GAO Provides Framework for Modernizing Financial Regulatory System
The GAO has provided Congress with a broad framework for modernizing the needlessly complex and fragmented financial regulatory system. The fragmentation of US financial regulation, said the report, has complicated efforts to coordinate securities regulation internationally. More broadly, the report sets forth four macro goals on which the new regulatory regime must be erected: adequate investor protection; market integrity and fairness, safety and soundness; and systemic financial stability.
The report recommends the creation of a systemic risk regulator to oversee market stability. It also emphasizes the need to bring hedge funds and other unregulated entities under some form of comprehensive federal regulation. There is also a need to effectively regulate complex new financial products, such as collateralized debt obligations.
The GAO found that the emergence of large financial institutions with obligations to thousands of counterparties and other entities revealed that the existing. regulatory system is not well-equipped for identifying and addressing risks across the financial system as a whole. In the current environment, with multiple regulators primarily responsible for just individual institutions or markets, no one regulator is tasked with assessing the risks posed across the entire financial system by a few institutions or by the collective activities of the industry. For example, multiple factors contributed to the subprime mortgage crisis, and many market participants played a role in these events.
Thus, the GAO said that the new regulatory system must focus on risks to the financial system, not just institutions. The GAO essentially endorsed the Treasury recommendation that a market stability regulator be created with broad authority to gather and disclose appropriate information, collaborate with other regulators on rulemaking, and take corrective action as necessary in the interest of overall financial market stability. Such a regulator could assess the systemic risks that arise at financial institutions, within specific financial sectors, across the nation, and globally.
However, the report cautioned Congress to be aware of the potential disadvantage of providing the market stability regulator with such broad responsibility for overseeing non-bank entities that could imply an official government endorsement of such activities, and thus encourage greater risk taking by financial institutions and investors. Regardless of whether a new regulator is created, said the report, all regulators under a new system should consider how their activities could better identify and address systemic risks posed by their institutions.
With the advent of complex derivatives products, the new regulatory regime must be designed so that regulators can readily adapt to market innovations and changes. As part that, it should include a formal mechanism for evaluating the full potential range of risks of new products and services to the system, to market participants, and to investors. Importantly, Congress should also consider the extent to which financial regulators should actively monitor and even approve new financial products and services as they are developed in order to ensure the least harm from inappropriate products. Some in Congress have called for creation of a Financial Products Safety Commission modeled on the Consumer Products Safety Commission, but the GAO did not go that far.
Another dramatic development in U.S. financial markets in recent decades has been the increasingly critical roles played by what the GAO calls less-regulated entities, such as hedge funds and special purpose vehicles. Hedge funds, for example, are not subject to regulatory capital requirements, are not restricted by regulation in their choice of investment strategies, and are not limited by regulation in their use of leverage.
It is now recognized that hedge funds’ activities can create systemic risk by threatening the soundness of other regulated entities and asset markets. Hedge funds have important connections to the financial markets, including significant business relationships with the largest regulated commercial banks and broker-dealers. They also act as trading counterparties with many of these institutions and constitute in many markets a significant portion of trading activity, from stocks to distressed debt and credit derivatives. The counterparty credit risk created when regulated financial institutions transact with hedge funds can be a primary channel for potentially creating systemic risk.
Counterparty credit risk is the risk that a loss will be incurred if a counterparty to a transaction does not fulfill its financial obligations in a timely manner.
The use by financial institutions of special-purpose entities provides another example of how less-regulated aspects of financial markets came to play increasingly important roles in recent years, creating challenges for regulators in overseeing risks at their regulated institutions.