GAO Study: Underlying Causes of The Financial Crisis

A new report released by the Government Accountability Office (GAO) studies the role that the financial institutions, their regulators and certain restrictions have contributed to the current financial crisis.

The GAO's report was requested by the Emergency Economic Stabilization Act to study the role of leveraging and deleveraging by financial institutions.

The GAO found some studies suggesting that leverage steadily increased before the crisis, and the deleveraging of financial institutions by selling financial assets may have caused the prices to spiral downward in the market's stress. It also says that deleveraging by restricting new lending could cause economic growth to slow. The GAO says as complex as the crisis was, there is no single theory to fully explain what occurred.

The GAO's report shows federal regulators impose capital and other requirements on their regulated institutions to limit leverage and ensure financial stability, but all are not equally regulated, especially hedge funds. Federal bank regulators impose minimum risk-based capital and leverage ratios on banks and thrifts and supervise the capital adequacy of such firms through on-site examinations and off-site monitoring. Bank holding companies are subject to similar capital requirements as banks, but thrift holding companies are not. The Securities and Exchange Commission (SEC) uses its net capital rule to limit broker-dealer leverage and used to require certain broker-dealer holding companies to report risk-based capital ratios and meet certain liquidity requirements. Other important market participants, such as hedge funds, use leverage. Hedge funds typically are not subject to regulatory capital requirements, but market discipline, supplemented by regulatory oversight of institutions that transact with them, can serve to constrain their leverage, the GAO states.

The GAO finds that the crisis revealed limitations in regulatory approaches used to restrict leverage. First, regulatory capital measures did not always fully capture certain risks. For example, many financial institutions applied risk models in ways that significantly underestimated certain risk exposures. Because of this, the institutions didn't hold capital to match their risks and some faced capital shortfalls when the crisis began. The GAO says federal regulators have called for reforms, including through international efforts to revise the Basel II capital framework.

The planned implementation of Basel II in the US markets would increase reliance on risk models for determining capital needs for certain large institutions. Saying although the crisis underscored concerns about the use of such models for determining capital adequacy, the GAO notes regulators have yet to say whether proposed Basel II reforms will address these concerns. A regulatory assessment is critical to ensure that changes to the regulatory framework address the limitations revealed by the crisis.

The GAO also finds that regulators face challenges in counteracting cyclical leverage trends and are working on reform proposals. The crisis has reinforced the need to focus greater attention on systemic risk. With multiple regulators responsible for individual markets or institutions, none has clear responsibility to assess the potential effects of the buildup of systemwide leverage or the collective activities of institutions to deleverage.

The GAO recommends that, as Congress considers establishing a systemic risk regulator, it should consider the merits of assigning such a regulator with responsibility for overseeing systemwide leverage. As U.S. regulators continue to consider reforms to strengthen oversight of leverage, the GAO recommends they assess the extent to which reforms under Basel II, a new risk-based capital framework, will address risk evaluation and regulatory oversight concerns associated with advanced modeling approaches used for capital adequacy purposes. The GAO notes that regulators generally agreed with its conclusions and recommendation.

The GAO report was released on Wednesday at same time President Barack Obama proposed a council for systemic risk, which would be chaired by the Treasury department.

Obama's Treasury-led council of regulators would monitor systemic risk in the financial industry in draft legislation sent to Congress.

The proposed Financial Services Oversight Council includes the heads of the Treasury, Federal Reserve, Commodity Futures Trading Commission, Federal Deposit Insurance Corp., Securities and Exchange Commission and Federal Housing Finance Agency. It also would include the directors of two new agencies the Obama administration wants to create: the Consumer Financial Protection Agency and the National Bank Supervisor.

About the Author

Linda McGlasson

Linda McGlasson

Managing Editor

Linda McGlasson is a seasoned writer and editor with 20 years of experience in writing for corporations, business publications and newspapers. She has worked in the Financial Services industry for more than 12 years. Most recently Linda headed information security awareness and training and the Computer Incident Response Team for Securities Industry Automation Corporation (SIAC), a subsidiary of the NYSE Group (NYX). As part of her role she developed infosec policy, developed new awareness testing and led the company's incident response team. In the last two years she's been involved with the Financial Services Information Sharing Analysis Center (FS-ISAC), editing its quarterly member newsletter and identifying speakers for member meetings.

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