Financial Regulatory Coordination: The Role and Functioning of the
President's Working Group (Letter Report, 01/21/2000, GAO/GGD-00-46).

Pursuant to a congressional request, GAO provided information on the
role and functioning of the President's Working Group on Financial
Markets, focusing on: (1) whether the issues listed for consideration by
the Working Group in Executive Order 12631 have been considered; (2)
what additional issues have been considered by the Working Group and how
they were identified; and (3) the nature of coordination and cooperation
within the Working Group and the views of members of Congress and
Working Group participants about whether it needs to be formalized in
statute.

GAO noted that: (1) the Working Group and the relevant agencies have
considered the issues articulated in the executive order concerning the
1987 market crash; (2) the 29 issues were divided among four categories:
(a) investor confidence; (b) the credit system; (c) market mechanisms;
and (d) the financial regulatory structure; (3) all of the issues were
discussed in the Working Group's 1988 report on the market crash, or
subsequently were addressed by the Securities and Exchange Commission,
the Commodity Futures Trading Commission, or the exchanges they
regulate; (4) the Working Group and the agencies have revised a few of
its May 1988 recommendations, such as the 1998 revision of coordinated
trading halts and expansion of their work on bankruptcy reform; (5)
since 1994, the Working Group also has considered a variety of other
financial issues; (6) most of its activities have resulted from
self-initiated or congressionally requested work following some market
event or issue; (7) the Working Group has drafted legislation aimed at
reforming provisions of the Bankruptcy Code that apply to certain types
of financial instruments; (8) the Working Group serves as an informal
mechanism for coordination and cooperation among its members and their
staffs; (9) according to the officials familiar with the Working Group,
the frequency of its meetings usually is driven by market events; (10)
the senior staffs of the agencies, who are responsible for carrying out
the work of the Working Group (the Steering Committee), generally meet
biweekly; (11) agency officials said that meetings of the Steering
Committee are informal and generally have focused on agency
perspectives, market events, agency actions, and financial legislation;
(12) various members of Congress have raised questions about the Working
Group's ability to coordinate and function effectively; (13) since 1994,
various proposals have been made to provide a statutory basis for the
Working Group; (14) although such proposals could enhance continuity,
they also raise resource and structural issues; and (15) agency
officials involved with the Working Group were generally averse to any
formalization of the group and said that it functions as an informal
coordinating body.

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

 REPORTNUM:  GGD-00-46
     TITLE:  Financial Regulatory Coordination: The Role and
	     Functioning of the President's Working Group
      DATE:  01/21/2000
   SUBJECT:  Financial institutions
	     Executive orders
	     Securities regulation
	     Commodities exchanges
	     Stock exchanges
	     Interagency relations

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United States General Accounting Office
GAO

Report to the Chairman, Subcommittee on Capital

Markets, Securities and GSEs, Committee on

Banking and Financial Services, House of

Representatives

January 2000

GAO/GGD-00-46

FINANCIAL REGULATORY COORDINATION
The Role and Functioning of the President's

Working Group

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Contents
Page 161GAO/GGD-00-46 Financial Regulatory Coordination
Letter                                                                      1
                                                                             
Appendix I                                                                 18
Overview of the Issues
the Working Group Was
Required to Consider
                                                                             
Appendix II                                                                20
Comments From the
Department of the
Treasury
                                                                             
Tables                     Table I.1. The Issues Articulated in            18
                           the Executive Order
                                                                             

Abbreviations

CFTC      Commodity Futures Trading Commission
FDIC      Federal Deposit Insurance Corporation
FRBNY     Federal Reserve Bank of New York
LTCM      Long-Term Capital Management
NYSE      New York Stock Exchange
OCC       Office of the Comptroller of the
Currency
OTC       over-the-counter
OTS       Office of Thrift Supervision
SEC       Securities and Exchange Commission
Y2K       Year 2000

B-282293

Page 2GAO/GGD-00-46 Financial Regulatory Coordinat
ion
     B-282293

     January 21, 2000

The Honorable Richard H. Baker
Chairman, Subcommittee on Capital Markets,
 Securities
 and GSEs
Committee on Banking and Financial Services
House of Representatives
 
 Dear Mr. Chairman:

As you requested, this report discusses the role
and functioning of the President's Working Group
on Financial Markets (Working Group). Following
the highly publicized losses experienced by a
large leveraged hedge fund1 in 1998 and the
potential implications for worldwide financial
markets, questions began to surface about the role
and functioning of the Working Group. This group
includes the Secretary of the Treasury (Treasury)
and the chairs of the Board of Governors of the
Federal Reserve System (Federal Reserve), the
Securities and Exchange Commission (SEC), and the
Commodity Futures Trading Commission (CFTC).
Although the Working Group was initially
established by Executive Order 12631,2 in response
to issues surrounding the 1987 stock market crash,
since 1994 it has served as a mechanism to
coordinate regulatory responses to various market
events that have arisen. Our objectives were to
determine (1) whether the issues listed for
consideration by the Working Group in the
executive order have been considered, (2) what
additional issues have been considered by the
Working Group and how they were identified, and
(3) the nature of coordination and cooperation
within the Working Group and the views of Members
of Congress and Working Group participants about
whether it needs to be formalized in statute.

Results in Brief
The Working Group and the relevant agencies have
considered the issues articulated in the executive
order concerning the 1987 market crash. The 29
issues were divided among four categories (1)
investor confidence, (2) the credit system, (3)
market mechanisms, and (4) the financial
regulatory structure.  All of the issues were
discussed in the Working Group's 1988 report3 on
the market crash, or subsequently were addressed
by SEC, CFTC, or the exchanges they regulate.
Since 1994, the Working Group, the agencies, and
the exchanges have continued to review some of the
issues raised by the 1987 market crash. The
Working Group and the agencies also have revised a
few of its May 1988 recommendations, such as the
1998 revision of coordinated trading halts, or
"circuit breakers,"4 and expansion of their work
on bankruptcy reform, which was raised in the
group's report on the 1987 market crash.

Since 1994, the Working Group also has considered
a variety of other financial issues. Most of its
activities have resulted from self-initiated or
congressionally requested work following some
market event or issue. For example, following the
1997 market disruption that triggered circuit
breakers,5 the Working Group began studying the
need for modifications to existing provisions.6
This study resulted in a letter to the New York
Stock Exchange (NYSE) that recommended a change in
the basis for circuit breakers from a point
decline in the Dow Jones Industrial Average (Dow)
to a percentage decline in the Dow.7 The Working
Group has also drafted legislation aimed at
reforming provisions of the Bankruptcy Code that
apply to certain types of financial instruments.
Members of Congress have also asked the Working
Group to examine issues involving hedge funds,
Year 2000 (Y2K) preparedness issues, and over-the-
counter (OTC) derivatives8 oversight. The Working
Group addressed these issues in April 1999,9
September 1999,10 and November 1999,11 respectively.

     Although the Working Group was established to
respond to issues raised by the 1987 market crash,
it currently serves as an informal mechanism for
coordination and cooperation among its members and
their staffs.12 Since 1994, the members of the
Working Group, or principals, have met several
times a year to discuss ongoing issues and current
market events. According to officials familiar
with the Working Group, the frequency of its
meetings usually is driven by market events. The
senior staffs of the agencies, who are responsible
for carrying out the work of the Working Group
(the Steering Committee), generally meet biweekly.
Agency officials said that meetings of the
Steering Committee are informal and generally have
focused on agency perspectives, market events,
agency actions, and financial legislation. The
agendas we reviewed provided examples of the
topics the Steering Committee was to discuss in
1998 and 1999. During this time, Committee agendas
focused on the group's ongoing reviews and studies
of circuit breakers, hedge funds, and OTC
derivatives.

     Various Members of Congress have raised
questions about the Working Group's ability to
coordinate and function effectively. For example,
following the near-collapse of Long-Term Capital
Management (LTCM), a large leveraged hedge fund;
questions were raised about the degree of
coordination and cooperation that existed within
the group before the crisis. Since 1994, various
proposals have been made to provide a statutory
basis for the Working Group. Although such
proposals could enhance continuity, they also
raise resource and structural issues. Agency
officials involved with the Working Group were
generally averse to any formalization of the group
and said that it functions well as an informal
coordinating body.

Background
The Working Group was established by an executive
order in 1988, in response to the 1987 market
crash. The executive order listed 29 issues that
the Working Group was required to consider during
the course of its review. (See app. I for a
complete list of the issues it was required to
consider.) Following the issuance of its report in
1988 and follow-up work in 1991, the Working Group
became largely inactive until 1994 when, at the
urging of Congress and others, it was reactivated
by the Secretary of the Treasury. Since that time,
its principals and a Steering Committee,
consisting of senior staff of the participating
agencies, have met regularly.

Creation of the
Working Group
On March 18, 1988, the President established the
Working Group to consider the major issues and
recommendations raised by the numerous studies on
the October 1987 market decline that had the
potential to improve the integrity, efficiency,
orderliness, and competitiveness of U.S. financial
markets.13 The group, which comprised the heads of
the primary federal financial regulatory agencies,
was required to provide a coordinating framework
for consideration, recommendation, action, and
resolution of the complex issues raised by the
market crash. The Secretary of the Treasury was
named as the group's chairman; and the other
members, or principals, are the chairs of the
Federal Reserve, SEC, CFTC, or their respective
designees. Members serve in the capacity as heads
of their respective agencies with no additional
compensation. Treasury has provided much of the
administrative support that is required for the
group's functioning. However, the Working Group
has no separate budget.

In addition to its official members, several other
financial regulators and groups, including the
Federal Reserve Bank of New York (FRBNY), the
Federal Deposit Insurance Corporation (FDIC), the
Office of the Comptroller of the Currency (OCC),
the Office of Thrift Supervision (OTS), the
National Economic Council, and the Council of
Economic Advisors, have participated regularly in
the activities of the Working Group and its
Steering Committee. At various times in the past,
staffs of other agencies, such as the Office of
Management and Budget, Department of Labor, and
the Department of Commerce, have participated in
discussions.

In May 1988, the Working Group submitted to the
President the Interim Report of the Working Group
on Financial Markets, which contained
recommendations to Congress, the federal financial
regulators, the securities and futures exchanges,
and the financial industry, on margin and credit
systems, clearance and settlement systems, and the
establishment of coordinated circuit breakers.
Following the issuance of this market crash report
and a 1991 review of how circuit breakers
performed in 1989 when the U.S. securities market
experienced volatility, the Working Group became
largely inactive. According to regulatory
officials, although the Working Group did not meet
regularly in the early 1990s, the principals and
agencies' staffs maintained some level of
communication during this period.

Activity Resumed in 1994
Following this period of relative inactivity in
the early 1990s, the Working Group was
reactivated, in part, at the request of the
Chairman and Ranking Minority Member of the Senate
Committee on Banking, Housing, and Urban Affairs.
In a letter dated September 23, 1993, they
requested the views of the Secretary of the
Treasury on the status of the Working Group; its
activities; and the adequacy of coordination among
and contingency planning by, the federal financial
regulatory agencies. Largely drawing from the
overall goals discussed in the 1988 executive
order, the letter asked whether revitalization of
the Working Group would be helpful in coordinating
the activities of the agencies amidst increasingly
integrated global financial markets.

In early 1994, the Treasury Secretary issued a
letter (1994 Bentsen letter) to the other
principals to confirm that the Working Group
should continue and to expand its activities. The
letter noted that potential problems in financial
markets may cross the current jurisdictional lines
among the federal financial regulators, and it
requested that the Working Group consider new
developments in financial markets beyond those
surrounding the 1987 market crash. The letter
suggested that the group serve as a means to
coordinate the policies and actions of these
regulators to respond to developments and
emergencies in the financial markets. Suggested
issues for consideration included risks in the OTC
derivatives markets and clearance and settlement
systems.

Scope and Methodology
To fulfill our objectives, we determined whether
the items the Working Group was required to
consider in the executive order were considered.
This effort included reviewing the Interim Report
of the Working Group on Financial Markets (May
1988) and annual Intermarket Coordination Reports
written by the constituent agencies for 1991
through 1995.14 We also examined various other
reports, articles, testimonies, and papers.
Finally, we met with SEC and CFTC officials to
discuss the efforts that were undertaken in
response to the issues articulated in the
executive order.

To determine what additional issues the Working
Group has considered, we interviewed officials
from Treasury, the Federal Reserve, SEC, and CFTC,
who, among others, constitute the Steering
Committee. We reviewed letters, reports, and other
relevant documents produced by the Working Group
since 1988. To determine the extent of
coordination and cooperation within the Working
Group and its Steering Committee, we met with
agency officials and reviewed the agencies'
Intermarket Coordination Reports, which discussed
their coordination activities. We also reviewed
1998 and 1999 Steering Committee meeting agendas
to determine the nature of the group's biweekly
meetings. Although regulators also coordinate
certain activities bilaterally and multilaterally,
we focused on the activities of the Working Group
(and Steering Committee). To gather information on
the views of Members of Congress about the Working
Group, we reviewed hearing transcripts and
legislative histories. We also interviewed CFTC,
Federal Reserve, SEC, and Treasury officials
involved with the Working Group to obtain their
views. Finally, we drew upon our relevant past
work.

We requested written comments on a draft of this
report from the Secretary of the Treasury and the
heads of CFTC, the Federal Reserve, and SEC.
Treasury provided written comments that are
discusses near the end of this letter and
reprinted in appendix II. CFTC, the Federal
Reserve, and SEC did not provide written comments.
We did our work in Washington, D.C., between March
1999 and December 1999 in accordance with
generally accepted government auditing standards.

The Working Group Addressed the Issues Specified
in the Executive Order
In May 1988, the Working Group issued its market
crash report, which generally responded to the
issues that the President required the Working
Group to consider in the executive order. These
issues were related to (1) investor confidence,
such as the adequacy of customer protection rules
and their enforcement in all markets; (2) the
credit system, such as private sector credit
arrangements for exchange settlement systems and
market participants; (3) market mechanisms, such
as revised equity short sale rules;15 and (4) the
financial regulatory structure, such as the need
for a formal federal financial regulatory body to
mediate intermarket issues. The report included
numerous recommendations made in response to the
issues listed in the executive order. Virtually
all of the recommendations were undertaken by the
relevant regulator, namely, SEC or CFTC and the
securities and futures exchanges they regulate.16
The issues listed in the executive order are
discussed in appendix I of this report.

In addition to discussing the issues, the market
crash report concluded that the Working Group
could monitor the progress of its recommendations
by serving as a consultative and coordinating
forum and by expediting resolution of the issues
that remained unresolved. Although the report
recognized the need for federal financial
regulatory coordination, it concluded that a more
formally structured version of the Working Group
was unnecessary because the current structure was
sufficient.

The Working Group Has Responded to Various Market
Events
The Working Group was established in response to a
market event, and its subsequent activities
focused on responding to market events. Since its
1994 reactivation, it has been the primary vehicle
regulators have used to respond collectively to
various intermarket events. Most recently, its
activities have included the 1997 market decline,
hedge funds and excessive leverage, Y2K
preparedness issues, and the rapid growth of the
OTC derivatives market.

1997 Market Decline Prompted Working Group to
Recommend Changes to Circuit Breaker Rules
After the creation of coordinated circuit breakers
following the 1987 market crash, the Working Group
formed a staff subgroup on circuit breakers, which
analyzed the regulators' review of the performance
of circuit breakers during October 1989, when U.S.
securities markets again experienced significant
price volatility. Further, the subgroup noted that
an ongoing objective for the Working Group was to
assess whether circuit breakers need to be
simplified and whether triggers should be adjusted
and better coordinated.  According to agency
officials, SEC, CFTC, and the securities and
futures exchanges also continued to monitor
circuit breakers.

Following the October 1997 market decline when
circuit breakers were triggered for the first time-
-10 years after the 1987 market crash--the Working
Group reevaluated their use. The Working Group
studied how circuit breakers performed during the
1997 market decline; and as a result of its
findings, it encouraged the NYSE to revise its
circuit breaker rules. The NYSE changed its rules,
which had been stated in terms of a point decline
in the Dow, to reflect a percentage decline in the
Dow, effective April 1998.17

Proposed OTC Derivatives Legislation Prompted
Renewed Bankruptcy Reform Activities
In its 1988 report on the market crash, the
Working Group recommended that SEC and CFTC review
existing bankruptcy laws and regulations to
formulate a coordinated approach toward broker-
dealer and futures commission merchant
bankruptcies and to identify areas requiring
legislative action. Although legislative changes
were not made at that time, work in this area
continued among the agencies. Following the
group's reactivation in 1994, it proposed
legislative changes to the Bankruptcy Code that
would clarify the validity of netting18 certain
foreign currency transactions. A similar proposal
was subsequently enacted into law.19

According to regulatory officials, the Working
Group's efforts in this area were an outgrowth of
proposed OTC derivatives legislation. The Federal
Reserve and FDIC separately had been working to
identify changes needed to improve the Bankruptcy
Code to suit more closely modern financial
contracts. Their efforts continued collectively
through the Working Group in the mid 1990s. In
March 1998, the group recommended that Congress
enact the "Financial Institution Insolvency Laws
Reform Act" (Proposal), which proposed additional
changes to bankruptcy laws. Overall, the Proposal,
which was crafted by the Working Group, was
designed to

"(1) clarify the treatment of certain financial
contracts (i.e., securities contracts, commodity
contracts, forward contracts,[20] repurchase
agreements,[21] and swap agreements[22]) upon the
insolvency of one of the counterparties to a
transaction and (2) recognize certain netting
arrangements in order to reduce the risk that the
failure of one entity to pay its obligations will
cause other firms to fail to meet their
obligations."

The Proposal also clarified that cross-product
close-out netting would be permitted under law.23
Thus, a master netting agreement would allow
obligations arising from certain financial
contracts to be netted against each other.
However, the Proposal maintained existing
limitations on the types of entities that would
benefit from the new provisions.24

The Working Group Responded to Issues Raised by
LTCM's Near-Collapse
Following the near-collapse of LTCM and renewed
concerns about the risks that hedge funds can pose
to financial markets, the Working Group issued a
report25 outlining the principal policy issues
raised by the episode. As indicated in our October
1999 report,26 LTCM was a large leveraged hedge
fund that lost nearly 90 percent of its capital
between January and September 1998, almost
rendering the hedge fund insolvent. LTCM's near-
collapse raised concerns at the Federal Reserve
and among its creditors and counterparties that
the 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. Therefore, in
September 1998, the Federal Reserve facilitated a
private sector recapitalization to prevent LTCM's
collapse.

The Working Group released a report in April 1999
that said constraining excessive leverage was the
principal policy issue arising from the events
surrounding LTCM's near-collapse. The report said
that constraining excess leverage not only among
hedge funds but also among other financial
institutions, was important to decreasing the
likelihood of a general breakdown in the
functioning of financial markets. The report
included recommendations for improvements in
several areas, such as more frequent and
meaningful public disclosure, regulatory
encouragement of improved private sector risk-
management practices, regulatory promotion of risk-
sensitive approaches to capital adequacy,
congressional expansion of risk-assessment rules,
resolution of bankruptcy issues, and regulatory
encouragement of compliance with international
standards by offshore financial centers.

The Working Group Was Asked to Report on Y2K
Preparedness
In May 1999, the Ranking Minority Member of the
House Committee on Commerce asked the group to
report on progress made on issues raised in our
April 1999 report on Y2K  preparedness within the
financial markets.27 In September 1999, the Working
Group issued a response to this request.28
Specifically, the group outlined work completed on
(1) coordination of actions and information among
regulators and other organizations during the date
change period; (2) promotion of additional Y2K
readiness disclosure by foreign organizations; (3)
development of strategies to communicate the
readiness of the financial sector to alleviate the
public's concerns; and (4) identification of
significant changes, if any, in the conditions
reported in our April 1999 report.

The Working Group Was Asked to Report on OTC
Derivatives
As mentioned earlier, the Working Group was
revitalized, in part, because of concerns raised
about risks posed by the rapid growth of the OTC
derivatives market. In 1994, following the release
of our report on OTC derivatives, Congress asked
the Working Group to respond to issues raised in
the report.29 In July 1994, it issued a response
and agreed to continue to discuss the issues
concerning OTC derivatives. In 1998, the
discussion on how to address OTC derivatives
oversight continued; however, CFTC's chairperson
became dissatisfied with the Working Group's
progress and CFTC issued a concept release on OTC
derivatives oversight as an alternative mechanism
for discussion about its stance on this issue.30
The stated purpose of the concept release was to
gather "relevant data and analysis that will
assist [CFTC] in determining whether its current
regulatory approach continues to be appropriate or
requires modification."

The concept release generated controversy among
market participants and other regulators.31
Consequently, SEC, the Federal Reserve, and
Treasury issued a joint statement expressing deep
concerns with the stance taken in the concept
paper. Additionally, they drafted proposed
legislation to limit temporarily CFTC's rulemaking
on swaps. Similar legislation was subsequently
passed,32 and in 1998, the Working Group was asked
to study OTC derivatives oversight. Issued on
November 9, 1999, the resulting report examined
the regulatory or legislative changes that may be
appropriate to reduce systemic risk, eliminate
legal uncertainty, and curtail regulatory
arbitrage; it also addressed the potential use of
derivatives for fraud or manipulation.

The Working Group Provides a Mechanism for
Coordination and  Cooperation
Agency officials involved with the Working Group
generally described it as an informal mechanism
that allows the free exchange of views and
information on market events, proposed rulemaking
or other regulatory action, and legislative
developments. Their description of the group as a
coordination vehicle is consistent with the stated
objective in the 1994 Bentsen letter. In addition
to Treasury, the Federal Reserve, SEC, and CFTC,
staffs of other agencies and relevant groups were
often included in the Working Group's activities.
Although officials involved with the Working Group
believe its current structure functions well, over
the years, various Members of Congress have
questioned the Working Group's ability to
coordinate and function effectively. Various
proposals have been made to provide a statutory
basis to ensure its continuity, accountability,
and effectiveness. However, these proposals also
raise issues that would have to be considered,
such as increased resource commitments and
potential structural issues.

The Working Group
Views Itself as an Informal Coordinating Mechanism
Although the Working Group is not based in statute
and thus has no authority, agency officials
involved with the Working Group view it as a
useful mechanism that facilitates informal
information sharing and coordination for various
intermarket issues. In 1998, agenda items for
biweekly Steering Committee meetings included
decimalization of stock price quotes, Y2K
initiatives, proposed revisions to the Bankruptcy
Code, and circuit breakers. The 1999 agendas we
reviewed were dominated by ongoing work on hedge
funds and OTC derivatives oversight reports.
According to agency officials, these biweekly
meetings also have resulted in greater
coordination among the regulators outside of the
Working Group. For example, they said that a
presentation at one of the Steering Committee
meetings by SEC's Chief Accountant on SEC's soon-
to-be released position on loan loss reserves
resulted in separate discussions on the issue
outside of the Working Group. The discussion was
referred to the Federal Financial Institutions
Examination Council,33 which held meetings with
accountants from various financial regulators to
discuss their differing positions on the issue.
The regulators subsequently issued a joint
statement "to better ensure the consistent
application of loan loss accounting policy and to
improve the transparency of financial statements."34

Agency officials described the Steering
Committee's discussions as "policy-oriented." They
added that although some of their activities
result in tangible products, such as reports and
legislative proposals, other issues are discussed
on a regular basis. For example, agency officials
said that they use the biweekly meetings to inform
others about recent or proposed regulatory
actions. In addition, some officials noted that
the meetings also provide a forum to discuss
upcoming hearings and share testimonies. In
addition to the periodic principal meetings and
biweekly Steering Committee meetings, the Working
Group provides a forum to address intermarket
events as they unfold.  For example, agency
officials said that when Barings35 failed in 1995,
the Working Group provided a forum to share
information about the unfolding crisis.

Although officials generally described the
Steering Committee's biweekly discussions as
policy oriented, they said that they generally did
not use these meetings as a forum to coordinate
regulatory oversight activities of its members'
agencies. Rather, they said the meetings provided
a forum to alert other regulators of current
events at the various agencies. For example,
agency officials said that these biweekly meetings
were not used to debate the merits of proposed
rulemaking. Instead, agency officials often used
the meetings to inform one another of agency
action shortly before or after public
announcements were made. When asked whether the
Steering Committee was ever used as a forum to
discuss potential regulatory concerns about an
individual financial institution (prior to a
crisis), officials said that it generally had not
been used in that manner but that it could be used
as such a vehicle in the future. The regulatory
officials also pointed out that coordination and
information sharing between the staffs of
regulators occurred bilaterally and multilaterally
on a "case-by-case" basis.

In recent years, because of the blurring 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. We
addressed this issue in our report on the
regulatory issues raised by LTCM and recommended
that federal financial regulators develop better
ways to coordinate the assessment of risks that
cross traditional regulatory and industry
boundaries.36 The agencies commented that the
Working Group already functions this way. However,
the Working Group was established in response to a
crisis and, as the need has arisen, has continued
to function as such. That is, activities generally
have been focused on responding to market events
and developing policies to improve the functioning
of markets. Generally, it has not functioned as a
group for coordinating regulatory oversight,
although it has discussed information sharing
among agencies. The Working Group's 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.37 However, as
mentioned previously, it has served as a mechanism
to share information during unfolding crises.

The Working Group Also Provides a Mechanism for
Members to Coordinate With Other Agencies and
Groups
Staffs of nonmember financial regulators also have
participated in the activities of the Working
Group. According to officials, these participants
take part in Working Group subgroups and
contribute to its reports and other activities.
For example, in the mid 1990s both the Federal
Reserve and FDIC separately began to explore
potential changes to the Bankruptcy Code to update
laws to reflect changes in the market and better
suit modern financial contracts.  A series of
meetings among various regulators led to the issue
becoming a matter for consideration by the Working
Group. FDIC, one of the nonmember participants in
the Working Group, led the work on this issue and
assisted in drafting the legislative proposal that
suggested changes to the Bankruptcy Code to
address netting certain financial products. More
recently, in addition to the member agencies, OCC
and FRBNY were involved in the Working Group's
April 1999 report on hedge funds and its November
1999 report on OTC derivatives.

Proposals to Provide Statutory Basis for the
Working Group Raise Issues of Resources and
Structure
Since 1994, various Members of Congress have
raised questions about the Working Group's ability
to coordinate and function effectively.  For
example, following the near-failure of LTCM, some
Members of Congress and others questioned the
degree of coordination and cooperation that
existed within the group prior to the development
of the potential crisis.  Various proposals have
been made to provide a statutory basis for the
Working Group, in the belief that such a basis
could ensure its continuity, make it more
accountable to Congress, and improve its
effectiveness.

Although such proposals to provide a statutory
basis for the Working Group could help ensure
greater continuity and improved accountability,
their impact on effectiveness could depend upon
how certain issues were resolved. First,
establishing the Working Group in statute and
providing it with a mission would likely lead to a
more formal structure than that of the current
Working Group, with its informal structure and
mission as articulated in the 1994 Bentsen letter.
A more formal structure and more clearly
articulated congressionally defined mission could
provide the basis for a more focused approach to
interagency coordination. However, members of the
Steering Committee expressed concerns that a more
formal structure could have the effect of limiting
the Working Group's ability to achieve its current
level of coordination, because it could lead to
more bureaucracy.  They believe its current
structure is adequate to achieve a set of modest
but realistic coordination goals.

Second, if Congress were to articulate a mission,
mission requirements likely would have staff and
budgetary implications. There is likely to be a
correlation between the expansiveness of the
mission and the resource commitment such a mission
would entail.  For example, certain improvements
to coordination, such as greater information
sharing of counterparty risk exposures across
markets, could potentially be achieved with little
or no additional staff or specified budget.
However, more formal monitoring and sharing of
routine company-level information aimed at
identifying potential systemic risks could require
full-time staff and other budgetary resources.

A third issue related to providing a statutory
basis for the Working Group is the Working Group's
lack of authority. Currently, it has no authority
to bind members to its decisions or positions. Its
members serve in their capacities as heads of
agencies, and three of the agencies are led by
commissions or a board; and thus Working Group
decisions or recommendations must be approved by
the respective commissions or board of the members
before they can be acted upon. Formalizing the
group would have little effect on addressing this
issue unless legislation provided a mechanism for
making decisions binding. For example, if the
group's membership were expanded to include the
entire commissions and board, they may be more
likely to adopt the group's decisions. However,
this would raise the additional issue of making
the size of the group difficult to manage.

Agency Comments and Our Evaluation
Treasury provided written comments on a draft of
this report that are reprinted in appendix II. In
general, Treasury raised no objections with our
findings, and it reiterated that the Working Group
provides a productive and valuable forum to
coordinate responses, share information, and shape
policy related to the financial markets.

As we agreed with your office, we plan no further
distribution of this report until 7 days from its
issuance date unless you publicly release its
contents sooner. We will then send copies of this
report to Representative Paul Kanjorski, Ranking
Minority of the Subcommittee and to Senator Phil
Gramm, Senator Tom Harkin, Senator Richard Lugar,
Senator Paul Sarbanes, Representative Tom Bliley,
Representative Larry Combest, Representative John
Dingell, Representative John LaFalce,
Representative Jim Leach, and Representative
Charles Stenholm in their capacities as Chairs or
Ranking Minority Members of other concerned Senate
and House Committees and Subcommittees. We are
also sending copies of this report to the
Honorable Alan Greenspan, Chairman, the Federal
Reserve Board of Governors; the Honorable Arthur
Levitt, Chairman, SEC; the Honorable William
Rainer, Chairman, CFTC; and the Honorable Lawrence
Summers, Secretary of the Treasury. Copies will
also be made available to others upon request.

If you have any questions on matters discussed in
this report, please contact me or Orice M.
Williams at (202) 512-8678. The other major
contributor to this report was Tonita W. Gillich.

Sincerely yours,

Thomas J. McCool
Director, Financial Institutions
 and Markets Issues
_______________________________
1Although there is no statutory definition of
hedge funds, it is the term commonly used to
describe private investment vehicles that often
engage in active trading of various types of
securities and commodities. Although some funds
are subject to certain federal reporting
requirements, hedge funds are generally exempt
from direct federal regulation.
2Executive Order 12631 of March 18, 1988, 3 C.F.R.
559 (1989), Working Group on Financial Markets.
3Interim Report of The Working Group on Financial
Markets, (May 1988), President's Working Group on
Financial Markets.
4Circuit breakers are coordinated trading halts in
the equity and equity-derivative markets that are
required when large price moves of predetermined
magnitude occur.
5On October 27, 1997, at 2:35 p.m., the 30-minute
circuit breaker was triggered when the Dow dropped
350 points. When the market then reopened at 3:05
p.m., the second circuit breaker was tripped 25
minutes later when the Dow dropped 550 points,
which closed the market for the rest of the day.
6SEC, CFTC, and the exchanges they regulate had
been studying the performance of circuit breakers
since 1987.
7Although the three triggers are stated in terms
of a point decline, the trigger value is
calculated at the beginning of each calendar
quarter using 10 percent, 20 percent, and 30
percent, respectively, of the average closing
value of the Dow for the month prior to the
beginning of the quarter.
8Derivatives are financial instruments whose value
is determined from an underlying reference rate
(interest rates, foreign currency exchange rates);
index (reflects the collective value of the
various financial products); or assets (stocks,
bonds, and commodities). Derivatives can be (1)
traded through central locations, called
exchanges, where buyers and sellers, or their
representatives, meet to determine prices or (2)
privately negotiated by the parties off the
exchanges or over the counter (OTC).
9Hedge Funds, Leverage, and the Lessons of Long-
Term Capital Management, Report of the President's
Working Group on Financial Markets, Apr. 1999.
10Response of the President's Working Group on
Financial Markets to Congressman John D. Dingell,
Sept. 30, 1999.
11Over-the-Counter Derivatives Markets and the
Commodity Exchange Act, Report of The President's
Working Group on Financial Markets, Nov. 9, 1999.
12Agency officials said that they consider the
Working Group to be informal because it is not
based in statute and has no statutory authority.
13Following the 1987 market crash, numerous studies
were conducted to determine what happened, and
what, if anything, could be done to avoid a
recurrence. Chief among the studies were those of
the Presidential Task Force on Market Mechanisms,
SEC, CFTC, and our 1988 work.
14The reports, produced for Congress by Treasury,
SEC, CFTC, and the Federal Reserve, were prepared
in fulfillment of section 8 of the Market Reform
Act of 1990.  We reviewed only SEC's 1991 report
because reports for others years were not
available.
1517 C.F.R., section 240.10a-1 (1998). Short sales
involve borrowing securities and selling them in
hopes of repurchasing them at a lower price at a
later date. SEC's short sale rule states that a
short sale can be made on a zero or plus tick.
1610 Years After: Regulatory Developments in the
Securities Markets Since the 1987 Market Break,
SEC, 1997.
17See, e.g., SEC Order Granting Approval of
Proposed Rule Changes (submitted by various self-
regulatory organizations), 63 Fed. Reg. 18477
(Apr. 15, 1998).
18Close-out netting provides that in the event that
one or both counterparties default, the
obligations between the two parties will be netted
to produce a single obligation.
19P. L. No. 103-394, title 11, section 215 (1994).
20Forward contracts 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.
21Repurchase agreements are agreements between
buyers and sellers of securities, whereby the
seller agrees to repurchase the securities at an
agreed-upon price and, usually, at a stated time.
22Swaps are agreements between counterparties to
make periodic payments to each other for a
specified period.
23On August 4, 1998, James Leach, Chairman of the
House Committee on Banking and Financial Services,
introduced the Proposal as the "Financial Contract
Netting Improvement Act," H.R. 4239. On August 5,
1998, the House Committee on Banking and Financial
Services reported a substantially similar version
of the bill as H.R. 4393. Neither bill was
enacted. On February 24, 1999, George Gekas,
Chairman of the Subcommittee on Commercial and
Administrative Law, House Committee on the
Judiciary, introduced H.R. 833. Title X of H.R.
833 was very similar to H.R. 4393. As of December
31, 1999, this bill had not been enacted.
24The Bankruptcy Code permits only certain classes
of counterparties to exercise their contractual
rights under a securities contract (i.e.,
stockbrokers, financial institutions, or
securities clearing agencies) and under a
commodity or forward contract (i.e., commodity
brokers or forward contract merchants).
25Hedge Funds, Leverage, and the Lessons of Long-
Term Capital Management, Report of the President's
Working Group on Financial Markets, Apr. 1999.
26Long-Term Capital Management: Regulators Need to
Focus Greater Attention on Systemic Risk (GAO/GGD-
00-3, Oct. 29, 1999).
27Year 2000: Financial Institution and Regulatory
Efforts to Address International Risks (GAO/GGD-99-
62, Apr. 27, 1999).
28Response of The President's Working Group on
Financial Markets to Congressman John D. Dingell,
Sept. 30, 1999.
29Financial Derivatives: Actions Needed to Protect
the Financial System (GAO/GGD-94-133, May 18,
1994).
30CFTC Concept Release concerning Over-the-Counter
Derivatives, 63 Fed. Reg. 26114 (1998).
31Some financial regulators and market participants
perceived that the paper was premised on the
conclusion that many swaps are subject to CFTC
jurisdiction as futures contracts and should be
regulated as such.
32P. L. No. 105-277, Division A, title I, section
760 (1998).
33The Federal Financial Institutions Examination
Council is a formal interagency body empowered to
prescribe uniform principles, standards, and
report forms for the federal examination of
financial institutions by the Federal Reserve,
FDIC, the National Credit Union Administration,
OCC, and OTS; it can make recommendations to
promote uniformity in the supervision of financial
institutions.
34See, e.g., SEC, FDIC, Federal Reserve, OCC, and
OTS Joint Press Release OCC NR-99-65 (Joint
Release, July 12, 1999); and Joint Press Release
(Nov. 24, 1998).
35Barings Brothers & Co., Ltd., a British
investment bank owned by Barings PLC, collapsed
after losing over $1 billion by trading financial
futures on exchanges in Singapore and Japan.
36GAO/GGD-00-3.
37Financial regulators participate in various
groups that conduct surveillance of particular
markets such as U.S. Treasury securities and
futures markets. For example, according to
regulatory officials, the staffs of CFTC, SEC,
Treasury, Federal Reserve, and the FRBNY hold
biweekly conference calls about financial market
developments. In addition, CFTC hosts a quarterly
meeting to discuss exchange-traded derivatives and
related markets.

Appendix I
Overview of the Issues the Working Group Was
Required to Consider
Page 19GAO/GGD-00-46 Financial Regulatory Coordina
tion
The executive order establishing the Working Group
included 29 issues that the Working Group was
required to consider. The issues were divided
among (1) investor confidence, (2) the credit
system, (3) market mechanisms, and (4) the
regulatory structure. In May 1988, the Working
Group issued its report, which included
recommendations that generally addressed some
aspect of each of the 29 issues. Most of the
recommendations were to be carried out by the
relevant agencies, primarily the Securities and
Exchange Commission (SEC) and/or the Commodity
Futures Trading Commission (CFTC) and the
securities and futures exchanges they regulate.
According to SEC and CFTC officials, although work
on some of the issues was completed, work on
others was an ongoing process. Table I.1 shows the
issues the executive order required the Working
Group to consider.

Although all of the issues have been considered,
the action taken varies.  SEC and CFTC officials
said that action on some of the issues is
considered part of an ongoing process or review.
For example, all of the issues listed under
"Credit system issues" were considered to be part
of a continuing process that included ongoing
reviews and revisions to regulations, standards,
and approaches. Other issues were considered by
SEC and/or CFTC and the securities and futures
exchanges that they regulate, but they were not
pursued because implementing them was determined
not to be feasible or practicable. For example,
according to SEC officials, some of these issues,
such as price limits on individual stocks, were
the result of academic articles and were
considered and rejected by the agencies and
exchanges. Some issues, such as "establishment of
separate trading of index baskets of stock," were
attempted and withdrawn due to lack of investor
interest. Finally, other issues were considered,
and the actions taken were considered complete.
One example involved the issues related to circuit
breakers, which officials generally considered
completed following the 1998 revisions.

Table I.1. The Issues Articulated in the Executive
Order
Issue for consideration
Investor confidence
1.  Adequacy of mechanisms to address intermarket 
frontrunning and price manipulation.
2.  Expansion of information dissemination and    
trade processing capacities of exchanges, member
firms, service bureaus, and clearing systems.
3.  Better evaluation and enforcement of          
affirmative market-maker obligations.
4.  Adequacy of customer protection rules and     
their enforcement in all markets.
5.  Adequacy of regulatory agency and self-       
regulatory organizatikon resources and staffing
levels.
6.  Assessment of a variety of approaches to      
ensuring better access and order execution for
individuals' orders.

Credit system issues
7.  Coordination of clearing system operations    
and information exchange.
8.  Adequacy of private sector capital for        
futures floor traders, market-makers, broker-
dealers, and futures commission
merchants-including any appropriate revisions of
capital rules.
9.  Adequacy and clarity of private sector credit 
arrangements for exchange settlement systems and
market participants.
10.  Progress toward on-line clearing and same-   
day trade comparisons for all equity and
derivative products.
11.  Changes in margin requirements and           
additional security deposits for financial
protection against price-spike volatility,
settlement capability for variation margin, and
positions with concentrated risk.
12.  Establishment of harmonized leverage         
requirements for uncovered customer positions in
cash and derivative markets.
Market mechanisms
13.  The desirability of simultaneous, brief      
trading halts in all markets based on clear
authority and carefully established and known
standards.
14.  Coordination of options and continuing       
trading of index futures and options with the
trading of the underlying stocks.
15.  Establishment of separate trading of index   
"baskets" of stock.
16.  Providing for or requiring physical delivery 
for settlement of index futures and options.
17.  Development of block trading procedures for  
index futures and options on futures.
18.  Revision of the equity market short-sale     
rules.
19.  Use of "open outcry," "one price auction,"   
and specialist book disclosure approaches in
large, intraday order imbalance situations in
specialist markets to facilitate price discovery
and market clearing and minimize intermarket
disruptions and discontinuities.
20.  Emergency measures to restrict large, rapid  
liquidations of positions.
21.  Preestablished standards for shortened       
trading hour for all markets in periods of
sustained heavy volume.
22.  Investigation of the usefulness of enhanced  
reporting requirements for broker-dealer
recordkeeping, large trader tracking systems, and
program traders, with due consideration to
financial privacy concerns and international
capital flows.
23.  Imposition of price limits for index futures 
and options.
24.  Full-day clearings in response to specified  
price moves.
25.  Restrictions on access to the Designated     
Order Turnaround system for program trades based
on either volume or price move limits.
26.  Price limits on individual stocks.           
27.  Aggregate cash and derivative market         
position limits.
Regulatory structure
28.  Careful consideration of the desirability of 
more formal intermarket coordination and
cooperation mechanisms, different regulatory
regimes, a "tie-breaking referee" for intermarket
issues, or emergency powers.
29.  Development of mechanisms for international  
coordination on multimarket issues.
Source: Interim Report of the Working Group on
Financial Markets; SEC, CFTC, Federal Reserve, and
Treasury Interagency Coordination Reports; and
interviews with SEC and CFTC officials.

Appendix II
Comments From the Department of the Treasury
Page 21GAO/GGD-00-46 Financial Regulatory Coordina
tion

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