervise the
    activities of regulated firms such as brokerdealers or banks. However,
    this option also has drawbacks. While the transition costs might be less
    than in some of the other options, the creation of a new entity or
    changing the role of an existing regulatory entity would still entail
    costs and likely some unintended consequences. It might also be difficult
    to maintain the appropriate balance between the interests of the large or
    internationally active firms and smaller, more-specialized entities. It
    also could involve creating one more regulatory agency in a system that
    already has many agencies.

    Agency Comments and Our Evaluation

    We received written comments on a draft of this report from the Chairman
    of the Board of Governors of the Federal Reserve System, the Chairman of
    FDIC, the Comptroller of the Currency, and the Director of SEC's Division
    of Market Regulation. Their comments generally noted that the U.S.
    financial regulatory system had balanced effective regulation and market
    forces to promote a strong and innovative financial system. Where
    appropriate, we have changed the report to clarify this balance. In
    addition, the Chairman of the Federal Reserve Board of Governors and the
    Chairman of FDIC stressed the importance of the insured depository in the
    regulatory scheme. We provided a draft of the report to Treasury, CFTC,
    and NAIC, for possible comments, but no written comments were provided.
    All of the agencies provided technical comments that were incorporated,
    where appropriate.

    The Director of the Office of Thrift Supervision provided comments on a
    draft of this report, saying that the report inadequately reflected OTS's
    authority to supervise thrift holding companies and OTS's international
    initiatives. While we have made some changes to the report to clarify
    these

    Executive Summary

    topics, we believe that the report does accurately discuss both topics. We
    also disagreed with the Director's request that we delete references to
    the failure of Superior Bank, FSB, which he thought did not reflect the
    causes of the failure or the significant costs to the insurance funds from
    other failures. We did change the report to make clear that this failure,
    and another commercial bank failure in 1999, were caused by actions of the
    banks themselves. However, these failures did highlight problems in
    coordinating actions by the primary federal bank regulators and FDIC,
    which also has authority to examine the banks it insures.

    Chapter 1

    Introduction

    The U.S. financial services industry has four sectors-banking, securities,
    insurance, and futures,1 which together had 5.8 million employees and were
    responsible for almost one-tenth of the U.S. gross domestic product in
    2001. Traditionally, the financial services industry promoted economic
    growth by intermediating between households, businesses, and governments
    seeking to increase their assets through savings and those interested in
    increasing their current spending through borrowing. Intermediation
    differed in specific ways across the major sectors. All financial services
    firms are exposed to a variety of risks, including credit and market risk,
    and the industry as a whole is exposed to systemic risk, which is
    generally defined as the risk that a disruption (at a firm, in a market
    segment, to a settlement system, etc.) could cause widespread difficulties
    at other firms, in other market segments, or in the financial system as a
    whole.

    The U.S. regulatory structure is composed of several agencies that tend to
    specialize in given financial sectors and activities and has a tradition
    of both state and federal regulation of some sectors and activities.
    Generally, banking is regulated by several federal regulators and by state
    bank regulators; securities by the Securities and Exchange Commission
    (SEC), self-regulatory organizations (SROs), and state regulators; futures
    by the Commodity Futures Trading Commission (CFTC) and SROs; and insurance
    by state insurance departments. Federal agencies are charged with
    overseeing particular types of institutions and activities, and state
    agencies exercise a similar function for entities that are not regulated
    exclusively by the federal government. The federal agencies also operate
    within an international framework that includes a variety of entities.

    1Futures are one type of derivatives contract. The market value of a
    derivatives contract is derived from a reference rate, index, or the value
    of an underlying asset, including stocks, bonds, commodities, interest
    rates, foreign currency exchange rates, and indexes that reflect the
    collective value of underlying financial products. The regulation of
    derivatives generally varies depending on whether they are traded on
    exchanges (exchange-traded) or traded over-the-counter (OTC) and on the
    nature of the underlying asset, reference rate, or index. Futures obligate
    the holder to buy or sell a specific amount or value of an underlying
    asset, reference rate, or index at a specified price on a specified future
    date and are often traded on exchanges. Options-contracts that grant their
    purchasers the right but not the obligation to buy or sell a specific
    amount of the underlying asset, reference rate, or index at a particular
    price within a specified period-are also sometimes traded on exchanges.
    See chapter 2 for more information about derivatives.

                                 Chapter 1 Introduction

    Traditionally, Financial Because those doing the saving in an economy and
    those doing the

    spending have not always had direct access to each other,
    financialInstitutions Served as services firms have traditionally served
    as intermediaries between them. Intermediaries and Figure 1 illustrates
    how financial services firms perform this role. Different Transferred Some
    institutions-depositories, securities firms, insurance companies, and

    futures firms-facilitated intermediation differently, using differentRisks
    markets and products. In addition, some firms helped households and
    businesses manage risk.

    Figure 1: Traditional Role of Financial Intermediaries

                                          $ $

                                     Intermediaries

                                           $

                  Sources of funds Users of funds (including spenders)

                                          $ $

    Households Businesses Government

    Financial markets

    Households Businesses Government

      Source: The Evolving Role of Commercial Banks in U.S. Credit Markets, FDIC.

    By most measures, depositories-commercial banks, thrifts,2 credit unions,3
    and industrial loan companies (ILCs)4-make up the largest group of
    financial intermediaries. Traditionally, depositories used the funds they
    received as deposits to make loans directly to businesses and consumers,
    and various types of depositories were set up to serve different

    2We use the term "thrifts" to refer to savings and loan associations and
    the term "thrift holding companies" to refer to savings and loan holding
    companies throughout this report.

    3Our report Credit Unions: Financial Condition Has Improved, but
    Opportunities Exist to Enhance Oversight and Share Insurance Management,
    GAO-04-91 (Washington, D.C.: Oct. 27, 2003) discusses the credit union
    industry and the National Credit Union Administration (NCUA). Because
    credit unions have only about 9 percent of domestic deposits, this report
    does not discuss them in detail.

    4ILCs are state-chartered institutions that may take deposits and offer
    some banking services, but generally are not permitted to offer a full
    range of bank services. GAO has an ongoing engagement looking at certain
    issues related to ILCs. Because ILC's have only about 1 percent of
    domestic deposits, this report does not discuss them in detail.

    Chapter 1 Introduction

    constituents. Today, their activities are considerably more diverse. For
    instance, banks and their affiliates are heavily involved in the OTC
    derivatives market, in which transactions involving financial derivatives
    are negotiated off exchanges. Depositories include commercial banks, with
    about 73 percent of domestic deposits at the end of 2003; thrifts, with
    about 14 percent of domestic deposits; credit unions, with about 9 percent
    of domestic deposits; and ILCS, with about 1 percent of domestic deposits.
    Although structural differences remain, most powers and services of
    depositories have converged over time, with few practical differences
    remaining in the activities they undertake. Thus, in this report we will
    generally refer to all depositories as banks.

    Securities firms are second to banks in the amount of assets held and
    revenue generated. Securities firms facilitate the transfer of funds from
    savers to businesses or government through capital markets by underwriting
    corporate equity securities (stocks) and corporate and government debt
    securities (bonds). In addition, securities firms facilitate the buying
    and selling of existing securities so that funds move from all kinds of
    savers to all kinds of spenders. Several types of securities firms
    participate in this process. Brokers are intermediaries for those who buy
    and sell securities, and dealers are those who buy and sell securities for
    their own accounts. Investment banks underwrite new debt securities and
    equity securities and perform broker-dealer functions. Investment banks
    buy the new issues and, acting as wholesalers, sell them to institutional
    investors such as banks, mutual funds, and pension funds. Investment
    companies, such as mutual funds and hedge funds, gather funds from savers
    and collectively pass them to spenders by purchasing assets in capital
    markets. Investment advisers and transfer agents also play a role in this
    market but do not act directly as intermediaries. By offering savings
    products with varying risks and returns, securities firms also help savers
    manage risk.

    Insurance companies, the third largest sector of the financial services
    industry, serve as intermediaries by taking the insurance premium payments
    of households and businesses in payment for insurance coverage and
    investing in corporate securities. The return on these investments is
    expected to fund insurance companies' future liabilities. Insurance
    premium payments come from the sale of products that usually fall into
    three categories: property-casualty, life and health, and reinsurance.
    Property-casualty insurance products cover business and household assets
    such as cars, houses, business structures, inventories, and goods in
    transit, as well as areas of liability such as product performance and
    professional

    Chapter 1 Introduction

    misconduct. Life insurance products provide a tax-free sum to the
    beneficiary of the policyholder in the event of the policyholder's death
    or other insured event. Health insurance, which covers expenses associated
    with medical care and often any financial losses individuals incur from
    injuries or illness, is not directly relevant to this study. Insurance
    companies purchase reinsurance, among other things, to spread risk and
    protect against catastrophic events. Along with their role as financial
    intermediaries, insurance companies have helped households and businesses
    manage risk by allowing them to insure themselves against certain
    contingencies. Agents who are employed by the insurance companies or work
    independently generally distribute insurance products.

    While firms that deal in exchange-traded futures (futures firms)
    facilitate the transfer of funds, the primary role of futures markets
    involves transferring risk and providing a mechanism for price discovery.
    Market participants include hedgers, who are managing risks, and
    speculators, who are taking a position on the direction of market movement
    in hopes of making a profit. Futures contracts protect sellers and
    purchasers of assets, such as physical commodities like pork bellies or
    financial commodities like currencies, from changes in value over time and
    provide opportunities for speculators to take varying positions on the
    future value of these commodities in hopes of making a profit. Several
    types of futures firms participate in this process. Futures firms that
    execute orders and hold retail customer accounts are futures commission
    merchants (FCMs). In addition, floor brokers make trades for others and,
    along with floor traders, also make trades for themselves. Commodity pool
    operators serve a function similar to that of investment companies in
    securities markets in that they pool funds for the purpose of trading
    futures contracts. Commodity trading advisers and others also participate
    in futures markets.5 The markets where exchange-traded futures contracts
    are traded are generally called boards of trade.

    5For example, associated persons who may act on behalf of other futures
    firms also play a role in futures markets.

                                 Chapter 1 Introduction

    The Financial Services Industry Faces Risks at the Institutional Level and
    Systemwide

    To varying degrees, financial institutions are exposed to the following
    types of risks:6

    Credit risk-the potential for financial losses resulting from the failure
    of a borrower or counterparty to perform on an obligation.

    Market risk-the potential for financial losses due to the increase or
    decrease in the value or price of an asset or liability resulting from
    broad movements in prices, such as interest rates, commodity prices, stock
    prices, or the relative value of currencies (foreign exchange).

    Liquidity risk-the potential for financial losses due to the inability of
    a firm to meet its obligations because of an inability to liquidate assets
    or obtain adequate funding, such as might occur if most depositors or
    other creditors were to withdraw their funds from a firm.

    Operational risk-the potential for unexpected financial losses due to
    inadequate information systems, operational problems, and breaches in
    internal controls, or fraud. These can include risks associated with
    clearing and settling transactions, either as a principal or as an agent,
    as well as risks associated with custodial functions (e.g., holding
    securities on behalf of others).

    Reputational risk-the potential for financial losses that could result
    from negative publicity regarding an institution's business practices and
    subsequent decline in customers, costly litigation, or revenue reductions.

    Legal risk-the potential for financial losses due to breaches of law or
    regulation that may result in heavy penalties or other costs.

    Business/event risk-the potential for financial losses due to events not
    covered above, such as credit rating downgrades (which affect a firm's
    access to funding), or factors beyond the control of the firm, such as
    major shocks in the firm's markets.

    Insurance/actuarial risk-the risk of financial losses that an insurance
    underwriter takes on in exchange for premiums, such as the risk of
    premature death.

    6We recognize that there are alternative ways to categorize risks.

                                 Chapter 1 Introduction

    In addition to these risks, the financial system as a whole may be
    vulnerable to systemic risk, which is generally defined as the risk that a
    disruption (at a firm, in a market segment, to a settlement system, etc.)
    could cause widespread difficulties at other firms, in other market
    segments, or in the financial system as a whole. The difficulties may be
    real in that institutions, markets, or settlement systems are linked by
    transactions or may result in customers panicking as a result of believing
    that failure at a given institution will affect similar institutions and
    taking actions such as removing deposits that precipitate systemic crises.

    U.S. Financial Services Regulation Has Multiple Goals

    Generally, the United States relies on markets to promote the efficient
    allocation of capital throughout the economy so as to best fund the
    activities of households, business, and government. Financial services are
    subject to oversight for several reasons that relate to the inability of
    the market to ensure that the efficient allocation of capital will take
    place. Essentially, markets cannot ensure that certain kinds of
    misconduct, including fraud and abuse or market manipulation, will not
    occur and that consumers/investors will have adequate information to
    discipline institutions with regard to the amount of risk they take on. In
    addition, because of systemic linkages, the system as a whole may be prone
    to instability. While financial services firms are aware of systemic risk,
    they will not likely take steps to minimize it.

    In the United States, laws define the roles and missions of the various
    regulators, and to some extent these are similar across the regulatory
    bodies. However, laws and regulatory agency policies can set a greater
    priority on some roles and missions than others. In addition, the goals
    and objectives of the regulatory agencies have developed somewhat
    differently over time, such that bank regulators generally focus on the
    safety and soundness of banks, securities and futures regulators focus on
    market integrity and investor protection, and insurance regulators focus
    on the ability of insurance firms to meet their commitments to the
    insured.

    In general, regulators help protect consumers/investors who may not have
    the information or expertise necessary to protect themselves from fraud
    and other deceptive practices, such as predatory lending or insider
    trading, and that the marketplace may not necessarily provide. Through
    monitoring activities, examinations, and inspections, regulators oversee
    the conduct of institutions in an effort to ensure that they do not engage
    in fraudulent activity and do provide consumers/investors with the
    information they need to make appropriate decisions and ultimately
    discipline the behavior

                                 Chapter 1 Introduction

    of financial institutions in the marketplace. However, in some areas
    providing information through disclosure and assuring compliance with laws
    are still not adequate to allow consumers/investors to influence firm
    behavior. In these cases, regulators oversee how risk is managed and seek
    to restrain excessive risk taking in order to promote the safety and
    soundness of institutions that engage in certain kinds of activities. In
    addition, by providing deposit insurance, overseeing other insurance or
    guarantee funds, or directly intervening in the marketplace, regulators
    take actions to ensure that the types of widespread financial instability
    that could seriously disrupt economic activity do not occur. However, with
    insurance or guarantee funds or the expectation that some firms are too
    big to fail, the normal disciplining of the market is disrupted, creating
    the "moral hazard" that institutions will take on more risk than they
    would in the absence of such insurance or expectations. As a result, the
    need for safety and soundness oversight is intensified.

    U.S. Financial Regulatory System Includes a Variety of Regulatory Bodies

    The objectives of U.S. financial services regulation are pursued by a
    complex combination of federal and state government agencies and
    selfregulatory organizations (SROs). Generally, regulators specialize in
    the oversight of financial entities in the various financial services
    sectors. This specialization stems largely from the laws that established
    these agencies and defined their missions. In addition, some regulators
    have responsibilities to regulate holding companies with subsidiaries that
    engage in various financial services activities. The Federal Reserve7 and
    the Department of the Treasury (Treasury) play a special role in
    maintaining financial stability.

    Regulators Specialize in the Oversight of Financial Entities in Various
    Sectors

    Five federal agencies oversee banks, including those chartered and
    overseen by state regulatory agencies. The specific regulatory
    configuration depends on the type of charter the banking institution
    chooses. Banks may be regulated by the federal government alone, if they
    are chartered by a federal regulator such as the Office of the Comptroller
    of the Currency (OCC) or Office of Thrift Supervision (OTS), or by both
    federal and state governments, if they are state-chartered institutions.
    Securities and futures firms are regulated at the federal level by the

    7We use the term Federal Reserve throughout this report to refer to the
    Federal Reserve's Board of Governors, the 12 Federal Reserve Banks, or
    both, unless otherwise specified.

                                 Chapter 1 Introduction

    Securities and Exchange Commission (SEC) and Commodity Futures Trading
    Commission (CFTC), respectively, which, in turn, rely on SROs to assist
    with their oversight. State regulators also have oversight and enforcement
    responsibilities for securities. Insurance entities are overseen largely
    at the state level. There are also regulators for government sponsored
    enterprises and pension funds, which lie outside the scope of this report.

    Multiple Regulators Oversee Banking institutions can generally determine
    their regulators by choosing a

    Banking Entities	particular kind of charter-commercial bank, thrift,
    credit union, or industrial loan company. These charters may be obtained
    at the state level or the national level for all except industrial loan
    companies, which are chartered only at the state level. State regulators
    charter institutions and participate in the oversight of those
    institutions; however, all of these institutions have a primary federal
    regulator if they have federal deposit insurance. State-chartered
    commercial banks that are members of the Federal Reserve are subject to
    supervision by that institution. Other statechartered banks, such as
    nonmember state banks, state savings banks, and ILCs, with federally
    insured deposits are subject to Federal Deposit Insurance Corporation
    (FDIC) oversight, while OTS supervises statechartered savings associations
    that are members of the Savings Association Insurance Fund. Federally
    chartered institutions are subject to oversight by their chartering
    agencies. OCC supervises national banks, OTS supervises federally
    chartered thrifts, and the National Credit Union Administration (NCUA)
    supervises federally chartered credit unions. To the extent that OTC
    derivatives activities take place in these institutions, they are subject
    to oversight by the appropriate regulator. In addition, FDIC has backup
    supervisory authority for those banks that are members of the insurance
    funds it oversees and have a different primary supervisor.

    The primary objectives of federal bank regulators include ensuring the
    safe and sound practices and operations of the institutions they oversee
    and the stability of financial markets. To achieve these goals, regulators
    establish capital requirements, conduct on-site 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. In addition,
    federal regulators oversee and take enforcement actions to ensure
    compliance with many consumer protection laws such as those requiring fair
    access to banking services and privacy protection.

                                 Chapter 1 Introduction

    The current bank regulatory structure evolved over time. OCC was created
    by the National Currency Act of 1863, which was rewritten as the National
    Bank Act of 1864. The Federal Reserve Act of 1913 created the Federal
    Reserve, partly in response to the financial panic of 1907. FDIC was
    established under the Banking Act of 1933. In 1933, Congress also
    authorized the federal chartering of savings and loans by the Federal Home
    Loan Bank Board, and, in 1934, the National Housing Act established the
    Federal Savings and Loan Insurance Corporation to provide for federal
    regulation of federally insured, state-chartered thrifts. In 1989, OTS
    replaced the Federal Home Loan Bank Board as the federal thrift
    institution regulator.8 Organizationally, OCC and OTS are within the
    Department of the Treasury; however, the Comptroller of the Currency and
    the Director of OTS are appointed by the President and confirmed by the
    Senate for fixed terms, an arrangement intended to help ensure the
    independence of these agencies. The Federal Reserve's Board of Governors
    and FDIC are independent federal agencies; the Comptroller of the Currency
    and Director of OTS sit on FDIC's five-person board of directors. The
    three other board members are appointed by the President for fixed terms
    with one appointed as Chairman and another as Vice Chairman. As with the
    Comptroller of the Currency and the Director of OTS, the Federal Reserve's
    Board of Governors are appointed by the President and confirmed by the
    Senate for fixed terms.

    SROs Contribute to Security and The Securities Exchange Act of 1934
    established the regulatory structure of

    Futures Regulation	U.S. securities markets. These markets are regulated
    under a combination of self-regulation (subject to SEC oversight) and
    direct SEC regulation. This regulatory structure was intended to give SROs
    responsibility for administering their own operations, including most of
    the daily oversight of the securities markets and their participants. One
    of the SROs-NASD-is a national securities association that regulates
    registered securities brokerdealers.9 Other SROs include national
    securities exchanges that operate the markets where securities are
    traded.10 These SROs are primarily

    8See Financial Institution Reform, Recovery and Enforcement Act of 1989
    (FIRREA) S: 407, 103 Stat. 363.

    9NASD is registered as a national securities association under section 15A
    of the Securities Exchange Act of 1934, 15 U.S.C. S: 78o-3, (2000 & Supp.
    2004) and is considered an SRO pursuant to section 3(a)(26), 15 U.S.C. &
    78c(a)(26).

    10These SROs include those dealing in exchange-traded options. SEC shares
    oversight of exchange-traded options with CFTC depending on the nature of
    the underlying.

    Chapter 1 Introduction

    responsible for establishing the standards under which their members
    conduct business; monitoring business conduct; and bringing disciplinary
    actions against their members for violating applicable federal statutes,
    SEC's rules, and their own rules. SEC oversees the SROs by inspecting
    their operations and reviewing their rule proposals and appeals of final
    disciplinary proceedings.

    The Securities Exchange Act also created SEC as an independent agency to
    oversee the securities markets and their participants. SEC has a
    fivemember commission headed by a chairman who is appointed by the
    President for a 5-year term. In overseeing the SROs' implementation and
    enforcement of rules, SEC may use its statutory authority to, among other
    things, review and approve SRO-proposed rule changes and abrogate (or
    annul) SRO rules.

    The futures market's regulatory structure consists of federal oversight
    provided by CFTC and industry oversight provided by SROs-the futures
    exchanges and the National Futures Association (NFA). Futures SROs are
    responsible for establishing and enforcing rules governing member conduct
    and trading; providing for the prevention of market manipulation,
    including monitoring trading activity; ensuring that futures industry
    professionals meet qualifications; and examining members for financial
    strength and other regulatory purposes. Their operations are funded by the
    futures industry through transaction fees and other charges. In regulating
    the futures market, CFTC independently monitors, among other things,
    exchange trading activity, large trader positions, and certain market
    participants' financial condition. CFTC also investigates potential
    violations of the Commodity Exchange Act and CFTC regulations and
    prosecutes alleged violators. Additionally, CFTC oversees the SROs to
    ensure that each has an effective self-regulatory program. In this regard,
    CFTC designates and supervises exchanges as contract markets and NFA as a
    registered futures association, audits SROs for compliance with their
    regulatory responsibilities, and reviews SRO rules and products that are
    traded on designated exchanges.

                                 Chapter 1 Introduction

    States Have Primary Responsibility for Regulating Insurance Entities

    Unlike other financial service sectors, the U.S. insurance industry is
    regulated primarily at the state level.11 To help coordinate their
    activities, state insurance regulators established a central structure,
    the National Association of Insurance Commissioners (NAIC), in 1871.
    Members of this organization are the heads of the insurance departments of
    50 states, the District of Columbia, and 4 U.S. territories and
    possessions. NAIC's basic purpose is to encourage consistency and
    cooperation among the various states and territories as they individually
    regulate the insurance industry. To that end, NAIC promulgates model
    insurance laws and regulations for state consideration and provides a
    framework for multistate examinations of insurance companies. State
    insurance regulators have tended to stress safety and soundness issues,
    but have also taken action in the conduct-ofbusiness area, especially with
    regard to sales practices. The McCarren-Ferguson Act of 1945 generally
    asserted the view that insurance regulation should be undertaken by the
    states.

    Some U.S. Regulators Engage in Holding Company Oversight

    Many of the largest financial legal entities are part of holding company
    structures-companies that hold stock in one or more subsidiaries. Many
    companies that own or control banks are regulated by the Federal Reserve
    as bank holding companies, and their nonbanking activities generally are
    limited to those that the Federal Reserve has determined to be closely
    related to banking. Under the Gramm-Leach-Bliley Act (GLBA), bank holding
    companies can qualify as financial holding companies and thereby engage in
    a range of financial activities broader than those permitted for
    "traditional" bank holding companies. Savings and loan or thrift holding
    companies (thrift holding companies), which own or control one or more
    savings and loan companies, are subject to supervision by OTS and,
    depending upon the circumstances of the holding company structure, may not
    face the types of activities restrictions imposed on bank holding
    companies. Investment bank holding companies that have a substantial
    presence in the securities markets can elect to be supervised by SEC as a
    supervised investment bank holding company (SIBHC) if the holding company
    does not own or control certain types of banks. Holding companies that own
    large broker-dealers can elect to be supervised by SEC

    11SEC regulates sales of discrete products, such as certain types of
    annuities considered to be securities. Also, banks engage in certain types
    of insurance activities, such as underwriting credit insurance and, under
    certain circumstances, acting as an insurance agent either directly or
    through a subsidiary. Although these activities are subject to OCC
    regulation, national banks can be subject to nondiscriminatory state laws
    applicable to certain insurance-related activities.

                                 Chapter 1 Introduction

    as consolidated supervised entities (CSE). SEC would provide groupwide
    oversight of these entities unless they are determined to already be
    subject to "comprehensive, consolidated supervision" by another principal
    regulator. While holding company supervisors oversee, to varying degrees,
    the holding company, the appropriate functional regulator, as described
    above, remains primarily responsible for supervising any functionally
    regulated subsidiary within the holding company.

    Bank and Financial Holding The Bank Holding Company Act of 1956, as
    amended, generally requires

    Companies

    that holding companies with bank subsidiaries register with the Federal
    Reserve as bank holding companies.12 Among other things, the Bank Holding
    Company Act restricts the activities of bank holding companies to those
    the Federal Reserve determined, as of November 11, 1999, to be closely
    related to banking. However, under amendments to the Bank Holding Company
    Act made in 1999 by GLBA, a bank holding company can qualify as a
    financial holding company that, under GLBA, may engage in a broad range of
    additional financial activities, such as securities and insurance
    underwriting. The Federal Reserve has primary authority to examine and
    supervise a bank holding company, financial holding company, and their
    respective nonbank affiliates, except for those that are "functionally
    regulated" by some other regulator.13 The Federal Reserve's authority to
    require reports from, examine, or impose capital requirements on a
    functionally regulated affiliate is limited. For example, the Federal
    Reserve has limited authority under GLBA to examine broker-dealer
    affiliates of bank and financial holding companies. These limitations were
    designed to lessen the regulatory burden on and provide for consistent
    regulation of a financial activity, such as securities, regardless of
    whether the entity conducting the activity is affiliated with a commercial
    bank. In this report, we sometimes refer to banks, bank holding companies,
    and financial holding companies as banking organizations.

    12The Bank Holding Company Act exempts certain types of depository
    institutions, such as ILCs chartered in certain states, from its
    definition of "bank," as well as some grandfathered banks. Consequently, a
    company's ownership or control of an ILC does not necessarily subject the
    company to supervision by the Federal Reserve.

    13The "functionally regulated" affiliates (and their respective functional
    regulators) are: registered broker-dealers, investment advisers, and
    investment companies (SEC); stateregulated insurance companies (state
    insurance authority); and CFTC-regulated firms (CFTC).

                                 Chapter 1 Introduction

    Thrift Holding Companies	Under the Home Owners' Loan Act of 1933, as
    amended, companies that own or control a savings association are subject
    to supervision by OTS. Historically, most thrift holding companies were
    designated as "exempt" and permitted to engage in a wide range of
    activities, including insurance, securities, and nonfinancial
    activities.14 GLBA expanded the activities authorized for nonexempt thrift
    holding companies to include those authorized for financial holding
    companies. However, GLBA curtailed the availability of exempt status to
    only those that meet all of the following criteria: the organization was a
    thrift holding company on May 4, 1999, or became a thrift holding company
    under an application pending with OTS on or before that date; the holding
    company meets and continues to meet the requirements for an exempt thrift
    holding company; and the thrift holding company continues to control at
    least one savings association (or successor savings association) that it
    controlled on May 4, 1999, or that it acquired under an application
    pending with OTS on or before that date. As a result, GLBA in effect
    redefined the requirements for an exempt thrift holding company.

    SEC's Consolidated Supervision	Beginning with the Market Reform Act of
    1990, SEC has been undertaking supervisory activities aimed at assessing
    the safety and soundness of securities activities at a consolidated or
    holding company level.15 That act authorized SEC to collect information
    from registered broker-dealers about the activities and financial
    condition of their holding companies and material unregulated affiliates.
    In 1992, SEC began receiving riskassessment reports from firms that
    permitted it to assess the potential risks that affiliated organizations
    might have on broker-dealers. By June 2001, SEC was meeting monthly with
    major securities firms in connection with their risk reports. SEC rules
    regarding more complete oversight of the activities of some holding
    companies-SIBHC and CSE-became effective

    14Before the enactment of GLBA, a unitary thrift holding company whose
    subsidiary thrift was a qualified thrift lender generally could operate
    without activity restrictions. Additionally, a multiple thrift holding
    company that acquired all, or all but one, of its subsidiary thrifts as a
    result of supervisory acquisitions generally could operate without
    activity restrictions if all of the subsidiary thrifts were qualified
    thrift lenders. These thrift holding companies have been referred to as
    "exempt." The majority of thrift holding companies qualify as exempt.
    Nonexempt thrift holding companies were permitted to engage only in those
    nonbanking activities that were: specified by the Home Owners' Loan Act;
    approved by regulation as closely related to banking by the Federal
    Reserve; or authorized by regulation on March 5, 1987.

    15Pub. L. No. 101-432S: 4(a), 15 U.S.C. S: 78q(h) (providing for, among
    other things, SEC risk assessment of holding company systems).

                                 Chapter 1 Introduction

    in August 2004.16 GLBA had amended the Securities Exchange Act of 1934 to
    permit an investment bank holding company that is not affiliated with
    certain types of banks and has a subsidiary broker-dealer with a
    substantial presence in the securities markets to elect to become an SIBHC
    and be subject to SEC supervision on a groupwide basis. SEC established a
    similar set of rules for holding companies with the largest broker-dealers
    to voluntarily consent to consolidated supervision by becoming a CSE.
    Under the CSE rules, broker-dealers may apply to SEC for a conditional
    exemption from the application of the standard net capital calculation
    and, instead, use an alternative method of computing net capital that
    permits utilization of mathematical modeling methods. As a condition for
    granting the exemption, broker-dealers' ultimate holding companies must
    consent to capital requirements consistent with Basel standards and
    groupwide SEC supervision unless they are determined to already be subject
    to "comprehensive, consolidated supervision" by another principal
    regulator. For companies that choose to become SIBHCs or CSEs, SEC would
    have supervisory authority over OTC derivatives transactions undertaken in
    previously unregulated affiliates.

    Federal Reserve and U.S. Treasury Play Roles in Maintaining Financial
    Stability

    As the U.S. central bank, the Federal Reserve also has responsibility for
    ensuring financial stability. In practice, this has entailed providing
    liquidity to financial markets during periods of crisis. For example, in
    the immediate aftermath of the September 11, 2001, attacks, the Federal
    Reserve provided about $323 billion to banks to overcome problems that
    resulted from the inability of a major bank to clear trades in government
    securities. In addition, the Federal Reserve is also both a provider and
    regulator of clearing and payment services.17

    The Department of the Treasury shares in the responsibility for
    maintaining financial stability and has other responsibilities related to
    financial institutions and markets as well. Treasury shares responsibility
    for managing systemic financial crises, coordinating financial market
    regulation, and representing the United States on international financial
    market issues. Treasury, in consultation with the President, may also

    16For the SEC rules regarding consolidated supervised entities, see 69
    Fed. Reg. 34428 (June 21, 2004). For the SEC rules regarding supervised
    investment bank holding companies, see 69 Fed. Reg. 34472 (June 21, 2004).

    17See GAO, Federal Reserve System: Mandated Report on Potential Conflicts
    of Interest, GAO-01-160 (Washington, D.C.: Nov. 13, 2000).

                                 Chapter 1 Introduction

    approve special resolution options for insolvent financial institutions
    whose failure could threaten the stability of the financial system.
    Twothirds of the members of the Federal Reserve's Board of Governors and
    of the FDIC Directors must approve any extraordinary coverage.

    The United States Participates in International Organizations Dealing with
    Regulatory Issues

    U.S. regulators meet with regulators from other nations in a number of
    different forums:

    o 	Basel Committee on Banking Supervision (Basel Committee). Agency
    principals from OCC, FDIC, and the Federal Reserve18 participate as
    members in the Basel Committee, along with central bank and regulatory
    officials of other industrialized countries.19 The committee formulates
    broad supervisory standards and guidelines, including those for capital
    adequacy regulation, and recommends best practices in the expectation that
    individual authorities will take steps to implement them through detailed
    arrangements-statutory or otherwise-that are best suited for their own
    national systems. One of the objectives of the Basel Committee is to close
    gaps in international supervision coverage so that no internationally
    active banks escape supervision and supervision is adequate. The committee
    encourages convergence toward common approaches and common standards
    without attempting detailed harmonization of member country supervisory
    techniques.

    o 	International Organization of Securities Commissions (IOSCO). IOSCO is
    the principal international organization of securities commissions, and is
    composed of securities regulators from over 105 countries. SEC is a member
    of IOSCO, and CFTC participates as an associate member. IOSCO develops
    principles and standards for improving cross-border securities regulation,
    reviews major securities regulatory issues, and coordinates practical
    responses to these concerns. Areas addressed by IOSCO include:
    multinational disclosure, accounting, auditing, regulation of the
    secondary markets, regulation of intermediaries,

    18The Federal Reserve is represented by principals from the Federal
    Reserve Board of Governors and the Federal Reserve Bank of New York. OTS
    officials say that they participate in the Basel Committee as a temporary
    member pending acceptance of OTS's request for permanent membership.

    19The committee's members come from Belgium, Canada, France, Germany,
    Italy, Japan, Luxembourg, the Netherlands, Spain, Sweden, Switzerland, the
    United Kingdom, and the United States.

    Chapter 1 Introduction

    enforcement and the exchange of information, investment management, credit
    rating agencies, securities analysts' conflicts of interest, and
    securities activity on the Internet.

    o 	International Association of Insurance Supervisors (IAIS). Established
    in 1994, IAIS represents insurance supervisory authorities of some 180
    jurisdictions. It was formed to promote cooperation among insurance
    supervisors, set standards for insurance supervision and regulation,
    provide training for members, and coordinate work with regulators in the
    other financial sectors and international financial institutions. NAIC
    works with IAIS.

    o 	Joint Forum. Established in early 1996 under the aegis of the Basel
    Committee, IAIS, and IOSCO, the Joint Forum publishes papers addressing
    supervisory issues that arise from the continuing emergence of financial
    conglomerates and the blurring of distinctions between the banking,
    securities, and insurance sectors.20 The Joint Forum comprises an equal
    number of senior insurance, bank, and securities supervisors representing
    13 countries.21

    o 	Financial Stability Forum (FSF). Convened in April 1999, FSF brings
    together national authorities responsible for financial stability in
    significant international financial centers, international financial
    institutions, sector-specific international groupings of regulators and
    supervisors, and committees of central bank experts. FSF seeks to
    coordinate the efforts of these various bodies in order to promote
    international financial stability, improve the functioning of markets, and
    reduce systemic risk. The Federal Reserve, SEC, and Treasury participate
    in FSF.

    The International Monetary Fund (IMF) also plays a role in promoting
    effective regulation of financial services. IMF is an organization of 184
    countries, working to foster global monetary cooperation, secure financial
    stability, facilitate international trade, promote high employment and

    20The Joint Forum was initially referred to as "The Joint Forum on
    Financial Conglomerates." During 1999, its name was shortened to "The
    Joint Forum" to recognize that its new mandate went beyond issues related
    to financial conglomerates to other issues of common interest to all three
    sectors.

    21The countries are Australia, Belgium, Canada, France, Germany, Italy,
    Japan, the Netherlands, Spain, Sweden, Switzerland, the United Kingdom,
    and the United States.

                                 Chapter 1 Introduction

    sustainable economic growth, and reduce poverty. As part of its
    surveillance activities, IMF and the World Bank have taken a central role
    in developing, implementing, and assessing internationally recognized
    standards and codes in areas that are crucial for the efficient
    functioning of a modern economy, including central bank independence,
    financial sector regulation, corporate governance and policy transparency,
    and accountability. In response to banking crises in the 1990s, they
    created the Financial Sector Assessment Program to assess the strengths
    and weaknesses of countries' financial sectors. The staffs of these
    institutions also conduct research related to these activities.

    These international institutions and forums have generally agreed on a set
    of principles or prerequisites for achieving the objectives of financial
    regulation. These generally include

    o  formulating clear objectives for regulators;

    o  ensuring regulatory independence, but with appropriate accountability;

    o 	providing regulators with adequate resources, including staff and
    funding;

    o  giving regulators effective enforcement powers; and

    o  ensuring that regulation is cost efficient.

    Objectives, Scope, and Methodology

    Our objectives were to describe changes over recent decades in (1) the
    financial services industry; (2) the U.S. regulatory structure and those
    of several other industrialized countries; and (3) U.S. financial market
    regulation, focusing on capital requirements, supervision, market
    discipline, and domestic and international coordination. Our objectives
    also included assessing (4) U.S. regulators' efforts to communicate,
    coordinate, and cooperate with each other and with regulators abroad, and
    (5) the strengths and weaknesses of the present U.S. financial regulatory
    system. While housing finance is often considered part of the financial
    services industry, this report does not include government-sponsored

    Chapter 1 Introduction

    enterprises with a major role in housing finance or their regulators.22 In
    addition, because credit unions have only about 9 percent of domestic
    deposits and ILCs have only 1 percent of domestic deposits, this report
    does not discuss them in detail.23 Finally, we have not included pension
    funds or their regulator in this report. In addition, we do not discuss
    the role of the Federal Trade Commission or the impact of tax policy on
    the financial services industry.

    To address the objectives of this report, we conducted interviews with
    senior supervisory and regulatory officials at the federal level,
    including the Federal Reserve, FDIC, OCC, OTS, SEC, and CFTC. At the state
    level, we interviewed supervisory and regulatory officials in Florida,
    Illinois, Massachusetts, Michigan, Minnesota, and New York as well as
    trade associations representing state regulators, including supervisors of
    the Conference of State Bank Supervisors, North American Securities
    Association of Administrators, and National Association of Insurance
    Commissioners. Finally, we spoke to a variety of SROs, including the New
    York Stock Exchange (NYSE), NASD (formerly the National Association of
    Securities Dealers), Municipal Securities Rulemaking Board, National
    Futures Association, Chicago Mercantile Exchange, Chicago Board of Trade,
    and Chicago Board Options Exchange. These agencies provided us with
    documents and statistics, including research studies, examination manuals,
    annual and strategic reports, performance plans, and financial and
    budgetary data. In addition to our interviews with supervisory and
    regulatory officials, we also met with officials representing financial
    services firms and exchanges and their trade associations, and academic
    experts. Information about depository institutions identified in this
    report was obtained from publicly available sources.

    This report also draws on extensive work we have done in the past on the
    financial services regulatory structure and includes information gathered
    from many sources. These sources include studies of the history of the
    financial services industry; records from congressional hearings related
    to regulatory restructuring; and professional literature concerned with
    the industry structure and regulation. We also reviewed relevant banking,
    securities, insurance, and futures legislation at the federal level.

    22We recently reviewed our work on regulation of government-sponsored
    enterprises in Government-Sponsored Enterprises: A Framework for
    Strengthening GSE Governance and Oversight, GAO-04-269T (Washington, D.C.:
    Feb. 10, 2004).

    23See GAO-04-91.

    Chapter 1 Introduction

    To address issues of international harmonization and to compare the U.S.
    regulatory regime with more consolidated structures abroad, we conducted
    fieldwork in Belgium, Germany, and the United Kingdom. During our field
    visit, we interviewed officials from the European Union (EU), European
    Central Bank, Financial Services Authority in the United Kingdom (UK-FSA),
    The Bank of England, Her Majesty's Treasury (HM-Treasury), Federal
    Financial Supervisory Authority in Germany (BaFin), Deutsche Bundesbank
    (Bundesbank), and German Treasury. Many of the officials we interviewed
    provided us with documents and research studies on their regulatory
    processes and the reasons for implementing more consolidated structures.
    We also interviewed officials from financial services firms, including
    subsidiaries of U.S. firms as well as two firms headquartered in the
    countries we visited. In addition, we spoke with trade associations and
    other experts on the EU and regulatory consolidation within various
    countries. For those countries we did not visit (Australia, Japan, and the
    Netherlands), we reviewed documents and provided our findings for review
    by government officials from the relevant country or other recognized
    experts. We did not conduct a full legal review of the regulatory regimes
    for any of these countries.

    To develop certain other information, we collected data from federal and
    state regulators and SROs on the resources they devoted to supervision
    from 1999 to 2003. We also collected information about ongoing regular
    communication these entities had with other regulatory bodies between
    January 2003 and March 2004. We did not use any nonpublic supervisory data
    in conducting our work for this report.

    We provided a draft of this report to the Department of the Treasury,
    Board of Governors of the Federal Reserve System, CFTC, FDIC, NAIC, OCC,
    OTS, and SEC for review and comment. The written comments of the Board of
    Governors, FDIC, OCC, OTS, and SEC are printed in appendixes I through V
    and are discussed at the end of chapter 7. The staffs of these agencies
    also provided technical comments that have been incorporated, as
    appropriate. The Department of the Treasury, CFTC, and NAIC did not
    provide written comments, but their staffs provided technical comments
    that have been incorporated, as appropriate. We conducted our work between
    June 2003 and July 2004 in accordance with generally accepted government
    auditing standards in Washington, D.C.; Boston; Chicago; New York City;
    Brussels, Belgium; London; and Berlin, Bonn, and Frankfurt, Germany.

    Chapter 2

    The Financial Services Industry Has Undergone Dramatic Changes

    The environment in which the financial services industry operates and the
    industry itself have undergone dramatic changes that include
    globalization, consolidation, conglomeration, and convergence. These
    forces have affected financial services firms, markets, and products.
    First, globalization that includes the financial services industry has
    become a characteristic of modern economic life. Second, consolidation
    (merging of firms in the same sector) and conglomeration (merging of firms
    in other sectors) have increasingly come to characterize the large players
    in the financial services industry. Third, the roles of financial
    institutions and the products and services they offer have converged so
    that institutions often offer customers similar services, although sectors
    still specialize to some extent. As a result of these changes, as well as
    the development of innovative financial products, the financial services
    industry has become more complex, and thus the kinds and extent of risks
    the industry faces have changed.

    Financial Services Globalization has had a major impact on a broad range
    of economic

    activities, including financial markets. Figure 2, which shows the
    ongoingHave Played an growth of international corporate and sovereign
    debt, illustrates the Integral Part in linkages among financial markets
    around the globe.

    Globalization

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    Figure 2: International Debt Securities, 1987-2004 Dollars in billions

    14,000 12,000 10,000 8,000 6,000 4,000 2,000 0 1987 1988 1989 1990 1991
    1992 1993 1994 1995 1996 1997 1998 1999 2000 2001 2002 2003 2004

    Source: Bank for International Settlements.

    The financial services industry-firms, markets, and products-have been an
    integral part of the globalization trend. At present, firms have a greater
    capacity and increased regulatory freedom to cross borders, creating
    markets that either eliminate or substantially reduce the effect of
    national boundaries. U.S.-owned financial services firms have increased
    their international activities, and a significant number of foreign-owned
    financial services companies are operating within the United States. In
    banking, for example, Citibank has substantial and growing retail banking
    activities in Germany and ING Direct, a Dutch-owned company, has a large
    deposit base in the United States. In the securities sector, in 2003 U.S.
    investors held $2.5 trillion of foreign securities, and foreign holdings
    of U.S. securities other than U.S. Treasury securities rose to $3.4
    trillion. In the insurance sector, a significant portion of U.S. insurers
    and the U.S. market are now foreign controlled. In 2001, 142 U.S. life
    insurers were foreignowned, up from 69 in 1995. And, according to the
    International Insurance Institute, from 1991 to 1999, sales by
    foreign-owned property-casualty insurers doing business in the United
    States grew by 62.8 percent.

    Deregulation and technological change have facilitated globalization.
    Barriers that once limited international financial transactions have been
    substantially reduced or removed, and greater computing power and better

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    telecommunications networks have driven the technological revolution.
    These technological changes have had a major effect on wholesale
    securities and futures markets around the world. Many securities and
    futures products can be traded 24 hours a day from any place in the world.
    Electronic trading and other changes have made this transformation
    possible. Large U.S.-based institutional investors can now buy stock in
    publicly traded foreign companies by accessing foreign stock markets.
    Smaller retail investors can participate in the equity markets of foreign
    countries by buying mutual funds that specialize in developed or emerging
    foreign markets.

    Large Institutions Have Become Larger through Consolidation and
    Conglomeration

    Generally, over the last several decades, large financial institutions
    have consolidated by merging with or acquiring other companies in the same
    line of business. Consolidation has occurred in all of the industry
    segments discussed in this report-banking, securities, futures, and
    insurance. While the number of firms declined, the percentage of industry
    assets concentrated in the largest 10 commercial banks, thrifts, life
    insurers, and property-casualty insurers rose between 1996 and 2002, as
    shown in figure

    3. While the percentage of assets of the largest 10 securities firms has
    fallen somewhat, these firms still have more than 50 percent of the
    industry's assets. The same technological and improvements and
    deregulation that have driven globalization have also contributed to
    consolidation and conglomeration. While large firms have gotten larger and
    often account for an increasing share of each industry, there are still a
    large number of firms in each industry segment. Some observers believe
    that the financial services sectors will come to be characterized by a few
    large players and lots of small, niche-market players, with few in
    between.

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    Figure 3: Share of Assets in Each Sector Controlled by 10 Largest Firms,
    1996-2002 Percent

    65 60

    55

    50

    45

    40

    35

    30

    25

    20 15 10 5

    0 1996 1997 1998 1999 2000 2001 2002

    Securities firms

    Property/casualty insurance

    Life insurance

    Commercial banks

    Savings institutions

    Source: TowerGroup.

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    The change in the banking sector has been especially dramatic, as it has
    been driven by both technological change and significant deregulation. In
    the early 1980s, bank holding companies faced limitations on their ability
    to own banks located in different states. Some states did not allow banks
    to branch at all. With the advent of regional interstate compacts in the
    late 1980s, some banks began to merge regionally. Additionally, the
    Riegle-Neal Interstate Banking and Branching Efficiency Act of 1994
    removed restrictions on bank holding companies' ability to acquire banks
    located in different states and permitted banks in different states to
    merge, subject to a process that permitted states to opt out of that
    authority.1 While the U.S. banking industry is still characterized by a
    large number of small banks and researchers have questioned whether
    economies of scale and scope exist, the larger banking organizations have
    grown significantly through mergers after 1995. As figure 4 shows, 40
    large banking organizations operating in 1990 had consolidated into 6
    banking organizations by August 2004. These six banking organizations had
    about 40 percent of total bank assets in the United States.

    1Pub. L. No. 103-328, 108 Stat. 2238 (1994).

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

     Figure 4: Merger Activity among Banking Organizations, January 1990-June 2004

    Source: GAO.

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    Many of the larger financial services firms are part of holding companies
    that operate in more than one of the traditional sectors. These firms are
    called conglomerates. A research study by IMF staff shows that based on a
    worldwide sample of the top 500 financial services firms in assets, the
    percentage of firms in the U.S. that are conglomerates-firms having
    substantial operations in more than one of the sectors (banking,
    securities, and insurance)-increased from 42 percent of the U.S. firms in
    the sample in 1995 to 61.5 percent in 2000; however, for the sample of
    U.S. firms, the percentage of assets controlled by conglomerates declined
    from 78.6 percent in 1995 to 73 percent in 2000.2 The largest banks in the
    United States have brokerage operations, and many sell insurance and
    mutual fund products. While much of the conglomeration in the United
    States took place prior to GLBA, that important piece of legislation
    removed restrictions on the extent to which conglomerates could engage in
    banking and nonbanking financial activities, thus, for example, making it
    possible for financial conglomerates to purchase insurance companies and
    other financial institutions to purchase banks.

    To facilitate and recognize the trend toward conglomeration, GLBA
    authorized new regulatory regimes. The act authorized bank holding
    companies to qualify as financial holding companies and provided for
    voluntary SEC supervision of investment bank holding companies. While
    rules for the latter were issued only in June 2004, financial holding
    companies grew from 477 in 2000 to 630 in March 2003. Metropolitan Life
    Insurance Company, one of the largest life insurance companies in the
    United States, and Charles Schwab & Co., a sizable securities firm,
    acquired or opened banks and became financial holding companies. In
    addition, several major insurance and commercial companies, including
    American International Group, General Electric, and American Express, have
    thrifts and Merrill-Lynch has chartered an ILC in addition to its
    commercial bank and thrift. As a result, a consumer can make deposits,
    obtain a mortgage or other loan, or purchase insurance products from the
    same company. Although some had expected that conglomeration would
    intensify after GLBA, as yet, this does not seem to have happened. The
    reasons vary: Many firms were already conglomerates before the passage of
    GLBA, the removal of some limitations on bank-affiliated broker-dealers
    allowed banks to grow internally, banks did not see any synergies with
    insurance

    2Gianni De Nicolo, Philip Bartholomew, Jahanara Zaman, and Mary Zephirin,
    "Bank Consolidation, Internationalization, and Conglomeration: Trends and
    Implications for Financial Risk" (IMF Working Paper 03/158, Washington,
    D.C., July 2003).

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    underwriting, and a general slowdown occurred in merger and acquisition
    activity across the economy in the early 2000s. While merger and
    acquisition activity in banking has picked up, sizable mergers between
    firms in different sectors have not materialized so far. It may be that
    these mergers are not economically efficient, the regulatory structure set
    up under GLBA is not advantageous to these mergers, or it may simply be
    too soon to tell what the impact will be. In addition, some cross-sector
    mergers have been unwound. For example, Citigroup sold off the
    property-casualty unit of Travelers, which had been affiliated with
    Citibank since their merger in 1998.

    Roles of Large Financial Services Firms Have Changed and Financial
    Products Have Converged, but Some Differences Remain

    Increasingly, financial intermediaries are relying on fee-based services,
    including asset management, for their profitability. Firms in all of the
    sectors are also increasingly involved in activities to manage their and
    their institutional customers' risks. In addition, product offerings by
    firms in different segments of the financial services industry have
    converged so that product offerings that might appear to be different are
    competing to meet similar customer needs, such as having access to liquid
    transaction accounts, saving for retirement, or insuring against the
    failure of a party to live up to the terms of a commercial contract.

    Market Developments Have Forced Financial Services Firms to Adapt

    Generally, financial services firms, especially banks, have had to adapt
    to the ease with which corporations can now directly access capital
    markets for financing, rather than depending on loans. For example, with
    the emergence of the commercial paper market, many large firms with strong
    credit ratings that had been dependent on bank loans were able to access
    capital markets more directly. As a result, those large banks that had
    been major lenders to these firms have had to find new sources of revenue.
    Banks are now relying more on fee-based income that is generated by
    structuring and arranging borrowing facilities, providing risk management
    tools and products, and servicing the loans they have sold off to other
    institutions as well as from fees on deposit and credit card activity,
    including account holder fees, late fees, and transactions fees. Many
    large banking institutions have moved into investment banking activities,
    including arranging OTC derivative transactions for their corporate
    customers. These institutions also earn fees on their investment banking
    activities as well as from their sales of insurance and mutual fund
    products.

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    These role changes have been facilitated by the development of new
    products, such as securitized assets, that depend on sophisticated
    mathematical models and the technology needed to support them. In its
    simplest form, asset securitization is the transformation of generally
    illiquid assets into securities that can be traded in capital markets. The
    process includes several steps: the firm that issued the loans creates a
    legal entity (a "pool"), segregates loans or leases into groups that are
    relatively homogeneous with respect to their cash-flow characteristics and
    risk profiles, including both credit and market risks, and sells the group
    to the pool. The pool then issues securities and sells them to an
    underwriter, who prices them and sells them to investors. Securitized
    assets generally consist of mortgage-backed securities and other asset
    backed securities where loans for products such as credit cards or
    commercial loans are securitized and sold. Mortgage-backed securities3
    grew from about $1,123 billion in 1990 to about $3,796 billion in 2003,
    while other asset-backed securities grew by a factor of 12 over that same
    period of time. Because the risk embedded in securitized assets can be
    structured and priced so that financial institutions and others may be
    better able to manage credit and interest rate risk with these
    instruments.

    Because banks and insurance companies could reduce their capital
    requirements by securitizing assets and removing those assets from their
    balance sheets, securitization was also driven by changes in capital
    requirements implemented in these industries in the early 1990s that
    required firms to hold more capital for certain assets.4

    Along with securitized assets, derivatives have been used increasingly by
    financial institutions to manage assets and risks for themselves and
    others or to take a position on the direction of market movements in hopes
    of making a profit. Derivatives are contracts that derive their value from
    a reference rate, index, or the value of an underlying asset, including
    stocks, bonds, commodities, interest rates, foreign currency exchange
    rates, and indexes that reflect the collective value of underlying
    financial products. There are several types of derivatives, including the
    following:

    3Mortgage-backed securities numbers are from the Federal Reserve's flow of
    funds data and include federal agency and government sponsored
    enterprise-backed mortgage pools and mortgages backing privately issued
    pool securities and collateralized mortgage obligations.

    4See chapter 4 for information about capital requirements.

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    o 	Futures and forwards-contracts that obligate the holder to buy or sell
    a specific amount or value of an underlying asset, reference rate, or
    index (underlying) at a specified price on a specified future date.
    Futures and forwards are used to hedge against changes or to speculate by
    attempting to make money off of predicting future changes in the
    underlying. Futures are often traded on exchanges and forwards are traded
    as OTC transactions and generally result in delivery of an underlying.
    (See ch. 1.)

    o 	Options-contracts that grant their purchasers the right but not the
    obligation to buy or sell a specific amount of the underlying at a
    particular price within a specified period. Options can allow their
    holders to protect themselves against certain price changes in the
    underlying or benefit from speculating that price changes in the
    underlying will be greater than generally expected.

    o 	Swaps-agreements between counterparties to make periodic payments to
    each other for a specified period. Swaps are often used to hedge market
    risk or speculate on whether interest rates or currency values will change
    in a particular direction.

    o 	Credit default swaps-a contract whereby the protection buyer agrees to
    make periodic payments to the protection seller for a specified period of
    time in exchange for a payment in the event of a credit event such as a
    default by a third party referenced in the swap. Credit default swaps
    allow market participants to keep loans or loan commitments on their books
    and essentially purchase insurance against borrower default.

    Figure 5 shows the growth in the number of exchange-traded futures since
    1995.5 In addition, Bank for International Settlements' estimates of the
    notional amounts of OTC derivatives outstanding increased globally by
    about 146 percent between 1998 and 2003, going from about $80 trillion in
    1998 to about $197 trillion in 2003.

    5For earlier information on derivatives, see GAO, Financial Derivatives:
    Actions Needed to Protect the Financial System, GAO/GGD-94-133
    (Washington, D.C.: May 18, 1994); and Financial Derivatives: Actions Taken
    or Proposed Since May 1994, GAO/GGD/AIMD-97-8 (Washington, D.C.: Nov. 1,
    1996).

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

                Figure 5: Number of Futures Contracts Traded, 1995-2003

                        Number of futures contracts in millions

    2,000

    1,500

    1,000

                      1995 1996 1997 1998 1999 2000 2001 2002 2003

                                     United States

    International Source: GAO analysis of Futures Industry Association data.

    The growth of derivatives activity attests to the usefulness of these
    instruments to the participants, but there are concerns about the
    management of derivatives risk. The complexity of some of these
    instruments can make it difficult for the users to understand and estimate
    the potential value or loss; moreover, the reliance on a counterparty to
    make an expected flow of payments during future years means that the
    recipient is exposed to the credit risk that the counterparty might
    default in the meantime.

    Product Offerings in While convergence has taken place among firms using
    similar securitized Different Sectors Have Also products and derivatives
    to manage assets and risks, it has also taken place Converged in product
    offerings by firms in different segments of the financial services

    industry. These firms are competing against each other to provide
    households, businesses, and governments with the same basic services. For
    example, table 1 illustrates how financial firms in the various sectors,
    regardless of whether they are affiliated with firms in other sectors, are

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    offering functionally similar products to satisfy the same retail customer
    needs.

        Table 1: Selected Retail Products by Financial Institution and Functiona

    Financial Transaction Fixed return Variable return
    institution accounts investments investments Risk management Raising money

             Checking,                 Variable                             Loans
    Banks   savings Certificates of annuities  Insurance distributionb    (all
                                                                           types)
                       deposit,
                       corporate
                           bonds,
                          municipal
                       bonds,
                       Treasuries

     Broker-dealers    Cash    Corporate   Stocks,        Options            Loans
                    management   bonds,                                 associated
                     account   municipal    mutual                         with
                                 bonds,     funds,                        margin
                               Treasuries  variable                      accounts
                                          annuities
                         Money
    Investment       market Guaranteed   Mutual
                        mutual              funds,
    companies       fund    investment  variable
                                          annuities
                               contracts
        Insurers                 Fixed    Variable   Property-casualty,
                               annuities, annuities, life
                               guaranteed   mutual       insurance
                                            funds
                               investment
                               contracts
     Futures firms                                    Futures, options
         Other                                                          Consumer
    financing                                                        loans
    companies

    Source: GAO

    aWhile most of these products could be offered by any financial
    institution through its affiliates, the products are classified here
    according to whether a stand-alone financial institution would offer the
    product.

    bSubject to a grandfathering provision, GLBA prohibits national banks from
    engaging in title insurance activities, except that national banks and
    their subsidiaries may act as agents to sell title insurance in states
    where state banks are permitted to engage in that activity. 15 U.S.C. 6713
    (2000 & Supp. 2004). Also, national banks may underwrite certain insurance
    products, such as credit insurance, where the activity is incidental to
    the business of banking, and may act as insurance agents directly only
    under certain circumstances, although they may engage fully as insurance
    agents through subsidiaries.

    Similarly, firms in different sectors compete by offering products that
    have similar ability to meet some business needs. Issuance of commercial
    paper can provide financing similar to commercial loans, and catastrophe
    bonds and reinsurance provide similar protection, as do surety bonds and
    standby letters of credit.

    Although financial services firms and products have converged in numerous
    ways, firms in the various sectors, especially smaller firms, continue to
    specialize in some traditional functions. Commercial banks still make
    commercial loans to businesses, especially those smaller businesses

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    that may not be able to raise funds directly in capital markets; insurance
    firms still underwrite the risks involved in insuring a life or property
    or casualty; and investment banks still underwrite new securities and
    advise firms on mergers and acquisitions.

    As Financial Services Institutions Have Diversified, Introduced New
    Products, and Become More Complex, Risks Have Changed

    Globalization, consolidation, conglomeration, and convergence of financial
    institutions have changed the risk profile of the institutions and the
    linkages among them. Today, a large modern financial firm may operate in a
    variety of product and geographic markets. Figure 6 illustrates how such a
    complex firm might be organized.

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

            Figure 6: Structure of a Hypothetical Financial Holding Company

    Source: GAO.

    Generally, diversification into new geographic and product markets would
    be expected to reduce risk, while securitized and derivative products have
    given firms new tools to manage risk. Because risks interact, however, the
    net result on the risk of an individual institution or the financial
    system cannot be definitively predicted. In addition, managing risks in an
    environment that crosses industry and geographic lines along with new
    products have increased the complexity of institutions and the industry.
    As a result of all of these factors, the risks facing the industry have
    changed in some ways.

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    Credit Risks Have Changed as a Result of Industry Changes

    Generally, diversification of borrowers will reduce the credit risk of a
    financial services firm, and many of the changes in the industry have done
    just that. U.S. banks have consolidated and spread across the country so
    that they are no longer operating in a single small town, city, or state.
    If a town or even a region falls on hard times and borrowers increasingly
    default on loans, the bank, or other institution that made the loans, may
    be less affected than they once would have been, because borrowers in
    other markets may be enjoying positive economic circumstances and defaults
    in those markets may be dropping. The same is true for firms diversifying
    their types of products and for those diversifying to other parts of the
    world. In addition, by securitizing loans and selling them off or by using
    credit derivative products, individual firms or sectors may also reduce
    credit risk. For example, in its Global Financial Stability Report issued
    in April 2004, the IMF reported that, for many years, banks have been
    transferring risk, especially credit risk, to other financial
    institutions, such as mutual funds, pension funds, insurers, and hedge
    funds.6

    Many of the same forces that may have reduced credit risk for some
    institutions, as well as other forces, may have increased risk as well.
    For example, while globalization allows for diversification, it also
    complicates the evaluation of credit risk. Because bankruptcy laws differ
    among countries, the assets of a failed household or corporate borrower in
    another country may be less available to U.S. creditors. In addition,
    little recourse exists when foreign governments default on their debt.
    Further, the extent to which diversification and new products reduce
    credit risk depends on how the firm to which the risk is passed
    understands, measures, and manages its new markets and products-as well as
    the combined risks of old and new exposures. If it does not manage them
    well, these normally credit reducing activities could actually increase
    credit or other kinds of risks.

    The degree to which diversification and new products reduce credit risk
    will also depend on the linkages between markets, products, and firms, and
    the relationship or correlation among the risks. For example, securitized
    products and credit derivatives can allow one institution to pass on risk
    to another. Regulators and others have expressed concern that this risk
    can become concentrated in a few firms or be passed to buyers that may be
    less

    6IMF, Global Financial Stability Report: Market Developments and Issues,
    April 2004 (Washington, D.C., April 2004).

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    equipped to handle it. Some research has been conducted because regulators
    and others were concerned that the banking sector was passing credit risk
    to the insurance sector or ultimately to households and that these
    developments could have implications for overall financial stability.7 For
    example, IMF reported in April 2004 that on a global basis the transfer of
    credit risk from banks to life insurers might increase financial stability
    because life insurers generally hold longer-term liabilities. However, the
    report notes that in recent years, many insurers have changed their
    products in ways that have begun to shorten the duration of their
    liabilities, raising questions about their advantage in handling credit
    risk. And as insurers in some parts of the world take steps to manage
    their balance sheet risk, they would likely transfer that risk to
    others-including the household sector, which might be less able to manage
    the risk.

    Because financial services firms are competing and cooperating with each
    other across traditional industry and geographic boundaries, there are
    increased linkages that may not be well understood. Thus, downturns
    somewhere in the world, such as those in Russia in 1998 or Mexico in 1995,
    can have a large impact on all of the major financial institutions. In
    addition, if the large financial institutions are linked to each other as
    counterparties in various transactions, a major credit failure at one
    could send systemic shockwaves through the United States and even the
    world's economy.

    Many of the concerns raised here were evident in the near collapse of
    Long-Term Capital Management (LTCM)-one of the largest U.S. hedge funds-
    in 1998 following the Russian downturn.8 Most of LTCM's balance sheet
    consisted of trading positions in government securities of major
    countries, but the fund was also active in securities markets,
    exchange-traded futures, and OTC derivatives. According to LTCM officials,
    LTCM was counterparty to over 20,000 transactions and conducted business
    with over 75 counterparties. Further, the Bank for International
    Settlements reported that LTCM was "perhaps the world's single most active
    user of interest rate

    7See IMF, Global Financial Stability Report, April 2004; FSA, Cross-Sector
    Risk Transfers (London, U.K., May 2002); and Committee on the Global
    Financial System of the Bank for International Settlements, Global Credit
    Risk Transfer (Basel, Switzerland, January 2003).

    8GAO, Long-Term Capital Management: Regulators Need to Focus Greater
    Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.: Oct. 29,
    1999).

    Chapter 2
    The Financial Services Industry Has
    Undergone Dramatic Changes

    swaps."9 In addition many of the financial institutions that LTCM dealt
    with failed to enforce their own risk management standards.

    Comparing the largest U.S. financial firms today with some large failures
    resulting from credit risk that did not appear to have systemic
    implications in the past can help shed light on the potential for systemic
    disruptions today. Bank of New England, which failed, in part, because of
    bad real estate loans, had $19.1 billion in assets at the time of its
    failure. In comparison, the largest bank holding company today had bank
    subsidiaries with assets of $823 billion in March 2004. Similarly, in the
    insurance area, one of the largest U.S. insurers has assets of $678
    billion, while the largest insurance failure on record is Mutual Benefit,
    which had assets of only $13.5 billion. While the unwinding of Drexel,
    Burnham, Lambert Group is sometimes pointed to as evidence that the
    failure of a major securities firm would not necessarily raise concerns
    about systemic risk sufficient to warrant intervention, some experts
    suggest that four trends in the international financial system since that
    collapse suggest that the outcome for a future failure of a major
    securities firm might be different:10 (1) Leading securities firms have
    become increasingly international, operating in markets around the world
    and through a complex structure of affiliates in countries with differing
    bankruptcy regimes; (2) securities firms are increasingly parts of
    conglomerates that include banks, and thus the systemic concerns related
    to bank failures might extend to securities firms; (3) securities firms
    themselves have grown in size so that while they may be less likely to
    fail, any failure is more likely to have systemic implications; and (4)
    the largest securities firms have become increasingly involved in global
    trading activities, particularly OTC derivatives. An SEC staff member told
    us that while they believe that a gradual unwinding of one of the largest
    securities firms today could still be handled without systemic
    implications, the sudden failure of one of these firms would likely have
    major implications for a broad swath of markets and investors. Because of
    the sheer size of today's financial institutions, some question whether
    these firms are too big to be allowed to fail. This belief could skew the
    incentives facing managers and investors to manage risk effectively.

    9Bank for International Settlements, 69th Annual Report, 1 April 1998-31
    March 1999 (Basel, Switzerland; June 7, 1999).

    10Richard Herring and Til Schuermann, "Capital Regulation for Position
    Risk in Banks, Securities Firms, and Insurance Companies" (paper at the
    Conference on Risk-Based Capital: The Tensions between Regulatory and
    Market Standards, Program on International Financial Systems, Harvard Law
    School (Cambridge, Massachusetts; June 10, 2003).

                                       Chapter 2
                          The Financial Services Industry Has
                               Undergone Dramatic Changes

    Other Risks Have Also Been Affected by Changes in the Industry

    Changes in the industry, especially the growth of large institutions that
    cross industry and national boundaries, have also affected the level and
    management of operational and reputation risk. An official at one of the
    large securities firms told us that opportunities for fraud or other
    violations of law or regulation in some part of the organization increase
    immediately after a merger of entities with different corporate cultures.
    And to the extent that a firm operates centrally and the public believes
    the parts are connected, the ability to isolate such problems in some part
    of an organization will be more difficult. The collapse of Barings, a
    British bank, demonstrates the potential vulnerability to operational risk
    of firms operating across a wide range of markets. In this case,
    management did not effectively supervise a trader in Singapore, and his
    actions brought down the bank.11 Further, a firm's reputation can be
    damaged by disreputable practices, such as happened when a major
    institution violated derivatives sales practices and when it was
    discovered that ownership of a U.S. bank in Washington, D.C., was tied to
    BCCI, a corrupt bank headquartered in Luxembourg. Regulators have
    recognized the increased importance of operational risks, including
    reputation risk, in the new capital standards adopted by the Basel
    Committee in June 2004. (See ch. 4.)

    11The failure of Barings did not involve the use of British government
    funds. In addition, officials at the Federal Reserve note that Barings was
    much smaller than many of today's banking organizations.

    Chapter 3

    While Some Countries Have Consolidated Regulatory Structures, the United
    States Has Chosen to Maintain Its Structure

    Since the mid-1990s, several major industrial countries, including
    Australia, Germany, Japan, the Netherlands, and the United Kingdom, have
    consolidated their regulatory structures, and some U.S. states have
    consolidated their structures as well. While proposals have been advanced
    that would change the U.S. regulatory structure, the United States, most
    notably with the passage of GLBA, has chosen not to adopt any substantial
    changes. Proposals to change the U.S. regulatory structure made throughout
    the 1990s and early 2000s included consolidating bank regulators, merging
    SEC and CFTC, changing the SRO structure for securities, and creating a
    federal regulator to oversee those companies opting for the proposed
    federal insurance charter. Proposals have also been made that would cut
    across sectors, including proposals for a single federal regulator in each
    area, an oversight board, and a fully consolidated federal regulator.

    Some Countries and States Have Consolidated Their Regulatory Structures

    During the 1990s and early 2000s, some other countries consolidated their
    regulatory structure. According to a research report by World Bank staff,1
    by 2002, 29 percent of the countries that supervise banking, securities,
    and insurance had consolidated their regulatory structure to include only
    a single regulator, and another 30 percent of the countries had
    consolidated regulators across two of the three sectors. The remaining
    countries had multiple regulators, with a minimum of one for each of the
    sectors. Countries within the EU2 made changes that sometimes reflect
    steps to create an integrated financial market but not an EU-wide
    regulatory regime. Generally, these countries' industries and regulatory
    structures historically had differed from those in the United States,
    largely because banking, securities, and insurance activities had not been
    legally separated as they were in the United States under the
    Glass-Steagall Act. The products and services that financial services
    firms in these countries offered had changed, however, reflecting the
    financial innovations that have also transformed the U.S. financial
    services industry. Some U.S. states have also consolidated their
    regulatory structure. In addition, many states have combined some aspects
    of their banking, insurance, and securities

    1Jose de Luna Martinez and Thomas A. Rose, "International Survey of
    Integrated Financial Sector Supervision" (World Bank Policy Research
    Working Paper 3096, July 2003).

    2The EU is a treaty-based organization of European countries in which
    those countries cede some of their sovereignty so that decisions on
    specific matters of joint interest can be made democratically at the
    European level.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    regulators, and some have chosen to combine all of their financial
    regulation in a single government agency.

    The EU Has Taken Steps Designed to Create an Integrated Financial Market
    but Not an EU-Wide Regulatory Regime

    EU member states that have consolidated their regulatory structures have
    done so in the larger context of efforts to create an integrated financial
    market in the EU. Building on long-term actions to create a single
    financial market in Europe, the EU has taken several actions that are
    influencing regulatory frameworks in European countries. First, in 1998
    the European Central Bank was established, and this has diminished the
    roles of the central banks in countries that began using the euro in
    2002.3 Second, the European Commission proposed an extensive Financial
    Services Action Plan (Action Plan) in 1999 that it expects to fully
    implement by 2005. Under the Action Plan, the EU would not create any
    EU-wide financial services regulatory bodies, but would instead enact
    legislation that would be adopted by the individual countries and
    implemented by their regulators. Since under the EU charter, firms can do
    business in all EU countries if they are located in one of them (the
    so-called Single Passport), EU officials and others have said that
    convergence is necessary to prevent duplicative requirements and
    regulatory arbitrage. That is, companies should not have an incentive to
    choose their location based on the regulatory regime in a particular
    country and should not be able to pit one regulator against another to get
    favorable regulatory decisions. Finally, to streamline European lawmaking
    and stimulate regulatory and supervisory convergence, the EU has created a
    process under which committees of securities, banking, and insurance
    regulators from the individual member states now consult and coordinate
    their work at several stages in the process between adoption of more
    detailed rules. These supervisory committees are the Committee of European
    Securities Regulators (CESR), the Committee of European Banking
    Supervisors, and the Committee of European Insurance and Occupational
    Pensions Supervisors.

    The United Kingdom, Along with other countries, the United Kingdom,
    Germany, and Japan have Germany, and Japan Have each adopted versions of
    the single regulator model. However, the Adopted a Single Regulator
    regulatory organizations in these countries differ significantly. The
    United Structure Kingdom's consolidation is the most notable in that,
    according to a

    3Together with the state central banks, the European Central Bank conducts
    monetary policy for the EU, but has no regulatory or supervisory powers.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    research paper by IMF staff, it provided an enormous impetus for other
    countries to unify their supervisory agencies.

    United Kingdom 	Beginning in 1997, the United Kingdom consolidated its
    financial services regulatory structure, combining nine different
    regulatory bodies, including SROs, into the Financial Services Authority
    (UK-FSA). While UK-FSA is the sole supervisor for all financial services,
    other government agencies, especially the Bank of England and Her
    Majesty's Treasury (HM-Treasury), still play some role in the regulation
    and supervision of financial services. Formal financial regulation and
    supervision are relatively new to the United Kingdom; before 1980,
    according to officials at the Bank of England, a "raised eyebrow" from the
    Head of the Bank of England was used to censure inappropriate behavior.
    Thus, most of the agencies and SROs that were replaced did not have long
    histories.

    Government officials and experts cited important changes in the financial
    services industry as some of the reasons for consolidating the regulatory
    bodies that oversee banking, securities, and insurance activities. These
    included the blurring of the distinctions between different kinds of
    financial services businesses, and the growth of large conglomerate
    financial services firms that allocate capital and manage risk on a
    groupwide basis. Other reasons for consolidating included some recognition
    of regulatory weaknesses in certain areas and enhancing the United
    Kingdom's power in EU and other international deliberations.

    U.K. officials have reported that the United Kingdom did not separate its
    regulators by objective-the twin peaks model, which usually includes a
    prudential or safety and soundness regulatory agency and a
    conduct-ofbusiness or market conduct regulatory agency-because the same
    senior management and groupwide systems and controls that determine a
    firm's ability to manage financial risk effectively also determine a
    firm's approach to market conduct. Similarly, while British experts
    acknowledge that groupwide supervision could be managed with regulators
    who specialize in the regulation of specific sectors, they say that the
    need for communication, coordination, cooperation, and consistency across
    the specialist regulatory bodies would make it exceedingly difficult to
    operate within a multiple regulator system.

    According to documents provided by UK-FSA officials, the agency's enabling
    legislation stipulated four goals:

    o  maintaining confidence in the financial system;

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    o  promoting public understanding of the financial system;

    o  securing the appropriate degree of protection for consumers; and

    o 	reducing the potential for financial services firms to be used for a
    purpose connected with financial crime.

    In pursuing these goals, UK-FSA is directed to take account of additional
    obligations, including achieving its goals in the most efficient and
    effective way; relying on senior management at financial services
    companies for most regulatory input; applying proportionality to
    regulatory decisions, including the costs and benefits of each act; not
    damaging the competitive position of the United Kingdom internationally;
    and avoiding any unnecessary distortions in or impediments to competition,
    including unnecessary regulatory barriers to entry or business expansion.

    UK-FSA is organized as a private corporation with a chairman and chief
    executive officer and a 16-person board of directors. Eleven members of
    the board are independent, while the other five are UK-FSA officials.
    UK-FSA is ultimately answerable to HM-Treasury and the British Parliament.
    The statute provides for a Practitioner Panel and a Consumer Panel to
    oversee UK-FSA for their respective constituencies. In addition, there are
    requirements for consultation on rules and an appeals process for
    enforcement actions.

    UK-FSA documents and officials present UK-FSA as an organization
    strategically focused on achieving its statutory objectives. It has
    adopted a risk analysis model that it believes allows it to allocate
    resources so as to minimize the chance that UK-FSA will fail to meet its
    goals. As a result of this analysis, it focuses on the largest firms-the
    ones most likely to pose significant costs of failure-and on the needs of
    retail consumers. To assure that UK-FSA accomplishes its goals
    efficiently, it is required to submit cost-benefit analyses for its
    proposals. In addition, UK-FSA must report annually on its costs relative
    to the costs of regulation in other countries and must provide its next
    fiscal year's budget for public comment three months prior to the end of
    the current fiscal year.

    UK-FSA officials say that they have also taken actions, within the
    institution, to break down the barriers-often called stovepipes or silos-
    between those regulating the different industries. From the beginning,
    they forged a new common language across industry segments and traditional
    regulatory boundaries. Staff have to explain why a requirement imposed on

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    one segment should differ from that imposed on other sectors. The current
    organizational structure is designed around retail and wholesale
    divisions. The structure also includes crosscutting teams looking at
    various issues, including asset management, financial crime, and financial
    stability as well as the traditional areas of banking, securities, and
    insurance.

    Most of the representatives of firms we spoke to in the United Kingdom,
    including U.K. subsidiaries of U.S. companies, felt that UK-FSA was doing
    a good job, but some industry representatives have raised concerns. Much
    of UK-FSA's success is attributed to the caliber of the people working
    there. For example, we heard that the ability to pull off the creation of
    UK-FSA depended greatly on the caliber of the early leadership and that
    using highquality bank supervisors to supervise in other areas has had
    benefits, even though these staff may not have expertise specific to a
    particular business. However, some industry participants were concerned
    about the future and about the lack of expertise in some areas such as
    insurance. In addition, the Practitioner Panel in its 2003 annual report
    expressed concerns about UK-FSA's cost-benefit analyses, saying that
    certain costs are often unrepresentative or not included at all, and that
    there is a disregard for the total cost of regulation and the industry's
    ability to absorb the incremental cost of rule changes. They also
    suggested that analyses should include potential areas of consumer
    disadvantage, such as a reduction in choice and the possibility of
    unintended consequences. However, a UK-FSA official said that while the
    agency is working to improve its cost-benefit analysis, one industry trade
    association working on the issue had noted that UK-FSA is a world leader
    in the area.

    Since UK-FSA took over, a major crisis in the life insurance area has come
    to light. Equitable Life is a mutual insurer in the United Kingdom that
    inappropriately sold policies in the high interest rate environment in the
    1970s and 1980s that are now coming due and failed to reserve
    appropriately for them. A major study of this problem, the Penrose report,
    was issued in March 2004. The report concluded that the crisis was due to
    the "light touch, reactive regulatory environment" that preceded UK-FSA
    and that UK-FSA's work since 1997 "has sought to anticipate many of the
    lessons that might be drawn by this inquiry and it should come as no
    surprise that it has largely succeeded." The report also concluded that
    the lack of coordination between safety and soundness and market conduct
    regulation in the past was unacceptable. HM-Treasury is now undertaking an
    extensive review of UK-FSA's authorizing legislation, in part, to
    determine the impact UK-FSA might be having on competition in the U.K.
    financial services sector.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    While UK-FSA is the sole financial services supervisor, other government
    entities still play a role in regulating the financial services industry.
    A tripartite agreement lays out the roles of the Bank of England,
    HM-Treasury, and UK-FSA. While UK-FSA is responsible for supervision of
    financial entities, the Bank of England retains primary responsibility for
    the overall stability of the financial system. It retains the lender of
    last resort responsibilities but must consult with HM-Treasury if
    taxpayers are at risk. High-level representatives from the three agencies
    meet monthly to discuss issues of mutual concern. According to officials
    at the Bank of England, it is difficult to tell how well the system is
    working because it has not yet had to weather a significant banking
    crisis.

    Germany	In 2002, Germany combined its securities, banking, and insurance
    regulators into BaFin; however, the changes appear less dramatic than at
    UK-FSA. Although crosscutting groups have been added to handle
    conglomerate supervision, international issues, and other cross-sectoral
    topics that concern all of the supervisory divisions, the new structure
    still maintains the old divisions related to banking, securities, and
    insurance. In addition, the insurance and banking divisions are housed in
    Bonn, while the securities markets regulators are in Frankfurt. Finally,
    BaFin shares supervisory responsibilities in the banking area with the
    Bundesbank, Germany's central bank.

    Organizationally, BaFin is a federal agency overseen by the treasury that
    must follow civil service laws. BaFin has an administrative board composed
    of the ministers of Finance, Economics, and Justice, members of
    Parliament, officials of the Bundesbank, and representatives of the
    banking, insurance, and securities industries. The Advisory Council made
    up of industry, union, and consumer representatives also advises BaFin.

    BaFin's statutory mandate is to take supervisory or enforcement actions to
    counteract developments that may

    o 	endanger the safety and soundness of the assets entrusted to
    institutions in the banking, insurance, and other financial services
    sectors;

    o 	impair the proper conduct of banking, insurance, and securities
    business or provision of financial services; or

    o  involve serious disadvantages to the German economy.

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    Much of the immediate impetus for the creation of BaFin came from
    developments in the EU. However, the new organization also recognizes the
    blurring of industry lines and the need for reducing the costs of
    supervision to the government. Specifically German government officials
    cited the following reasons for the creation of a consolidated regulator:

    o 	Financial institutions that are taking on similar risks must be treated
    the same.

    o  Conglomerates need effective oversight.

    o 	The cost of regulation could be reduced through greater efficiency and
    by providing for industry funding of BaFin's operations.

    o 	The role of the Bundesbank, in light of the creation of the European
    Central Bank, would be clarified.

    o  International standing and clout could be increased.

    Like the United States, Germany has a state system of financial
    institutions and regulators as well as the federal system. The banking
    system consists of private banks and state banks, or Sparkassen, that are
    owned by a city or other government entity. The fragmentation of the
    banking industry has impacted the commercial banking industry in that
    private banks have difficulty expanding their retail banking operations.
    In addition, securities exchanges, as well as some insurance activities,
    are overseen at the state level.

    Statutes and agreements lay out the complex relationship between BaFin and
    the Bundesbank. When we last reviewed the German bank regulatory system in
    1995, we noted that while the Bundesbank played a role in the oversight of
    banks, this role was not then spelled out statutorily. With creation of
    the European Central Bank, the role of the Bundesbank in the supervision
    of credit institutions was also clarified. While BaFin conducts its own
    document analyses and, if required, its own investigations of troubled
    institutions and institutions of relevance to the system, BaFin is
    required to consult with the Bundesbank on new rules, and the Bundesbank
    is responsible for most of the ongoing monitoring of institutions.
    Officials at one of the German subsidiaries of a U.S. investment bank we
    spoke with said that most of their dealings are with the Bundesbank.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    Japan	Japan consolidated and modified its financial services regulatory
    structure in response to persistent problems in that sector. Japan's
    financial markets sector had certain similarities to that of the United
    States. Most notably, until 1996, Japan maintained legal separations
    between commercial banking, investment banking, and insurance. Japanese
    law, however, did allow cross ownership of financial services and
    commercial firms, permitting development of industrial groups or keiretsu
    that dominated the Japanese economy. These groups generally included a
    major or lead bank that was owned by other members of the group and that
    provided financial services to the members.

    Problems in Japan's financial sector are generally accorded some
    responsibility for the persistent stagnation of its economy through the
    1990s. The Financial Reform Act of 1992 allowed the Ministry of Finance to
    impose capital requirements for banks and banks to own securities
    affiliates and created the Securities Exchange and Surveillance
    Commission. According to one author, while these laws were designed to
    reduce the Ministry of Finance's control over the financial sector, the
    ministry retained its role. In 1998, the Financial Supervisory Agency,
    renamed the Financial Services Agency (Japan-FSA) in 2000, was created,
    with functions and staff transferred from the Ministry of Finance. The
    Securities Exchange and Surveillance Commission was also moved into that
    organization. Japan-FSA has overseen the mergers of several large banks
    and reports progress in addressing the issue of nonperforming loans held
    by Japanese banks. In the review of Japan-FSA issued in 2003, however, IMF
    raised questions about the independence and enforcement powers of the
    agency.

    The Netherlands and Australia Have Consolidated Their Regulatory Structure
    Using the Twin Peaks Model

    Both the Netherlands and Australia consolidated their regulatory
    structure, but they did not adopt the single regulator structure. Instead,
    they adopted a structure that separates the regulators by objective,4 such
    that one regulatory body is responsible for prudential regulation and
    another for conduct-of-business regulation-often referred to as the twin
    peaks model.

    In 2001, when the Netherlands Ministry of Finance proposed a restructuring
    of the financial regulatory structure, the country had three

    4Officials in the Netherlands call this functional regulation as do
    officials in other countries that have adopted a similar structure.

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    regulatory bodies-the Dutch Central Bank regulated banks, the Pensions and
    Insurance Supervisor regulated insurance, and the Securities Board
    regulated securities. Both the Central Bank and the Insurance Supervisor
    had some responsibility for financial stability. Since 1999, the Council
    of Financial Supervisors had helped to coordinate regulatory activities
    between the three agencies, but has received less attention as the country
    moves to the new structure.

    The Netherlands is now in the final stages of consolidating its regulatory
    system and separating it into prudential and market conduct activities.
    The Pensions and Insurance Supervisor is merging with the Dutch Central
    Bank so that all prudential supervision will be done within the central
    bank, and in 2003, the Securities Board became the Netherlands Authority
    for the Financial Markets (AFM), the body responsible for market conduct
    in all segments of financial services.

    As with the other countries, several factors contributed to the
    Netherlands' decision to change its regulatory structure. The Netherlands
    is the home of several of the largest, most globally active conglomerates.
    Supervision of these conglomerates had been divided among the three
    regulatory bodies and was not always consistent. As with the other central
    banks of other countries that adopted the Euro, the Dutch Central Bank no
    longer has primary responsibility for monetary policy or for the nation's
    currency. Like Germany, the Netherlands needed to clarify the role of its
    central bank after the formation of the European Central Bank.

    With regard to its regulatory and supervisory roles, the Dutch Central
    Bank operates as an autonomous administrative authority. After the merger
    with the Pensions and Insurance Supervisor, its main objective is to
    ensure that banks, insurance companies, pension funds, and other financial
    service providers are sound businesses that can meet their liabilities to
    others now and in the future. The supervision focuses on protecting as
    well as possible the interests of consumers of financial services, whether
    they are individuals or businesses.

    A three-person executive board, subject to oversight by a five-person
    supervisory board appointed by the Minister of Finance, manages AFM.
    According to its 2003 Annual Report, this authority's objectives are to

    o  promote access to financial markets;

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    o 	promote the efficient, fair, and orderly operation of financial
    markets; and

    o  ensure confidence in financial markets.

    AFM is not organized around traditional industry sectors, but around three
    clusters of activities: Supervision Preparation, Supervision
    Implementation, and Business Operations.

    In 1998, Australia's regulatory reforms provided for the establishment of
    the Australian Prudential Regulation Authority (APRA) to regulate the
    safety and soundness of financial institutions and the Australian
    Securities and Investments Commission (ASIC) to regulate corporations,
    market conduct, and consumer protection in relation to financial products
    and services. These changes followed a major study of Australia's
    regulatory regime-called the Financial System Inquiry or Wallis
    Report-that reported to the Australian Government in March 1997. This
    report identified the following reasons for recommending reform:

    o 	to achieve a more competitive and efficient financial system while
    maintaining financial market stability, prudence, integrity, and fairness;

    o 	to design a regulatory framework that is adaptable to future financial
    innovations and other market developments; and

    o 	to ensure that the regulation of similar financial functions, products,
    or services is consistent between different types of institutions.

    APRA, the safety and soundness regulator, provides prudential regulation
    for deposit-taking institutions, insurers, and pension funds. APRA
    consolidated prudential regulation responsibilities at the national level,
    taking on the responsibilities of nine regulatory agencies (the Reserve
    Bank of Australia, the Insurance Superannuation Commission and seven
    statebased regulators). It is an independent authority that is overseen by
    a threeperson executive group. Its structure includes a risk management
    and audit committee and has four major divisions-diversified institutions,
    specialized institutions, supervisory support and policy, research and
    statistics.

    ASIC is an independent commonwealth government body that has
    responsibility for regulating financial markets and corporations as well
    as consumer protection in relation to the provision of financial products
    and

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    services, including securities, derivatives, pensions, insurance, and
    deposit taking. As one ASIC official put it, ASIC looks after consumers as
    individual customers, ensuring they receive proper disclosure, are dealt
    with fairly by qualified people, and continue to receive useful
    information about their investments. ASIC replaced the Australian
    Securities Commission, which had replaced the National Companies and
    Securities Commission at the federal level and the Corporate Affairs
    offices of the states and territories in 1991.

    Along with APRA and ASIC, the Wallis report recommended that a Council of
    Financial Supervisors, initially composed of representatives of APRA,
    ASIC, and the central bank, be formed to deal with issues of coordination
    and cooperation. The council comprises high-level executives from each
    group and meets at least quarterly to discuss issues of mutual interest.
    As part of regulatory reforms flowing from a recent significant failure of
    an insurer, representatives of the treasury have also been included on the
    council.

    Some U.S. States Have Also Consolidated Their Regulatory Structures
    Largely in Response to Industry Conglomeration and Product Convergence

    According to information provided by the Conference of State Bank
    Supervisors, in July 2004, 23 states supervise banking and either
    insurance or securities in one department. That information also shows
    that 14 states have consolidated financial regulatory structures,
    combining banking, securities, and insurance regulation into one
    department.5 We interviewed officials in large states-Florida, Michigan,
    and Minnesota-that had consolidated their regulatory structures.
    Regulatory officials from each of these states told us they consolidated
    in response to industry changes that were blurring the traditional
    demarcations between banking, securities, and insurance activities. In all
    three states, officials said that although consolidation was not designed
    to conserve resources, they believed there had been cost savings due to
    consolidation.

    State officials from Florida, Michigan, and Minnesota told us that
    consolidation had improved information sharing across different financial
    services sectors, specifically in the areas of licensing and customer
    complaints. Michigan has consolidated licensing of all sales agents,
    including mortgage, insurance, and securities. Now that all financial

    5Regarding exchange-traded futures, federal law generally pre-empts state
    authority. However, states may have jurisdiction to enforce anti-fraud
    laws related to activities involving futures contracts.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    licensing is housed in one division, the state can more easily detect and
    discipline fraudulent behavior. For instance, individuals who have
    recently lost their license to sell securities due to fraudulent or other
    criminal acts cannot apply for a license to sell insurance or mortgages.
    Consolidation of customer complaints call centers has enabled Florida,
    Michigan, and Minnesota to downsize personnel and provide better services
    to consumers of financial products, according to officials from those
    states.

    United States Has Chosen to Maintain the Federal Regulatory Structure,
    although Proposals Have Been Made to Change It

    While GLBA removed restrictions against affiliations among financial
    services providers across sectors, it did not change the financial
    services regulatory structure. Over the years, many proposals had been
    made to change the U.S. regulatory structure. Many of the proposals,
    including one we made in 1996, have concerned reducing the number of
    federal bank regulators. Suggestions have also been made to combine SEC
    and CFTC, and to consolidate the securities SRO structure. In addition,
    proposals for an optional federal charter for insurance companies are
    currently being considered. Finally, some proposals for consolidating
    across sectors were made in the discussions leading up to the passage of
    GLBA, and that law did not end calls for regulatory restructuring across
    sectors.

    GLBA Permitted Affiliations across Areas without Changing the Regulatory
    Structure

    While GLBA removed many of the barriers that had restricted firms from
    engaging in banking, securities, and insurance activities, thus allowing
    many financial services firms to offer a wider array of services, it did
    not change the regulatory structure. By allowing banking organizations,
    securities firms, and insurance companies to affiliate with each other
    through a financial holding company structure, GLBA addressed several
    regulatory developments that had already permitted the affiliation of
    depository institutions with providers of nonbanking financial services.
    In 1998, the Federal Reserve had permitted Citicorp, at the time the
    largest bank holding company in the United States, to become affiliated
    with Travelers Group, a diversified financial services firm engaged in
    insurance and securities activities.6 Without the adoption of GLBA, the
    combined entity would have been subject to a requirement to divest or
    otherwise restructure many of its securities and insurance activities. In
    addition, OCC had promulgated regulations permitting national bank
    subsidiaries to

    6See Federal Reserve Board, Order Approving Formation of a Bank Holding
    Company and Notice to Engage in Nonbanking Activities, 84 Fed. Res. Bull.
    985 (1998).

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    engage in activities that were not permissible for the banks themselves.7
    Moreover, as discussed earlier, most thrift holding companies were not
    subject to activities restrictions. GLBA codified regulatory developments
    that had already allowed expanded services within a holding company or
    from a national bank subsidiary.

    After GLBA, banking, securities, and insurance activities continued for
    the most part to be regulated by the same primary federal regulator that
    had regulated them when only separate firms could participate in each
    activity. For instance, SEC primarily regulates securities activities
    regardless of where they occur within a financial holding company
    structure.8 Similarly, states continue to be responsible for regulation of
    insurance underwriting and other insurance-related activities undertaken
    by insurance companies.9 However, because the blurring of distinctions
    that once separated the financial products and services of banks,
    securities firms, and insurances companies also could blur the regulatory
    responsibilities of their respective regulators, GLBA contains provisions
    designed to enhance regulatory consultation and coordination. For example,
    with respect to insurance activities by insurance companies that are part
    of a financial holding company, the act calls for consultation,
    coordination, and information sharing among federal financial regulators
    and state insurance regulators.10 In addition, although GLBA established
    the Federal Reserve as the umbrella regulator of financial holding
    companies, the act requires the Federal Reserve generally to coordinate
    with and defer to the "functional" regulators with respect to the
    institutions they regulate.11 Federal Reserve supervision of holding
    companies is to focus primarily on the consolidated

    7Under OCC regulations effective December 31, 1996, national banks were
    permitted to engage in a broader range of activities through subsidiaries
    than the Comptroller permitted within the banks themselves. See 61 Fed.
    Reg. 60351-52 (Nov. 27, 1996).

    8National banks can be subject to SEC broker registration requirements if
    they execute orders for customers that involve securities not exempt from
    SEC jurisdiction or transactions not subject to an exception under the
    securities laws. See 15 U.S.C. S: 78c(a)(4) (2000 & Supp. 2004).

    9Subject to the preemption standard set forth in GLBA and prohibitions
    against discriminatory state laws, GLBA authorizes limited state
    regulation of insurance sales by banks and savings associations. Pub. L.
    No. 106-102 S: 104, 15 U.S.C. S: 6701 (2000 & Supp. 2004).

    10Pub. L. No. 106-102 S: 307, 15 U.S.C. S: 6716 (2000 & Supp. 2004).

    11Pub. L. No. 106-102 S:S: 111, 112, 12 U.S.C. S:S: 1844(c), (g).

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    risk position of the entire holding company, the risks the holding company
    system may pose to the safety and soundness of any of its depository
    institution subsidiaries, and compliance with consumer protection laws it
    is charged with enforcing.12 GLBA also retained OTS responsibility for
    supervising thrift holding companies, although it did limit the ability of
    nonfinancial companies to obtain thrift charters after May 4, 1999. In
    addition to establishing the scheme for the regulation of consolidated
    financial organizations involving a bank or thrift, GLBA provided for a
    program allowing for consolidated supervision by the SEC of investment
    bank holding companies.

    One area for which GLBA discussed a potential new regulatory agency was
    insurance. As an incentive for states to modernize and achieve uniformity
    in insurance regulation, GLBA provided for a federal licensing agency, the
    National Association of Registered Agents and Brokers, that was to come
    into existence three years after the enactment of GLBA, if a majority of
    states failed to enact legislation for state uniformity or reciprocity.13
    However, that agency has not come into existence because a majority of the
    states adopted the types of laws and regulations called for in the
    section.

    Since 1990, Various Proposals Have Sought to Simplify the Bank Regulatory
    Structure and Reduce the Number of Regulators

    According to FDIC, many regulatory restructuring proposals concerned the
    restructuring of the multiagency system for federal oversight of banking
    institutions in the United States have been made since the 1930s, when
    federal deposit insurance was introduced. Since 1990 several additional
    proposals have been made, including the following three made between 1993
    and 1994:

    o 	1994 Treasury proposal.14 This proposal would have realigned the
    federal banking agencies by core policy functions-that is, bank
    supervision and regulation function, central bank function, and deposit
    insurance function. Generally, this proposal would have combined OCC, OTS,
    and certain functions of the Federal Reserve and FDIC into a new

    12Pub. L. No. 106-102 S: 111, 12 U.S.C. S: 1844(c).

    13Pub. L. No. 106-102 S: 321.

    14This proposal was outlined in the statement of the Honorable Lloyd
    Bentsen, Secretary of the Treasury, before the Committee on Banking,
    Housing, and Urban Affairs of the U.S. Senate (Mar. 1, 1994).

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    independent agency, the Federal Banking Commission, that would have been
    responsible for bank supervision and regulation. FDIC would have continued
    to be responsible for administering federal deposit insurance, and the
    Federal Reserve would have retained central bank responsibilities for
    monetary policy, liquidity lending, and the payments system. Although FDIC
    and the Federal Reserve would have lost most bank supervisory rule-making
    powers, each would have been allowed access to all information of the new
    agency as well as limited secondary or backup enforcement authority. In
    addition, the Federal Reserve would be authorized to examine a cross
    section of large and small banking organizations jointly with the new
    agency. FDIC would have continued to oversee activities of state banks and
    thrifts that could pose risks to the insurance funds and to resolve
    failures of insured banks.

    o 	H.R. 1227 (1993).15 This proposal would have consolidated OCC and OTS
    in an independent Federal Bank Agency and aligned responsibilities among
    the new and the other existing agencies. It also would have reduced the
    multiplicity of regulators to which a single banking organization could be
    subject, while avoiding the concentration of regulatory power of a single
    federal agency. The role of the Federal Financial Institution Examination
    Council would have been strengthened; it would have seen to the uniformity
    of examinations, regulation, and supervision among the three remaining
    supervisors. According to a Congressional Research Service (CRS) analysis,
    this proposal would have put the Federal Reserve in charge of more than 40
    percent of banking organization assets, with the rest divided between the
    new agency and a reorganized FDIC.16

    o 	1994 LaWare proposal.17 The LaWare proposal was outlined in
    congressional testimony, but never presented as a formal legislative
    proposal, according to Federal Reserve officials. It called for a division
    of responsibilities defined by charter class and a merging of OCC and OTS
    responsibilities. The two primary agencies under the proposal

    15H.R. 1227: The Bank Regulatory Consolidation and Reform Act of 1993
    (Mar. 4, 1993).

    16CRS, Bank Regulatory Agency Consolidation Proposals: A Structural
    Analysis (Washington, D.C.; Mar. 18, 1994).

    17This proposal was outlined in the statement of Alan Greenspan, Chairman,
    Board of Governors of the Federal Reserve System, before the Committee on
    Banking, Housing, and Urban Affairs of the U.S. Senate (Mar. 2, 1994).

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    would have been an independent Federal Banking Commission and the Federal
    Reserve, which would have supervised all independent state banks and all
    depository institutions in any holding company whose lead institution was
    a state-chartered bank. The new agency would have supervised all
    independent national banks and thrifts and all depository institutions in
    any banking organization whose lead institution was a national bank or
    thrift. FDIC would not have examined financially healthy institutions, but
    would have been authorized to join in examination of problem banking
    institutions. Based on estimates of assets of commercial banks and thrifts
    performed by CRS, the LaWare proposal would have put the new agency in
    charge of somewhat more commercial bank assets than the Federal Reserve.

    In 1996, we also recommended ways to simplify bank oversight in the United
    States in accord with four principles for effective supervision:

    o 	consolidated and comprehensive oversight of entire banking
    organizations, with coordinated functional regulation and supervision of
    individual components;

    o 	independence from undue political pressure, balanced by appropriate
    accountability and adequate congressional oversight;

    o  consistent rules, consistently applied for similar activities; and

    o 	enhanced efficiency and as low a regulatory burden as possible
    consistent with maintaining safety and soundness.

    We recommended consolidating the primary supervisory responsibilities of
    OTS, OCC, and FDIC into a new, independent federal banking agency or
    commission. This new agency, together with the Federal Reserve, would be
    assigned responsibility for consolidated, comprehensive supervision of
    those banking organizations under its purview, with appropriate functional
    supervision of individual components. We also recommended that in order to
    carry out its primary responsibilities effectively, the Federal Reserve
    should have direct access to supervisory information as well as influence
    over supervisory decision making and the banking industry. In addition, we
    recommended that Treasury have access to supervisory information,
    including information on the safety and soundness of banking institutions
    that could affect the stability of the financial system. Furthermore, we
    recommended that under any restructuring, FDIC should have an explicit
    backup supervisory authority to enable it to effectively discharge its

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    responsibility for protecting the deposit insurance funds. In coordination
    with other regulators, such authority should allow FDIC to go into any
    problem institution on its own without the prior approval of any other
    regulatory agency.

    Partly in Response to Market Convergence, Proposals Have Been Made to
    Consolidate Securities and Futures Regulators

    Over the years, proposals have been made to consolidate SEC and CFTC,
    partly in response to increasing convergence in new financial instruments
    and trading strategies of the securities and futures markets. For
    instance, according to a 1990 CRS study, futures contracts based on
    financial instruments such as stock indexes are used by securities firms
    and large institutional investors simultaneously and are sometimes
    interchangeable with certain securities products. However, these
    transactions are regulated separately by CFTC and SEC. Prior to the
    passage of the Commodity Futures Modernization Act (CFMA) in 2000, the two
    agencies had disagreed on the jurisdiction of certain derivatives. In
    addition, new trading strategies involving both securities and futures
    transactions that have significant potential impacts on price movements
    have called for the need for better monitoring. Treasury also proposed
    three options to address these industry changes: (1) merging SEC and CFTC,
    (2) giving SEC regulatory authority over all financial futures, or (3)
    transferring regulation of stock index futures from CFTC to SEC.

    In 1995, Members of Congress introduced the Markets and Trading
    Reorganization and Reform Act, which was intended to improve the
    effectiveness and efficiency of financial services regulation by merging
    SEC and CFTC. In testimony before the House Committee on Banking and
    Financial Services, we presented the major benefits and risks of merging
    SEC and CFTC, as well as specific issues related to this bill, to be
    considered in merging the two agencies. The anticipated benefits of a
    merger would have included reduced regulatory uncertainty concerning the
    two agencies' regulatory jurisdictions over particular financial products,
    a clarification that would likely have enhanced market efficiency and
    innovation. Another potential benefit we identified was greater ease in
    conducting international regulatory negotiations. We also identified some
    risks involved in such a merger, including (1) a potential for
    over-regulation that might have resulted in decreased market innovation
    and (2) a potential dominance of one market and regulatory perspective to
    the detriment of the other. In addition, we noted some operational risk
    that might arise during the transition to a single government agency, such
    as differences in institutional cultures and histories. Finally, we
    cautioned those considering the merger about the difficulty of quantifying
    both potential benefits and

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
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    risks, and noted further that a merger might yield only small budgetary
    cost savings.

    Efforts Have Been Made to Change the SRO Structure for Securities

    In 2002, NASD completed the sale of its subsidiary Nasdaq Stock Market
    Inc. (NASDAQ), in recognition of the inherent conflicts of interest that
    exist when SROs are both market operators and regulators. These conflicts
    had become evident in the mid-1990s when NASD was under scrutiny for price
    fixing. Concerns about conflicts of interest and regulatory inefficiencies
    also prompted proposals to simplify the SRO structure for securities. In
    January 2000, the Securities Industry Association (SIA) detailed the
    following three possibilities for changing the SRO structure.18

    o 	Hybrid SRO model. Under this model, a single consolidated entity
    unaffiliated with any market would have assumed responsibility for
    broker-dealer self-regulation and cross-market issues, such as those
    related to sales practices, industry admissions, financial responsibility,
    and cross-market trading. Individual SROs would have remained responsible
    for market-specific rules, such as those related to listings, governance,
    and market-specific trading. The majority of SIA members believed that the
    hybrid SRO model would reduce member-related conflicts of interest and SRO
    inefficiencies. Eliminating duplicative SRO examinations, in their view,
    would have reduced inefficiencies in areas such as rule making,
    examinations, and staffing. SEC officials agreed that consolidating member
    regulation into one SRO could be an advantage of the hybrid SRO model.
    They noted that the industry was moving toward a hybrid model as NASDAQ
    separated from NASD and NASD contracted to provide regulatory services to
    more SROs.

    o 	Single SRO model. Under this model, a single SRO would have been vested
    with responsibility for all regulatory functions currently performed by
    the SROs, including market-specific and broker-dealer regulation.
    According to SIA, the single SRO model could have eliminated the conflicts
    of interest and regulatory inefficiencies associated with multiple SROs,
    including those that would remain under

    18SIA, Reinventing Self-Regulation, White Paper of the Securities Industry
    Association's Ad Hoc Committee on Regulatory Implications of
    De-Mutualization (Washington, D.C.; Jan. 5, 2000). We discussed this
    report and SEC's views in our report Securities Markets: Competition and
    Multiple Regulators Heighten Concerns about Self-Regulation, GAO-02-362
    (Washington, D.C.: May 3. 2002).

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
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    the hybrid SRO model. However, SIA did not endorse this alternative,
    primarily because of the risk that self-regulation would have become too
    far removed from the functioning of the markets. In May 2002, we reported
    that, according to SEC officials, it might not be appropriate or feasible
    to give a single SRO responsibility for surveilling all of the markets,
    such as NASDAQ and NYSE, which have different rules that reflect
    differences in the way trades are executed.19

    o 	SEC-only model. Under this model, SEC would have assumed all of the
    regulatory functions currently performed by SROs. SIA did not endorse the
    SEC-only model because doing so would have eliminated selfregulation of
    the securities industry, taking with it the expertise that market
    participants contribute. SIA also expected the SEC-only model would have
    been more expensive and bureaucratic, because implementing it would have
    required additional SEC staff and mechanisms to replace SRO regulatory
    staff and processes. In addition, according to SIA's report and SEC, a
    previous SEC attempt at direct regulation was not successful, owing to its
    high cost and low quality (relative to self-regulation), and this
    convinced SEC and other market participants that it was not a feasible
    regulatory approach.20

    We reported in 2002 that at that time, none of the models appeared to have
    the support from market participants that would be needed for
    implementation. However, since that time the governance structures of SROs
    have been under greater scrutiny.

    Proposals Have Been Made While proposals to regulate insurance at the
    federal level have been made for an Optional Federal from time to time,
    since 2000 this idea has been gathering steam. Several Insurance Charter
    trade associations have made proposals for some federal regulation of

    insurance, and bills have been introduced in Congress. According to a CRS
    study, two bills introduced in the 107th Congress-the National Insurance
    Chartering and Supervision Act and the Insurance Industry Modernization

    19GAO-02-362.

    20In 1965, SEC became responsible for direct regulation of a small number
    of broker-dealers that traded only in the over-the-counter market. This
    program, called the Securities and Exchange Only program, was designed to
    provide participating firms with a regulatory alternative to NASD. In
    1983, SEC concluded that the industry would be better served if the
    program were discontinued, because needed improvements would be costly and
    not an efficient use of agency resources.

    Chapter 3
    While Some Countries Have Consolidated
    Regulatory Structures, the United States Has
    Chosen to Maintain Its Structure

    and Consumer Protection Act-included an optional federal charter for
    insurance companies that would be similar to a national bank charter. The
    proposals would have required the creation of a federal insurance
    regulator. These proposals suggested creating a new federal agency
    (similar to OCC and OTS) in Treasury. A bill introduced in July 2003, the
    Insurance Consumer Protection Act, would create a federal commission
    within the Department of Commerce to regulate the interstate business of
    property-casualty and life insurance and require federal regulation of all
    interstate insurers. It thus would pre-empt most current state regulation
    of insurance. Generally, these proposals differed in whether a federal
    charter would include insurance agencies, brokers, or agents and where a
    federal regulator would be housed.

    Supporters of an optional federal charter include members of trade
    associations that generally represent the interests of larger life and
    property-casualty insurers-the American Council of Life Insurers, the
    American Bankers Insurance Association, and the American Insurance
    Association. These and other supporters have argued that an optional
    federal charter had benefited the banking sector by encouraging
    competition, regulatory efficiency, and product expansion and would
    benefit insurers by (1) removing the disadvantage large insurers have in
    competing with other financial service providers because large insurers
    have to comply with multiple state insurance standards; (2) allowing for
    more innovation among insurers because they would no longer have to secure
    product approval from different state regulators; (3) better representing
    the industry in federal policy and international trade negotiations
    through a single federal regulator; and (4) allowing consumers to have
    more product choices and more uniform protections across states.

    Opponents of an optional federal charter, including some smaller life
    insurers, property- casualty insurers specializing in local services such
    as auto and homeowners insurance, and consumer groups, have argued that
    creating a new federal regulator would (1) create competition over
    industry charters between the federal regulator and state regulators and
    hence cause deterioration in the state regulatory system and industry
    regulatory standards; (2) lead to the loss of regulatory innovation and
    the testing and emergence of better policies because the current state
    system allows for regulatory innovation; and (3) be more costly than
    supporting NAIC's current efforts to achieve uniformity in the state
    system; and (4) be less responsive to consumer needs.

                                       Chapter 3
                         While Some Countries Have Consolidated
                      Regulatory Structures, the United States Has
                            Chosen to Maintain Its Structure

    Proposals Made Before and After GLBA Cut across Functional Areas

    Prior to the passage of GLBA, some proposals to restructure the U.S.
    regulatory system concerned regulators across the financial services
    sectors. For example, in the early 1990s the Chicago Mercantile Exchange
    proposed that all federal financial regulation, including that of OCC,
    OTS, FDIC, CFTC, SEC, and certain functions of the Federal Reserve, be
    consolidated into "a single cabinet level department within the executive
    branch" to, among other things, facilitate regulatory coordination and
    allow for equal regulation of similar products, services and markets. In
    1997, a congressional proposal included a National Financial Services
    Oversight Committee with representatives from Treasury, each of the
    federal bank regulators, SEC, and CFTC that would, among other things,
    establish uniform examination and supervision standards for financial
    services providers and identify providers that require "special
    supervisory attention." Following the passage in 1999 of GLBA, which did
    not change the regulatory structure, calls for regulatory restructuring
    across sectors continued, including a recommendation in 2002, by the
    Chairman of FDIC, for a single bank regulator, securities regulator, and
    insurance regulator at the federal level.

    Chapter 4

    Regulators Are Adapting Regulatory and Supervisory Approaches in Response
    to Industry Changes

    Although the U.S. regulatory structure has not changed in response to the
    industry changes we have identified-globalization, consolidation,
    conglomeration, and convergence-some U.S. regulators have adapted their
    regulatory and supervisory approaches to these changes. Some of these
    adaptations, especially those related to large, internationally active
    firms, have been made as part of or in response to efforts to achieve some
    degree of harmonization across the major industrial nations and within the
    EU. Some U.S. regulatory agencies have also made or considered other
    changes in response to the industry changes that we have identified.

    New Basel II Structure and EU Requirements Will Likely Affect Oversight of
    U.S. Financial Institutions

    As part of the evidence of continuing globalization and increased
    complexity of financial institutions, the Basel Committee adopted a new
    set of standards (Basel II) in June 2004 that member and nonmember
    countries may adopt.1 These Basel II requirements are designed to address
    some of the shortcomings of the Basel I standards, and include supervision
    and market discipline requirements as well as standards for minimum
    capital levels. U.S. bank regulators are in the process of determining how
    to apply these standards for large, internationally active firms. Because
    the EU is requiring securities firms and other firms with significant
    insurance operations operating in the EU to adopt Basel standards as part
    of its Action Plan, international harmonization efforts are also having an
    impact on other U.S. regulators that oversee large, internationally active
    firms.

    While U.S. Regulators Applied Basel I Standards to All Banks, They Propose
    to Require Only Large, Internationally Active Banks to Adopt Basel II
    Standards

    In 1988, the Basel Committee adopted the Basel Accord for international
    convergence of capital standards (now referred to as Basel I) to provide
    uniform risk-based capital requirements with the objectives of
    strengthening the soundness and stability of the international banking
    system and diminishing a source of competitive inequality among
    international banks. These risk-based capital requirements, which were
    available for implementation in the Basel Committee members' countries
    between 1990 and 1992, focused on limiting credit risk by requiring
    certain firms to hold capital equal to at least 8 percent of the total
    value of their risk-weighted on-balance sheet assets and off-balance sheet
    items, after adjusting the value of the assets according to certain rules
    intended to

    1The Basel II framework includes several levels of approaches for
    determining capital requirements for banks. While the standard approaches
    will be available for implementation in 2006, the most advanced
    approaches, which are the only ones being proposed for some U.S. banks,
    will not be available for implementation until 2007.

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    reflect their relative risk.2 U.S. bank regulators applied these standards
    to banks and bank holding companies. Basel I was amended in 1996 to
    include capital requirements for market risks for those banks or bank
    holding companies with a certain amount of securities and derivatives
    trading activity or, if deemed necessary by the regulator for safety and
    soundness purposes. Although Basel I generally is credited with improving
    the regulatory capital levels of most banks and reducing competitive
    inequities among international banks, it did not fully address changes and
    risks arising from increasingly complex financial markets. For instance,
    Basel I did not account for the internal credit risk mitigation activities
    of large, internationally active banks. Also, the limited number of
    risk-weighted categories under Basel I meant that the standards had
    limited risk sensitivity. This has, among other outcomes, allowed banks to
    take on higher risk assets within each category without having to hold
    more capital for regulatory purposes. Moreover, Basel I did not explicitly
    account for operational risks, such as poor management or security and
    process failures.

    Basel II, which is available for implementation in banking organizations
    in 2006 or 2007, is intended to address the shortcomings of Basel I. As
    illustrated in figure 7, Basel II has three pillars: (1) minimum capital
    requirements, (2) supervision of capital adequacy, and (3) market
    discipline in the form of increased disclosure.

    2Off-balance sheet items are financial contracts that can create credit
    losses for banks but are not reported on banks' balance sheets under
    standard accounting practices. An example of such an off-balance sheet
    position is a letter of credit or an unused line of credit committing the
    bank to making a loan in the future that would be on the balance sheet and
    thus creates a credit risk. To adjust for credit risks created by
    financial positions not reported on the balance sheet, U.S. regulations
    provide conversion factors to express offbalance sheet items as equivalent
    on-balance sheet items, as well as rules for incorporating the credit risk
    of off-balance sheet derivatives.

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    Figure 7: The Three Pillars of Basel II

    Source: GAO.

    Under the first pillar of Basel II-the definition of capital-the treatment
    of market risk and the minimum capital requirement of 8 percent of
    riskweighted assets remain the same as that in Basel I. With regard to
    credit and operational risk, however, Basel II allows firms with
    sophisticated risk management systems-generally large or internationally
    active firms-to use their internal risk assessment models and techniques
    to determine the appropriate amount of regulatory capital, with certain
    restrictions. These advanced approaches will not be available for
    implementation until the end of 2007.

    The second pillar of Basel II focuses on supervisory review of and action
    in response to banks' capital adequacy. Supervisory review is expected to
    capture potential risks, including those that are external to banks, that
    are not fully captured under Pillar I and to assess banks' compliance with
    minimum standards and disclosure requirements of the more advanced capital
    calculation options being used by some firms. Supervisors are to evaluate
    banks' assessment, monitoring, and maintenance of their capital adequacy
    relative to their risk profile, including compliance with regulatory
    capital ratios. Supervisory review can involve on-site examinations or
    inspections, off-site review, discussions with bank management, review of
    work done by external auditors, and periodic reporting. Basel II calls for

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    supervisors to intervene at an early stage to prevent capital from falling
    below minimum levels and to require remedial action if capital is not
    maintained or restored.

    The third pillar of Basel II-market discipline-calls for banks to disclose
    information about their risk profile, risk assessment processes, and
    adequacy of their capital levels. The rationale is that a bank's borrowing
    and capital costs will rise if market participants perceive a bank to be
    risky, and banks will thus have an incentive to refrain from excessive
    risk taking. Members of the Basel Committee note that market discipline
    will become more important once banks are using their internal models and
    techniques to make capital decisions.

    In recognition that large, internationally active banks pose different
    risks and use different risk management techniques than smaller, less
    internationally active banks, U.S. regulators are proposing to require
    that only a number of large, internationally active institutions comply
    with capital standards that are consistent with Basel II. Federal
    regulators expect that fewer than 10 large, internationally active banking
    organizations will be required to operate under rules consistent with
    Basel II by the end of 2007. Under current proposals, other U.S. banks
    that satisfy certain requirements will have the option of implementing the
    Basel II framework, and federal regulators expect roughly another 10 large
    banking organizations to adopt capital standards consistent with Basel II
    requirements.

    EU Financial Conglomerates Directive Is Requiring Some Securities and
    Insurance Firms to Have Consolidated Supervision and Apply Basel Capital
    Standards

    Certain directives in the EU Action Plan, especially the Financial
    Conglomerates Directive, will impact some internationally active firms in
    the United States, especially those that have not been subject to bank or
    financial holding company oversight by the Federal Reserve because they do
    not own commercial banks. In recognition of the risks posed by financial
    conglomerates and other financial firms that do not have consolidated
    supervision, the directive specifies minimum requirements for consolidated
    supervision of such firms conducting business in the EU. The directive
    defines a financial conglomerate as a firm with insurance operations that
    also engages in banking or securities activities. In addition, the
    directive requires that non-European conglomerates, banks, and securities
    firms have adequate consolidated supervision, which would

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    generally include application of Basel standards.3 Under the directive,
    which goes into effect at the beginning of 2005, a non-European financial
    conglomerate or group that has a banking presence in the EU that is not
    considered to be supervised on a consolidated basis by an equivalent home
    country supervisor would be subject to additional requirements by EU
    regulators, which could include additional direct supervision.

    U.S. regulators that provide or might provide consolidated oversight-the
    Federal Reserve, OTS, and SEC, among others-responded to EU requests for
    information about their activities as holding company supervisors. This
    information was used to develop EU guidance for EU country regulators in
    determining whether U.S. firms doing business in EU countries have
    consolidated supervision that is equivalent to that required to be in
    place in EU host countries. According to EU officials, specific regulators
    in EU countries will use this guidance to determine whether a specific
    U.S. company operating in Europe has adequate consolidated supervision.

    Officials at the Federal Reserve say that they do not expect to have to
    make any changes in the way they oversee bank or financial holding
    companies to be deemed an equivalent home country supervisor for affected
    companies under their supervision. However, because U.S. securities firms
    that are not owned by a bank or financial holding company are currently
    not supervised on a consolidated basis the way bank and financial holding
    companies are, to comply with the directive, these securities firms that
    conduct business in the EU will need to have a consolidated supervisor
    sometime in 2005.4 Some of these firms requested that SEC develop a
    program to provide them with consolidated supervision, and SEC responded
    with its CSE proposal. Firms opting to become CSEs will be subject to
    capital requirements that are consistent with Basel standards,5 which are
    described by the rules governing CSEs as an alternative to the

    3EU member states have been required to adopt capital adequacy rules that
    are generally consistent with Basel standards for credit institutions
    (banks and securities firms). Thus, to satisfy the EU requirements, U.S.
    banks and securities firms operating in EU member states would be subject
    to similar requirements. The EU is currently considering amendments to
    relevant directives partly in response to the adoption of Basel II.

    4See SEC, Alternative Net Capital Requirements for Broker-Dealers That Are
    Part of Consolidated Entities, 69 FR 34428 (June 21, 2004); and Supervised
    Investment Bank Holding Companies 69 FR 34472 (June 21, 2004).

    5Because the EU Financial Conglomerate Directive is effective in January
    2005 and the Basel II standards are not required until year-end 2006,
    there is some question as to whether CSEs will adopt Basel II standards at
    the time of their registration.

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    net capital requirements generally required for broker dealers.6 Because
    the requirements of Basel II were not established with U.S. securities
    firms in mind, SEC staff notes that it is participating in a joint working
    group established by IOSCO and the Basel Committee to address issues
    relating to the treatment of positions held in the trading book. One issue
    of interest to holding companies with broker-dealer subsidiaries is the
    development of a more risk-based approach to capital requirements for
    securities activities. For example, since the Basel II standards were
    developed with the expectation of long-term credit exposures that are
    common for banks, securities firms believe that credit risk in their
    trading books that have much shorter exposures is overstated using Basel
    II requirements. IOSCO and the Basel Committee have had several meetings
    to discuss this and other issues.

    With regard to required examination and disclosure requirements at the
    consolidated level, SEC says it expects to better monitor the financial
    condition, risk management, and activities of a broker-dealer's affiliates
    that could impair the financial and operational stability of the
    broker-dealer or CSE. SEC will examine regulated affiliates of CSE's that
    do not have a principal U.S. regulator, but will defer to the UK-FSA (or
    another EU regulator) to examine affiliates in EU countries. For the
    ultimate holding company, SEC will examine the holding company unless it
    determines that it is already subject to "comprehensive, consolidated
    supervision" by another principal regulator. Thus, bank or financial
    holding companies generally would be exempt from SEC examination. In the
    case of holding companies, SEC believes the disclosure requirements that
    are part of Basel II are not consistent with those required by SEC.7
    However, SEC staff said that they would apply Basel II disclosure
    standards while working to make them more consistent. SEC says that data
    being collected by the Basel Committee to measure the impact of Basel II
    will include data from the large securities firms that will register as
    CSEs, and this may allow the standards to better reflect the risks of
    these firms over time.

    In response to the Financial Conglomerates Directive, U.S. and other firms
    with insurance and banking operations in the EU will need to choose a
    consolidated regulator and comply with Basel II. OTS is responsible for
    the

    6Some bank, financial, and thrift holding companies with significant
    broker-dealer affiliates may also register as CSEs. Their broker-dealers
    will have the option of complying with the capital standards consistent
    with Basel II rather than SEC's net capital rule.

    7SEC staff notes that it raised this issue before completion of the final
    Basel II draft.

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    consolidated supervision of Thrift Holding Companies, including a number
    of firms that are conglomerates under the EU directive. Some of the
    largest such firms may choose OTS as their consolidated supervisor for
    purposes of the directive. These firms qualify as thrift holding companies
    because they own a thrift under the exemption provided before May 1999 or
    have obtained a thrift charter since then. Officials at OTS say that 40
    companies with insurance operations are now thrift holding companies, but
    not all of these are operating in EU countries or would be deemed
    conglomerates. These companies may not qualify as financial holding
    companies because they do not own a commercial bank and the scope of their
    activities, which may include commercial enterprises, make doing so
    impractical. Furthermore, they may not qualify for SEC oversight because
    they do not have a broker-dealer affiliate with a substantial presence in
    the securities markets. OTS expects its level of supervisory coordination
    with foreign regulators to increase as a result of the EU directive.

    U.S. Regulators Have Made or Considered Some Other Changes to Their
    Regulatory and Supervisory Approaches in Response to Industry Changes

    Because of the increased size and complexity of some banks, U.S. bank
    regulators had adopted risk-focused examination procedures that tailor
    reviews to key characteristics of each bank, including its asset size,
    products offered, markets in which it competes, and its tolerance for
    risk. In recognition of the increased size of the largest banks and the
    possibility that shareholders and creditors believe that these banks are
    too big for regulators to allow them to fail, regulators have considered
    requiring banks to issue subordinated debt as a mechanism to enhance
    market discipline of banking institutions. However, regulators have not
    adopted this requirement, because evidence of its potential effectiveness
    is limited. Bank regulators also have adjusted their approaches in
    response to what appears to be heightened concern about reputational risk.
    SEC had made some changes related to the increased size and complexity of
    securities firms prior to adopting its consolidated supervision rules in
    response to the EU financial conglomerates directive. These changes
    affected the collection of information related to risk management from the
    parents and affiliates of broker-dealers. While CFTC and state insurance
    regulators will not adopt Basel II requirements, they have made other
    changes that acknowledge how the industry is changing. CFMA acknowledges
    the increasingly global nature of the futures industry and the increasing
    importance of new financial products. As a result of property-casualty
    failures in the 1980s and recognition of changes in the insurance
    industry, NAIC adopted a new Solvency Policy Agenda that included
    risk-based capital and the creation of a Financial Analysis Unit that
    analyzes the behavior of insurers that operate across state lines.

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    U.S. Bank Regulators Adopted Risk-Focused Supervision for Large, Complex
    Firms and Made or Considered Other Changes

    In response to the development of large, complex banking organizations
    with diverse and changing risks and sophisticated risk management systems,
    U.S. bank regulators have generally placed greater emphasis on examining
    an institution's internal control systems and on the way it manages and
    controls its risks, rather than on assessing a bank's condition at a
    specific point in time. The federal bank regulators generally apply
    riskfocused examinations. We reported in 2000 that since the mid-1990s,
    the Federal Reserve and OCC have developed and refined their on-site
    examination policies and procedures for large, complex banks to focus on
    risk assessments along business lines, which often cross bank charters
    within the banking organization.8 Under the risk-focused approach, Federal
    Reserve and OCC examiners are to continually monitor and assess an
    institution's financial condition and risk management systems through the
    review of a variety of management reports and frequent meetings with key
    bank officials, documenting the areas they select for review, including
    their rationale for selecting those areas. Federal Reserve officials noted
    that detecting fraud remains a difficult task under the risk-focused
    approach, but that the approach was designed to detect the areas of a
    bank's (or bank holding company's) activities that posed the greatest risk
    to the safety and soundness of the institution.

    In 2002, FDIC adopted an agreement with OTS, OCC, and the Federal Reserve
    that allows FDIC to examine insured depository institutions that pose a
    greater than normal risk to the deposit insurance funds. According to
    FDIC's annual report, under the agreement FDIC has assigned dedicated
    examiners to each of the eight largest insured banking institutions to
    monitor their financial condition and risk management processes and obtain
    timely information on the potential risks of these institutions. As FDIC
    is not the primary regulator of these institutions, it will rely on
    supervisory information provided by the primary regulators. In 2003, FDIC
    established a Risk Analysis Center to analyze information generated from
    the dedicated examiner program, among other tasks.

    One change that has been discussed but not made in response to the growing
    size of banks is whether banks should be required to issue subordinated
    debt as a market discipline tool. The usual disclosure requirements for
    publicly traded companies may not be sufficient for large

    8GAO, Risk-Focused Bank Examinations: Regulators of Large Banking
    Organizations Face Challenges, GAO/GGD-00-48 (Washington, D.C.: Jan. 24,
    2000).

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    banks because shareholders may believe that the banks are too big for
    regulators to allow them to fail. Because subordinated creditors are
    especially sensitive to risks that a bank may fail, mandatory issuance of
    subordinated debt has been proposed as a means of enhancing market
    discipline to inhibit risk-taking activities and limit losses to the
    insurance funds when excessive risk taking damages a bank. Requiring banks
    to issue subordinated debt has been discussed in relation to the market
    discipline pillar of Basel II, but no such requirement appears in the
    standards adopted in June 2004. Similar proposals have not been adopted in
    the United States. GLBA directed the Federal Reserve and Treasury to study
    the feasibility of requiring depository institutions that pose significant
    systemic risk and their holding companies to maintain some portion of
    their capital in the form of subordinated debt. The Federal Reserve and
    Treasury supported the use of subordinated debt as a way of enhancing
    market discipline but said that more evidence would be needed to make such
    a policy mandatory. According to the report, almost all of the largest
    banking organizations had voluntarily issued and had subordinated debt
    outstanding in excess of 1 percent of their assets, providing some degree
    of direct market discipline and transparency. The Federal Reserve, OCC,
    and OTS agreed to continue to use various data and supervision to evaluate
    the use of subordinated debt.

    U.S. bank regulators are also charged with ensuring that banks comply with
    various consumer protection laws and laws concerning money laundering and
    corporate governance issues. In addition to safety and soundness
    examinations, banks are also subject to examinations that evaluate their
    performance in meeting the needs of their communities under the Community
    Reinvestment Act and their compliance with anti-money laundering rules
    under the Bank Secrecy Act and the USA PATRIOT Act. The regulatory
    agencies recently announced new examination procedures for banks' customer
    identification programs, for instance; this program was required under
    section 326 of the USA PATRIOT Act.9 Regulators also note that failure to
    comply with consumer protection and anti-money laundering laws and
    regulations can endanger a bank's safety and soundness because they may
    affect the bank's reputation. For example, OCC asserts that predatory
    lending practices in national banks could damage the reputations

    9See joint press release issued by Federal Reserve, FDIC, NCUA, OCC, and
    OTS (Washington, D.C.; July 28, 2004),
    http://www.federalreserve.gov/boarddocs/press/
    bcreg/2004/20040728/default.htm (downloaded Sept. 10, 2004). See also 31
    U.S.C. 5318(l) (2000 & Supp. 2004).

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    and thus the safety and soundness of those institutions. Furthermore,
    recent money laundering activities at some banks-which could affect the
    reputation of those banks-appear to have heightened regulatory efforts to
    prevent such activity.

    SEC Had Made Changes Related to Size and Complexity of Firms Prior to
    Becoming a Consolidated Regulator

    With regard to adopting consolidated regulations for CSEs and SIBHCs, SEC
    officials said that what appear to be significant changes in their
    regulatory and supervisory approach are merely continuations of previously
    ongoing trends that recognized the increased size and complexity of many
    securities firms. Further, SEC officials recognize that because of the
    size of the parent firms, the sudden failure of a large securities firm
    that has broker-dealer affiliates could have a major impact on markets and
    investors.

    SEC says that in setting capital requirements, it has been concerned with
    the safety and soundness of broker-dealers for some time. Since 1975, the
    net capital rule has required that broker-dealers maintain a minimum level
    of net capital sufficient to satisfy all obligations to customers and
    other market participants and to provide a cushion of liquid assets to
    cover potential credit, market, and other risks. SEC amended its net
    capital rule in early 1997 to allow broker-dealers to use statistical
    models to calculate required capital charges for exchange-traded financial
    instruments to better reflect market risk. In 1999, SEC adopted an
    optional regulatory framework that includes alternative net capital
    requirements for OTC derivatives dealers. Under this framework, OTC
    derivatives dealers may be permitted to use statistical models to
    calculate capital charges for market risk and to take alternative charges
    for credit risk. SEC rules also require firms to integrate their
    statistical models into their daily risk management processes and
    establish a system of internal controls to monitor and manage the risks
    associated with their business activities, including market, credit,
    leverage, liquidity, legal, and operational risks. With regard to
    supervision of risk management of securities firms, SEC officials say that
    they have long sought more information on the parents and affiliates of
    broker-dealers. Since 1992, SEC has collected risk assessment information
    from securities firms that own large broker-dealers. And, beginning in
    1999, SEC has held monthly discussions regarding these risk assessments.

    Much of SEC's examination program is related to ensuring that SROs,
    broker-dealers, and investment advisers comply with federal securities
    laws and rules, including having adequate systems and procedures in place
    to ensure compliance. SEC's examination procedures have evolved over

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    time. In the mid-1990s, SEC's examination office began conducting fewer
    full scope examinations, which review all aspects of operations, and more
    frequent risk-focused examinations, which focus on specific areas or
    issues. We noted in a 2002 report10 that although SEC officials said they
    had been able to maintain their examination schedules and workload with
    their existing staff levels, some officials were concerned that the cycle
    for certain types of reviews could stretch beyond the planned time frames.
    In that report, we noted SEC officials also said that newly implemented
    rules would add time and complexity to the reviews. Overall, SEC officials
    said their examination office had lost a lot of experienced staff at the
    junior level and that new staff requires constant training.

    With the corporate governance and accounting scandals that came to light
    beginning in 2002 and with the 2003 revelation of market timing and late
    trading abuses in mutual funds, SEC has made additional changes in its
    compliance exams and developed rules to improve corporate governance. We
    have reported that SEC did not identify the abusive practices in mutual
    funds for several reasons, including the inherent difficulty of detecting
    fraud and the focus of examinations on operations of mutual funds rather
    than on trading in the funds themselves.11 In response to late trading and
    other abuses in the mutual fund industry, SEC says that it is reassessing
    its supervision of investment companies.

    We also reported that anticipating and identifying problems in a timely
    manner is a continuing problem for SEC:

    One of the challenges SEC faces is being able to anticipate potential
    problems and identify the extent to which they exist. Historically,
    limited resources have forced the SEC to be largely reactive, focusing on
    the most critical events of the day. In this mode, the agency lacked the
    institutional structure and capability to systematically anticipate risks
    and align agencywide resources against those risks. In an environment like
    this, it is perhaps not surprising that SEC was not able to identify the
    widespread misconduct and trading abuses in the mutual fund industry.
    Increasing SEC's effectiveness would require it to become more proactive
    by thinking strategically, identifying and prioritizing emerging issues,
    and marshaling resources from across the organization to answer its most
    pressing needs.12 SEC

    10GAO, SEC Operations: Increased Workload Creates Challenges, GAO-02-302
    (Washington, D.C.: Mar. 5, 2002).

    11GAO, SEC Operations: Oversight of Mutual Fund Industry Presents
    Management Challenges, GAO-04-584T (Washington, D.C.: Apr. 20, 2004).

    12GAO-04-584T, 14.

                                       Chapter 4
                         Regulators Are Adapting Regulatory and
                         Supervisory Approaches in Response to
                                    Industry Changes

    is in the process of staffing a new risk assessment office that may lead
    to more proactive risk-based policies in the future.

    Futures and Insurance Regulators Have Not Adopted Basel Standards, but
    Have Made Changes in Their Regulatory and Supervisory Approaches

    Many of the changes being made in CFTC's regulatory and supervisory
    approaches have come as a result of the passage of CFMA in 2000. The
    primary goal of that legislation was to address changes in market
    conditions such as the introduction of a wider variety of products,
    including contracts based on individual stocks. CFMA replaced
    "one-sizefits-all" regulation with broad, flexible core principles.13
    Generally, the new rules recognize the speed with which these markets
    change by laying out core principles for participants and markets, rather
    than by specifying prescriptive rules.14 For example, a CFTC regulation
    requires that certain entities-derivatives transaction execution
    facilities and contract markets- provide authorities and the public with
    trading information such as trading practices and contract conditions and
    prices, and that they enforce rules to minimize conflicts of interest in
    the decision making process, but it does not require specific measures for
    carrying out the principles.15

    CFTC has also changed its net capital rules for FCMs to better reflect
    changes in the commodity business. To modernize capital requirements for
    FCMs, CFTC adopted rules in August 2004 that replace the net capital
    requirement based on segregated customer funds with minimum risk-based
    capital requirements. The new rules attempt to reflect an FCM's complete
    exposure to commodity positions carried for both customers and
    noncustomers. According to CFTC's 2003 annual report, the rules are
    expected to ensure that a firm's capital requirement reflects the risks of
    the futures and options positions it carries.

    In addition to the self-regulatory programs administered by the exchanges
    and NFA, CFTC oversees the compliance activities of SROs through audits
    and financial surveillance to ensure that SRO member firms are properly
    capitalized, maintain appropriate risk management capabilities, and

    13See 7 U.S.C. S: 7a(d) (2000 & Supp. 2004).

    14See Trading Facilities, Intermediaries and Clearing Organizations; New
    Regulatory Framework; Final Rule, 66 Fed. Reg. 42256-42289 (Aug. 10,
    2001); see also Proposed Rules for Execution of Transactions: Regulation
    1.38 and Guidance on Core Principle 9 69 Fed. Reg. 39880-39886 (July 1,
    2004).

    1517 C.F.R. S: 37.6 (2004).

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    segregate customer funds. According to CFTC's 2003 annual report, to meet
    CFMA objectives, in the early 2000s CFTC modified its oversight process
    for SROs, moving from compliance-based examinations to risk-focused
    programs that respond to regulatory core principles. These exams were to
    focus on an institution's exposure to, and internal controls for, managing
    underlying risks. These programs were first implemented in 2003 in an SRO
    oversight examination of the Chicago Mercantile Exchange covering
    "financial capacity, customer protection, risk management, market move
    surveillance and stress testing, and operational capability." According to
    its 2003 annual report, CFTC is also developing a risk management tool
    that uses data received from firm financial filings and large trader
    reports to proactively monitor firm risk exposure and assess trader losses
    from risky positions that may cause firms to become undercapitalized.

    According to an NAIC official, during the mid-to the late 1980s, a high
    number of failures among property-casualty insurers as well as a
    collective recognition on the part of the insurance regulatory community
    that the industry was becoming more complex, in part, because of
    technological advances, globalization, and capital market innovations, led
    NAIC to adopt its Solvency Policy Agenda. The agenda was composed of a
    number of initiatives, including risk-based capital and the Financial
    Analysis Unit.

    According to NAIC, by 1990 a number of states were experimenting with
    risk-based capital formulas, and NAIC approved risk-based capital
    standards for life insurance companies in 1992 and for property-casualty
    insurers in 1993. NAIC developed and recommended that states adopt the
    Risk-Based Capital for Insurers Model Act, which gave state insurance
    regulators the authority to act on the results generated by the risk-based
    capital formulas. For life insurers, companies are required to hold
    minimum percentages of various assets and liabilities as capital, with
    these percentages based on the historical variability of the value of
    those assets and liabilities. Risk factors are to be applied, usually as
    multipliers, to selected assets, liabilities, or other specific company
    financial data to establish the minimum capital needed to bear the risk
    arising from that item (similar to risk-weights in banking). In addition,
    the risk-based capital formula requires the performance of sensitivity
    tests to indicate how sensitive the formula is to changes in certain risk
    factors.

    NAIC's Solvency Policy Agenda also led to the setting up of the Financial
    Analysis Unit. This unit's mission is to assist insurance regulators in
    achieving their objective of identifying, at the earliest possible stage,
    insurance companies that may be financially troubled. In pursuit of this

    Chapter 4
    Regulators Are Adapting Regulatory and
    Supervisory Approaches in Response to
    Industry Changes

    mission, the Unit performs financial analysis of insurance companies under
    the direction of an NAIC working group. The working group was formed to
    identify nationally significant insurance companies-large firms or firms
    operating in a number of states-that are, or may become, financially
    troubled, and to determine whether appropriate regulatory action is being
    taken with regard to these firms.

    Chapter 5

    Regulators Communicate and Coordinate in Multiple Ways, but Concerns
    Remain

    In a system with multiple financial services regulators, communication and
    coordination are essential to preventing duplication in agency oversight,
    while ensuring that all regulatory areas are effectively covered. U.S.
    federal financial services regulators communicate and coordinate with
    other federal, state, and foreign regulators within their sector, and
    state insurance regulators communicate and coordinate across states and
    with insurance regulators in other countries; however, in each sector
    concerns remain. To a lesser extent, financial services regulators
    communicate and coordinate across sectors with U.S., state, and foreign
    regulators, but coordinating regulatory activities and sharing information
    continue to be sources of concern. Agencies have had problems
    systematically sharing information across sectors, making it more
    difficult for regulators to identify potential crises, fraud, and abuse,
    and for consumers to identify the relevant regulators. In addition,
    regulators do not routinely assess risks that cross traditional regulatory
    and industry boundaries.

    U.S. Financial Regulators Communicate and Coordinate with Other Regulators
    in Their Sectors, but Sometimes Find It Difficult to Cooperate

    Within each of the four sectors, federal regulators have established
    interagency groups to facilitate coordination and also communicate
    informally on a variety of issues. Within sectors the federal regulators
    generally communicate with each other, with SROs, with relevant state
    regulators, and with their international counterparts. In insurance, NAIC
    is the primary vehicle for state regulators to communicate with each other
    and to coordinate with insurance regulators in other countries.

    Federal Banking Regulators The Financial Institutions Regulatory and
    Interest Rate Control Act of Coordinate Their Activities, 19781
    established the Federal Financial Institutions Examination Council but
    Bank Failures and (FFIEC) in 1979 as a vehicle through which bank
    regulators could

    communicate formally. FFIEC is empowered to prescribe uniformInternational
    Negotiations standards and principles and to devise report forms for
    member agencies' Have Been Problematic examinations of financial
    institutions. FFIEC makes recommendations to

    promote uniformity in the supervision of financial institutions, conducts

    schools for examiners, and has also established interagency task forces on

    1Pub. Law No. 95-630, Title X. See http://www.ffiec.gov/about.htm.

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    consumer compliance, examiner education, information sharing, supervision,
    reports, and surveillance systems. Finally, it serves as a forum for
    dialogue between federal and state bank supervisory agencies.

    A joint evaluation by the Offices of the Inspector General from three
    federal banking regulators found that FFIEC was accomplishing its
    legislative mission of prescribing uniform principles, standards, and
    report forms.2 Some officials criticized it for not accomplishing its
    mission more effectively and taking too long to complete interagency
    projects, however. FFIEC is discussing improvements to its effectiveness
    by developing annual goals, objectives, and work priorities. In response
    to questions about whether FFIEC should have a broadened role in
    coordinating banking, insurance, and securities regulators as a result of
    GLBA, most officials interviewed were not in favor of broadening FFIEC to
    include regulatory representatives from the insurance and securities
    industries. Most officials also did not see the need for a separate
    coordinating entity under GLBA modeled after FFIEC. Officials indicated
    that coordination under GLBA was occurring as needed and on an ad hoc
    basis and through periodic cross-sector meetings hosted by the Federal
    Reserve. Banking industry and professional associations said that FFIEC
    could be more proactive in communicating with the banking industry,
    however.

    The 1994 Riegle Community Development and Regulatory Improvement Act
    mandated improvements to the coordination of examinations and supervision
    of institutions that are subject to multiple bank regulators. A set of
    basic principles, issued by the regulators in 1993, said that the agencies
    place a high priority on working together to identify and reduce the
    regulatory burden and on coordinating supervisory activities with each
    other as well as with state supervisors, securities and insurance
    regulators, and foreign supervisors.3 Their objective is to minimize
    disruption and avoid duplicative examination efforts and information
    requests by

    o 	coordinating the planning, timing, and scope of examinations and
    inspections of federally insured depository institutions and their holding
    companies;

    2Offices of the Inspector General at Treasury, FDIC, and Federal Reserve,
    Joint Evaluation of the Federal Financial Institutions Examination Council
    (Washington, D.C.; June 21, 2002).

    3See OCC, "Policy Statement on Examination Coordination and Implementation
    Guidelines," Examination Planning and Control Handbook (Washington, D.C.,
    July 1997).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    o  conducting joint interagency examinations or inspections;

    o 	coordinating and conducting joint meetings between bank or bank holding
    company management and regulators;

    o  coordinating information requests; and

    o  coordinating enforcement actions.

    The Federal Reserve, FDIC, and OCC have additional mechanisms to
    communicate and coordinate. Under the Shared National Credit Program, for
    example, they jointly review large syndicated loans that involve several
    banks to ensure that loans are reviewed consistently and to reduce
    regulatory burden on financial institutions. Program reports also include
    information on the level of credit risk in banks overall and by type of
    bank as well as credit exposures to certain industries. Similarly,
    representatives from the agencies meet regularly as the Interagency
    Country Exposure Review Committee to jointly determine the level of risk
    for credit exposures to various countries.

    U.S. bank regulators also communicate regularly with bank regulators in
    other countries, both bilaterally and through multicountry organizations
    that specialize in bank issues. U.S. bank regulators overseeing U.S.
    subsidiaries of foreign banks work with the host-country regulators in
    overseeing those institutions. U.S. bank regulators and UK-FSA explained
    how they coordinate examinations of U.K. institutions with U.S. operations
    such as HSBC and U.S. banks with U.K. subsidiaries such as MBNA.
    Similarly, some U.S. regulators coordinate with BaFin in overseeing
    Citigroup's activities in Germany and Deutsche-Bank Securities' activities
    in the United States. The Federal Reserve, FDIC, and OCC are members of
    the Basel Committee4 and a Federal Reserve Official chaired that committee
    during much of the Basel II discussions.

    Throughout our meetings with banking agencies, officials told us they
    communicate regularly on both a formal and informal basis. They explained
    that officials in different agencies, both at the federal and regional
    level, know each other well and have each other's personal cell phone
    numbers so they can easily contact each other in case of a crisis. At

    4OTS officials say that they participate in the Basel Committee as a
    temporary member pending acceptance of OTS's request for permanent
    membership.

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    the regional level, officials and staff from the Federal Reserve, OCC,
    FDIC, OTS, and state bank regulatory agencies regularly meet formally and
    talk often. Communication across these agencies, according to several
    officials, is facilitated by staff often moving between agencies and by
    long-standing working relationships.

    In some cases, however, interagency cooperation between bank regulators
    has been hindered when two or more agencies share responsibility for
    supervising a bank. The Superior Bank and the First National Bank of
    Keystone (West Virginia) episodes illustrate this problem. Superior Bank,
    FSB, a federally chartered savings bank located outside Chicago failed in
    2001. The failure was caused by Superior's strategy of originating and
    securitizing large volumes of high-risk loans and the failure of its
    management to properly value and account for the interest that Superior
    retained in pooled home mortgages. Shortly after the bank's closure, FDIC
    projected that the failure of Superior Bank would result in a substantial
    loss to the deposit insurance fund. We found that federal regulators had
    not identified and acted on the problems at Superior Bank early enough to
    prevent a material loss to the deposit insurance fund. Problems between
    OTS, Superior's primary supervisor, and FDIC hindered a coordinated
    supervisory approach; OTS refused to let FDIC participate in at least one
    examination.5 Similarly, disagreements between OCC and FDIC contributed to
    the 1999 failure of Keystone Bank, which was caused by the bank's
    maintaining loans that it did not own on its balance sheet; these
    overstated assets were attributed to alleged fraud. FDIC subsequently
    announced that it had reached agreement with the other banking regulators
    to establish a better process for determining when FDIC will examine an
    insured institution where FDIC is not the primary federal regulator.

    Over the last couple of years, bank regulators have expressed differing
    views concerning the complex Basel Committee negotiations over Basel II
    (see ch. 4). However, it is unclear whether the differing views of the
    regulators improved the process, as the regulators claim, or unnecessarily
    complicated the process and possibly disadvantaged U.S. companies, as
    others have claimed. Bank regulators who sit on the Basel Committee told
    us that the outcome of the Basel II negotiations is better than it would
    have been with a single U.S. representative because of the contributions
    of regulators who represent the perspectives and expertise of their varied

    5See GAO, Bank Regulation: Analysis of the Failure of Superior Bank, FSB,
    Hinsdale, Illinois, GAO-02-419T (Washington, D.C.: Feb. 7, 2002).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    agencies. Regulators note that they have communicated regularly, but still
    have the responsibility of representing their agencies' differing
    objectives publicly. U.S. Basel Committee members said that this
    requirement to discuss differences in an open and transparent manner,
    rather than privately, is a strength of the system. The regulators also
    noted that some of the concerns raised by others about the timeliness of
    U.S. agencies' involvement in the negotiations might stem primarily from
    the long public comment period mandated in U.S. law, rather than the
    involvement of multiple agencies. This public comment period, they noted,
    would be a requirement even if fewer agencies were involved.

    However, the lack of a single contact or negotiating position has raised
    questions about these negotiations. Since each of the agencies on the
    Basel Committee is charged with representing the objectives of its agency
    or the firms it oversees, the negotiations may not represent the interests
    of those who are not at the table. For example, OTS-which oversees some
    firms that will likely have to comply with Basel II, due, in part, to the
    EU Action Plan-does not have a permanent seat on the Basel Committee.
    Since the large firms overseen by OTS differ in some important ways from
    those overseen by the other agencies, their positions may not be
    adequately represented in these negotiations. However, OTS officials say
    that they have a temporary seat on the Basel Committee, while that body
    considers their request for membership. OTS also noted that they are
    active members of two Basel capital implementation groups. In addition,
    the sometimesconflicting views being expressed by U.S. regulators made it
    difficult for other countries to understand our position. Finally, in
    November 2003 members of the House Financial Services Committee warned in
    a letter to the bank regulatory agencies that the discord surrounding
    Basel II had weakened the negotiating position of the United States and
    resulted in an agreement that was less than favorable to U.S. financial
    institutions.6 H.R. 2042 would establish a committee of financial
    regulators chaired by the Secretary of the Treasury to ensure that there
    is a unified U.S. position in Basel Committee negotiations.

    6Letter from Representative Michael Oxley et al. to Chairman Alan
    Greenspan et al., Nov. 3, 2003.

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

    Federal Securities Regulators Often Communicate and Coordinate Activities
    with State Regulators, Securities' SROs, and Foreign Securities
    Regulators, but Problems Persist

    Federal securities regulators communicate and coordinate with SROs and
    state securities regulators. State securities regulators, including those
    in New York and Massachusetts, told us that for the most part they
    coordinate enforcement activities with SEC. One difficulty they pointed to
    was that privacy issues prevent them from discussing a case before they
    are ready to bring charges. However, they note that state regulators, SEC,
    and some SROs have jointly pursued securities law violators.

    In addition to overseeing the securities SROs, SEC communicates regularly
    with them about various issues. For example, SEC and the SROs have taken
    steps to coordinate their examinations. In 2002, we reported that,
    according to SEC and SRO officials, representatives of SEC, all SROs, and
    the states attend annual summits to discuss examination coordination,
    review examination results from the prior year, and develop plans for
    coordinating examinations for the coming year. In addition, regional SEC
    staff and SRO compliance staff are to meet quarterly to discuss and plan
    examination coordination, and SRO examiners are to meet monthly to plan
    specific examinations of common members. At these latter meetings,
    examiners are expected, among other things, to collaborate on fieldwork
    dates, document requests, and broker-dealer entrance and closeout
    meetings. SROs also are to share their prior examination reports before
    beginning fieldwork. We noted, however, that SEC officials told us that
    some broker-dealers that have tried the coordinated examination program
    have concluded that it is more efficient for them to have two separate
    examinations.7 Additionally, SEC met with NYSE to discuss registrations of
    private foreign issuers.

    Securities SROs also communicate regularly with each other. Ten of them,
    the major U.S. securities exchanges, are full members of the Intermarket
    Surveillance Group (ISG), a group they created in 1983 to share
    information across jurisdictions. The purpose of ISG is to share
    information and to coordinate and develop procedures designed to assist in
    identifying possible fraudulent and manipulative acts and practices across
    markets, particularly, between markets that trade the same or related
    securities and between markets that trade equity securities and options on
    an index in which such securities are included.

    7GAO, Securities Markets: Competition and Multiple Regulators Heighten
    Concerns about Self-Regulation, GAO-02-362 (Washington, D.C.: May 3,
    2002).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    Internationally, SEC communicates and coordinates with international
    securities regulators through IOSCO and has worked with the EU's CESR to
    help harmonize activities between the EU and United States. SEC staff
    notes that it is participating in a joint working group established by
    IOSCO and the Basel Committee to address issues relating to the treatment
    of security positions held in the trading book, which includes securities
    held for dealing or proprietary trading. One issue is the development of a
    riskbased approach to capital requirements for securities activities, an
    issue of interest to holding companies with broker-dealer subsidiaries.
    And CESR officials told us that their communications with SEC have been
    fruitful in easing certain concerns, such as those associated with
    European companies' U.S. operations having to adopt Sarbanes-Oxley
    requirements. In May 2004, SEC and CESR announced their intentions to
    increase their cooperation and collaboration aimed at two primary
    objectives, namely to

    o 	identify emerging risks in the U.S. and EU securities markets to
    address potential regulatory problems at an early stage; and

    o 	engage in early discussion of potential regulatory projects in the
    interest of facilitating converged, or at least compatible, ways of
    addressing common issues.

    For the rest of 2004 and 2005, SEC and CESR proposed considering issues
    related to market structure, mutual fund regulation, accounting
    convergence, and credit rating agencies.

    Despite efforts of SEC and state securities regulators to communicate and
    coordinate their activities, some well-publicized disagreements developed
    following the corporate, accounting, and mutual fund scandals. After a
    settlement with one of the major U.S. securities firms concerning the use
    of research and during investigations of mutual fund irregularities, SEC
    and state regulators sometimes disagreed on what is an appropriate role
    for each, and on how effective each has been. For example, the Attorney
    General of New York, testifying before Congress concerning analyst
    conflicts of interest, said that while the issues had been widely reported
    in the press for years, SEC had issued no meaningful new regulations and
    had taken no serious enforcement actions prior to New York's
    investigation. Some securities industry officials told us that state
    officials should leave securities issues to federal officials and noted
    that unilateral actions by states have led to differing state securities
    laws. In addition, an official at one of the SROs told us that
    communication often takes place in a crisis situation, but that there is
    little or no time for strategic thinking.

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

    NAIC Is the Coordinating Body for State Insurance Commissioners, but
    States Often Pursue Their Own Course

    NAIC is the long-standing structure for communication and coordination
    among state insurance commissioners. NAIC's meetings of all state
    regulators occur four times a year and interstate working groups meet
    regularly in various locations or by teleconference or videoconference to
    consider almost every aspect of insurance. Through its development of
    model laws such as those concerning risk-based capital standards and its
    accreditation program, NAIC has been a mechanism for achieving some
    harmonization in state securities regulation. In addition, NAIC officials
    and individual state insurance commissioners have coordinated with
    insurance regulators from other countries through IAIS and other forums.
    IAIS has developed core principles of insurance supervision and is working
    on developing a regulatory framework.

    Because each state ultimately determines what actions it will take, NAIC
    cannot ensure uniform regulation. One tool NAIC has used to attempt to
    achieve a consistent state-based system of solvency regulation throughout
    the country is its accreditation program. However, we have reported that
    the accreditation program has weaknesses. In our review of the program in
    2001, we noted that while the accreditation program had improved over the
    10 years of its existence, and 47 state insurance departments had been
    accredited by NAIC, it still had weaknesses that raised questions about
    NAIC's accreditation reviews.8 For example, Mississippi and Tennessee
    received accreditation during and after a $200 million theft that involved
    four failed insurance companies in those states as well as two others. In
    addition, because New York will not adopt the risk-based capital model
    law, what is usually considered one of the strongest state regulatory
    bodies is not accredited. As a result of NAIC's inability to force states
    to adopt certain rules and regulations, some critics think the voluntary
    aspect of NAIC reduces it effectiveness. Other critics argue that because
    NAIC operates as a quasi-governmental entity, it exercises too much power
    over individual state regulators.

    8GAO, Insurance Regulation: The NAIC Accreditation Program Can Be
    Improved, GAO01-948 (Washington, D.C.: Aug. 31, 2001).

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

    CFTC Coordinates Activities with SROs and Futures Regulators in Other
    Countries

    According to CFTC, it coordinates with futures SROs and foreign financial
    services regulators. CFTC says it coordinates with exchanges in monitoring
    of daily trading activities, looking at the positions of large traders,
    and reviewing products listed by exchanges. CFTC's coordination with
    futures regulators in other countries-for example, UK-FSA and BaFin-takes
    place partially through CFTC's participation in the activities of IOSCO.
    CFTC participates in IOSCO working groups on secondary markets and market
    intermediaries, enforcement and information sharing, and investment
    management. CFTC also participates on IOSCO task forces covering issues
    such as implementation of IOSCO objectives and principles of securities
    regulation, and payment and settlement systems. While CFTC participates in
    working groups and task forces, it does not have the same status at IOSCO
    that SEC has; CFTC is an associate member of that organization, rather
    than a ordinary member.

    Financial Services Regulators Also Communicate across Financial Sectors,
    but Do Not Effectively Identify Some Risks, Fraud, and Abuse That Cross
    Sectors

    Federal financial regulators also communicate and coordinate their
    activities across "functional" areas. Federal Reserve officials note that,
    as directed by GLBA, they rely on information that is shared by functional
    regulators, including SEC, in the Federal Reserve's supervision of bank
    and financial holding companies. Channels for communication and
    coordination have been set up by the regulators or at the direction of the
    President or Congress, often in response to a crisis. However, regulators
    do not always share information or monitor risks across sectors.

    Federal Reserve Reports That It Relies on Functional Regulators in
    Supervision of Bank and Financial Holding Companies

    GLBA directed the Federal Reserve to rely on functional regulators in its
    supervision of nonbanking activities in bank and financial holding
    companies. For example, broker-dealer subsidiaries of bank or financial
    holding companies are subject to oversight by SEC, NASD, and, potentially,
    other SROs. In its 2001 strategic plan, the Federal Reserve reported that
    it is coordinating with other regulators to fulfill its role as the
    holding company supervisor. Federal Reserve officials told us that this
    coordination is a key component in their supervision of bank and financial
    holding companies, and that information has been readily provided by
    functional regulators as part of that process.

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

    Regulators and SROs Have Created Mechanisms for Communicating across
    Sectors

    SEC and CFTC have jointly developed regulations implementing portions of
    CFMA that lifted the ban on certain types of securities-based futures, but
    the process was difficult. Before CFMA was enacted, SEC and CFTC competed
    over regulation of single-stock futures for nearly two decades. SEC
    claimed jurisdiction because single-stock futures behave like the
    underlying individual stocks and bonds; CFTC claimed jurisdiction because
    single-stock futures behave like futures. As a result of this stalemate,
    Congress banned the trading of single-stock futures. CFMA lifted the
    prohibition on trading single-stock futures and narrow-based stock index
    futures and allows these futures to be traded under a system of joint
    regulation by SEC and CFTC. However, according to CFTC and SEC officials,
    the market for single-stock futures has been slow to develop. In addition,
    a CFTC official told us that it had long had routine, if informal,
    contacts with SEC concerning financial integrity and on how certain firm
    assets and liabilities should be treated in calculating net capital. SEC
    staff told us that they agree with this statement. Similarly, CFTC
    coordinates its efforts with SEC on enforcement cases with jurisdiction in
    several different geographic areas.

    Since its creation in 1983, ISG has expanded to include futures and
    foreign exchanges as affiliate members. According to CFTC, the purpose of
    ISG today is to provide a framework for the sharing of information and the
    coordination of regulatory efforts among exchanges trading securities and
    related products to address potential intermarket manipulation and trading
    abuses. ISG plays a crucial role in information sharing among markets that
    trade securities, options on securities, security futures products, and
    futures and options on broad-based security indexes. ISG also provides a
    forum for discussing common regulatory concerns, thus enhancing members'
    ability to fulfill efficiently their regulatory responsibilities.

    Internationally, regulators from multiple sectors have established forums
    to facilitate multinational communication across sectors. The Joint Forum
    and FSF are two such forums. The Basel Committee, IOSCO, and IAIS
    established the Joint Forum in 1996 to examine cross-sectoral supervisory
    issues related to financial conglomerates such as risk assessment and
    disclosure. The Federal Reserve, Treasury, and SEC serve on FSF, which was
    initiated in 1999 in response to the Asian financial crisis. FSF brings
    together, on a regular basis, representatives of governments,
    international financial institutions, and others to promote international
    financial stability through information exchange and international
    cooperation in financial supervision and surveillance.

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

    Congress and the President Have Directed Regulators to Communicate across
    Sectors, Especially after Crises

    By executive order in March 1988, the President established the
    President's Working Group on Financial Markets, which is composed of the
    heads of the Federal Reserve, SEC, and CFTC and chaired by Treasury, to
    address issues related to the 1987 stock market crash. As we reported in
    2000,9 the President's Working Group was established in response to a
    crisis and, as the need had arisen, had continued to function as such. The
    President's Working Group was formally reactivated in 1994 and since then
    has considered several issues, including the 1997 market decline, hedge
    funds and excessive leverage, year 2000 preparedness issues, the rapid
    growth of the OTC derivatives market, and threats to critical
    infrastructure.10 The group meets on a bimonthly basis at the staff level
    and has sent letters to Congress with common positions on issues such as
    energy derivatives legislation and mutual fund reform.

    After the events of September 11, 2001, the President issued an executive
    order to create the Financial and Banking Information Infrastructure
    Committee (FBIIC), which is charged with coordinating federal and state
    financial regulatory efforts to improve the reliability and security of
    the U.S. financial system. Chaired by Treasury's Assistant Secretary for
    Financial Institutions, FBIIC includes representatives from federal and
    state financial regulatory agencies, including CFTC, the Conference of
    State Bank Supervisors, FDIC, the Federal Housing Finance Board, the
    Federal Reserve, NAIC, NCUA, OCC, the Office of Cyberspace Security, the
    Office of Federal Housing Enterprise Oversight, the Office of Homeland
    Security, OTS, and SEC.

    In passing GLBA, Congress recognized the need for regulators engaged in
    supervising parts of holding companies to communicate and coordinate
    across "functional" areas. For example, the Federal Reserve and state
    insurance regulators must coordinate efforts to supervise companies that
    control both a bank and a company engaged in insurance activities;
    similarly, OTS and state insurance regulators have to coordinate
    activities as well. The Federal Reserve, FDIC, OCC, and OTS have signed
    regulatory cooperation agreements with almost all insurance jurisdictions;
    NAIC and the bank regulators say the remainder of the insurance
    jurisdictions have

    9GAO, Financial Regulatory Coordination: The Role and Functioning of the
    President's Working Group, GAO/GGD-00-46 (Washington, D.C.: Jan. 21,
    2000).

    10GAO, Critical Infrastructure Protection: Efforts of the Financial
    Services Sector to Address Cyber Threats, GAO-03-173 (Washington, D.C.:
    Jan. 30, 2003).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    state laws that prohibit them from sharing information. GLBA also
    established the National Association of Registered Agents and Brokers,
    subject to NAIC's oversight, and stipulated that the association
    coordinate with NASD in order to ease the administrative burden on those
    who are members of both organizations-that is, agents and brokers that
    deal both in insurance and securities.

    Other congressionally directed communication includes directing the
    Federal Reserve, OCC, and SEC to form an interagency group to draft
    guidance on complex structured finance transactions following the
    corporate and accounting scandals of the late 1990s. At the invitation of
    these agencies, FDIC and OTS joined the interagency group. On May 19,
    2004, the agencies issued that guidance for comment. More recently,
    Congress has created the Financial Literacy and Education Commission to
    coordinate federal efforts and develop a national strategy to promote
    financial literacy.11 The commission, which is chaired by the Secretary of
    the Treasury, consists of 20 federal agencies, including all of the
    federal financial regulators.

    In light of the major changes being made in the EU as a result of the
    Action Plan as well as other factors, Treasury and EU officials agreed in
    early 2002 to establish an informal dialogue on financial market issues.
    As part of that dialogue, U.S. and EU financial services policymakers,
    including officials from the Federal Reserve and SEC, meet regularly (1)
    to foster a mutual understanding of each other's approach to the
    regulation of financial markets, (2) to identify any potential conflicts
    in approaches as early in the regulatory process as possible, and (3) to
    discuss regulatory issues of mutual interest. Some of the issues that have
    been considered in the dialogue are Sarbanes-Oxley, the Financial
    Conglomerates Directive, accounting standards, and allowing the placement
    of foreign electronic trading screens in the United States absent
    registration of either the exchange or its listed securities. As figure 8
    shows, regulators and others are talking to their EU counterparts in a
    number of separate venues.

    11The commission was created in Title V of the Fair and Accurate Credit
    Transactions Act of 2003, known as the Financial Literacy and Education
    Improvement Act. See Pub. L. No. 108159, Title V, 117 Stat. 2003 (codified
    at 20 U.S.C. S:S: 9701-08). The act also mandated that GAO report on
    recommendations for improving financial literacy among consumers. On July
    28, 2004, GAO hosted a forum entitled "Improving Financial Literacy: The
    Role of the Federal Government." The results of this forum will appear in
    a forthcoming GAO report.

     Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but Concerns
                                         Remain

                     Figure 8: United States-EU Regulatory Dialogue

                    Source: GAO analysis of HM-Treasury information.

    Cross-Sector In evaluating some of the means by which U.S. regulators
    communicate Communication Has Not across sectors, we have found that these
    generally do not provide for the Facilitated Sharing of systematic sharing
    of information, making it more difficult for regulators to

    identify potential fraud and abuse, and for consumers to identify
    theImportant Information or relevant regulator. In addition, these means
    do not allow for a satisfactoryMonitoring of Risks assessment of risks
    that cross traditional regulatory and industry

    boundaries and therefore may inhibit the ability to detect and contain

    certain financial crises, as can be seen in the following.

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    o 	With regard to the President's Working Group, we reported in 2000 that
    although it has served as a mechanism to share information during
    unfolding crises, its activities generally have not included such matters
    as routine surveillance of risks that cross markets or of sharing
    information that is specific enough to help identify potential crises.12

    o 	In reviewing the near collapse of LTCM-one of the largest U.S. hedge
    funds-in 1998, we reported that regulators continued to focus on
    individual firms and markets but failed to address interrelationships
    across industries. Thus, federal financial regulators did not identify the
    extent of weaknesses in bank, securities, and futures firm risk management
    practices until after LTCM's near collapse and had not sufficiently
    considered the systemic threats that can arise from unregulated
    entities.13

    o 	Our reviews of financial crises showed that almost never did a single
    federal financial services regulator have the necessary authority,
    jurisdiction, or resources to contain the crisis. Several officials told
    us that this dispersion had sometimes limited the federal government's
    ability to identify incipient financial crises or to monitor a crisis once
    it had occurred.14

    o 	In reviewing responses to the events of September 11, 2001, we reported
    that the multiorganization nature of U.S. financial services regulation
    has slowed the development of a strategy that would ensure continuity of
    business for financial markets in the event of a terrorist attack.15

    o 	In a recent review of interagency communication regarding enforcement
    actions taken by the regulatory agencies against individuals and firms, we
    reported that while information sharing among financial regulators is a
    key defense against fraud and market abuses, the regulators do not have
    ready access to all relevant data related to

    12GAO/GGD-00-46.

    13GAO, Long-Term Capital Management: Regulators Need to Focus Greater
    Attention on Systemic Risk, GAO/GGD-00-3 (Washington, D.C.: Oct. 29,
    1999).

    14GAO, Financial Crisis Management: Four Financial Crises in the 1980s,
    GAO/GGD-9796 (Washington D.C.: May 1, 1997).

    15GAO, Potential Terrorist Attacks: Additional Actions Needed to Better
    Prepare Critical Financial Market Participants, GAO-03-251 (Washington,
    D.C.: Feb. 12, 2003).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    regulatory enforcement actions taken against individuals or firms. We also
    reported that many financial regulators do not share relevant consumer
    complaint data among themselves on certain hybrid products such as
    variable annuities (products that contain characteristics of both
    securities and insurance products) in a routine, systematic fashion,
    compounding the problem that consumers may have in identifying the
    relevant regulator.16 Determining the relevant regulator for variable
    annuities has been a source of regulatory disagreement for some time.
    After years of court battles, it was determined that variable annuities
    would be regulated as securities by the federal government but also fall
    under the authority of state insurance and securities regulators. At the
    federal level, SEC regulates the registration of variable annuity
    products. Under federal law, variable annuity products registered with SEC
    are generally exempt from registration with state securities regulators.
    As with other securities products, NASD regulates the sale of variable
    annuity products through broker-dealers. At the state level, the insurance
    companies that offer variable annuities generally fall under the
    jurisdiction of insurance regulators, though sales of such products can
    also fall under the jurisdiction of state securities regulators, or some
    combination of both regulators, depending on the state. Some state
    securities regulators told us they are making an effort to amend the
    Uniform Securities Act to place the oversight of variable annuities sales
    under the jurisdiction of state securities departments.

    While financial regulators generally supported better sharing of
    regulatory information, they cited some barriers to sharing. Those
    barriers generally centered on the need for individual agencies to meet
    their statutory objectives, including protecting confidential regulatory
    information from public disclosure. Officials at one banking agency,
    additionally, noted that they are sometimes reluctant to discuss some
    issues with SEC because of concern that the discussion would immediately
    trigger an investigation, while the banking officials are working to
    resolve the issue in a manner that does not compromise safety and
    soundness. However, officials at that agency also note that if the agency
    becomes aware of a securities law violation, they make an immediate
    referral to SEC.

    Officials at several of these regulatory agencies noted that their
    responsibilities are outlined in law. For example, with regard to airing

    16GAO, Better Information Sharing among Financial Services Regulators
    Could Improve Protections for Consumers, GAO-04-882R (Washington, D.C.:
    June 29, 2004).

    Chapter 5 Regulators Communicate and Coordinate in Multiple Ways, but
    Concerns Remain

    differences on Basel II, bank regulators noted that they are required to
    put documents out for public comment and respond to those comments. In
    other cases, agencies note that they were created as independent agencies
    rather than as components of executive agencies and departments to avoid
    interfering with these responsibilities. Officials at one agency, for
    instance, noted that while Treasury would have a role in coordinating the
    efforts of executive agencies prior to or during international
    negotiations, their agency would have to ensure that any such coordinating
    role did not interfere with their statutory responsibilities. We have also
    reported that banking and securities regulators have said that NAIC's
    status as a nonregulatory entity was a barrier to information sharing,
    even when NAIC was acting on behalf of its member agencies. In some cases,
    current state statutes may also hinder information sharing.

    Chapter 6

    The U.S. Regulatory System Has Strengths, but Its Structure May Hinder
    Effective Regulation

    While structure is not the determining factor in the success of efforts to
    provide efficient and effective regulation, it can facilitate or hinder
    regulators' efforts. Some U.S. regulators and financial market
    participants we spoke with cited the contribution of the current
    regulatory structure to the development of U.S. capital markets, and the
    U.S. economy overall- for example, for encouraging competition and
    promoting stability. However, the regulatory system does not facilitate
    the monitoring of risks across firms and markets and does not provide for
    a proactive, strategic approach to systemwide issues. In addition, some
    outside the U.S. regulatory system, including foreign regulators, have
    criticized the U.S. regulatory system for hindering effective oversight of
    large, complex firms. We also found that dividing supervision of large,
    complex firms among U.S. regulators can result in inconsistent
    supervision. In addition, the U.S. regulatory system is not well
    structured for dealing with issues in a world where financial firms and
    markets operate globally.

    While the demarcations between the "functional" areas have blurred and
    large firms have diversified across sectors, differences among the sectors
    are still important. Thus, the system benefits from having regulators that
    specialize in the "functional" areas. However, "functional" specialization
    has drawbacks as well, including the inability to take advantage of
    economies of scale and scope, the danger of becoming a voice for certain
    interests, and the possibility that firms may seek supervision from the
    least intrusive regulators.

    U.S. Financial Services Regulatory System Has Generally Been Successful
    but Lacks Overall Direction

    The U.S regulatory system has allowed financial intermediaries and markets
    to contribute broadly to the U.S. economy. Corporations have a range of
    financing options to choose from-including bank lending and securities
    issuance-that have generally allowed the economy to grow and consumers
    have a range of options to choose from that allow them to make purchases
    and save for retirement. In addition, new products have been developed
    that allow financial institutions to manage risk. Some of the people we
    spoke with wondered why anyone would want to change a regulatory system
    that has generally supported these aspects of our economy. Officials at
    one trade association told us that because our system is so successful,
    some other countries are trying to replicate aspects of it. In addition,
    at least one academic researcher has commented that European countries
    tried to create SEC-type regulatory agencies where the focus, in part, is
    on protecting consumers.

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    U.S. financial institutions are generally characterized as dynamic and
    innovative and some aspects of the regulatory system have these
    characteristics as well. In chapter 4 of this report, we showed how some
    regulatory approaches have evolved over time to better address changes in
    the industry. The U.S. financial system is dynamic and innovative because
    it is populated by a large number of firms and different industries that
    compete with each other in an environment where no one sector or firm has
    gained the market power that would stifle innovation. Similarly, the
    regulatory system is characterized by a large number of regulators that
    must often compete with each other to provide more innovative or vigilant
    regulation. Competition among the banking regulators, especially the
    Federal Reserve and OCC, is given credit for changes in regulation
    including the modernization that removed prohibitions against securities
    firms, banks, and insurance companies operating in a single holding
    company structure, and increased regulatory attention to the provision of
    loans in certain minority areas. Similarly actions by some state attorneys
    general and other securities officials helped prod the Justice Department
    and SEC to take more aggressive action and may have helped to highlight a
    need for increased resources at SEC.

    Having multiple regulators also allows for regulatory experimentation. An
    insurance regulator in Illinois can allow the market to set insurance
    rates, while insurance regulators in Massachusetts must approve rate
    increases. Similarly, for depository institutions, Utah offers certain
    advantages to ILCs that obtain charters in that state. The movement of
    CFTC to a principlesbased approach while SEC stays with a rules-based
    approach to regulation is another example of how regulators can be
    innovative in experimenting with different approaches to regulation.

    One of the international criteria for a successful regulatory system is to
    have adequate resources, and the success of the U.S. regulatory system is
    often attributed to the overall quality of U.S. regulators. Many of the
    industry officials we talked with felt that their regulators had the
    needed skills to provide effective supervision. Whether the U.S.
    regulatory structure facilitates the hiring of a sufficient number of
    quality staff across all of the regulatory agencies is an open question.
    Officials at UK-FSA said they felt they were better able to attract good
    staff in a consolidated regulatory structure because they had better
    visibility in the marketplace, could offer better career paths, and in
    some cases, were able to pay higher salaries than the agencies that
    existed before consolidation. However, that organization still has only
    about 2,300 staff members. Because several of the U.S. regulators are this
    large, have visibility in the marketplace, and are

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    able to offer competitive salaries, they are well positioned to hire good
    staff. However, some of the federal regulators and state insurance
    regulatory agencies are relatively small and could face difficulties in
    attracting qualified staff due to the substantial demand by other
    government agencies and the private sector for the best personnel.

    The regulatory system is also credited with helping to foster financial
    stability and maintain continuity. The system has allowed for creative
    solutions to potentially destabilizing events. For example, between
    January and September 1998, LTCM lost almost 90 percent of its capital. In
    September 1998, the Federal Reserve determined that rapid deterioration of
    LTCM's trading positions and the related positions of some other market
    participants might pose a significant threat to global financial markets
    that were already unsettled with Russia's default on its debt. As a
    result, the Federal Reserve facilitated a privately funded
    recapitalization to prevent LTCM's total collapse.1 While some experts
    believe that the market would have handled this crisis, the Federal
    Reserve Bank of New York is credited by many with facilitating the
    resolution of a major liquidity crisis with potential systemic
    repercussions. Again, when the events of September 11, 2001, led to
    unsettled government securities trades and other financial market
    disruptions, the Federal Reserve provided needed liquidity to financial
    markets. Federal bank regulators also provided guidance to banks on
    maintaining business relations with their customers that had been affected
    by the attacks and issued a joint statement advising banks that any
    temporary drops in bank capital would be evaluated in light of a bank's
    overall financial condition. SEC took similar actions to facilitate the
    successful reopening of stock markets, including providing temporary
    relief from some regulatory requirements.2

    Through its supervision of bank and financial holding companies, the
    Federal Reserve does have oversight responsibility for a substantial share
    of the financial services industry. The scope of its oversight, however,
    is limited to bank and financial holding companies. However, no government
    agency is charged with looking at the financial system as a whole, and the
    ability of regulators to meet their objectives on an ongoing basis. We
    have repeatedly noted that regulators do not share information or monitor
    risks

    1See GAO/GGD-00-3; and GAO, Responses to Questions Concerning Long-Term
    Capital Management and Related Events, GAO/GGD-00-67R (Washington, D.C.:
    Feb. 23, 2000).

    2See GAO-03-251.

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    across markets or "functional" areas preventing them from identifying
    potential systemic crises and limiting opportunities for fraud and abuse
    (see ch. 5). In addition, we noted limitations on effectively planning
    strategies that cut across regulatory agencies.

    In addition, there is no mechanism for the regulatory agencies to perform
    this task cooperatively. From an overall perspective the system is not
    proactive, but instead reacts in a piecemeal, ad hoc fashion-often when
    there is a crisis. No one has the authority, and there is no cooperative
    mechanism to conduct risk analyses, prioritize tasks, or allocate
    resources across agencies, although the Office of Management and Budget
    may perform some of these tasks for agencies that are funded by federal
    appropriations. Similarly, no one has the responsibility, and there is no
    cooperative mechanism, for putting together a long run strategic plan that
    develops a clearly defined set of objectives for the financial regulatory
    system and lays out a plan for achieving those goals over time.

    Each agency does develop its own strategic plan. The Federal Reserve, for
    instance, published its most recent plan in December 2001, providing three
    primary goals-including promoting "a safe, sound, competitive, and
    accessible banking system and stable financial markets." The plan provided
    specific objectives and performance measures, and discussed the external
    factors that would affect the Federal Reserve. For instance, it noted the
    following:

    Continued integration of U.S. financial market sectors, accompanied by the
    introduction of new financial products and means for their delivery, is
    further blurring lines between banks and nonbanks. Securities firms,
    insurance companies, financial companies, and even many prominent
    industrial companies-as well as commercial banks-are exploiting
    technological and financial innovations to seek to capture larger shares
    of the financial services market. Industry consolidation will affect the
    way the Federal Reserve operates to ensure safety and soundness and limit
    systemic risk.

    However, no entity is charged with developing a strategic plan like this
    that would address how industry changes affect the ability of the
    financial regulatory system, as a whole, to meet its many missions.

                                       Chapter 6
                       The U.S. Regulatory System Has Strengths,
                         but Its Structure May Hinder Effective
                                       Regulation

    Structure of U.S. Financial Services Regulatory System May Not Facilitate
    Oversight of Large, Complex Firms

    Legal experts and some regulators in EU and Joint Forum countries believe
    that large, complex, internationally active firms need to be supervised on
    a consolidated level. In response, the EU is requiring consolidated
    supervision for certain financial institutions on the assumption that
    these firms are so large and so complex that a failure at anyone of them
    could pose systemic threats within and across countries. In addition, many
    of the countries we studied said that one of the primary reasons they
    consolidated their regulatory structure was to better supervise
    conglomerates. Historically, in the U.S., holding company supervision-a
    form of consolidated supervision-has been required for companies owning
    commercial banks and thrifts. These bank and thrift holding companies were
    expected to be sources of financial and managerial strength to their
    subsidiary banks. They were supervised to ensure this, and to enforce laws
    intended to protect the insured bank even if the parent failed. The goal
    is to protect the banking system and, by extension, the deposit insurance
    fund. Another goal of this supervision has been to wall off the bank, so
    that other parts of the holding company do not benefit from any subsidy
    inherent in the provision of deposit insurance or other safety net
    provision. Holding company supervision in the United States has evolved to
    include broader concerns about the potential systemic risk posed by large
    financial services firms.

    GLBA continued the U.S. tradition of requiring holding company supervision
    when such a company owns a commercial bank or thrift, and provided for
    supervision of investment bank holding companies. However, the structure
    set up in GLBA has led to concerns about (1) the scope and effectiveness
    of the Federal Reserve's authority to examine functionally regulated
    entities within a financial holding company, and (2) the possibility of
    competitive imbalances among holding company supervisors. Officials at the
    Federal Reserve say that because firms file consolidated financial
    statements and the Federal Reserve has the authority to conduct
    examinations of the holding companies, including verifying information in
    the consolidated financial statements, it generally has the information it
    needs to oversee bank and financial holding companies. The officials also
    said that when the Federal Reserve has needed information from other
    regulators, they have been able to obtain it.

    However, some large financial services firms offer insured deposits and
    provide a range of banking services without incurring bank holding company
    supervision from the Federal Reserve. By owning or obtaining thrift
    charters, for instance, some have opted to be thrift holding

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    companies under OTS supervision. Given the complexity of some of these
    parent companies, OTS officials told us they have had to hire staff and
    develop expertise needed to understand these companies. We have neither
    evaluated OTS's efforts nor compared the depth and coverage of OTS
    examinations of large, complex thrift holding companies with that of
    Federal Reserve examinations of similarly large, complex bank and
    financial holding companies. Other companies have obtained or control
    firms with ILC charters, and are not, by virtue of that affiliation,
    subject to federal holding company supervision unless the holding company
    elects to be a CSE subject to SEC consolidated oversight.

    The differential oversight of holding companies in the different sectors
    has the potential to create competitive imbalances. In discussions with
    some of these companies, we were told they offer similar services and see
    themselves as competing more with other large, internationally active
    firms in other sectors than with smaller entities in their own sector.
    They also raise funds in the same markets and often participate in the
    same transactions. Thus, they are taking on similar risk profiles.
    However, they may not be subject to the same supervision and regulation.
    Bank and financial holding companies are supervised by the Federal
    Reserve. Other companies may opt to organize themselves as thrift holding
    companies under OTS supervision, and with SEC's recent CSE and SIBHC
    rules, some may opt for SEC oversight. While these differences stem from
    differences among the supervisory agencies and their regulatory goals, the
    differences potentially could have competitive implications as well. There
    is no mechanism to ensure that differences in these regulatory approaches
    do not create competitive differences among the different types of holding
    companies. Further, under the new CSE rules some firms could be subject to
    both SEC and OTS holding company oversight and, as OTS pointed out in its
    response to the CSE proposal, perhaps subject to conflicting regulatory
    requirements. Finally, there is no mechanism to ensure that any systemic
    risk that these large firms might pose would be treated in a consistent
    manner.

    The regulatory system for consolidated supervision set up under GLBA rests
    on the "functional" regulatory system envisioned there-a system in which
    "functional" regulators oversee specific activities or products. Some
    industry experts believe that this system conflicts with reality in that
    it rests, in part, on preserving distinctions between financial firms
    based on their lines of business, even though the differences between
    financial products and services are blurring and management of affiliated
    firms is more efficient and effective when it is performed centrally,
    rather than on a

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    firm-by-firm basis. Businesses say that to benefit from conglomeration,
    they integrate certain functions such as risk management and capital
    allocation. In addition, new corporate governance standards require that
    the board and senior management of a consolidated corporation be
    responsible for a variety of conduct-of-business issues throughout the
    organization. Moreover, using a brand name or symbol across these legal
    entities further links subsidiaries and affiliates in these large, complex
    firms. Some legal experts and regulators note that because conglomerates
    are managed centrally, regulators that specialize in understanding risks
    specific to their "functional" sector may not appreciate complex risks
    that span financial sectors and may not understand the risk aggregation
    methodologies employed by these firms. Moreover, they note that the
    existence of a range of supervisory authorities poses the risk that
    financial firms will engage in a form of regulatory arbitrage that
    involves the placement of particular financial services or products in
    that part of the financial conglomerate in which supervisory oversight is
    the least intrusive.

    GLBA considers linkages among affiliated firms and contains several
    provisions under which regulators are to coordinate and cooperate with
    each other to achieve effective and efficient regulation. However, as we
    have seen, cooperation among regulators in different sectors is difficult
    within a system that values regulatory competition-a feature of our system
    that is often credited with making the regulatory system dynamic and
    innovative but that may be inefficient as well. As figure 9 shows, the
    agency overseeing a holding company might have to rely on a large number
    of other regulators for information about subsidiaries engaged in many
    different functions.

                                       Chapter 6
                       The U.S. Regulatory System Has Strengths,
                         but Its Structure May Hinder Effective
                                       Regulation

           Figure 9: Regulators for a Hypothetical Financial Holding Company

    U.S. Federal            Other
    regulators
    CFTC                OTS    State regulator
    FDIC                SEC Non-U.S. regulator
         Federal Reserve   SRO    Unregulated

    OCC

    Source: GAO.

    Consolidated regulators in the United States also rely on consolidated
    financial statements that may include descriptions of risk management
    techniques as well. However, these same firms have to create reports and
    risk analyses to meet the specific demands of individual "functional"
    regulators, particularly when the focus of the regulators differs from the
    firm's focus on its consolidated position and risk management techniques.

    Chapter 6
    The U.S. Regulatory System Has Strengths,
    but Its Structure May Hinder Effective
    Regulation

    These reports may have little connection to the overall risk position of
    the larger entity.

    Regulators say that in certain cases they are not concerned about the
    holding company because the entity they supervise is walled off from the
    larger entity. For example, several state insurance regulators noted that
    the entities they regulate are incorporated and do business only within
    their states, although the companies are subsidiaries of parent companies
    in other states. Similarly, FDIC notes that the safety net provided in the
    form of deposit insurance is only extended to banks as legal entities.
    However, it is difficult to imagine that problems in a significant
    subsidiary of a conglomerate would not impact the rest of the
    organization. Especially when the parts of an organization are being
    managed centrally and a company brand name is used across sectors, the
    reputation of any part of an organization is likely to impact the other
    parts. The problems of its junk bond operations led to the wider collapse
    of Drexel Burnham Lambert Group, for instance. Some observers have noted
    that when an organization is interconnected in these ways, it is less
    likely that a healthy organization would let any one of its significant
    parts fail. In addition, Federal Reserve regulations say that bank holding
    companies are to be a source of strength for their bank subsidiaries.
    Regulators also note that unlike other countries, the United States still
    has a large number of small and mediumsized firms in all of the financial
    sectors who engage in activities that are primarily within one sector;
    however, a research study issued in 2000 by IMF staff shows that based on
    a sample of the top 500 financial services firms in assets worldwide, 73
    percent of the financial assets held by U.S. firms in the sample were held
    by firms that engaged in some significant degree in at least two financial
    services sectors.3

    3Gianni De Nicolo, Philip Bartholomew, Jahanara Zaman, and Mary Zephirin,
    "Bank Consolidation, Internationalization, and Conglomeration: Trends and
    Implications for Financial Risk" (IMF Working Paper 03/158, Washington,
    D.C., July 2003).

                                       Chapter 6
                       The U.S. Regulatory System Has Strengths,
                         but Its Structure May Hinder Effective
                                       Regulation

    Structure of U.S. Financial Services Regulatory System May Not Facilitate
    Response to Increased Globalization

    For multinational financial services firms to have effective oversight,
    regulators from various countries must coordinate, if not harmonize,
    regulation/supervision of financial services across national borders and
    must communicate regularly. Many of the companies we spoke with told us
    that international harmonization of regulatory requirements would be good
    for their businesses. In addition, the degree to which financial services
    are integrated across countries makes it essential for regulators in
    different countries to communicate regularly. (See ch. 5.) However, as we
    have seen in the Basel II discussions and with the U.S.-EU dialogue, the
    current U.S. regulatory structure is not conducive to communicating a
    single U.S. position in these discussions. Negotiations related to
    harmonizing financial regulation across international borders differ from
    negotiations related to international trade, such as those involving the
    General Agreement on Tariffs and Trade or the allocation of
    radio-frequency spectrum.4 In those negotiations, a structure is in place
    to develop a unified negotiating position. And while the outcome of
    negotiations may not depend on the number of regulators involved-the
    relative importance of U.S. financial institutions, especially in overseas
    capital markets, and many other factors are also important-speaking with a
    single voice would ensure that the U.S. position is effectively heard.

    One area where the mismatch between globalization and the U.S. regulatory
    structure is marked is in the area of insurance regulation. Companies in
    the insurance industry increasingly operate on a national and
    international basis and many companies are foreign-owned, but the industry
    is regulated by 55 independent jurisdictions. While insurance regulators
    in the United States responded through NAIC to a solvency crisis in that
    industry during the early 1990s, the NAIC process remains cumbersome in a
    multinational world. Some of the kinds of problems that can develop as a
    result of an international industry being overseen at the state level are
    evident in the case of Executive Life. In 1998, issues surrounding the
    sale of Executive Life, a life insurer that became insolvent in the early
    1990s after investing heavily in junk bonds, came to light. The issue
    essentially pitted the insurance regulator of California against the
    national government of France. While this problem was handled within the
    current structure, the structure did not facilitate the solution. Not
    surprisingly, officials at the EU, UK-FSA, and BaFin told us that having a

    4See GAO, Telecommunications: Better Coordination and Enhanced
    Accountability Needed to Improve Spectrum Management, GAO-02-906
    (Washington, D.C.: Sept. 30, 2002).

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                                       Regulation

    single point of contact on insurance issues within the United States would
    facilitate international decision making. EU officials noted that
    international negotiations with NAIC led to the creation of IAIS; however,
    the effectiveness of this organization may be limited by its inability to
    speak for the actual insurance regulators in the U.S. In addition, NAIC's
    supervisory stance embodied in its model laws differs from the Solvency II
    model being created in the EU, especially with regard to the oversight of
    insurance groups. NAIC says that IAIS is developing a model for insurance
    supervision that conforms to the U.S. position. Finally, some
    foreign-based financial services firms that want to sell insurance
    products in the United States have characterized the fragmented U.S.
    regulatory system as an unfair trade barrier.

    Regulators Provide Some Other Benefits by Specializing in Particular
    Industry Segments or Geographic Units, but Specialization Has Costs As
    Well

    Since there are still significant differences in many areas of the
    banking, securities, insurance, and futures businesses, specialized
    expertise with knowledge of those businesses is still deemed important. In
    addition, state regulators often argue that they have better knowledge of
    the needs of consumers in their respective states. Officials at OTS felt
    that even though all of the banking regulators are in the banking sector,
    OTS is able to focus its skills on the needs of institutions whose primary
    asset is mortgages. According to officials in the futures industry and at
    CFTC, creating a specialized regulator for the futures industry has
    permitted that industry to be innovative in ways that would not have been
    possible under either an SEC or bank regulatory environment. Many of the
    people we talked with were concerned about what might happen to these
    specialized skills and knowledge if regulators were combined into fewer
    agencies. In addition, a few industry representatives in the United
    Kingdom mentioned the lack of industry specific skills and knowledge as a
    concern in the United Kingdom once the regulator was unified across
    sectors.

    Specialization in a particular industry segment ensures that the issues of
    that segment will get considered in larger forums, before Congress, or in
    international negotiations. This is particularly evident in the Basel II
    negotiations, where FDIC and OTS have expressed the concerns facing
    smaller banks-including the possibility that lower capital requirements
    for larger banks could place smaller banks at a competitive disadvantage.
    The Federal Reserve says that it is conducting a series of studies looking
    at the likely impact of Basel II. After two such studies, they have found
    no potential negative effects on smaller banks; however, one study did
    suggest that larger banks that do not adopt Basel II could face some
    competitive

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    The U.S. Regulatory System Has Strengths,
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    Regulation

    disadvantage. Similarly, OCC expressed the concerns of trust banks over
    the capital charges they will have for operational risk.

    Of course, specialization can be a double-edged sword that requires
    vigilance on the part of the regulator. First, a regulator's
    specialization can lead to an inability to track risks that cross sectors.
    This inability can be the result of statutory limitations on the
    regulator, as well as the regulator's policies and procedures that reflect
    its focus on particular risks. Second, if the regulator becomes too
    responsive to the needs of the industry, its independence can be in
    jeopardy. Again, the Basel II negotiations illustrate the trade-offs. It
    is unclear whether regulators who presented the views of particular
    segments of the industry were exhibiting their specialized knowledge or
    lobbying for the segment of the industry they oversee. One regulator told
    us they did not present certain issues earlier in the process because the
    regulator had not yet heard from the industry. The chance for regulators
    to lose their independence is stronger for agencies that oversee
    relatively few entities. An agency is at greater risk of being "captured"
    by the industry as consolidation in industry segments reduces the number
    of firms being overseen by that regulator. Alternatively, combining
    regulators could reduce the impact of any one segment in decisions, but
    runs the risk of swallowing up particular industry segments.

    Although having knowledge of a particular industry segment is important
    for regulators, other specialized skills and knowledge cut across
    regulatory agencies, and these skills and knowledge may not be efficiently
    allocated across some of the smaller agencies. All regulators write rules,
    conduct offsite monitoring, and examine firms to determine whether firms
    are managing their risks effectively and complying with rules and
    regulations. In Massachusetts, we found former Federal Reserve examiners
    on the staff of OCC and at the Massachusetts Department of Insurance. In
    addition, CFTC told us that part of their implementation of new
    risk-focused examination procedures includes some training by Federal
    Reserve examiners. However, having some relatively small agencies limits
    the ability of these agencies to take advantage of economies of scope and
    scale relative to these skills. This is especially true with regard to the
    specialized skills related to understanding the complex statistical models
    that firms are using to manage risks and the structured products they
    provide. These skills are needed in varying degrees by all financial
    regulatory agencies. Finding people with the requisite skills is
    complicated because they are scarce and in demand by the industry, where
    the pay is often considerably higher than at a regulatory agency.
    Regulators say that consolidating regulatory agencies would not alleviate
    this shortage because even if they

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    Regulation

    added together all of the staff of all of the regulatory agencies involved
    in these complex tasks, there would still not be enough staff with the
    requisite skills. However, the current system does not provide a mechanism
    to ensure that the staff is allocated optimally.

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    Congress May Want to Consider Changes to the U.S. Regulatory Structure

    As we have seen, over the last several decades the financial services
    industry has changed in many significant ways. These changes have blurred
    the clear-cut boundaries between the "functional" areas underlying our
    regulatory structure, so that large firms and products increasingly
    compete across or otherwise ignore these boundaries. Very large firms are
    increasingly competing in more than one of the four sectors of the
    industry and across national boundaries. In addition, these firms take on
    similar risks and manage these risks at the consolidated level. Policies
    and procedures related to market conduct and corporate governance also
    tend to be set centrally in these organizations. Moreover, hybrid products
    are blurring the lines between "functional" activities, and even firms
    that specialize in a specific functional area are competing to provide
    similar services to the same consumers and businesses.

    The financial services industry is critical to the health and vitality of
    the U.S. economy. While the industry itself bears primary responsibility
    to effectively manage its risks, the importance of the industry and the
    nature of those risks have created a need for government regulation as
    well. While the specifics of a regulatory structure, including the number
    of regulatory agencies and the roles assigned to each, may not be the
    critical determinant in whether a regulatory system is successful, the
    structure can facilitate or hinder the attainment of regulatory goals. The
    skills of the people working in the regulatory system, the clarity of its
    objectives, its independence, and its management systems are critical to
    the success of financial regulation.

    The U.S. regulatory structure facilitates regulators having detailed
    knowledge about banking, insurance, securities, and futures activities,
    and these regulators report that they do exchange information relevant to
    the supervision of institutions that operate in more than one of these
    areas. However, the regulatory structure hinders comprehensively
    understanding and, when appropriate, containing the risk-taking activities
    of large, complex, internationally active institutions; promoting the
    global competitiveness of the U.S. financial services industry;
    maintaining to the greatest extent possible competitive neutrality; and
    handling possible systemic repercussions. The U.S. regulatory structure
    also does not have an ability to develop a strategic focus that would
    guide the priorities and activities of each agency and does not have the
    ability to allocate resources across agencies.

    Because our regulatory structure relies on having clear-cut boundaries
    between the "functional" areas, industry changes that have caused those
    boundaries to blur have challenged the regulatory framework. While

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    diversification across activities and locations may have lowered the risks
    being faced by some large, complex, internationally active firms,
    understanding and overseeing them has also become a much more complex
    undertaking, requiring staff that can evaluate the risk portfolio of these
    institutions and their management systems and performance. Regulators must
    be able to ensure effective risk management without needlessly restraining
    risk taking, which would hinder economic growth. Similarly, because firms
    are taking on similar risks across "functional" areas, to understand the
    risks of a given institution or of the system as a whole, regulators need
    a more complete picture of the risk portfolio of the financial services
    industry both in the United States and abroad. For example, in our report
    on LTCM and its rescue, we said the following:

    Because of the blurring in recent years of traditional lines that separate
    the businesses of banks and securities and futures firms, it is more
    important than ever for regulators to assess information that cuts across
    these lines. Regulators for each industry have generally continued to
    focus on individual firms and markets, the risks they face, and the
    soundness of their practices, but they have failed to address
    interrelationships across each industry. The risks posed by LTCM crossed
    traditional regulatory and industry boundaries, and the regulators would
    have needed to coordinate their activities to have had a chance of
    identifying these risks. Although regulators have recommended improvements
    to information reporting requirements, they have not recommended ways to
    better identify risks across markets and industries.1

    The regulatory framework envisioned in GLBA recognizes some of the
    linkages within institutions and contains a framework for consolidated
    oversight of some types of firms. Activities at the Basel Committee and
    requirements that take affect in early 2005 for firms conducting business
    in EU countries have led regulators to adopt some new policies and rules
    in this area. However, different regulatory treatment of bank and
    financial holding companies, consolidated supervised entities, supervised
    investment bank holding companies, and thrift holding companies may not
    provide a basis for consistent oversight of their consolidated risk
    management strategies, guarantee competitive neutrality, or contribute to
    better oversight of systemic risk.

    Recognizing that regulators could potentially overcome the impediments of
    a fragmented regulatory structure through better communication and
    coordination across agencies, Congress has created mechanisms for
    coordination and on a number of specific issues directed agencies to

    1GAO/GGD-00-3, 3.

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    coordinate their activities. In addition, we have repeatedly recommended
    that federal regulators improve communication and coordination. For
    example, in our report on LTCM, we recommended that federal financial
    regulators develop ways to better coordinate oversight activities that cut
    across traditional regulatory and industry boundaries. While we continue
    to support these recommendations, we recognize that the sheer number of
    regulatory bodies, their underlying competitive nature, and differences in
    their regulatory philosophies will continue to make the sharing of
    information difficult and true coordination and cooperation in the most
    important or most visible areas problematic as well. Therefore, Congress
    might want to consider some changes to the U.S. financial services
    regulatory structure that address weaknesses and potential vulnerabilities
    in our current system, while maintaining its strengths.

    However, structural changes themselves will not ensure the attainment of
    various regulatory goals. That will require a structure with the right
    people and skills, clear regulatory objectives, effective tools, and
    appropriate policies and procedures. A different organizational structure
    will not necessarily make the inherently difficult task of detecting fraud
    in a financial institution easier, and it also would not ensure more
    accurate and comprehensive detection. In addition, any major change in the
    regulatory structure poses the risk of unintended consequences and
    transition costs. Organizational changes may take place over several
    years, and regulators might lose sight of their objectives while
    management jockeys for control of the agenda of a new or reformulated
    regulatory body, staff worry about having jobs in the new system, or
    employees become accustomed to their new roles in the new organization.

    Matter for While maintaining sector expertise and ensuring that financial
    institutions

    comply with the law, Congress may want to consider some consolidation
    orCongressional modification of the existing regulatory structure to (1)
    better address the Consideration risks posed by large, complex,
    internationally active firms and their

    consolidated risk management approaches; (2) promote competition
    domestically and internationally; and (3) contain systemic risk. If so,
    our work has identified several options that Congress may wish to
    consider:

    o  consolidating the regulatory structure within the "functional" areas;

    o 	moving to a regulatory structure based on a regulation by objective or
    twin peaks model;

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    o  combining all financial regulators into a single entity; or

    o 	creating or authorizing a single entity to oversee all large, complex,
    internationally active firms, while leaving the rest of the structure in
    place.

    If Congress does wish to consider these or other options, it may want to
    ensure that legislative goals are clearly set out for any changed
    regulatory structure and that the agencies affected by any change are
    given clear direction on the priorities that should be set for achieving
    these goals. In addition, any change in the regulatory structure would
    entail changing laws that currently govern financial services oversight to
    conform to the new structure.

    The first option would be to consolidate the regulatory structure within
    "functional" areas-banking, securities, insurance, and futures-so that at
    the federal level there would be a primary point of contact for each. The
    two major changes to accomplish this at the federal level would be
    consolidation of the bank regulators and, if Congress wishes to provide a
    federal charter option for insurance, the creation of an insurance
    regulatory entity. The bank regulatory consolidation could be achieved
    within an existing banking agency or with the creation of a new agency. In
    1996, we recommended that the number of federal agencies with primary
    responsibilities for bank oversight be reduced. However, we noted that in
    the new structure, FDIC should have the necessary authority to protect the
    deposit insurance fund and that the Federal Reserve and Treasury should
    continue to be involved in bank oversight, with access to supervisory
    information, so that they could carry out their responsibilities for
    promoting financial stability. We have not studied the issue of an
    optional federal charter for insurers, but have through the years noted
    difficulties with efforts to normalize insurance regulation across states
    through the NAIC-based structure. Having a primary federal entity for each
    of the functional sectors would likely improve communications and
    coordination across sectors because it would reduce the number of entities
    that would need to be consulted on any issue. Similarly, it would provide
    a central point of communication for issues within a sector. Fewer bank
    regulators might reduce the cost of regulation and the opportunities for
    regulatory arbitrage, choosing charters so that transactions have the
    least amount of oversight. In addition, issues related to the independence
    of a regulator from the firms they oversee with a given kind of charter
    would be alleviated. However, consolidating the banking regulators and
    establishing a federal insurance regulator would raise concerns as well.
    While improved

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    communication and cooperation within sectors would help to achieve the
    other objectives outlined above, it would not directly address many of
    them. In addition, some constituencies, such as thrifts, might feel they
    were not getting proper attention for their concerns; and opportunities
    for regulatory experimentation and the other positive aspects of
    competition in banking could be reduced. Further, while this option
    represents a more evolutionary change than some of the others, it might
    still entail some costs associated with change, including unintended
    consequences that would undoubtedly erupt as various banking agencies and
    their staff jockeyed for position within the new banking regulator.
    Similarly, the establishment of a federal insurance regulator might have
    unintended consequences for state regulatory bodies and for insurance
    firms as well.

    Another option would be consolidating the regulatory structure using a
    regulation by objective, or twin peaks model. The twin peaks model would
    involve setting up one safety and soundness regulatory entity and one
    conduct-of-business regulatory entity. The former would oversee safety and
    soundness issues for insurers, banks, securities, and futures activities,
    while the latter would ensure compliance with the full range of
    conduct-ofbusiness issues, including consumer and investor protection,
    disclosure, money laundering, and some governance issues. This could be
    accomplished by changing the tasks assigned to existing agencies or by
    restructuring the agencies or creating new ones. On the positive side,
    this option would directly address many of the regulatory objectives
    related to larger, more complex institutions, such as allowing for
    consolidated supervision, competitive neutrality, understanding of the
    linkages within the safety and soundness and conduct-of-business spheres,
    and regulatory independence. In addition, conduct-of-business issues would
    not become subservient to safety and soundness issues, as some fear. On
    the negative side, in addition to the issues raised by any change in the
    structure, this structure would not allow regulators to oversee the
    linkages between safety and soundness and conduct-of-business. As
    reputational risk has become more important, the linkages between these
    activities have become more evident. In addition, if the controls and
    processes for conduct-of-business issues and safety and soundness issues
    are coming from the top of the organization, they are probably closely
    related. Finally, combining regulators into multifunctional units might
    not allow the regulatory system to maintain some of the advantages it now
    has, including specialized expertise and the benefits of regulatory
    competition and experimentation.

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    The most radical option would combine all financial regulators into a
    single entity, similar to UK-FSA. The benefits of the single regulator are
    that one body is accountable for all regulatory endeavors. It can more
    easily evaluate the linkages within and across firms, including those
    between conduct-of-business and safety and soundness considerations, plan
    strategically across sectors, and facilitate the allocation of resources
    to their highest priority use. However, achieving these goals would depend
    on having the right people and skills, clear regulatory objectives,
    effective tools, and appropriate policies and procedures. While the UK-FSA
    model is intriguing, this option raises some concerns for the United
    States. First, because of the size of the U.S. economy and the number of
    financial institutions this entity would have to be very large and, thus,
    could be unwieldy and costly. UK-FSA has about 2,300 employees, while
    estimates of the number of regulators currently in the United States range
    from about 30,000 to 40,000. In addition, officials at UK-FSA have
    commented about the difficulty of setting priorities when a large number
    of issues have to be dealt with. Prioritizing these issues for the United
    States would be particularly difficult. Further, an entity with this scope
    and size might have difficulty responding to smaller players and might
    therefore damage the diversity that has enriched the U.S. financial
    industry. Also, staff at such an entity might lose or not develop the
    specialized skills needed to understand both large and small companies and
    risks that are specific to the different "functional" sectors. And without
    careful oversight, such a large and allpowerful entity might not be
    accountable to consumers or the industry.

    A more evolutionary change would be to have a single entity with
    responsibility for the oversight of all large, complex, or internationally
    active financial services firms that manage risk centrally, compete with
    each other within and across sectors, and, by their size and presence in a
    wide range of markets, pose systemic risks. Having a single regulatory
    entity for large, complex, or internationally active firms could be
    accomplished by giving this responsibility to an existing regulator or by
    creating a new entity. A new entity might consist of a small staff that
    would rely on the expertise of staff at existing regulatory agencies to
    accomplish supervisory tasks.

    Having a single regulatory entity for large, complex, or internationally
    active firms would have the advantage of addressing industry changes,
    while leaving much of the U.S. regulatory structure unchanged. A single
    regulatory entity for large, complex holding companies would have
    responsibilities that more closely align with the businesses' approach to
    risk than the current regulatory structure. In addition, this entity could

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    promote competition between these firms by ensuring, to the greatest
    extent possible, that oversight is competitively neutral. A single
    regulatory entity for internationally active firms would also be better
    positioned to help coordinate the views of the United States in
    international forums, so that the U.S. firms are not competitively
    disadvantaged during negotiations. Finally, this entity would be better
    able to appraise the linkages across large, complex, internationally
    active firms and, thus, with the aid of the Federal Reserve and Treasury,
    could contribute to promoting financial stability. These potential
    improvements could be obtained without losing the advantages afforded by
    our current specialized regulators, who would continue to supervise the
    activities of regulated firms such as brokerdealers or banks. However,
    this option also has drawbacks. While the transition costs might be less
    than in some of the other options, the creation of a new entity or
    changing the role of an existing regulatory entity would still entail
    costs and likely some unintended consequences. It might also be difficult
    to maintain the appropriate balance between the interests of the large or
    internationally active firms and smaller, more-specialized entities. It
    also could involve creating one more regulatory agency in a system that
    already has many agencies.

    Agency Comments and Our Evaluation

    We received written comments on a draft of this report from the Chairman
    of the Board of Governors of the Federal Reserve System, the Chairman of
    Federal Deposit Insurance Corporation, the Comptroller of the Currency,
    the Director of the Office of Thrift Supervision, and the Director of
    SEC's Division of Market Regulation. These letters are reprinted in
    appendixes I-V of this report.

    In his comments, the Chairman of the Federal Reserve's Board of Governors
    said that GLBA provided for a regulatory framework that struck a balance
    between the need for regulation and the need for adaptability. Congress at
    that time chose to retain and build upon the functional regulation
    approach, one that has worked well for the United States and, as the
    report notes, has helped promote the competition and innovation that is a
    "hallmark" of the U.S. financial system. He further wrote that, in GLBA,
    "Congress also reaffirmed its determination that functional regulation
    needed to be supplemented by consolidated supervision of holding companies
    only in the case of affiliations involving banks and other insured
    depository institutions" because of risks associated with the access that
    banks and other insured depository institutions have to the federal safety
    net. These risks include the subsidy implicit in the federal safety net
    being extended to nonbank affiliates and ownership of an insured bank
    reducing

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    market discipline. In addition, he cautioned that if Congress were to
    consider restructuring the federal financial regulatory agencies, it
    should carefully consider the benefits and costs, including the effect on
    the industry's competition and innovation and that any agency "strategic
    plan" would be unable to anticipate the effects of this innovation.

    The Chairman of the Federal Deposit Insurance Corporation wrote that the
    draft report paid insufficient attention to the fact that deposit
    insurance is limited to insured depository institutions, and the danger
    that focusing on consolidated supervision would blur the distinction
    between the insured depository institution and any uninsured affiliates.
    He noted that this distinction would become more important if the
    marketplace drives greater mixing of commerce and finance than currently
    occurs. He also warned that, if federal financial regulators were to be
    consolidated, the value of differing perspectives within the regulatory
    system would be lost and independence of the deposit insurer could be
    diminished.

    The Comptroller of the Currency also warned that any change in the federal
    financial regulatory structure "should be approached judiciously and
    cautiously." Like the Chairman of the Federal Reserve's Board of
    Governors, the Comptroller cautioned that changes in the federal
    regulatory structure could diminish the value of the dual banking system,
    with both state and federal charters for banks and thrifts. He noted that,
    while some foreign regulators may have preferred the "convenience" of
    having only one U.S. negotiator in the Basel II negotiations, this might
    have been less important than their desire to reach an agreement without
    the formal rule-making process that U.S. regulators must follow.

    We agree with many of these comments, and believe the report accurately
    reflects the challenges that Congress would face if it were to choose to
    consider some consolidation or modification of the current federal
    financial regulatory structure. Achieving a balance between market forces
    and regulation is an inherently difficult task. We have made several
    changes to our report to ensure that it reflects this difficulty. In
    particular, we expanded our discussion of the statutory goals for the
    federal financial regulators. We also changed phrasing in the report to
    make clear that federal deposit insurance does not extend beyond
    FDIC-insured depository institutions. It is a valid concern that deposit
    insurance not be extended beyond the insured depository under any
    circumstances. We have also noted that the federal rule-making process
    could contribute to the statements made to us by foreign financial
    regulators about U.S. participation in the Basel II negotiations. In
    addition, we expanded our

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    discussion of agency strategic plans to make clear that their purpose is
    better preparing agencies to meet the challenges posed by the industry's
    innovations. During our study, we were impressed by the strategic focus
    that appears to permeate UK-FSA and believe that, in this regard, it is a
    useful model for U.S. agencies to study. We agree with the Chairman of the
    Federal Reserve's Board of Governors that a single regulator could
    "prohibit or restrain" innovation, and believe that the report does
    recognize this risk. In addition, while we recognize that Congress
    referred to the importance of deposit insurance and of not extending the
    safety net in its discussion of the Federal Reserve's role as a
    consolidated supervisor, it did not limit its discussion of consolidated
    supervision to this purpose and did not ensure that all insured
    depositories owned by other entities would be subject to consolidated
    supervision. For example, GLBA gave SEC the authority to oversee
    SIBHCs-investment bank holding companies that do not own certain types of
    insured depositories (at the option of the investment bank.) In addition,
    because GLBA exempts some insured depositories, either directly or as a
    result of grandfathering some preexisting conditions, some of the most
    complex institutions in the United States that own insured depositories
    are not required to have consolidated supervision. Instead, these
    institutions are seeking consolidated supervision because of changes in EU
    law.

    In his comments, the Director of the Office of Thrift Supervision wrote
    that the report inadequately recognized OTS's authority over thrift
    holding companies, including the top-tier parent company; that the report
    inaccurately portrayed OTS's international activities; and presented an
    "unbalanced" view in referring to the failure of Superior Bank, FSB,
    without referring to other bank failures.

    We do not agree. Our report recognizes OTS's authority, noting that, under
    the Home Owners' Loan Act and other legislation, "companies that own or
    control a savings association are subject to supervision by OTS." Further,
    the report includes a section in chapter 1 devoted to a discussion of
    OTS's authority to oversee thrift holding companies; again in chapter 4,
    we discuss OTS's authority as a consolidated supervisor. In the report, we
    acknowledge that because OTS oversees some of the largest, most complex
    U.S. financial services firms, it may serve as the consolidated supervisor
    for some of these firms under the Conglomerates Directive of the EU Action
    Plan. As noted, however, we have neither evaluated OTS's thrift holding
    company examinations nor compared them with Federal Reserve examinations
    of bank or financial holding companies of similar size and complexity. Our
    report also discusses OTS's role in international

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    forums-specifically its participation in the Basel II negotiations-and at
    OTS's suggestion, we have modified the report to make clear that OTS has
    applied to be a permanent member of the Basel Committee. However, we note
    that they continue to be the only federal regulator of depository
    institutions, other than NCUA, that does not have a permanent seat on this
    important committee.

    Finally, while Superior Bank failed because of its own actions, the
    failure also provided lessons on the need for federal regulators to work
    together better. The then-Director of OTS acknowledged this need in
    testimony before the Senate Committee on Banking, Housing, and Urban
    Affairs.2 In our assessments of that failure, both the FDIC Inspector
    General and we found that effective coordination was lacking.3 We did
    revise this report to make explicit that the primary reason for Superior's
    failure was actions by its owners and management. We also added a
    reference to the failure of the First National Bank of Keystone (West
    Virginia) that, according to a report by the Treasury Inspector General,
    also showed the need for better communication between FDIC and a primary
    federal regulator. (In the Keystone instance, OCC was the primary federal
    regulator.) Our report does discuss an agreement among federal bank
    regulators establishing a better process to determine when FDIC will join
    in the examination of an insured bank. In the comments, OTS also noted
    that, as a percentage of assets, the cost to the insurance fund of
    resolving Superior Bank was the lowest of the group of failures it cited
    (including Keystone). However, the Keystone and Superior failures did
    incur the largest costs to the insurance funds ($635 million and $436
    million, respectively) of the failures that OTS cited.

    In SEC's comments on the draft report, the Director of the Division of
    Market Regulation noted that "supervision and regulation can always be
    improved, but the costs of change must always be weighed against its
    benefits." As noted above, we concur.

    2Statement of Ellen Seidman, Director of the Office of Thrift Supervision,
    in U.S. Senate, Committee on Banking, Finance, and Urban Affairs, "The
    Failure of Superior Bank, FSB, Hinsdale, Illinois," September 11, 2001,
    and October 16, 2001, S. Hrg. 107-698, p. 13.

    3Office of the Inspector General, FDIC, Issues Related to the Failure of
    Superior Bank, FSB, Hinsdale, Illinois, Audit Report 02-005 (Washington,
    D.C.; Feb. 6, 2002); and GAO, Bank Regulation: Analysis of the Failure of
    Superior Bank, FSB, Hinsdale, Illinois, GAO-02-419T (Washington, D.C.:
    Feb. 7, 2002).

    Chapter 7
    Congress May Want to Consider Changes to
    the U.S. Regulatory Structure

    In addition to the written comments, we also received technical comments
    and corrections from the staffs at these agencies, or in the case of OTS
    as part of their written comments. We have incorporated these into the
    report, as appropriate.

    We also provided the Department of the Treasury and CFTC with a draft of
    the report, so that they could provide written comments, if they wished.
    Neither agency chose to provide such comments. Because the report
    discusses proposals for an optional federal insurance charter, we also
    provided a draft to NAIC, representing the state insurance regulatory
    agencies, for them to provide comments; NAIC did not provide comments. We
    did receive technical comments and corrections from Treasury, CFTC, and
    NAIC staff that we have incorporated into the report, as appropriate.

    Appendix I

    Comments from the Board of Governors of the Federal Reserve System

    Appendix I
    Comments from the Board of Governors of
    the Federal Reserve System

    Appendix I
    Comments from the Board of Governors of
    the Federal Reserve System

    Appendix II

    Comments from the Federal Deposit Insurance Corporation

    Appendix II
    Comments from the Federal Deposit
    Insurance Corporation

    Appendix II
    Comments from the Federal Deposit
    Insurance Corporation

    Appendix III

    Comments from the Office of the Comptroller of the Currency

    Appendix III Comments from the Office of the Comptroller of the Currency
    Appendix III Comments from the Office of the Comptroller of the Currency

    Appendix IV

    Comments from the Office of Thrift Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix IV
    Comments from the Office of Thrift
    Supervision

    Appendix V

    Comments from the Securities and Exchange Commission

    Appendix V Comments from the Securities and Exchange Commission

    Appendix VI

                         GAO Contacts and Staff Acknowledgments

    GAO Contacts	Thomas J. McCool, (202) 512-8678 James M. McDermott, (202)
    512-5373

    Staff 	In addition to the individuals named above, Nancy S. Barry, Emily
    Chalmers, Patrick Dynes, James Kim, Marc W. Molino, Suen-Yi Meng, Kaya

    Acknowledgments 	Leigh Taylor, Paul Thompson, John Treanor, and Cecile
    Trop also made key contributions to this report.

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