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
Executive Summary
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.
Executive Summary
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,
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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
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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.
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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
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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
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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
Chosen to Maintain Its Structure
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
Chosen to Maintain Its Structure
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
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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
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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.
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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.
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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).
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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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The U.S. Regulatory System Has Strengths,
but Its Structure May Hinder Effective
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,
but Its Structure May Hinder Effective
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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The U.S. Regulatory System Has Strengths,
but Its Structure May Hinder Effective
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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Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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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Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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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Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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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Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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.
Chapter 7
Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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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Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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
Chapter 7
Congress May Want to Consider Changes to
the U.S. Regulatory Structure
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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the U.S. Regulatory Structure
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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Congress May Want to Consider Changes to
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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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