Long-Term Capital Management:

Regulators Need to Focus Greater Attention on Systemic Risk

GGD-00-3: Published: Oct 29, 1999. Publicly Released: Nov 19, 1999.

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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, and 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.

Matter for Congressional Consideration

  1. Status: Closed - Implemented

    Comments: As a result of the 2008 financial crisis, various market developments and regulatory changes have occurred that will provide for the type of comprehensive regulation that our report sought for entities overseen by the Securities and Exchange Commission or the Commodity Futures Trading Commission. During the crisis, the largest securities firm holding companies either dissolved or merged with or converted to bank holding companies, resulting in Federal Reserve oversight for such firms going forward. In addition, the Dodd Frank Wall Street Reform and Consumer Protection Act that was enacted in July 2009 tasks the Federal Reserve with overseeing--including conducting examinations, setting reporting requirements, and taking enforcement actions--any systemically important nonbank financial companies and their subsidiaries, which could include any firms previously regulated by the Securities and Exchange Commission or the Commodity Futures Trading Commission. The Federal Reserve is to consult with the primary financial regulators and avoid duplication to the fullest extent possible. For any systemically important company, the Federal Reserve is also responsible for establishing enhanced risk-based capital, leverage and liquidity requirements and overall risk management requirements, among other things, for such companies. To tailor these requirements, the Federal Reserve is authorized, in prescribing enhanced prudential standards, to differentiate among companies on an individual basis or by category, taking into account their size, capital structure, riskiness, complexity, financial activities, including those of their subsidiaries and any other risk-related factors the Federal Reserve deems appropriate. The Federal Reserve must also take into account differences between systemically important nonbanks and bank holding companies.

    Matter: In an effort to identify and prevent 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.

Recommendations for Executive Action

  1. Status: Closed - Implemented

    Comments: As a result of the 2007/08 financial crisis, the Dodd Frank Wall Street Reform and Consumer Protection Act that was enacted in July 2009 created an interagency council of the financial regulators that is specifically tasked with considering market developments that could pose systemic risks, including those arising from activities that cross existing regulatory agency boundaries. This group is the Financial Stability Oversight Council (the Council), which is chaired by the Treasury Secretary and includes the head of the other federal financial regulatory agencies, including the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The Council is charged with the goal of identifying risks to U.S. financial stability that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or risks that could arise outside the financial services marketplace. It is also supposed to promote market discipline and respond to emerging threats to U.S. financial markets. A new entity, the Office of Financial Research will serve as the information-gathering arm of the Council. For a class of financial institutions designated as systemically important companies, the Act also tasks the Federal Reserve with establishing enhanced risk-based capital, leverage and liquidity requirements, overall risk management requirements, resolution plans, credit exposure reporting, concentration limits and prompt corrective action to apply to these companies. The Council is authorized to make recommendations to the Federal Reserve concerning the establishment and refinement of prudential standards and reporting and disclosure requirements applicable to these systemically important companies, to prevent or mitigate risk to U.S. financial stability that could arise from the material financial distress, failure or ongoing activities of these companies. In the fall of 2010, the Council began meeting to consider issues that posed potential threats to the U.S. financial system's stability.

    Recommendation: 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.

    Agency Affected: Federal Reserve System: Board of Governors

  2. Status: Closed - Implemented

    Comments: As a result of the 2007/08 financial crisis, the Dodd Frank Wall Street Reform and Consumer Protection Act that was enacted in July 2009 created an interagency council of the financial regulators that is specifically tasked with considering market developments that could pose systemic risks, including those arising from activities that cross existing regulatory agency boundaries. This group is the Financial Stability Oversight Council (the Council), which is chaired by the Treasury Secretary and includes the head of the other federal financial regulatory agencies, including the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The Council is charged with the goal of identifying risks to U.S. financial stability that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or risks that could arise outside the financial services marketplace. It is also supposed to promote market discipline and respond to emerging threats to U.S. financial markets. A new entity, the Office of Financial Research will serve as the information-gathering arm of the Council. For a class of financial institutions designated as systemically important companies, the Act also tasks the Federal Reserve with establishing enhanced risk-based capital, leverage and liquidity requirements, overall risk management requirements, resolution plans, credit exposure reporting, concentration limits and prompt corrective action to apply to these companies. The Council is authorized to make recommendations to the Federal Reserve concerning the establishment and refinement of prudential standards and reporting and disclosure requirements applicable to these systemically important companies, to prevent or mitigate risk to U.S. financial stability that could arise from the material financial distress, failure or ongoing activities of these companies. In the fall of 2010, the Council began meeting to consider issues that posed potential threats to the U.S. financial system's stability.

    Recommendation: 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.

    Agency Affected: Congress

  3. Status: Closed - Implemented

    Comments: As a result of the 2007/08 financial crisis, the Dodd Frank Wall Street Reform and Consumer Protection Act that was enacted in July 2010 created an interagency council of the financial regulators that is specifically tasked with considering market developments that could pose systemic risks, including those arising from activities that cross existing regulatory agency boundaries. This group is the Financial Stability Oversight Council (the Council), which is chaired by the Treasury Secretary and includes the head of the other federal financial regulatory agencies, including the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The Council is charged with the goal of identifying risks to U.S. financial stability that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or risks that could arise outside the financial services marketplace. It is also supposed to promote market discipline and respond to emerging threats to U.S. financial markets. A new entity, the Office of Financial Research will serve as the information-gathering arm of the Council. For a class of financial institutions designated as systemically important companies, the Act also tasks the Federal Reserve with establishing enhanced risk-based capital, leverage and liquidity requirements, overall risk management requirements, resolution plans, credit exposure reporting, concentration limits and prompt corrective action to apply to these companies. The Council is authorized to make recommendations to the Federal Reserve concerning the establishment and refinement of prudential standards and reporting and disclosure requirements applicable to these systemically important companies, to prevent or mitigate risk to U.S. financial stability that could arise from the material financial distress, failure or ongoing activities of these companies. In the fall of 2010, the Council began meeting to consider issues that posed potential threats to the U.S. financial system's stability.

    Recommendation: 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.

    Agency Affected: Department of the Treasury

  4. Status: Closed - Implemented

    Comments: As a result of the 2007/08 financial crisis, the Dodd Frank Wall Street Reform and Consumer Protection Act that was enacted in July 2009 created an interagency council of the financial regulators that is specifically tasked with considering market developments that could pose systemic risks, including those arising from activities that cross existing regulatory agency boundaries. This group is the Financial Stability Oversight Council (the Council), which is chaired by the Treasury Secretary and includes the head of the other federal financial regulatory agencies, including the Federal Reserve, the Securities and Exchange Commission, and the Commodity Futures Trading Commission. The Council is charged with the goal of identifying risks to U.S. financial stability that could arise from the material financial distress or failure, or ongoing activities, of large, interconnected bank holding companies or nonbank financial companies, or risks that could arise outside the financial services marketplace. It is also supposed to promote market discipline and respond to emerging threats to U.S. financial markets. A new entity, the Office of Financial Research will serve as the information-gathering arm of the Council. For a class of financial institutions designated as systemically important companies, the Act also tasks the Federal Reserve with establishing enhanced risk-based capital, leverage and liquidity requirements, overall risk management requirements, resolution plans, credit exposure reporting, concentration limits and prompt corrective action to apply to these companies. The Council is authorized to make recommendations to the Federal Reserve concerning the establishment and refinement of prudential standards and reporting and disclosure requirements applicable to these systemically important companies, to prevent or mitigate risk to U.S. financial stability that could arise from the material financial distress, failure or ongoing activities of these companies. In the fall of 2010, the Council began meeting to consider issues that posed potential threats to the U.S. financial system's stability.

    Recommendation: 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.

    Agency Affected: Commodity Futures Trading Commission

 

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