Long-Term Capital Management: Regulators Need to Focus Greater Attention
on Systemic Risk (Letter Report, 10/29/1999, GAO/GGD-00-3).

Pursuant to a congressional request, GAO provided information on Long
Term Capital Management (LTCM) funds, focusing on: (1) how LTCM's
positions became large and leveraged enough to be deemed a potential
systemic threat; (2) what federal regulators knew about LTCM and when
they found out about its problems; (3) what the extent of coordination
among regulators was; and (4) whether regulatory authority limits
regulators' ability to identify and mitigate potential systemic risk.

GAO noted that: (1) LTCM was able to establish leveraged trading
positions of a size that posed potential systemic risk, primarily
because the banks and securities and futures firms that were its
creditors and counterparties failed to enforce their own risk management
standards; (2) other market participants and federal regulators relied
upon these large banks and securities and futures firms to follow sound
risk management practices in providing LTCM credit; (3) however,
weaknesses in the risk management practices of these creditors and
counterparties allowed LTCM's size and use of leverage to grow
unrestrained; (4) the effects of these weaknesses became apparent during
the unsettled market conditions that occurred in the summer of 1998; (5)
LTCM began to lose large amounts of money in various trading positions
worldwide and by mid-September was on the verge of failure; (6) the
Federal Reserve facilitated a private sector recapitalization of LTCM
because of concerns that a rapid liquidation of LTCM's trading positions
and related positions of other market participants in already highly
volatile markets might cause extreme price movements and cause some
markets to temporarily cease functioning; (7) although regulators were
aware of the potential systemic risk that hedge funds can pose to
markets and the perils of declining credit standards, until LTCM's
near-collapse, they said they believed that creditors and counterparties
were appropriately constraining hedge funds' leverage and risk-taking;
(8) however, examinations done after LTCM's near-collapse revealed
weaknesses in credit risk management by banks and broker-dealers that
allowed LTCM to become too large and leveraged; (9) regulators for each
industry have generally continued to focus on individual firms and
markets, the risks they face, the soundness of their practices, but they
have failed to address interrelationships across each industry; (10)
lack of authority over certain affiliates of securities and futures
firms limits the ability of the Securities and Exchange Commission (SEC)
and the Commodity Futures Trading Commission (CFTC) to identify the kind
of systemic risk that LTCM posed; and (11) the President's Working Group
report recommended that Congress provide SEC and CFTC expanded authority
to obtain and verify information from unregistered affiliates of
broker-dealers and future commission merchants.

--------------------------- Indexing Terms -----------------------------

 REPORTNUM:  GGD-00-3
     TITLE:  Long-Term Capital Management: Regulators Need to Focus
	     Greater Attention on Systemic Risk
      DATE:  10/29/1999
   SUBJECT:  Securities regulation
	     Brokerage industry
	     Regulatory agencies
	     Risk management
	     Securities
	     Reporting requirements
	     Financial institutions
	     Interagency relations
	     Financial analysis
IDENTIFIER:  Long Term Capital Management Fund

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United States General Accounting Office
GAO

Report to Congressional Requesters

October 1999

GAO/GGD-00-3

LONG-TERM CAPITAL MANAGEMENT
Regulators Need to Focus Greater Attention on

Systemic Risk

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Contents
Page 361 GAO/GGD-00-3 Long-Term Capital Management
Letter                                                                      1
                                                                             
Appendix I                                                                 38
Overview of LTCM's Near
Collapse And Related
Events
                           Hedge Funds                                     38
                           LTCM Overview                                   38
                           Investment Strategy                             40
                           Use of Leverage                                 41
                           Market Turmoil Resulted in Huge Losses          42
                           for LTCM
                           What the Regulators Knew                        42
                           The Recapitalization                            44
                           Subsequent Events                               45
                                                                             
Appendix II                                                                46
Comments From the
Commodity Futures
Trading Commission
                                                                             
Appendix III                                                               47
Comments From the
Federal Reserve
                                                                             
Appendix IV                                                                49
Comments From the
Securities and Exchange
Commission
                                                                             
Appendix V                                                                 51
Comments From the
Department of the
Treasury
                                                                             
Appendix VI                                                                52
GAO Contacts and Staff
Acknowledgments
Tables                     Table 1:  Comparison of LTCM's                   7
                           Leverage to Major Securities and
                           Futures Firms
                           Table 2:  Comparison of Total Notional          25
                           Value of Derivatives Contracts
                           (dollars in billions)
                           Table I.1: Chronology of Events                 39
                                                                             

Abbreviations

BIS       Bank for International Settlements
CFTC      Commodity Futures Trading Commission
CPO       Commodity Pool Operator
DPG       Derivatives Policy Group
FCM       futures commission merchant
LTCM      Long-Term Capital Management
NASD      National Association of Securities
Dealers
NASDR     NASD Regulation, Inc.
NFA       National Futures association
NYSE      New York Stock Exchange
OCC       Office of the Comptroller of the
Currency
OTC       over-the-counter
SEC       Securities and Exchange Commission
SRO       self-regulatory organization

B-281371

Page 31  GAO/GGD-00-3 Long-Term Capital Management
     B-281371

     October 29, 1999

The Honorable Byron L. Dorgan
United States Senate
 
The Honorable Tom Harkin
United States Senate

The Honorable Harry Reid
United States Senate

The Honorable Edward J. Markey
United States House of Representatives

This report responds to your request that we
review Long-Term Capital Management's (LTCM) near-
collapse and some of the broader issues it raised.
Between January and September 1998, LTCM, one of
the largest U.S. hedge funds,1 lost almost 90
percent of its capital. In September 1998, the
Federal Reserve determined that rapid liquidation
of LTCM's trading positions and related positions
of other market participants might pose a
significant threat to already unsettled global
financial markets. Thus, the Federal Reserve
facilitated a private sector recapitalization to
prevent LTCM's collapse. Although the crisis
involved a hedge fund, the circumstances
surrounding LTCM's near-collapse and
recapitalization raised questions that go beyond
the activities of LTCM and hedge funds to how
federal financial regulators fulfill their
supervisory responsibilities and whether all
regulators have the necessary tools to identify
and address potential threats to the financial
system. As agreed, the issues we addressed were
(1) how LTCM's positions became large and
leveraged2 enough to be deemed a potential
systemic threat, (2) what federal regulators knew
about LTCM and when they found out about its
problems, (3) what the extent of coordination
among regulators was, and (4) whether regulatory
authority limits regulators' ability to identify
and mitigate potential systemic risk. 3

Results in Brief
LTCM was able to establish leveraged trading
positions of a size that posed potential systemic
risk, primarily because the banks and securities
and futures firms4 that were its creditors and
counterparties failed to enforce their own risk
management standards. Other market participants
and federal regulators relied upon these large
banks and securities and futures firms to follow
sound risk management practices in providing LTCM
credit. However, weaknesses in the risk management
practices of these creditors and counterparties
allowed LTCM's size and use of leverage to grow
unrestrained. According to federal financial
regulators, these weaknesses, at least in part,
resulted from overreliance on the reputations of
LTCM's principals, the relaxing of credit
standards that typically occurs during periods of
sustained economic prosperity, and competition
between banks and securities and futures firms for
hedge fund business.

The effects of these weaknesses became apparent
during the unsettled market conditions that
occurred in the summer of 1998. LTCM began to lose
large amounts of money-$1.8 billion in August
alone-in various trading positions worldwide and
by mid-September was on the verge of failure. The
Federal Reserve facilitated a private sector
recapitalization of LTCM because of concerns that
a rapid liquidation of LTCM's trading positions
and related positions of other market participants
in already highly volatile markets might cause
extreme price movements and cause some markets to
temporarily cease functioning. Following the LTCM
crisis, a group of major financial firms prepared
a report that addressed risk management issues and
recommended improvements to financial firms'
existing counterparty risk practices.

Federal financial regulators did not identify the
extent of weaknesses in banks' and securities and
futures firms' risk management practices until
after LTCM's near-collapse. Although regulators
were aware of the potential systemic risk that
hedge funds can pose to markets and the perils of
declining credit standards, until LTCM's near-
collapse, they said they believed that creditors
and counterparties were appropriately constraining
hedge funds' leverage and risk-taking. However,
examinations done after LTCM's near-collapse
revealed weaknesses in credit risk management by
banks and broker-dealers that allowed LTCM to
become too large and leveraged. The existing
regulatory approach, which focuses on the
condition of individual institutions, did not
sufficiently consider systemic threats that can
arise from nonregulated entities, such as LTCM.
Similarly, information periodically received from
LTCM and its creditors and counterparties did not
reveal the potential threat posed by LTCM. Since
LTCM's near-collapse, regulators and industry
groups have taken steps to address many of the
issues raised, including revising examination
guidance and enhancing information reporting.

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. We are recommending that
federal financial regulators develop ways to
better coordinate oversight activities that cross
traditional regulatory and industry boundaries.

Lack of authority over certain affiliates of
securities and futures firms limits the ability of
the Securities and Exchange Commission (SEC) and
the Commodity Futures Trading Commission (CFTC) to
identify the kind of systemic risk that LTCM
posed. Although SEC and CFTC regulate registered
broker-dealers and futures commission merchants
(FCMs),5 they do not have the authority to
regulate unregistered affiliates of broker-dealers
and FCMs except for limited authority to gather
certain information. This lack of authority, or
regulatory "gap," has become more significant as
the percentage of assets held outside the
regulated entities has grown; for example, almost
half of the total assets of four major securities
and futures firms are held outside the registered
broker-dealers. These unregistered affiliates
often have large positions in such markets as over-
the-counter derivatives and can be major providers
of leverage in the markets, as they were in the
LTCM case. How they manage their own risks, as
well as their provision of leverage to
counterparties, can affect the financial system.

The President's Working Group report recognized
this regulatory gap and recommended that Congress
provide SEC and CFTC expanded authority to obtain
and verify information from unregistered
affiliates of broker-dealers and FCMs. However,
this recommendation may not go far enough in
enabling SEC and CFTC to more quickly identify and
respond to the next potential systemic crisis. The
Working Group recommendation would still leave
important providers of credit and leverage in the
financial system without firmwide risk management
oversight by financial regulators. For example,
LTCM was able to become too large and excessively
leveraged, in part, through its dealings with
these providers-the unregulated affiliates of
broker-dealers and FCMs. Without additional
authority to regulate the affiliates, SEC and CFTC
do not have the authority needed to identify and
address potential weaknesses in securities and
futures firms' risk management practices that
might lead to the next systemic crisis. Such
authority could be similar to that already
available to the Federal Reserve over bank holding
companies.

Expanding SEC's and CFTC's regulatory authority
over unregistered affiliates of broker-dealers and
FCMs to include the ability to examine, set
capital standards, and take enforcement actions,
raises controversial issues and operational
considerations that would have to be recognized
and addressed. For example, some believe that
expanding SEC's and CFTC's authority would
undermine market discipline. However, we believe
that expanded authorities would not lessen the
role of effective market discipline and that
imprudent behavior could result in a firm's
failure with creditors and investors suffering
losses. It also would require that SEC and CFTC
evaluate their operational and resource capacities
to accommodate any expanded authority. However,
the number of firms that are likely to be of
concern is limited and thus should not involve a
significant resource commitment. In order to
identify and prevent potential future crises, we
are suggesting that Congress consider providing
SEC and CFTC authority to regulate affiliates of
broker-dealers and FCMs.

Background
Following the announcement of the Russian debt
moratorium in mid-August 1998, investors began to
seek superior credit quality and higher liquidity;
and credit spreads widened in markets around the
world, creating major losses for LTCM and other
market participants. The Bank for International
Settlements (BIS)6 described the events of last
summer as follows:

"In mid-August 1998 . financial markets around the
globe experienced extraordinary strains, raising
apprehensions among market participants and policy
makers of an imminent implosion of the financial
system. As investors appeared to shy away from
practically all types of risk, liquidity dried up
in financial markets in both industrial and
emerging economies, and many borrowers were unable
to raise financing even at punitive rates. Prices
for all asset classes except the major industrial
country government bonds declined and issuance of
new securities ground to a halt."

It was in this financial environment that Federal
Reserve officials deemed the rapid liquidation of
LTCM's worldwide trading positions and those of
others in the market a potential systemic threat
to markets worldwide. As a result, the Federal
Reserve facilitated the private sector
recapitalization of LTCM by its largest creditors
and counterparties (the Consortium).7

Oversight of hedge fund leverage and risk-taking
is left to creditors and counterparties, which
includes banks and securities and futures firms.
These firms are expected to perform risk analysis
and price according to risk, i.e., charge higher
interest rates for more risky activities. These
activities are part of market discipline.
Regulators play a secondary role in that they are
supposed to conduct oversight activities to help
ensure that regulated banks and securities and
futures firms follow prudent practices, including
their business dealings with hedge funds.

Long-Term Capital Management
LTCM was considered unique among hedge funds
because of the large scale of its activities and
size of its positions in certain markets. BIS
considered LTCM to be a "market-maker" in some
markets. According to some in the industry, LTCM's
counterparties often treated it more like an
investment bank than a hedge fund. Hedge fund
researchers estimate that 70 percent of hedge
funds use leverage, most with a leverage ratio of
less than 2 to 1. However, leverage was an
important part of LTCM's investment strategy.
LTCM's leverage was achieved in various ways,
including derivatives transactions,8 repurchase
agreements,9 short sales,10 and direct financing
(loans). LTCM was also able to increase its
leverage by negotiating favorable credit terms for
these transactions. For example, LTCM was able to
negotiate credit enhancements, including zero
initial margin,11 two-way collateral requirements,12
and rehypothecation rights.13 Although leverage was
key to LTCM's high returns, it also magnified
LTCM's losses. For additional detail about the
events surrounding LTCM's near-collapse, see
appendix I.

Although LTCM relied on leverage as an integral
part of its investment strategy, as shown in table
1, high leverage is not unique to LTCM. A simple
leverage ratio is only one indicator of riskiness.
Although several large securities and futures
firms had leverage ratios comparable to LTCM's,
according to SEC, the assets carried by the
securities firms were less volatile. In addition,
the President's Working Group report14 noted that
these firms may be in a better position to ride
out market volatility because they tend to have
more diversified revenue and funding sources than
hedge funds. These benefits, however, tend to be
offset by securities and futures firms' more
constricted costs structures, higher fixed
operating expenses, and illiquid assets.

Table 1:  Comparison of LTCM's Leverage to Major
Securities and Futures Firms
Institution                       Leverage Ratioa
LTCM                                      28-to-1
Goldman Sachs Group,                      34-to-1
L.P.
Lehman Brothers                           28-to-1
Holdings, Inc.
Merrill Lynch & Co.,                      30-to-1
Inc.
Morgan Stanley Dean                       22-to-1
Witter & Co.
aSimple balance sheet leverage calculation (ratio
of assets to equity capital).
Source: GAO analysis of the President's Working
Group hedge fund report and the firms' 1998 annual
report data.

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
over-the-counter (OTC) derivatives. According to
regulators, some of its positions were considered
"very significant" relative to trading in specific
securities in those markets. As of August 31,
1998, LTCM held about $1.4 trillion notional value
of derivatives contracts off-balance-sheet, of
which more than $500 billion were contracts on
futures exchanges and at least $750 billion were
OTC derivatives. Although the notional, or
principal, amount of derivatives contracts is one
way that derivatives activity is measured, it is
not necessarily a meaningful measure of actual
risk involved. The actual amount at risk for many
derivatives varies by both the type of product and
the type of risk being measured. A few of the
futures positions, both on U.S. and foreign
exchanges, were quite large (over 10 percent)
relative to activity in those markets. According
to LTCM officials, LTCM was counterparty to over
20,000 transactions and conducted business with
over 75 counterparties. BIS reported that LTCM was
"perhaps the world's single most active user of
interest rate swaps."15

Financial Regulatory Structure
Hedge funds are generally not subject to direct
federal regulation, instead they are indirectly
"regulated" by the banks and securities and
futures firms that are their creditors and
counterparties. The regulators' role is to ensure
that those banks and securities and futures firms
are practicing prudent risk management, including
the risks they take in dealing with hedge funds. A
primary mission of bank regulators is to promote
the safety and soundness of the banking system,
and this is achieved primarily through ensuring
the safety and soundness of individual
institutions. Three federal bank regulators
oversee banks, some of which are also subject to
state regulatory oversight.16 Bank regulators have
the authority to establish capital requirements,
establish information-reporting requirements,
conduct periodic examinations, and take
enforcement actions. The Federal Reserve, the
lender of last resort for banks and other
financial institutions, also has an additional
objective of ensuring the overall stability of the
U.S. financial system.

SEC's and CFTC's primary purposes are to protect
investors or customers in the public securities
and futures markets and to maintain fair and
orderly markets. Unlike the bank regulators, which
can regulate all bank activities, SEC and CFTC are
authorized to regulate only activities involving
securities and futures and only those entities
that trade these products. SEC regulates
activities involving securities and the firms that
trade these products. Such firms include broker-
dealers, which must register with SEC and comply
with its requirements, including capital
requirements. Broker-dealers must also comply with
the requirements of various self-regulatory
organizations (SROs) of which they are members,
such as the New York Stock Exchange (NYSE) and
National Association of Securities Dealers (NASD).17
CFTC regulates activities involving FCMs, which
must also comply with rules imposed by futures
SROs-the various futures exchanges, such as the
Chicago Board of Trade and Chicago Mercantile
Exchange, and an industry association, the
National Futures Association (NFA). SEC and CFTC
have the authority to establish capital standards
and information reporting requirements, conduct
examinations, and take enforcement actions against
registered broker-dealers and FCMs, but generally
not their unregulated affiliates.

The U.S. financial regulatory system has evolved
over time, in part, in response to financial
crises. For example, SEC and the Federal Deposit
Insurance Corporation (FDIC) were created during
the depression to fill perceived gaps in the
regulatory structure. In the 1980s and 1990s,
crises and disruptions to markets have revealed
additional regulatory gaps. Many of these gaps
have been filled by extensions of authority rather
than by the creation of new agencies. For example
in 1990 and 1992, in response to the Drexel
bankruptcy, Congress provided SEC and CFTC,
respectively, with authority to obtain information
from certain broker-dealer and FCM affiliates.
However, SEC and CFTC still lack consolidated
regulatory authority over securities and futures
firms.

Scope and Methodology
As agreed, our objectives were to discuss (1) how
LTCM became large and leveraged enough to pose a
potential systemic threat, (2) what federal
regulators knew about LTCM and when they found out
about its problems, (3) what the extent of
coordination among regulators was, and (4) whether
regulatory authority limits regulators' ability to
identify and mitigate potential systemic risk. To
fulfill our objectives, we reviewed the events
surrounding LTCM's near-collapse, including
reviews of information collected by CFTC, the
Federal Reserve, and SEC and relevant documents
obtained from various other financial regulators.
We reviewed "Hedge Funds, Leverage, and the
Lessons of Long-Term Capital Management" issued on
April 28, 1999, by the President's Working Group
on Financial Markets (President's Working Group).18
We also reviewed "Improving Counterparty Risk
Management Practices" issued on June 21, 1999, by
the Counterparty Risk Management Policy Group
(Policy Group).19 In addition, we reviewed the
following reports and regulatory guidance:

ï¿½    "Sound Practices for Banks' Interactions with
Highly Leveraged Institutions," Jan. 1999, Basle
Committee on Banking Supervision;20
ï¿½    "Banks' Interaction with Highly Leveraged
Institutions," Jan. 1999, Basle Committee on
Banking Supervision;
ï¿½    "Supervisory Guidance Regarding Counterparty
Credit Risk Management" (SR-99-3)(SUP), Feb. 1,
1999;
ï¿½    OCC Bulletin 99-2, Jan. 25, 1999; and
ï¿½    "Broker-Dealer Risk Management Practices
Joint Statement," July 29, 1999, SEC, NYSE, and
NASD Regulation, Inc. (NASDR).

 Finally, we reviewed various other articles,
studies, surveys, reports, papers, and guidance.

We interviewed officials from the Federal Reserve
Board, the Federal Reserve Bank of New York, SEC,
CFTC, the Department of the Treasury (Treasury),
Office of the Comptroller of the Currency (OCC),
FDIC, and the Department of Justice. However, we
focused on the activities of the members of the
President's Working Group, which includes the
heads of Treasury, the Federal Reserve Board, SEC,
and CFTC. We also interviewed various industry
officials. In addition, we collected information
from the 14 consortium members and met with LTCM
officials. Finally, we drew upon our relevant
prior work.21

We requested comments on a draft of this report
from the heads of CFTC, the Federal Reserve, SEC,
and Treasury. They provided written comments,
which are discussed near the end of this letter
and reprinted in appendixes II through V. We did
our work in Washington, D.C.; New York, NY; and
Greenwich, CT between October 1998 and August 1999
in accordance with generally accepted government
auditing standards.

Lapses in Market Discipline Enabled LTCM to Have
Large, Leveraged Trading Positions, Creating
Potential Systemic Risk
The LTCM crisis demonstrated that lapses in market
discipline can create potential systemic risk.
Although the creditors and counterparties that
supplied leverage to LTCM had policies requiring
that they conduct due diligence of LTCM's
activities, they were not fully aware of the size
of LTCM's trading positions and the risk these
might pose to financial markets until days before
its imminent collapse. The LTCM crisis has renewed
concerns among regulators about systemic risk and
illustrates the risks that can exist in large
trading positions. Since LTCM's near-collapse, at
the request of SEC's chairman, a group of
creditors and counterparties has developed a
framework to strengthen their risk management
practices and enhance market discipline.

Market Discipline Did Not Constrain LTCM's
Leverage and Risk-taking
In our market-based economy, market discipline is
the primary mechanism to control risk-taking. For
market discipline to be effective, it is essential
for creditors and counterparties to increase the
costs or decrease the availability of credit to
customers as the latter assume greater risks. The
President's Working Group's hedge fund report
stated that increasing the cost or reducing the
availability of credit "provides a powerful
economic incentive for firms to constrain their
risk-taking." It added, however, that "[market
participants'] motivation is to protect themselves
but not the system as a whole . No firm . has an
incentive to limit its risk-taking in order to
reduce the danger of contagion for other firms."

Although market discipline can be effective in
constraining leverage and risk-taking, the
regulators found that some of LTCM's creditors and
counterparties failed to apply appropriate
prudential standards in their dealings with that
firm. According to the President's Working Group
report, such standards include (1) due diligence
assessments of the financial soundness and
managerial ability of the counterparty, including
its risk profile; (2) requirements for ongoing
financial reports, supplemented by information on
the prospective volatility of the counterparty's
positions and qualitative evaluations; (3)
collateral requirements against present and
potential future credit exposures, when
insufficient information is available on the
counterparty's creditworthiness; (4) credit limits
on counterparty exposures; and (5) ongoing
monitoring of the counterparty's financial
condition. Although some firms were willing to
compromise their standards to do business with
LTCM, others refused to do so. According to LTCM
officials, these firms believed that LTCM would
not provide sufficient information about its
investment strategies.

Regulators cited a number of reasons why some
financial firms did not apply adequate market
discipline in their dealings with LTCM, including
the following:

ï¿½    LTCM benefited from a "halo" effect; that is,
creditors and counterparties appeared to base
their credit decisions for LTCM on the credentials
of its principals-among whom were a former vice
chairman of the Federal Reserve Board and two
Nobel laureates-rather than on traditional credit
analysis.

ï¿½    Business with LTCM and other hedge funds was
profitable for financial firms, and competition
for this business among major banks and securities
firms provided an additional incentive to relax
credit standards.

ï¿½    Favorable economic conditions had prevailed
for several years, contributing to an atmosphere
in which financial firms liberalized their credit
standards.

In addition, regulators found that some of the
analytical tools used by banks and securities and
futures firms to assess LTCM's riskiness appeared
to have been flawed. The firms apparently shared
LTCM's view that its risks were widely diversified
because its positions were spread across markets
around the globe. However, LTCM's worldwide losses
in August and September showed that although its
risks were spread across global markets, LTCM had
replicated similar strategies in each market. As a
result, when its strategies failed, they failed
across markets. According to the President's
Working Group report, the firms' risk models
underestimated the size of shocks and the
resulting price movements that might affect world
markets. Related to this, they did not fully
consider the potential impact on markets of a
liquidation of LTCM's positions.

The LTCM Crisis Illustrated that Potential
Systemic Risk Can Exist in Large Trading Positions
The Federal Reserve's decision to facilitate the
private sector recapitalization of LTCM was based
on its concern that LTCM's failure might pose
systemic risk. Although a systemic crisis can
result from the spread of difficulties from one
firm to others, in this case the potential threat
was to the functioning of financial markets.
According to Federal Reserve officials, they were
concerned that rapid liquidation of LTCM's very
large trading positions and of its counterparties'
related positions in the unsettled market
conditions of September 1998 might have caused
credit and interest rate markets to experience
extreme price moves and even temporarily cease
functioning. This could have potentially harmed
uninvolved firms and adversely affected the cost
and availability of credit in the U.S. economy.

LTCM's creditors and counterparties would have
faced sizeable losses if LTCM had failed.
Estimates are that individual firms might have
lost from $300 million to $500 million each and
that aggregate losses for LTCM's top 17
counterparties might have been from $3 billion to
$5 billion. However, according to financial
regulators, these losses were not large enough to
threaten the solvency of LTCM's major creditors.
Among the eight U.S. firms that participated in
the recapitalization, equity capital at the end of
fiscal 1998 ranged from $4.7 billion to $42.7
billion. The Basle Committee on Banking
Supervision noted that these losses could have
increased further if the repercussions had spread
to markets more generally.

According to Federal Reserve officials, LTCM's
failure, had it occurred in the unsettled market
conditions of September 1998, might have disrupted
market functioning because of the size and
concentration of LTCM's positions in certain
markets and the related sales of other market
participants. As noted previously, the firm had
sizeable trading positions in various securities,
exchange-traded futures, and OTC derivatives
markets. Moreover, LTCM's counterparties might
have faced the prospect of "unwinding" their own
large LTCM-related positions in the event of that
firm's default. Unwinding these positions could
have been difficult: according to LTCM officials,
about 20,000 transactions were outstanding between
LTCM and its counterparties at the time of its
near-collapse.

According to Federal Reserve officials, a default
by LTCM on its contracts might have set off a
variety of reactions. For example, most of LTCM's
creditors and counterparties held collateral
against their current credit exposures to LTCM. In
the event of LTCM's default, however, the
exposures might have risen in value by the time
the collateral was sold, resulting in considerable
losses. Also, derivatives counterparties, faced
with sudden termination of all their contracts
with LTCM, would have had to rebalance their
firms' overall risk positions; that is, they would
have had to either purchase replacement
derivatives contracts or liquidate their related
positions. In addition, firms that had lent
securities to LTCM might have had to sell the
collateral held and buy replacement securities in
the marketplace at prevailing prices. In
considering the prospect of these developments,
Federal Reserve officials said that a "fire sale"
of financial instruments by LTCM's creditors and
counterparties might have set off a cycle of price
declines, losses, and further liquidation of
positions, with the effects spreading to a wider
group of uninvolved investors.

After the Crisis, Major Financial Firms Proposed
Improved Risk Standards
In January 1999, a group of 12 major,
internationally active commercial and investment
banks formed the Policy Group to promote enhanced
management of counterparty risk by financial
firms. In July 1999, the Policy Group issued a
report that reviewed key risk management issues,
evaluated emerging improvements, and made
recommendations.22 In addition to recommendations
to improve risk management practices, the report
recommended ways to improve financial
institutions' assessments of their own leverage
and that of their counterparties. It also
recommended that risk evaluation frameworks
incorporate linkages among various types of risk,
such as between credit and market risks, and that
stress-testing include a focus on potential
illiquidity in markets. The report further
recommended enhanced information-sharing with
regulators on counterparty relationships but
stated that this should be strictly voluntary,
informal, and confidential. (We discuss this in
greater detail later in the report.)

The industry reportedly already had begun to
respond to the risks posed by LTCM. According to
surveys done by Arthur Andersen LLP,23 the LTCM
crisis prompted strong reactions from virtually
all large firms that were counterparties of hedge
funds and an increased sense of awareness
regarding risk management policies and procedures.
Andersen noted that all surveyed firms reported a
lower level of hedge fund exposures in mid-1999
compared to before the crisis, notwithstanding a
slow increase toward the end of the period.
Andersen reported that industry reactions have
included the following:

ï¿½    The number of banks and securities and
futures firms doing business with hedge funds has
decreased, and the business is substantially more
concentrated among the largest, globally active
firms.
ï¿½    These firms have focused on their risk
management activities, including obtaining more
complete information through required data reports
and on-site visits; tightening credit terms and
increasing margin requirements; and improving risk
models and recognizing the risks of unanticipated
market events.
ï¿½    The hedge funds have become more forthcoming
with meaningful data and information ensuring
greater transparency to their activities.

Although these reactions appear to have improved
market discipline, as the President's Working
Group noted, market history indicates that even
painful lessons recede from memory with time.
Regulators, through their oversight activities,
can play a role in helping to ensure the
maintenance of sound risk management practices.

Regulatory Oversight Did Not Identify Lapses in
Risk Management Practices and the Threat Posed by
LTCM
Regulators had expressed general concern about the
potential risks posed by hedge funds and the
perils of declining credit standards, but they
said they generally believed that hedge funds'
creditors and counterparties were appropriately
constraining the funds' leverage and risk-taking.
Examinations, which are one way regulators oversee
the activities of their regulated entities and
markets, done after the crisis revealed that banks
and securities and futures firms had not
consistently followed prudent standards. In
addition, information collected through off-site
monitoring from regulated entities and, in some
cases, from LTCM also did not fully identify the
potential threat that LTCM posed to financial
markets. Since the LTCM crisis, many of the
regulators have issued additional regulatory
guidance and have recommended additional
regulatory steps that could help them better
identify lapses in risk management practices like
those involving LTCM. Some market participants
have also recommended ways to enhance the
information voluntarily reported to regulators in
addition to enhancing their own practices.

Federal Regulators Had Expressed General Concerns
About Hedge Funds for Years
Since the early 1990s, regulators have been aware
that the activities of hedge funds could
significantly affect financial markets. In 1992,
SEC observed that "Hedge funds have the potential
to both increase and decrease liquidity in the
markets in which they invest." Also in 1992,
Treasury, the Federal Reserve, and SEC issued a
joint report on government securities that stated
that "their capacity for leverage allows hedge
funds to take large trading positions
disproportionate to their capital base."24 In 1994,
one of the members of the Federal Reserve Board
testified before the Committee on Banking, Finance
and Urban Affairs that ". hedge funds, because
they are large and are willing to take large
positions, can have important effects on financial
markets." Between 1992 and early 1998, regulators
observed that fund managers and their creditors
and counterparties appeared to have adequate
controls in place.

In late 1997 and early 1998, the Federal Reserve
updated its previous work on hedge fund activities
by surveying several large banks about their
relationships with hedge funds. The Federal
Reserve survey results revealed that LTCM was one
of the large hedge funds mentioned but did not
identify any specific concerns about bank
relationships with LTCM. In addition, the survey
results indicated that banks had adequate
procedures in place to manage their relationships
with hedge funds and indicated no concern about
exposures to the funds because of the quality of
collateral held (cash and U.S. Treasuries). Bank
examiners did not independently verify actual
credit practices at the time of the survey but
were instructed to focus special attention on bank
relationships with hedge funds given their
"special" risk profile.

As is common during periods of economic expansion,
bank regulators had been urging bankers to
maintain prudent lending standards and alerting
them to underwriting practices that could become
unsound. In June 1998, the Federal Reserve and OCC
also warned banks not to succumb to competitive
pressures and compromise standards. However,
before LTCM's near-collapse, regulators generally
appeared to be unaware of the extent to which
credit standards had declined in relation to
certain hedge funds. Just days before federal
officials visited LTCM in Greenwich, CT, to
discuss its problems, the Chairman of the Federal
Reserve Board testified before the House Committee
on Banking and Financial Services that "hedge
funds were strongly regulated by those who lend
the money." At the same hearing, the Secretary of
the Treasury basically agreed with the Chairman
that hedge funds are "in effect, regulated by the
creditors." However, he raised questions about
whether additional things could be done to
maintain discipline among creditors.

Regulators Did Not Identify Weaknesses in Firms'
Risk Management Practices Until After the Crisis
Federal bank, securities, and futures regulators
did not identify the lapses in risk management
practices and the threat posed by LTCM, primarily
because they limited their focus to problems
involving the largest credit exposures of the
firms they regulated. However, LTCM was not among
the largest exposures of any of these firms. After
the crisis, when they looked again at the
regulated firms, the regulators found substantial
lapses in credit risk management practices of
banks' and broker-dealers' relationships with
hedge funds.

Federal financial regulators do on-site
examinations to obtain first-hand knowledge about
the operations of the firms that they regulate.
Bank regulators focus their examinations on
internal control systems and risk management and
look for problems in areas that could
significantly affect the safety and soundness of
the bank, such as major credit exposures. Bank
regulatory officials said that because its
positions were generally collateralized, examiners
did not identify LTCM as a major risk to any bank
and did not investigate the full range of the
banks' transactions with LTCM until after the
crisis. Securities examinations, which focused
primarily on investor protection and financial
responsibility, internal controls, and risk
management of individual broker-dealers, did not
identify the extent of activity with LTCM, much of
which was done in affiliates outside the regulated
entities.

After the crisis, when federal financial
regulators focused their examinations on banks'
and broker-dealers' relationships with LTCM, they
discovered a number of risk management weaknesses.
The weaknesses were also reported to be evident in
the firms' dealings with other highly leveraged
customers, including commercial and investment
banks. For example, Federal Reserve officials
found that banks failed to perform adequate due
diligence, relying primarily on collateralization
of their current exposures. When hedge funds
failed to provide sufficient details about their
positions and investment strategies, banks
generally failed to apply controls to mitigate
their risks. According to regulatory officials,
LTCM's creditors were largely unaware of the size
and scope of its trading positions until its near-
collapse. Federal Reserve officials also reported
that the banks had inadequate credit stress-
testing procedures and weaknesses in ongoing
exposure monitoring.

SEC officials found similar problems at broker-
dealers. For example, SEC found that credit
decisions were often not consistent with
established policies, and hedge funds provided
limited or no information on aggregate security
portfolios, leverage, risk concentrations,
performance, or trading strategies. SEC officials
also found that hedge funds were not always
subject to greater disclosure requirements
commensurate with their greater risks. In
addition, broker-dealers, like commercial banks,
failed to factor concentration and liquidity risks
into assumptions about the riskiness of certain
activities, and stress-testing was not thoroughly
performed at all firms. CFTC investigated the
dealings between LTCM and two of its FCMs, which
had numerous and extensive relationships with
LTCM, to determine if there were any violations of
the Commodity Exchange Act or the rules thereunder
but found no such violations.

Offsite Monitoring Did Not Reveal the Potential
Systemic Threat Posed by LTCM
In addition to on-site examinations, regulators
perform off-site monitoring through periodic
information received from regulated entities and
other market participants, such as LTCM. However,
periodic information provided to the regulators
did not reveal the potential systemic threat posed
by LTCM. For example, although bank regulators
require each individual bank and bank holding
company to file detailed quarterly statements of
financial condition and income and operations,
this information does not identify any individual
creditors and counterparties and would not be
expected to have identified potential problems
related to LTCM.

SEC and CFTC require periodic reports from
registered broker-dealers and FCMs and receive
voluntary information from the unregulated
derivatives affiliates of these firms. For
example, they require broker-dealers and FCMs to
report quarterly statements of financial
condition, including supplemental information.
However this information, like the information
provided to bank regulators, does not identify
individual exposures. SEC and CFTC, under their
risk assessment authorities, also require broker-
dealers and FCMs to provide certain information
about significant affiliates.25 However, the
affiliates' net exposures to LTCM were not large
enough to be classified as material and were not
reported. In addition, members of the Derivatives
Policy Group (DPG) voluntarily provide information
to SEC and CFTC about the OTC derivatives
activities of their unregulated OTC derivatives
affiliates.26 This information identifies the
affiliates' 20 largest individual counterparty
credit exposures (net of collateral) but does not
routinely identify the counterparties by name.
According to SEC officials, LTCM did not show up
as a significant exposure because its positions
with these affiliates were collateralized.

CFTC also received certain information directly
from LTCM because of the nature of its activities.
For example, LTCM provided CFTC its annual
financial statements and other information because
it was a registered commodity pool operator (CPO).27
LTCM's year-end 1997 statement showed its large
asset positions, leverage of about 28 to 1, and
off-balance sheet derivatives positions exceeding
$1 trillion in notional amount. According to
CFTC's testimony in 1998, CFTC staff reviewed
LTCM's financial statements, along with more than
1,000 such statements received annually, and found
no compliance problems.28 Further, LTCM was
considered well capitalized and profitable, and
its balance sheet leverage ratio was comparable to
other leveraged hedge funds as well as investment
and commercial banks. CFTC officials explained
that CFTC does not have the authority to regulate
CPOs for prudential purposes, nor does it review
the appropriateness or nature of CPO investments.
Instead, they said that CFTC focuses on whether
CPOs engage in improper activity, such as market
manipulation or fraud. NFA completed a limited
compliance audit of LTCM's annual statement in
April 1998 but was not required to, nor did it,
analyze the report for the appropriateness of
LTCM's investment strategy and risk management.
LTCM also provided CFTC daily information
concerning some of its exchange-traded futures
positions because those positions made it a large
trader as defined by CFTC regulation.29 CFTC
officials said that the Large Trader System works
well for detecting price manipulation in the
exchange-traded futures markets but is not useful
for monitoring activities in broader financial
markets because the information is limited to
futures trading.

Finally, SEC requires institutional investment
managers to file a quarterly report of equity
holdings if they have equity securities under
management of $100 million or more. Pursuant to
Section 13(f) of the Exchange Act, LTCM filed an
itemized schedule of its equity holdings exceeding
the reporting threshold, including the name of the
issuer, fair market value, number of shares held,
and other information.30 SEC officials said that
the reports offered no indication of the potential
threat LTCM's other activities posed to global
financial markets because the information received
covered only LTCM's equity securities activities.

Regulators and Industry Adopted and Recommended
Improved Oversight and Practices
Following their post-crisis examinations, OCC and
the Federal Reserve both issued additional
examination guidance on supervising credit risk
management. SEC and its SROs also issued joint
guidance on risk management practices for broker-
dealers. Finally, the President's Working Group
and the Policy Group recommended enhanced
information reporting requirements.

In early 1999, OCC and the Federal Reserve each
issued supplements to their existing guidance to
bank examiners that were intended to improve the
focus on issues raised by the LTCM crisis and by
other world financial problems in 1997 and 1998.
Although the degree of detail in the supplements
varied, each had similar emphasis on both
improving the sophistication of banks' risk
management policies concerning counterparties and
ensuring that banks practiced and enforced these
policies. The regulators intended to prepare their
examiners to address not only hedge fund issues,
but also other challenges arising from banks'
evolving business. They responded to specific
flaws in banks' risk management involving LTCM.
For example, both agencies noted the unexpected
interactions that could occur among market,
credit, and liquidity risks in unsettled times and
emphasized the importance of stress-testing to
ensure that banks did not risk facing unacceptable
exposures to their counterparties during such
times. They also emphasized the importance of
banks' understanding the risk profiles of their
counterparties.

In July 1999, SEC and two securities SROs, NYSE
and NASDR, issued a joint statement that included
a compendium of sound practices and weaknesses
noted during their review of risk management
systems of registered broker-dealers. The
statement provided examples of weaknesses
identified, as well as examples of sound practices
observed during the review, and stressed the
importance of sound practices in today's dynamic
markets. Finally, the statement concluded by
stressing the importance of maintaining an
appropriate risk management system and noted that
examination staffs of SEC, NYSE, and NASDR were to
increase their emphasis on the review of risk
management controls during regulatory
examinations.

In its April 1999 report, the President's Working
Group identified several areas where information
reporting could be improved. It recommended that
Congress grant SEC and CFTC authority to collect
and verify additional information on broker-dealer
and FCM affiliates.31 The expanded reporting would
include information on credit risk by
counterparty; nonaggregated position information;
and more detailed data on concentrations (e.g.,
financial instruments, region, and industry
sector), trading strategies, and risk models. It
also recommended giving regulators the authority
necessary to review risk management procedures and
controls at the holding company level and to
examine the books and records of the unregulated
affiliates. (This issue is discussed in greater
detail later in this report.) The Chairman of the
Federal Reserve Board declined to endorse this
recommendation but deferred to the judgment of
those with supervisory responsibility. To enhance
market discipline, the President's Working Group
also recommended improvements to public reporting
and disclosure. First, it recommended that hedge
funds be required to disclose current information
to the public.32 Second, it recommended that all
public companies disclose a summary of direct
material exposures to significantly leveraged
financial institutions. These entities would be
aggregated by sector (for example, commercial
banks, investment banks, insurance companies, and
hedge funds). According to the President's Working
Group, requiring such public disclosure about
material exposures to significantly leveraged
financial entities could reinforce market
discipline.

Finally, the Policy Group report included
recommendations about enhancing the quality,
timeliness, and relevance of information flows
between the major market participants and their
regulators, with the provision that such flows be
informal, voluntary, and confidential. The report
noted that information flows should include
informal high-level meetings on a periodic basis
to discuss principal risks, market conditions, and
trends with potential for market disruptions or
systemic risks. In addition, it recommended that
financial intermediaries, such as banks and
securities and futures firms, voluntarily provide
reports to regulators, if requested, detailing
information on large exposures on a consolidated
basis. The proposed voluntary reporting would
include information on large exposures to
counterparties.

The format for the voluntary reports would be
similar to the voluntary DPG reporting, but with
important differences. First, the proposed report
would cover not just derivatives but many other
types of transactions with counterparties. Second,
the proposed report would list a greater number of
counterparties than is covered by the DPG report
and would include counterparty names. Third, the
report would call for the firms to explicitly
quantify how potential market illiquidity might
affect their risks. Thus, if these reports are
provided to regulators, and if they are used to
seek additional information on large or growing
counterparties, regulators' ability to identify
significant concentrations of risk could be
enhanced. Although much of the information
reporting could provide regulators with additional
information that might help them monitor and
identify systemic risk, the voluntary nature of
the reporting means that firms could withhold
information or refuse to cooperate if regulators
request additional information. In addition,
regulators would not be able to verify the
accuracy or completeness of the information
provided through examination or inspection.

Existing Coordination Could be Improved to Enhance
Regulators' Ability to Identify Risks Across
Industries and Markets
Federal financial regulators followed their
traditional approaches to oversight in the LTCM
case: bank regulators focused on risks to banks;
and securities and futures regulators focused on
risks to investors, regulated entities, and
markets. However, these approaches were not
effective because the risks posed by LTCM crossed
traditional regulatory and industry boundaries.
Regulators would have had a better opportunity to
identify these risks if their oversight activities
had been better coordinated. More broadly, cross-
industry risks have become more common as the
activities of major firms have blurred the
boundaries among industries, making effective
coordination among regulators more important.
Although the importance of coordination among the
federal financial regulators continues to grow,
the President's Working Group report on the LTCM
crisis did not include recommendations about ways
that the regulators might enhance their
coordination.

Bank regulators' traditional role has been to
protect the banking system from disruptions and to
help reduce the risk to taxpayers from the
government-backed guarantees on bank deposits
provided through the deposit insurance fund. In
fulfilling this role, their approach has been to
focus on maintaining the safety and soundness of
banks, including, in the case of the Federal
Reserve, examining risks posed by bank affiliates
in a bank holding company structure. Bank
regulators have various coordination mechanisms,
including the Federal Financial Institutions
Examination Council33 and the Shared National
Credit Program.34 Securities and futures
regulators' traditional role has been to protect
investors and the integrity of securities and
futures markets. Their approach to maintaining the
financial integrity of the regulated firms has
been to focus on the extent to which investor
funds and investments might be at risk in case of
firm failures. SEC and CFTC also have coordinated
their efforts through various groups, such as the
Intermarket Financial Surveillance Group.35 Other
broader coordinating groups exist that cut across
industries, including the President's Working
Group. However, these groups generally do not
provide the type of coordination that includes
routine staff-level interaction, including sharing
information and observations about specific firms
and markets that would be required to reveal
potential systemic risk like that posed by LTCM.

Traditional approaches to coordination, although
necessary for achieving their regulatory purposes,
did not help regulators identify the cross-
industry risks that LTCM posed. As discussed
previously, the Federal Reserve's December 1997
and January 1998 survey of large banks' relations
with hedge funds revealed that LTCM was a large
hedge fund. On the basis of what they were told,
officials concluded that bank procedures were
adequate to control the risks hedge funds posed.
In addition, as discussed previously, LTCM did not
surface as a problem during routine examinations
because bank examiners focused their attention on
each bank's exposure (net of collateral), which
appeared small in the case of LTCM (and hedge fund
exposures overall). In March 1998, CFTC received a
year-end 1997 financial report from LTCM. The
report showed both the leverage and large
derivatives positions that LTCM had accumulated
worldwide. CFTC found nothing in the report to
raise questions about LTCM's commodity pool
operations. On a daily basis LTCM provided CFTC
information concerning its reportable positions on
U.S. futures markets, but CFTC determined that
these positions did not threaten those markets. In
August 1998, SEC heard about troubles at LTCM
through market sources. It investigated the
exposures of large broker-dealers to LTCM and
other hedge funds, but the information submitted
indicated that any exposure to LTCM existed
outside the registered broker-dealer. Because none
of the regulators considered the information they
obtained important enough to share with the other
regulators, LTCM raises questions about how
regulators decide what information needs to be
shared.

Even if they had fully coordinated their
activities, the regulators still may not have
identified the cross-market and industry risks
that LTCM posed. In part, this could result
because of the information that regulators relied
on, such as exposures net of collateral, to
determine risk. Had they looked at gross exposures
and aggregated them across industry lines, they
may have been more likely to recognize the
linkages among markets. However, the potential
benefits of such coordination could increase as
better information becomes available. As discussed
previously, the President's Working Group and the
Policy Group each recommended that financial
intermediaries, including banks and securities and
futures firms, make additional information
available to their regulators. For example, the
Policy Group has recommended that banks and
securities and futures firms supply their primary
regulator with lists of the counterparties with
whom they have their largest aggregate credit risk
exposures. The reports would cover a broad range
of transactions, such as derivatives contracts,
repo agreements, and loan agreements. These
reports would also include information on
potential future exposures. To fully benefit from
this information, regulators might share these
lists with one another to identify those
counterparties that have large cross-industry
activity.

Officials from the Federal Reserve, SEC, and CFTC
told us that they share information they judge to
be important with other regulators on a case-by-
case basis and that this approach generally works
well. Moreover, the President's Working Group,
which includes the heads of these agencies and the
Secretary of the Treasury, did not make
recommendations for enhanced coordination, and the
Policy Group only acknowledged the possibility of
sharing information among regulators under tight
restrictions. However, because the traditional
lines that separate banks, securities, and futures
businesses have been blurred, and large financial
firms now compete with each other in offering the
same financial services, activities generating
risks that cross industries and markets may be
increasingly common.

Developing ways to routinely coordinate assessment
of cross-industry risks among regulators may take
time and require ingenuity. They might have to
develop criteria to determine when and what
information needs to be shared. Also, focusing on
data needed to develop measures of risk that may
have systemic implications under stressful
conditions may be a place to start. In addition,
regulators would have to consider how to address
issues related to sharing proprietary and
confidential information.36 Nonetheless, given the
potential for risks across industry and market
lines and the inability of existing coordination
methods to effectively monitor such risks, each
regulator should be held accountable for
identifying methods for coordinating their
activities to identify potential systemic risk
across industries.

Gap in SEC's and CFTC's Regulatory Authority
Limits Their Ability to Identify and Mitigate
Systemic Risk
SEC and CFTC lack the regulatory authority to
supervise unregistered affiliates of broker-
dealers and FCMs. The lack of authority over these
affiliates, which often act as financial
intermediaries, creates a regulatory gap that
impedes SEC's and CFTC's ability to identify and
mitigate problems that may threaten markets or the
entire financial system. The significance of the
gap has grown as the amount of activity conducted
outside of the broker-dealers and FCMs has
increased. The President's Working Group
recognized this gap and the need for SEC and CFTC
to have greater authority. However, it did not
recommend consolidated regulatory authority over
securities and futures firms, which would expand
SEC's and CFTC's regulatory authority over
unregulated affiliates-primarily the authority to
set capital standards, conduct comprehensive
examinations, and take enforcement actions.
Instead, it recommended greater authority to
collect and verify information. As we have stated
in past reports, we believe that the existing
regulatory gap should be closed, and previous
attempts to fill it with greater information
reporting have been inadequate. However, we
recognize that there are controversial issues to
be resolved before filling this gap.

SEC and CFTC Lack Authority to Regulate Affiliates
of Broker-Dealers and FCMs
SEC and CFTC generally lack authority to regulate
the unregistered affiliates of broker-dealers and
FCMs. This gap impedes their ability to identify
and mitigate problems at securities and futures
firms that could contribute to systemic risk and
threaten financial markets. For example, when
market participants notified SEC of LTCM's
problems in August 1998, SEC surveyed the
registered broker-dealers about their hedge fund
exposures, in general. However, information
submitted suggested that any exposure to LTCM
existed outside the registered broker-dealers,
either in the holding companies or in their
unregulated affiliates. Because of SEC's limited
authority, officials were unable to determine the
extent of hedge fund activity at unregulated
affiliates of broker-dealers. If SEC had the
authority to supervise the activities of the
broker-dealer and its affiliates firmwide, it
would have been able to obtain information about
the exposures of unregulated affiliates of broker-
dealers to LTCM. In addition, when SEC staff
examined major broker-dealers following LTCM's
near-collapse, they had limited access to certain
documents and information because credit risk
management is primarily a firmwide function
conducted at the holding company level and thus
outside of SEC's jurisdiction. According to SEC
officials, this information is often provided to
SEC on a voluntary basis.

Regulators have full regulatory authority over
securities and futures activities of broker-
dealers and FCMs, but the percentage of assets
held outside the regulated entities has grown
significantly. At four major securities and
futures firms, the percentage of assets held
outside the regulated broker-dealer grew from an
average of 22 percent in 1994 to 41 percent in
1998. The OTC derivatives activities of the major
securities and futures firms are usually conducted
through non-broker-dealer and FCM affiliates and
are therefore generally outside of the regulatory
authority of SEC and CFTC. As a result, SEC and
CFTC are not able to supervise all activities that
may pose potential threats to the financial
system. Table 2 shows that in 1998 the notional
value of total derivatives contracts at four major
securities and futures firms was larger than
LTCM's.37

Table 2:  Comparison of Total Notional Value of
Derivatives Contracts (dollars in billions)
Entity                      Total notional valuea
LTCM                                       $1,400
The Goldman Sachs Group,                    3,410
L.P.
Lehman Brothers                             2,398
Holdings, Inc.
Merrill Lynch & Co.,                        3,470
Inc.
Morgan Stanley Dean                         2,860
Witter & Co.
aTotal notional value includes OTC and exchange-
traded derivatives.
Source: GAO analysis of data from the President's
Working Group for LTCM as of August 31, 1998.
Annual reports for Goldman, Lehman as of November
30, 1998; Morgan Stanley as of November 30, 1998;
and Merrill Lynch as of December 25, 1998.

Regulators Recommended Limited Expansion of SEC
and CFTC Authority Over Activities of Affiliates
of Broker-Dealers and FCMs, but Regulatory Gap
Would Remain

The President's Working Group recommended that
Congress expand SEC and CFTC risk assessment
authority over unregistered affiliates of broker-
dealers and FCMs, but the regulatory gap would
remain. As part of that expanded authority, SEC
and CFTC would be authorized to (1) require broker-
dealers and FCMs and their unregulated affiliates
to report credit risk information for significant
counterparties; (2) require recordkeeping and
reporting of nonaggregated position information;
(3) obtain additional data on concentrations,
trading strategies, and risk models; and (4)
review risk management procedures and controls
conducted at the holding company level and examine
the records and controls of the holding company
and its material unregulated affiliates. According
to an official involved with the President's
Working Group report, examinations would be
limited to verification of the information
provided, rather than a comprehensive examination
of the entities' risk management and operations.
The President's Working Group also reported that
it would consider potential additional steps,
including consolidated supervision, if evidence
emerges that indirect regulation of currently
unregulated market participants is not working
effectively to constrain excessive leverage and
risk-taking in the market.38

     If adopted by Congress, providing for
enhanced information reporting and giving SEC and
CFTC the ability to verify it would be important
steps, but SEC and CFTC would still lack the
authority to perform comprehensive examinations,39
set capital standards, and take general
enforcement actions. These additional authorities
could help to ensure that SEC and CFTC are able to
supervise the activities of unregulated affiliates
of broker-dealers and FCMs that they believe could
pose a risk to financial markets. As discussed
earlier in the report, the U.S. regulatory
structure generally leaves the oversight of hedge
funds and highly leveraged institutions to their
creditors and counterparties. Regulators are to
play a secondary role in overseeing the activities
of banks and securities and futures firms, yet SEC
and CFTC lack the authority to regulate affiliates
of broker-dealers and FCMs. The extent to which
SEC and CFTC would choose to exercise this
authority could vary on the basis of some
articulated criteria, such as asset size,
complexity, and riskiness of the unregulated
affiliates' activities. The examinations performed
after the LTCM crisis illustrate the importance of
examinations as part of the supervisory process,
not only to verify the accuracy and completeness
of information, but also to determine whether
firms are following prudent risk management
practices and to review their overall operations.
Because of the existing gap, SEC was not able to
fully assess the operations of all of the broker-
dealers; at some firms certain management
functions were conducted outside of the regulated
broker-dealer and thus beyond SEC's regulatory
purview. Although the President's Working Group
recommendation, if adopted by Congress, would
authorize SEC to receive this information, it
would not ensure that SEC would be granted access
to information not specifically referred to in
statute.

     The authority to set capital standards, among
other benefits, would provide a mechanism to
better relate leverage to risk in the affiliates
of securities and futures firms, which may employ
as much leverage as LTCM did.40 LTCM has renewed
regulatory concerns about leverage and how to
measure and manage it. Finally, enforcement
authority would provide SEC and CFTC with recourse
to take action against the affiliates of broker-
dealers and FCMs if they failed to adhere to
regulations.

     Since 1990, Congress has tried to address
this gap through enhanced information reporting.
In 1990 and 1992, Congress granted SEC and CFTC,
respectively, the authority to establish rules to
obtain certain information from affiliates of
broker-dealers and FCMs to provide insights into
the operations of unregulated affiliates in lieu
of direct regulatory authority. Limitations of
these risk assessment rules surfaced in the mid-
1990s. To supplement the information received
under the risk assessment rules, in 1994 the
industry formed DPG, whose members voluntarily
provide SEC and CFTC with information on the
activities of their unregulated OTC derivatives
dealer affiliates. For example, DPG firms are to
provide SEC and CFTC a list of their 20 largest
individual credit exposures (net of collateral)
quarterly. However, LTCM's OTC derivatives
exposures (net of collateral) to DPG participants
did not make it large enough to be included in
these reports despite its potential systemic
threat to financial markets worldwide. The Policy
Group also recommended additional voluntary
reporting that could supplement the DPG
information. However, it appears that additional
information would not fill the regulatory gap that
exists for affiliates of broker-dealers and FCMs.
Since 1992, we have also recommended that Congress
and regulators address the gap in regulatory
authority that exists for affiliates of broker-
dealers because of the growing importance of these
activities to the regulated entities and the
financial system.41

Expanding SEC and CFTC Authority Over Affiliates
Would Raise Controversial Issues
Although expanding SEC and CFTC authority to
include the ability to examine, set capital
standards, and take enforcement actions, as they
deem necessary, would close the existing gap,
several controversial issues must be considered.
First, extending regulation to previously
unregulated activities could increase certain
costs of doing business, which, in turn, could
partially offset these firms' competitive edge
compared to other providers of financial services.
However, many of the affiliates' U.S. bank and
foreign competitors are already subject to
regulatory oversight, so that some oversight of
these currently unregulated affiliates may help
restore a more level playing field along with
reinforcing practices consistent with market
discipline. In any case, the amount of regulatory
interference can be kept to a minimum by focusing
attention on risk management activities already in
place. In past work, we found that many
sophisticated financial firms were managing risks
comprehensively at the holding company level.42
Bank regulators are attempting to use the existing
risk management systems, including systems of
internal control and internal audit, as a focal
point for their oversight of banks and bank
holding companies. A similar approach could be
used by SEC and CFTC to better understand the risk
management systems of holding companies in which
broker-dealers or FCMs are the primary financial
component. By using the existing framework of
internal controls, including the internal audit
function, after testing its reliability,
regulators can minimize the burden imposed on
those firms whose risk management systems are up
to industry standards.

Second, designing appropriate risk-based capital
standards for all affiliates is a controversial
issue. Traditional SEC and CFTC capital standards
for broker-dealers and FCMs are related to risk
but are not truly risk-based. For example,
payments due a broker-dealer or FCM on certain OTC
derivatives, such as interest rate swaps, are
deducted from the firm's net worth, which is the
equivalent of a 100-percent capital requirement.
This is one reason that such activities are
effected outside of the regulated entity. To
encourage OTC derivatives-dealing affiliates to
move under a regulatory umbrella, SEC has
developed a new voluntary regulatory structure for
OTC derivatives dealers that provides capital
standards for derivatives activities that are more
risk-based.43 SEC has announced further initiatives
to make capital standards of broker-dealers more
risk-based.

Third, Federal Reserve officials expressed concern
that extension of regulatory authority, as
recommended by the President's Working Group,
might undermine market discipline-instead of
strengthening it as intended-by creating the
impression that the newly regulated firms would be
included in the government "safety net." However,
focusing regulatory attention on the risk of
securities and futures firms does not mean that
the government would keep those institutions from
failing. If a large broker-dealer or FCM affiliate
became insolvent and could be allowed to fail
without undue market disruption, it should be
allowed to fail. If it is too large to be allowed
to fail or liquidated quickly, it may need to be
eased into failure.

Finally, some operational issues would take
additional time and effort to resolve. For
example, SEC and CFTC would have to coordinate to
resolve overlapping authorities and functions
within securities and futures firms over broker-
dealers and FCMs with dual registrations.44
Additional information sharing and coordination
would be necessary to minimize the burden on these
firms of consolidated regulation. In addition, SEC
and CFTC would have to evaluate their operational
and resource capacities to accommodate any new
authority. In particular, SEC and CFTC may have to
hire new staff or train existing staff that is
currently analyzing risk assessment and DPG
information. Understanding the risk management
system of sophisticated financial firms requires
substantial expertise. However, the number of such
firms that are likely to be of concern should not
be large. Thus, the staff and resource commitment
should not be substantial.

Conclusions
The LTCM case illustrated that market discipline
can break down and showed that potential systemic
risk can be posed not only by a cascade of major
firm failures, but also by leveraged trading
positions. LTCM was able to establish leveraged
trading positions of a size that posed potential
systemic risk primarily because the banks and
securities and futures firms that were its
creditors and counterparties failed to enforce
their own risk management standards. Subsequent to
the LTCM crisis, major financial firms issued
recommendations for enhanced risk management by
firms. However, as LTCM illustrated, conditions
can arise in which self-imposed standards are
ignored.

Although market participants have the primary
responsibility to practice prudent risk management
standards, prudent standards do not guarantee
prudent practices. The LTCM crisis demonstrated
the importance of regulatory on-site examinations
and off-site monitoring in identifying and
prompting correction of weaknesses in practices.
Since the derivatives problems in the 1990s,
awareness of the importance of risk management
systems has continued to grow, and regulators have
made risk management an integral part of their
examination process. However, as shown by the
inability of regulators to identify the extent of
firms' activities with LTCM, the traditional focus
of oversight on credit exposures is not sufficient
to monitor the provision of leverage to trading
counterparties.

LTCM's crisis showed that the traditional focus of
federal financial regulators on individual
institutions and markets is not adequate to
identify potential systemic threats that cross
these institutions and markets. Developing ways to
enhance coordination of activities related to
identifying risks that cross traditional
boundaries could better position these regulators
to address potential systemic risk before it
reaches crisis proportions. Because coordinating
requires judgments about what information would
need to and could be shared and about how best to
share it, the regulators are in the best position
to determine the most effective ways to enhance
their coordination. Changes in markets that have
blurred the traditional lines of market
participants' activities will continue to create
risks that cross institutions and markets, thus
making the need for effective coordination even
more critical.

     Gaps in SEC's and CFTC's regulatory authority
impede their ability to observe and assess
activities in securities and futures firms'
affiliates that might give rise to systemic risk.
Although the Federal Reserve's consolidated
oversight of bank holding companies did not reveal
banks' risk management weaknesses related to LTCM,
recommended or already-implemented improvements in
examination focus and in information gathered may
give bank regulators a better opportunity to
identify future problems that might pose systemic
risk. Without similar authority over the
consolidated activities of securities and futures
firms, SEC and CFTC cannot contribute effectively
to regulatory oversight of potential systemic
risk, because a large and growing proportion of
those firms' risk taking is in their unregulated
affiliates. The affiliates may have large
positions in markets such as OTC derivatives and
can be major providers of leverage in the markets,
as they were in the LTCM case. How they manage
their own risks, as well as their provision of
leverage to counterparties, can affect the
financial system. The President's Working Group
has recommended granting new authority for SEC and
CFTC over the affiliates. However, the new
authority would not grant capital-setting or
enforcement authority and would not involve the
type of examination of their risk activities and
management that would allow a thorough assessment
of potential systemic risk. Further, expanding
SEC's and CFTC's authority over unregulated
affiliates would require resolving several
controversial issues and operational
considerations, including increased costs for
unregulated affiliates and potentially higher
staffing and resource commitments for SEC and
CFTC.

Recommendation
We recommend that the Secretary of the Treasury
and the Chairmen of the Federal Reserve, SEC, and
CFTC, in conjunction with other relevant financial
regulators, develop better ways to coordinate the
assessment of risks that cross traditional
regulatory and industry boundaries.

Matter for Congressional Consideration
In an effort to identify and prevent potential
future crises, Congress should consider providing
SEC and CFTC with the authority to regulate the
activities of securities and futures firms'
affiliates similar to that provided the Federal
Reserve with respect to bank holding companies. If
this authority is provided, it should generally
include the authority to examine, set capital
standards, and take enforcement actions. However,
SEC and CFTC should have the flexibility to vary
the extent of their regulation depending on the
size and potential threat posed by the securities
and futures firm.

Agency Comments and Our Evaluation
CFTC, the Federal Reserve, SEC, and Treasury
provided written comments on a draft of this
report, which are reprinted in appendixes II, III,
IV and V. The agencies raised no objections with
our findings in general but provided additional
insights from their unique perspectives, which we
summarize below and discuss fur